The vulnerability of some African economies has been compounded by a spate of new bond issues in foreign denominated currencies. During 2013 African countries issued US $10bn of dollar bonds to international markets, breaking the 2010 record. Investors in search of yield provided medium-term funding which would not have been available five years ago. While governments may prefer raising foreign currency through borrowing rather than a trade surplus, borrowing places a higher burden on foreign currency obligations in the future. It also increases susceptibility to ‘hot money’ flows. For instance, an economic shock – such as tapering – will increase bond yields as short-term investors disinvest; possibly causing devaluation or interest rate rises. There are similar concerns that corporates in emerging markets have a mismatch of foreign borrowing and local investment. Currency devaluation will increase their leverage and make repayments more expensive.
The trigger for the recent volatility in emerging markets was widely attributed to a reduction in US Federal Reserve asset purchases by US $10bn to $65bn per month. Quantitative easing has depressed interest rates in developed markets and prompted investors to look at emerging markets for higher yield. As tapering increases it will have the effect of increasing global interest rates causing ‘hot money’ flows out of emerging markets. One theory suggests maintaining a constant interest rate or yield differential with the US will not be sufficient for emerging markets to hold onto foreign investment. Instead that would require maintaining a constant interest rate ‘ratio’, so that if US yields double from 1 to 2% emerging market yields must also double. This would place too high a burden on emerging markets and makes the prospect of further devaluation likely.
While building reserves through saving and trade surpluses can minimise the possibility of financial instability, it can also come at the expense of new infrastructure projects and investment which support long-term structural growth. On the other hand, the extent to which market volatility has a long-term effect on the fundamentals of GDP growth is an important but as yet unanswered question. Many investors and policy makers will pay close attention to trade deficits and the bid-ask currency spreads. These are among the key indicators of impending devaluation and financial instability.
1) TMEASGDY Index
2) UNCTAD 2011 – http://www.uneca.org/sites/default/files/page_attachments/report_on_international_and_intra-african_trade.pdf
4) Latitudes, November 2013, White & Case
5) http://data.worldbank.org/indicator/FI.RES.TOTL.MO/countries/ZM-GH-MZ-ZA-TN-EG-TZ?display=graph
Nicolas Clavel is chief investment officer and Ben Storrs is an investment analyst, both at Scipion Capital
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