By Virginia Furness
The pressure is on African countries, once again, to develop their domestic debt markets to meet state and corporate borrowing needs, rather than rely on the international markets to load up on bonds denominated in dollars or euros.
With global liquidity set to tighten, African borrowers of foreign currencies are exposed to exchange rate risk, which can lead to large-scale defaults. The IMF warned that capital flow reversals could coincide with the initial wave of Eurobonds reaching maturity, highlighting the risk in its Regional Economic Outlook for Sub-Saharan Africa in April 2018.
While international bond markets have offered a ready stream of funding for African borrowers, there hasn’t been an urgent need to develop alternative sources, says Francesc Balcells, a portfolio manager of several emerging market funds at Pimco.
“Locally, the cost of money was expensive, or there was not the infrastructure to do that,” he says.
“My sense is that foreign money will be less forthcoming [now] because the global economy is changing, and debt ratios are getting worse,” Balcells adds. “This will force governments to look creatively at sources of funding. Local markets are taking a long time to improve – it takes a strong regulatory framework and judicial system – but this is the direction we have seen across other emerging market countries, so you would think it would happen in Africa as well.”
The IMF notes in its report that progress has been made, with several markets feeling “induced, or compelled,” to finance growing budget deficits through domestic issuance. Côte d’Ivoire, Namibia and Uganda have more than doubled domestic bond issuance, bringing the stock of local currency bonds to an average of 8.5% of GDP across these three countries, according to the IMF.
Several African countries have also deliberately extended their domestic debt profile, with the average maturity of bonds increasing from 1.5 years to 6.4 years. Ghana, Kenya, Namibia, Nigeria and Tanzania have all issued local bonds out to 15 years, according to the report.
But governments are also nervous of the potentially destabilizing effect of international investor participation in their domestic markets. Tanzania, for example, will not allow foreign investors to buy local bonds. A balance has to be struck between attracting potentially fickle foreign investors and having to rely on a clutch of local banks to buy domestic bonds.
Nigeria is a good example of a country that has made progress in developing its local market – despite having a large, offshore borrowing programme and a complicated relationship with international investors following the ejection of Nigerian debt from the major local government bond indices in 2015.
|Francesc Balcells, Pimco|
Nigeria’s Debt Management Office is one of the most active and innovative in sub-Saharan Africa. In addition to regular naira bond auctions, in the past year the sovereign has issued a naira-denominated green bond and a dollar-denominated diaspora bond, and has made good use of the ready availability of international investor demand for its debt to extend its dollar debt curve to 2047.
Wesley Davis, a former investment banker and co-founder of Alluvial, an integrated farm business based in Nigeria, says that the DMO’s efforts are helping to give a lift to the country’s nascent corporate bond market, although his firm has had substantial difficulties raising capital.“It’s still going to take some time,” Davis says. “Local interest rates have to come down but that process is running its course now. The government is able to manage its finances in a prudent manner, and if government yields come down, this will be the first step towards blue-chip companies starting to borrow in naira.”
However, domestic interest rates are still daunting for potential borrowers.
“When government bonds are yielding 25%, the additional spread [for corporate risk] is like the cost of equity,” Davis says. “The first step is the government getting its house in order, and getting its benchmark borrowing rate to a low level.”
Nigeria was expelled from JPMorgan’s index of emerging market government bonds a little over three years ago after the country imposed capital controls to protect the naira. The expulsion triggered substantial capital outflows, with many investors facing arduous legal battles to repatriate their money; not surprisingly, some are still reluctant to return to the market.
When government bonds are yielding 25%, the additional spread for corporate risk is like the cost of equity- Wesley Davis, Alluvial
But in the intervening years, Nigeria has made progress in liberalizing its currency. Now several large funds see opportunities for investing in Nigeria’s local markets.
“If you look across the continent, what typically tends to draw investors is the yield, and the outlook for the currency, the relatively stability,” says Brent David, who manages two local currency bond funds at BlueBay Asset Management.
With low global interest rates continuing to eat into returns, even as global quantitative easing is being unwound, high-yielding Nigerian government bonds start to look relatively attractive.
BlueBay’s David notes that a promising policy response by the Nigerian government regarding FX liberalization is beginning to attract investment again, although he adds that the spectre of 2015 still hangs over the market.
“We’ve seen greater normalization of policy since then, and this has re-attracted investors to the local market,” David says.
The improvements have led to discussions about whether Nigeria is able to re-enter JPMorgan’s Government Bond Index – Emerging Markets (GBI-EM). If so, it would be the only African country outside of South Africa to be included.
“Any inclusion back into the index with yields of 12% to 15% does somewhat force people back in to the markets,” says David. “It is particularly attractive in an environment where oil prices are going up and we’ve seen a number of positive reforms.”
Local currency market
Nigeria has a liquid government bond market and has started to develop its corporate bond market. Nigeria-based Stanbic IBTC, a member of South Africa’s Standard Bank Group, has worked on several deals for Nigerian corporates in the last 12 months.
Kobby Bentsi-Enchill, head of debt capital markets at the bank, notes a pick-up in activity as the country emerges from 12 to 18 months of recession. In the last 12 months, Stanbic has arranged local currency debt deals for Dufil Prima – which is known for manufacturing instant noodles – the State of Lagos and for Viathan Engineering, a power generation company, among others.
In January this year, Viathan issued Nigeria’s first corporate infrastructure bond to raise N10 billion at a yield of 16%. Dufil’s deal in October 2017 also raised N10 billion, with a 18.25% coupon.
But just as Davis of Alluvial points out, the cost of funding can be prohibitive. One way to overcome this is to issue structured or enhanced notes, which is what Viathan did.
“There will be more of this kind of product,” says Bentsi-Enchill. “We’re in discussions with a number of potential issuers for other deals. This is the real value-add in terms of capital markets development.”
We have a high desire to diversify, but liquidity needs to improve first- Esther Law, Amundi
Viathan’s deal came with the backing of a credit guarantee from InfraCredit, which was the first of its kind.
InfraCredit provides local-currency guarantees to enhance the credit quality of debt instruments issued to finance infrastructure projects in Nigeria. It was set up as a joint venture with GuarantCo, which encourages infrastructure development in low-income countries and is funded by the governments of Australia, the UK, Sweden, Switzerland and the Netherlands.
But Nigeria’s naira corporate bond market is a long way from becoming mainstream. David says that BlueBay is yet to invest in any local-currency Nigerian corporates. However, he is keen to see that market develop, and suggests that a good starting point would be the issuance of an internationally clearable naira bond.
Such a product would bypass investor concerns about discrepancies between international and local law in the event of a default, and mean that funds are able to buy the product without having local operations. Internationally clearable, local currency denominated bonds have gained increasing traction over the past 18 months, with several euro-rouble, euro-lira and an internationally clearable Georgian lari-linked bond all proving attractive to investors.
David believes that Nigeria won’t be far behind and suggests that there would be demand for a top-tier corporate, development bank or quasi-sovereign to issue the product.
“What they need to do is get the documentation in place for them to issue a Eurobond,” he says.
“There is enough of a liquid sovereign bond market in naira for us to get comfortable with the currency and corporate credit risk and additional liquidity risk,” David adds. “What it does do is help open up the market to corporates to issue in their local currency and tap international investors. This is a market that ultimately corporates should be tapping and it is not far behind.”
International and local development banks like the World Bank’s IFC can also play a role in opening up local currency markets by issuing bonds in local currency, but issuance has remained small in sub-Saharan Africa.
Another possible way to attract international investors is by using global deposit notes (GDN), or securities issued by a bank and backed by local bonds that are held by a custodian in the country where the underlying bonds have been offered or sold. Nigeria already has a GDN programme that allows investors to hold Nigerian risk without having to purchase or hold the bonds directly.
“This is the way by which a lot of international investors get exposure, but it is an interim step,” says Chris Jones, head of local currency syndicate at HSBC in London.
Jones adds that several sovereigns have expressed an interest in developing a bridge between their local clearing systems and international systems such as Euroclear and Clearstream. This would lower the barriers to entry for international participants, improve liquidity and hopefully improve pricing for the borrower as a result.
You need to do a lot of due diligence... Once you are in, you are in for good- Francesc Balcells, Pimco
One of the biggest impediments to developing a local currency debt market is the lack of a diverse investor base, whether local pension funds or international investors. Typically, in the early stages of market development, the main buyers of local bonds are local banks, which often have a short-term investment horizon.
Bentsi-Enchill says that one of the most important developments for the Nigerian market has been the growth of the pension fund industry over the last decade or so. Nigerian pension funds now have assets of $25 billion and are growing fast.
“This has been helpful in terms of having a ready buy side,” he says. “Having the multiplicity of investors is very interesting for Nigeria as it introduces some competition. It means, as a potential issuer, you have more options when you come to the market.”
With its proximity, resources and growing pension fund industry, South Africa has the potential to be an important investor base for other sub-Saharan governments and corporates, but current regulation, as well as reticence to invest in the region, keeps allocations slim.
“The structure of our market, of the retail and institutional investor bases, is driven by exchange controls, and pension funds have restricted allocations outside of South Africa,” says Simon Howie, co-head of South Africa and Africa fixed income at Investec Asset Management.
“That dictates the appetite, and when it comes to their global investment strategies, the large pension funds have traditionally looked to allocate to uncorrelated developed markets.”
However, in the last budget, the South African government allowed an increase in pension fund allocation to Africa from 5% to 10%, and local fund managers are also showing greater interest in the asset class.
“While developed markets are often preferred, the additional allocation to Africa does offer some diversification from South Africa and potentially higher returns,” Howie says, adding that his clients are showing increasing interest in Africa in general, and in fixed income and credit specifically.
The demand though is mainly for hard currency credit in Africa. This has the benefit of higher returns without the currency volatility. Sub-Saharan local currency credit is unattractive for investors, Howie says; those investors in search of higher risk tend to allocate their money to equity, private equity and mezzanine debt.
Beyond South Africa, it is difficult to attract more international investor participation in local African markets, particularly for corporate and financial bonds. Investing in a region as diverse as sub-Saharan Africa takes a lot of work and resources. For many international funds, allocating the necessary resources is either prohibitively expensive, or simply not worth the effort.
Balcells of Pimco says the lack of information and liquidity gap are barriers to investing in African local bonds.
“We have invested a huge amount of time and resources to deal with these issues [of obtaining information]… It is very time-consuming and taxing. [Due to the lack of] transparency, you need to do a lot of due diligence and we take it very seriously. Once you are in, you are in for good, given the liquidity. This is a luxury that we at Pimco can have.”
A lack of standardization of both regulatory frameworks and legal processes across sub-Saharan Africa exacerbates the problems.
Esther Law, who manages a global local currency emerging market bond fund at asset manager Amundi, says that until liquidity improves, investment will always be limited, despite its importance.
“We have a high desire to diversify, but liquidity needs to improve first,” she says. “If I have uncertainty or am unable to sell the bonds when I have outflows, I can’t raise the money sufficiently,” she adds.“Transparency is almost part of liquidity. Nigeria, for example, has a debt management office website and publishes the auction tender in English so foreign investors can follow it. When these two come together you have better transparency, better coverage and better liquidity.”
Law notes that the difficulty of hedging African local currencies means that sometimes you have to go into a market unhedged, meaning that liquidity is even more important.
“You have to be fairly confident that you are happy not to go in fully hedged. If there is volatility in local currencies, there is a high probability that the bonds will be volatile, too.”
While countries such as Nigeria, Ghana and Zambia are making progress in local market development, there are restrictions which make it difficult for investors to withdraw funds, says Brian Holmes, who is also a portfolio manager in Pimco’s emerging-market fixed income team.
“In some places, you can’t bring the money out if there is a sudden change in risk, like Ghana and Zambia. Their net reserves only cover two to three months of imports, so it would be difficult if investors tried to take all their money out at once,” Holmes says.
“Some countries that look challenging now can improve two to three years down the road. It is really important, no matter how constructive you feel with the balance sheet, that any investors in those markets need to be cognisant of the liquidity gap. We will not get out over our skis here in any given credit and we want to get paid for the liquidity premium.”
Lack of information is also a barrier to entry, according to Pimco’s Balcells, who notes the investment banks needto play a bigger part in the dissemination of quality information. He adds that while one local African bank with an international foothold has been invaluable in providing information and “making connections with the right people”, the larger international banks are lagging.
Balcells says there is often a large disconnect from the regions in which they operate and the countries they cover on the capital markets side.
“It is very difficult to get a good sense of the events on the ground in Africa, given the number of countries and the quality and timeliness of business journalism, and the number of people covering Africa – you may only get one per bank.”
Alluvial Agriculture, an integrated farm business based in Nigeria, provides technology support to small-scale farmers in Nigeria and the Niger delta and knows only too well how difficult it is to obtain funding in underdeveloped local capital markets.
Wesley Davis, its co-founder, says the local bond markets are not an option for most businesses in Nigeria. For a business like Alluvial, which has its operations and revenues in naira, borrowing in dollars is a risk, even if the cost of funding is lower than it would be from naira-denominated sources. And there is plenty of precedent to support this view.
“The original sin in finance is borrowing in dollars when your revenues are in local currency,” he says. “In the financial crisis, many emerging market countries which were commodity-dependent experienced a large financial shock. Local interest rates went through the roof and currencies devalued. Thus, servicing hard currency debt became extremely burdensome.”
In 2008, the IMF and World Bank provided about $42 billion of debt relief to 19 African countries under the Heavily Indebted Poor Countries (HIPC) Initiative and Multilateral Debt Relief Initiative.
But the finances of many African countries limit the risk appetite for local banks and make it more difficult for companies like Alluvial to raise capital through bank lending, Davis says.
“Local banks had a lot of impairments on their balance sheets so their ability to extend credit was very limited. It is still a very difficult time for a growing business to access reasonably priced capital in Africa.”
Davis says Alluvial has approached more than seven local banks for a loan, but the cost, with the requirement for expensive property valuations, was prohibitive. One of the issues, he explains, is that local banks prefer asset-backed lending in order to ensure there is a physical asset to take as collateral.
It is easier for large, blue-chip companies to secure funding, but “no one is willing to go down to the level of small farms”, says Davis. “Medium-sized agribusinesses have really suffered. Very few have a clear, unencumbered title to land, so it is very difficult to pledge the land their business is based on.”