Addressing the challenges of sustainable financing in African capital markets in times of crisis

This article is extracted from the MFW4A Covid-19 Report.

The Covid-19 crisis has caused significant disruptions to global financial systems, seriously impacting all advanced, emerging and developing economies. All growth and balanced budget forecasts were revised downwards, creating liquidity problems for many countries. While Covid-19 was morphing into a global pandemic and concern was growing, emerging market economies and those of border countries experienced a dual shock:

• The prices of oil and other basic commodities tumbled;
   
• Global financial conditions tightened markedly, particularly with reduced access to dollar financing.

The lack of flexibility in frontier and emerging economies has shown the importance of the development of their capital markets, and the leading role that the financial sector particularly commercial banks, microfinance institutions, fintech, insurance and pension funds – must play.

The crisis, debt and capital markets: a sustainable future

Early stages of the pandemic: Frontier and emerging economies experienced a sharp reversal in capital flows. Exchange rates in major frontier and emerging economies depreciated abruptly, putting sovereign bond spreads under pressure. However, the situation is particularly critical in frontier countries, particularly in Sub-Saharan Africa (SSA). The World Bank and IMF estimated that ten years of gains on SSA’s real GDP per capita would be lost in 2020 (a drop of +/- 5-7%). Savings in Sub-Saharan Africa are thus facing a dual challenge exacerbated by the crisis. The first relates to the problem of short-term liquidity to keep states functioning while managing the volatility of capital flows, drops in tax revenue (USD 70 billion has been lost according to the IMF), and the reduction of export earnings (particularly for commodity exporters) and remittances. The second has to do with the permanent damage to their economies in the medium and long term. The private sector particularly faces potential damage, including the most seriously affected economic industries (such as air transport and tourism) as well as the problem of limited resources to support development financing.

The Institute of International Finance (IIF) estimates that more than USD  80 billion left emerging markets in March 2020 alone, with outflows of more than USD 100 billion between February and early Junes 2020. Capital flight from emerging economies during the Covid-19 crisis was, therefore, more acute than during the 2008 global financial crisis. Moreover, the pandemic’s impact on emerging and frontiers economies has been pronounced, with oil exporters, heavily indebted countries and frontier countries taking the hardest hit.

Today

We know how to manage this crisis. Managing an exogenous crisis like Covid-19 well depends on the available information once the damages it has caused have been assessed. The following policy mix could be an effective response:

• adopting expenditure reduction and streamlining policies. This can be achieved by reducing public and private deficits to align spending with decreasing long-term revenues; and allocating a larger share of expenditure to health care;
   
• increasing financial resources and expanding the available fiscal space. This will provide support in mobilizing both domestic and external finances to spend on critical sectors for early recovery.

But this approach is much less effective when all countries are caught up in a global pandemic. This is because incomes fall, health care costs soar, and access to capital markets is closed or too expensive. These factors, combined with the direct effect of the general depreciation of African currencies, render the debt burden unsustainable.

In addition to a health crisis, African countries have been compelled to focus on the economic crisis. Because they borrowed in hard currency, they now face higher debt service payments, due to the depreciation of local currencies at a time when their economies are slowing, and health infrastructure is under heavy pressure. In addition, the macroeconomic effects are spilling over into the financial and economic sectors.

The financial sector, as the primary driver of the economy, has been put under pressure in a number of different ways.

• Lockdowns have had a significant impact on the economy and will heighten the credit and liquidity risk of banks and their customers, and increase market volatility.
   
• The crisis has led to a considerable outflow of foreign investments, estimated at four times the amount of foreign investment made during the 2008 Lehman crisis.
   
• The shortage of US  dollars  within  Africa  has  caused currencies to depreciate. It will also impact the financial performance of real sector banks or companies with open foreign currency positions.

Financial institutions had to urgently guarantee liquidity, reinforce their balance sheets while supporting their customers.

Tomorrow

This crisis has highlighted the importance of having more resilient economies. So after Covid-19, what should we do?

Offshore

• For African countries that had access to international debt markets before the crisis, the financial sector should help preserve or restore market access by contributing to a robust macroeconomic framework, supported by sound economic policies. For other countries, sound economic policies and support from multilateral institutions will be key.
   
• In addition, development finance institutions (DFIs) could provide these markets with funds and temporary risk mitigation instruments (such as guarantees) to encourage the return of international investors. The instruments should be used for a limited period, for example, up to the end of 2021.
   
• More importantly, the funds should be denominated in local currency to avoid currency mismatches and defaults owing to scarcity. The financial sector should play a leading role in the long-term macroeconomic stability of their economies by helping to implement policies and strategies that actively encourage local currency financing.

Onshore

• There should be a strong motivation to reduce dependence on the dollar and accelerate the development of national capital markets in local currency.
   
• The financial sector, led by Central Banks and the capital markets authority, has a role to play in helping countries implement a set of policies to strengthen the financial market, develop a domestic secondary market and promote an investor base to foster stable and long-term liquidity.

As with every external shock, declining remittances, commodity prices and tourism revenues are drastically reducing currency inflows. These factors leave little leeway and create volatility in the capital markets. Meanwhile, particularly in Africa, large-scale debt restructuring, and relief operations are creating uncertainty in the markets. It is therefore understandable that exchange rates have depreciated over time and acted as a shock absorber.

However, using exchange rate flexibility to reduce the balance of payments deficit can also lead to an even larger crisis in a dollarized economy, and degrade the credit quality of local financial institutions.

It is therefore essential to protect local financial actors against rate volatility and support the financial sector: these financial institutions have the catalytic power to support and develop the real economy in a sustainable manner. But in return, these institutions must be tasked with supporting their markets in local currency.

Whether onshore or offshore, dollar scarcity and foreign exchange risks must be mitigated at the structural level (through regulatory rules and policies), to reduce the vulnerability of emerging and frontier economies to external shocks. As a key stakeholder in the economy, the financial sector should take the lead in establishing sustainable local currency capital market infrastructure. 

About the author 

Isabelle is SVP at TCX, a development fund created by DFIs, multilaterals and some governments to provide currency risk solutions where there is none, where she is responsible for investor relations and external affairs as well as strategic partnerships. Prior to joining TCX, she held senior roles at Philips Capital, GE Capital and other financial institutions in negotiating and financing complex projects and long-term assets across EMEA. Isabelle studied Business administration and financial risks management at Louvain School of Management in Belgium and has an MBA from IESE Business School in Spain. She is also Non Executive Board member at Rawbank in DRC.