Economists Pitch Africa’s Favourable External Condition, Explain Key Risks
Economists at NKC African Economics, a leading provider of independent economics and political research, have pitched Africa’s favourable external condition for investment destination aftermath of Covid-19 disruption.
In a research briefing, the firm stated that Africa has a favourable external backdrop, though expert noted that key risks remain.
According to NKC, a more favourable external backdrop and looser global liquidity conditions – shaped by unprecedented policy stimulus in advanced economies, vaccine optimism and a strong credit pulse from China – underpin reawakening appetite for frontier market investment opportunities.
It said this is however juxtaposed by idiosyncratic risks, with concerns centred on slow inoculation rollouts, fiscal vulnerability amid receding external support, pre-emptive restructuring prospects in high-debt countries, and setbacks to regional integration.
In turn, the investment decision in the post-pandemic era is more opaque and more exposed to tail risks, NKC added.
“The Covid-19 pandemic exposed vulnerabilities in the various income-, asset- and market-based approaches to valuations, as atypical liquidity conditions, volatility in deal flows, depressed market multiples and risk premia estimation posed challenges.
“Within African frontier markets, mispricing may present with the utilisation of a policy-distorted risk-free rate and inadequate risk premia adjustment, thereby potentially inflating valuations”.
NKC added that idiosyncratic risks aside, a strong argument can be made for an old economy play – the credit upswing in China and policy-induced softening of the dollar support ongoing demand- driven recovery in commodity prices, which would favour the industrials and materials sectors.
“Following this narrative, high exposure to extractive sector activities should play in African frontiers’ favour.
“Caution is warranted, however, as consumer demand recovery threatens to lag advanced economies and tax burdens rise.
“High-beta rode the tailwinds of strengthening global trade prospects, a policy-led weakening of the US dollar, and vaccine optimism”, the firm added.
The report reads that the expected expansion in the US Federal Reserve (Fed) balance sheet – to accommodate a wider fiscal deficit – is decidedly dollar-negative, while a more transparent, predictable approach to policymaking should limit the safe-haven appeal to the greenback, allowing for a phased correction of the dollar.
Furthermore, the recent rebound in the China credit impulse created a more accommodative backdrop for commodity-linked instruments in the absence of underlying supply drivers.
“Combined, these factors boosted reflation concerns, but we think market concerns may be overblown and accelerated industrial growth should favour risk assets”.
Potential challenges to sectoral growth outlooks across Africa
“That being said, we are cautious of an African dividend falling due as the opposing forces of rising idiosyncratic risks undermine the benefit that can be derived from external tailwinds.
“This is partially due to stress on government finances expected to increasingly spill over to the corporate sector”, the report said.
In turn, NKC economists believe that uneven growth recovery in Africa will not merely be a function of rising idiosyncratic risks but rebounds may be challenged on sectoral level by the following broad themes.
It said these include downside risks to vaccination rollouts, market anxiety pertaining to potential pre-emptive debt structuring, and higher medium-term tax burdens.
“The absence of fiscal space to procure vaccines in their individual capacity render lower-income African nations vulnerable to the success of collective procurement and donations”, the firm noted.
In addition to the financial, NKC explained that implementation and political challenges posed to planned inoculation strategies, Covid-19 denialism and vaccine resistance may strain recovery in high-contact, labour-intensive sectors.
Country Divergence and Sectorial Schism
Experts revealed that potential challenges to sectoral growth outlooks, which may affect equity performance, include Country divergence and sectoral schism.
“In stark contrast to advanced economies, frontier markets dragged the legacy of weak fiscal space into the post-pandemic era”.
Explaining further, NKC economists said the absence of a domestic savings glut to access renders fiscal authorities vulnerable to non-resident demand for government securities.
“Concomitantly, debt sustainability concerns eroded foreign appetite for new issuance from high-debt countries, while higher-quality issuers were welcomed back into the global capital market fold.
“Lower complacency from external investors towards idiosyncratic risks, which shrunk the capital base, raises the probability of premature fiscal tightening as tax burdens are adjusted”, the report stated.
Along with a more protracted timeline towards consumer spending recovery, the strain on government finance subsequently pose short-term growth risks.
According to the report, the East (and, to a lesser extent, the Southern) African growth model relies almost entirely on a debt-financed government capex strategy, which implies considerable downside risk within the construction and transport services sectors.
Nonetheless, it added that considerable opportunity exists for private capital to step into the void left by receding government capex by partnering under joint ventures (JV) or public-private partnerships (PPP).
It said another potential deviation in sectoral growth performance, where Africa may be a laggard, relates to the consumer discretionary sector.
“In advanced economies, a policy-supported surge in consumer spending should accelerate recovery in the consumer discretionary sector, especially from second half of 2021 onwards”.
NKC economists said foregone spending and fiscal support strengthened household balance sheets in advanced economies, while the latest retail sales releases signaled that private sector consumption recovery is underway.
“We do not anticipate that this accelerated consumer recovery narrative will be mirrored in Africa, with a rebound constrained by the absence of fiscal space to alleviate the pandemic-induced burden on households, rising cost-push inflation eroding real disposable income, and constraints to vaccination strategy implementation.
“A more protracted vaccination rollout heightens the risk of delays to reopening, which may stifle mean reversion in the consumer sector”, the firm noted.
Economists explained that narrowing capital bases in high-debt countries limit the usability of capital market funding strategies, which in turn pressures fiscal authorities to utilise tax adjustments on demand-inelastic goods to narrow the residual gap.
“This was most recently illustrated by Botswana; in a bid to address the deteriorating fiscal and debt metrics, the 2021 budget speech proposed new fiscal measures including the implementation of a sugary beverages tax, an increase in the withholding tax rate on dividends and an adjustment of the value-added tax (VAT) rate.
“Pressure to broaden the fiscal receivables base may extend to higher tax burdens on production, (for example mineral royalty adjustments) and repatriation (withholding tax) to accommodate declines in cycle-sensitive receivables (tax on profit)”, it explained.
Expiry of debt moratoriums, divergence in monetary aggregates
NKC explained that most acutely within the East African region (Tanzania, Uganda) and some Southern African (Zambia) countries, crowding-out challenges presented as private sector credit extension slowed while credit to government surged.
It said Governments absorbed an increasingly larger share of available capital to meet residual funding shortfalls, with this trend set to continue in 2021.
Concurrently, the report noted that deteriorating asset quality fuelled risk aversion in the banking sector, with a rotation towards higher government security holdings in lieu of private sector credit extension.
“This was noted across East Africa”, NKC economists said in the research briefing.
According to the firm, the increase in the premia partially or wholly offset the benefit of monetary stimulus to the real economy.
In advanced economies, it stated that monetary policy took the lead in orchestrating recovery, supported by an efficient transmission mechanism.
It was noted that the expiry of debt moratoriums may create problems in East and Southern Africa with the elevated risk of a more protracted recovery to cycle-sensitive sectors set against eroding policy capacity to roll out additional liquidity support.
“Faced with rising food costs, real disposable income recovery could be strained, contributing to weaker rebounds in household discretionary segments.
“In turn, the tourism & hospitality segment, deprived of international tourists, is expected to carry pandemic scars well into 2023”.
Policy toolkits, liquidity challenges and benchmark distortion
The Covid-19 crisis exposed an accelerated divergence between monetary policy toolkits in emerging and frontier market economies, economists at NKC maintained.
Whereas the former could rely on a stronger countercyclical policy toolkit than before – including quantitative easing (QE), broadening the range of acceptable collateral in operations, and funding backstops via liquidity lines with the Fed or the European Central Bank (ECB) – frontier market economies were, generally speaking, strained by weak monetary policy transmission mechanisms.
Frontier markets’ countercyclical policy response to the pandemic-induced demand shock was effectively limited to liquidity injections and reductions in policy rates.
As such, the monetary authorities explored avenues to broaden their toolkit: this took the shape of bond purchases on the primary market, reductions in reserve requirements; adjustments to standing facilities, and restrictions on repatriations by the banking sector, expanding the pool of eligible collateral in operations, and opening liquidity lines with the Fed (Ghana).
Economists at NKC said the efficiency of these avenues was greatly limited by structural impediments to policy transmission.
“This was evidenced in the incomplete pass-through of stimulus measures to secondary market yields and commercial interest rates.
“Our medium-term outlook foresees a deviation in policy and market rates as the latter reflect risk premium shifts and system liquidity factors”, it added.
“Connected to the previous point, slow fiscal consolidation paths – as revenue collection post lower-than-budgeted recovery – will absorb a higher portion of available capital, thereby driving a divergence in rates”.
Furthermore, NKC said despite the ongoing strain from the demand shock and weak asset quality, the scope for additional monetary stimulus measures is very limited, as frontier countries already reached the effective lower bound.
“While cost-push inflation could previously be dismissed as transitory, higher international commodity prices now reflect recovering demand conditions.
“To anchor inflation expectations amid rising commodity prices, countries including Zambia have commenced with a tightening cycle in 2021 Q1”, it said.
Related to the risk premium estimation conundrum, NKC said the pandemic added another layer of complexity to the long-term discount rate decision.
Traditional valuation approaches (income, asset and market) were distorted by the pandemic amid atypical transaction volumes, volatility and panic-selling.
Heightened economic uncertainty however dampen confidence in cash flow projections, with the expected duration of operational disruptions playing an important part in the valuation assessment.
In turn, estimation of the required rate of return (typically the weighted average cost of capital, WACC) is complicated by policy-induced distortions to the risk-free rate and opacity surrounding the appropriate risk premium.
“While these challenges have been encountered across the globe, the unprecedented scale and scope of monetary stimulus in Africa heighten the probability of mispricing assets due to the discount rate decision.
“For instance, disregard for the weak pass-through of monetary stimulus to the real economy may result in too-low discount rates being used in the valuation assessment, thereby inflating the valuation.
“Advanced economies carry the benefit of a potentially shorter timeline towards value chain amendment and a return to pre-crisis operations; companies operating in frontier markets, however, may face a protracted timeline towards normalised economic conditions.
“As a result, determining the appropriate WACC calculation inputs will be a more challenging exercise”, the company explained.
The Covid-19 shock muddied the estimation of sectoral exposure to cash flow risks, especially where loan book restructuring, or liquidity relief measures, were skewed to a particular sector.
Furthermore, market-based estimations may overstate the impact of event risk – case in point being Zambia’s default on sovereign debt, which may overstate the risk premium estimation for companies within robust sectors with minimal exposure to government (e.g. petroleum imports directly to private companies).
Greater reliance on forward-looking inputs, as pre-pandemic approaches are less meaningful, may amplify mispricing errors.
Capturing “the new economic reality” will be more art than science as the second- and third-round effects of Covid-19 remain uncertain.
“Amplifying country-specific policy risks – as illustrated by Nigeria, whose policy-induced artificial liquidity conditions and portfolio flow restrictions reshaped behaviour in the financial sector – the pandemic will place greater emphasis on scenario development and qualitative narrative assessments”, economists at NKC stated.
Economists Pitch Africa’s Favourable External Condition, Explain Key Risks