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Par Mthuli Ncube
Private capital flows to emerging markets are benefiting from an overall supportive global environment, in particular improved global outlook and strong projected growth in Africa. While the monetary policy of the Federal Reserve Bank has been shifting from quantitative easing to a tightening mode, the European Central Bank and the Bank of Japan are expected to undertake further monetary easing. Hence private capital flows to Africa’s emerging and frontier markets are expected to be higher than at the beginning of 2014. Nevertheless, risks of sudden stops or even reversals remain. Surprises in the timing, speed and size of the Fed quantitative easing (QE) tapering constitute some of the downside risks.
The African Development Bank Chief Economist and Vice-President, Prof. Mthuli Ncube, answers questions on this topic in an interview prepared for the African Bond Market Review.
What has been the impact of the end of QE on African economies? How does this differ with predictions set in your November 28, 2012 blog post?
Since the burst of the financial crisis in 2008, some of the world’s largest Central Banks, namely the US Federal Reserve, the Bank of Japan, the Bank of England, and the European Central Bank, adopted unconventional monetary policies to mitigate the crisis’ impact. These policies comprised mostly quantitative easing programs, i.e. influencing prices and output when short-term rates are near zero by increasing liquidity, particularly by purchasing long-term assets. The ECB and Bank of Japan focused their QE programs on direct lending to banks while the Federal Reserve and the Bank of England relied mostly on purchasing bonds. While the QE programs initially aimed to alleviate financial market distress, the policy goals soon broadened to inflation, growth, and containing the European sovereign debt crisis.
Through channels such as global liquidity and global portfolio rebalancing, the QE has impacted developing and emerging market economies. As previously predicted, the implementation of QE has brought about increased capital flows to the region, including portfolio flows. In some countries, it has led to appreciation of local currencies, which weakened their export competitiveness. Empirical evidence also shows that the investment driven African countries (frontier markets), which were more integrated into the global financial markets, were relatively more exposed to effects of QE than the rest of the continent.
What effect could Fed tapering have on African countries that have issued bonds on international capital markets?
By keeping benchmark interest rates at historical low, QE had played a role in stimulating bond issuances of African countries on international capital markets. In 2013, SSA [Sub-Saharan African] countries were able to raise more than $5 billion. The following countries issues 10-year bonds that year: (i) Rwanda issued $400 million with yield at issue of 6.88%; Nigeria issued $500 million at 6.63% yield; Ghana issued $750 million at 8% yield; and Gabon $1.5 billion at 6.38% yield. One of the advantages of Eurobonds are their lower costs – yields on Ghana’s domestic bonds reached 20% and those of Kenya and Nigeria ranged between 10 and 16%.
Countries issued the Eurobonds under favourable conditions. The interest rate on Zambia’s first Eurobond ($750 million) issued in September 2012 was only 5.375. Rwanda’s Eurobond ($400 million) issued in April 2013 was well oversubscribed (demand was $3.5 billion). As a result, public debt to GDP ratio of some African countries, particularly the frontier markets, has risen fast. This trend, alongside the tapering, will raise cost of external borrowing in the future.
Even though issuances of African sovereign bonds in 2013 were over-subscribed and low-priced, a number of risks remain from the point of view of investors, including the countries’ lack of liquidity and underdeveloped financial markets, making exiting challenges. From the point of view of countries the main challenges are (i) utilizing the borrowed funds for growth enhancing outlays and (ii) being able to refinance the debt, if needed, on favourable terms.
With the rise of interest rates in advanced economies, cost of borrowing associated with Africa’s international sovereign bonds may also increase in the future as risk pricing becomes more nuanced. From the point of view of longer term debt sustainability, this may be a positive development as the use of borrowed funds is likely to be more carefully scrutinized.
Reports often indicate that as developed economies recover, emerging markets will be the biggest victims. What can African countries that have tapped into the capital markets do to shield themselves from any negative fall-out of tapering?
The recent recovery of developed economies and the associated normalization of monetary policies triggered some instability in emerging economies, such as the devaluation of local currencies making imports more expensive. The reduction or even reversal of capital flows induced sell-offs in emerging-market assets. As the risks associated with foreign investment increased, investors have been paying greater attention to economic fundamentals. On balance, emerging markets are expected to benefit from the recovery of their developed counterparts, which is expected to bring about increased trade.
There is no one-size-fits-all solution. To shield African issuers from possible negative effects of tapering, policy-makers need to assess their vulnerabilities and the type of shocks their countries may be exposed to before deciding on policy options. A range of policy options is available, including a mix of monetary and fiscal policies, foreign exchange intervention, capital account management, targeted prudential measures, etc. The appropriate responses will always depend on country-specific situations of the countries and the availability of policy buffers.
What advice would you give to specific African countries (i.e. South Africa) that are facing the impact of the U.S. quantitative easing?
Given its integration into global financial markets and the capital inflows received during the QE, South Africa is more vulnerable than other African countries to the effects of Fed’s tapering. South Africa’s vulnerability also stems from certain features of its economy, particularly large current account deficits, limited foreign currency reserves and low official interest rates.
In order to stabilize its currency weakened during the QE tapering, South Africa has raised its policy rate. The country needs to adopt macroeconomic policies and structural reforms to reduce its current account deficit. Adequate and liquid foreign currency reserves can provide buffers against unanticipated currency shocks. In addition, greater global policy coordination would help ensure that the normalization of monetary policies in advanced economies will not cause further large-scale turmoil in emerging market economies.
The devaluation of the South African rand and the Ghanaian cedi notwithstanding, most African currencies have emerged largely unscathed from the global capital sell-off. Still, countries with wide current account deficit and large external debt need to stay vigilant and may need to intervene in forex markets. Over the longer term they may also need to improve fundamentals.
Emerging market analysts now list South Africa among the ‘troubled five’, together with Brazil, India, Indonesia, and Turkey. These countries are characterized by high current account deficits (and in some cases also high external debt), weakening currency and/or rising inflation. The sizable financing requirements of the current account deficit continue to add to the risk factors that have already weakened the rand.
How do you think the planned creation of the African Domestic Bond Fund (ADBF) will help tamper the effects of the end of the US QE? What are some other measures through which the Bank helps countries develop their financial market ?
The creation of the ADBF will help mitigate the effects of QE tapering on African economies. The Fund will contribute to the development of sound domestic debt markets on the continent by investing in African local currency denominated sovereign bonds. This is expected to reduce African countries’ reliance on foreign currency denominated debt, and thus help build resilience against the transmission of capital flow shocks. The Bank seeks to further deepen domestic financial markets through borrowing and lending in local currencies. This will help reduce currency imbalances and exposure to forex risks.
The Bank has also recently introduced innovative financing instruments for private sector development. For example, a partial credit guarantee (PCG), complementing the partial risk guarantee (PRG), helps well-performing low income countries with low risk of debt distress mobilize commercial financing. The product serves to partially guarantee eligible countries’ and State Owned Enterprises’ debt service obligations. This should help borrowers extend debt maturities and reduce effective borrowing costs and overall facilitate mobilization of long-term resources from international and domestic capital markets.
Due to the Fed tapering, African currencies, such as the Ghanaian cedi and South African rand, are depreciating against the dollar. What actions can African Central Banks take (noting your December 13, 2011 blog post on currency volatility)?
It is expected that countries that received the largest amount of capital inflows during the period of ultra-loose monetary policies are likely to be most affected by the tapering process. South Africa and Ghana are among the more vulnerable African countries and have witnessed large capital outflows and weakening of their currencies.
In the short run, African Central Banks could use their policy tools, such as interest rates, to mitigate the tapering-induced adverse effects. In the long run, they should build up adequate foreign currency reserves which provide policy buffers in the event of currency shocks, and at the same time diversify their reserve currencies thereby reducing exposure to US dollars. In addition, African Central Banks should also strengthen their policy coordination with other major economies to prevent unintended and unfavorable spillovers from the rest of the world.
What key lessons should Africa take from this QE exercise as more nations look to tap into international capital markets while also trying to develop their domestic markets?
One major feature of the world economy is the globalization of the financial markets. Increasingly, emerging economies including those in Africa are integrated with developed ones through both trade ties and capital flows. A key lesson from the QE exercise is that the policy maneuvers in developed countries can inadvertently disrupt developing countries’ currencies, exports and inflation levels. Apart from temporary policy measures that can be used in response to QE-driven boosts and tapering-induced declines, African countries should also consider long-term measures such as reforming domestic economies to build resilience to external shocks.
Put differently, in the situation of greater risk aversion, the investors are also looking at countries’ economic fundamentals. Structural reforms that would raise economic flexibility and resilience thus cannot be emphasized enough.
Mthuli Ncube est l’ancien économiste en chef et vice-président à la Banque africaine de développement. Il détient un doctorat en finance mathématique de l'Université de Cambridge, Royaume-Uni, sur «Options de tarification sous volatilité stochastique".