by Steve Kayizzi-Mugerwa and Daniel Gurara
On March 18, 2015, the Fed indicated that it could consider raising rates during its June 2015 meeting. However, the market is skeptical, far from convinced of the possibility for faster policy normalization given the fundamentals. Investors are still betting on low interest rates for the longer term that is about 1.8% by 2017, while the Fed’s median projection is about 3%.
This rift of expectations could indeed surprise the market if the Fed moves aggressively as it tries to avoid remaining behind the curve as was the case in the mid-2000s. A faster than expected rate rise could result in massive capital flows from the rest of the world to the US and lead to market volatility. Moreover, the strong demand for the US dollar following the interest rate increase would strengthen the dollar against other major currencies. Notably, given the divergent paths between the US and the Euro zone, the interest rate differential between them could attenuate the positive effects of quantitative easing in the EU, threatening the region’s recovery.
For Africa and other low-income countries, the crux of the matter lies in what the eventual impact on commodity prices would be. A strong dollar coupled with the slow recovery of the Eurozone would put further downward pressure on commodity prices, which have declined by 10 to 40% since January 2014. A further weakening of commodity prices would adversely affect Africa’s commodity exporters with strong neighbourhood effects. Current account deficits would also expand, because export earnings would decline by more than the cost of imports. We have calculated that on average, a 20% decline in Africa’s commodity prices is associated with a 1.3 percentage point decline in output growth (see Table 1).
But, also significant, the rise in the US interest rate would trigger capital outflows from the emerging African markets, as witnessed during the “tapper tantrum” of the mid-2013. This could lead to currency depreciation on a massive scale. For instance, between May 1 and August 29, 2013, the South African Rand depreciated by 10.6% mainly due to capital outflows. In that eventuality, some countries react by raising interest rates to defend their currencies, but at the cost of lower growth. A wider fiscal gap would be inevitable, as government revenue falls, following contractionary monetary policy. In this regard, countries with weaker fundamentals and limited foreign exchange reserves would suffer the most.
Disrupting Africa’s reach for the global bond markets
Over the past couple of years, low global interest rates have paved the way for some African countries to enter the market for sovereign bonds. Yields on Africa’s sovereign bonds are relatively high, also suggested by their over-subscription by investors. In 2013 and 2014 alone, African countries raised more than US $15 billion from the markets, an all-time record. The question is whether the rate lift-off, when it happens, would reduce investors’ appetite for African debt, leading to higher borrowing cost for Africa’s “emerging economies”.
But that increase in premium is already evident. Recently, yields on major African securities have risen in response to political uncertainties, and economic fundamentals including currency volatility due to the fall in commodity and oil prices. Yield increases of between 156 and 300 basis points have been noted for commodity-rich African countries in the past two years: Gabon, Ghana, Nigeria, and Zambia.
Excepting for incidences where the proceeds of the sovereign bonds financed current expenditures and hence were considered “non-developmental” spending, the proceeds of the bond issues have generally been used to finance public infrastructure, health and education sectors. The rising interest rate would severely curtail this financing source.
Normalization: Hard but manageable
The irony of the US Fed’s move toward normalization is that it will have negative short- and medium-term consequences for African countries and other developing regions – and might not be conducive for the Euro zone either. The costs of adjustment will not be inconsequential.
The recent strength of the US dollar is expected to continue as policy normalization sets in. This will have important implications for African countries as they almost exclusively issued their sovereign bonds in US dollars. The depreciation of the local currencies that we discussed above will elevate the cost of debt servicing significantly in the coming months. Estimates indicate that the depreciation of the local currencies of the sovereign bond issuers that are equivalent to those suffered by the Ghanaian cedi in 2014 (a depreciation of some 30%), would cost US $10.8 billion in additional debt servicing cost for the countries involved. The absence of forward exchange rate market markets in Africa has implied that for the moment domestic exchange rate risks cannot be hedged.
Normalization by the US Fed will not be the catastrophe for emerging countries and Africa as alluded to in the papers. However, African economies are headed for a period of relative turbulence. Now is the time for countries to shore up buffers before the difficult times set in. Across the board, countries must be cautious of the need to internalize the interest rate and exchange rate risks associated to their debt accumulation and public expenditure profiles. It is imperative to build adequate foreign exchange reserves, institute rigorous public debt management schemes, and capital flow management to help countries weather the turbulence.
 See Tyson, Judith (2015). Sub-Saharan Africa International Sovereign Bonds: Part II Risks for Issuers, Overseas Development Institute.
 Mozambique allegedly diverted the proceeds for the purchase of military equipment, Ghana to raise public sector salaries.
 Source: Tyson, Judith (2015). Sub-Saharan Africa International Sovereign Bonds: Part II Risks for Issuers, Overseas Development Institute. The cost is throughout the bond life.