The Impact of Quantitative Easing on Africa and Its Financial Markets
14 August 2014
Director of the Development Research Department (EDRE) of the African Development Bank, Mr. Kayizzi-Mugerwa
Q: What has been the impact of the end of Quantitative Easing (QE) on African economies? How does this differ with predictions set in your November 28, 2012 blog post?
Since the onset 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 of QE 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.(1)
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.
Q: What effect could Fed tapering have on African countries that have issued bonds on international capital markets?
By keeping benchmark interest rates at a historical low, QE had played a role in stimulating bond issuances of African countries on international capital markets. In 2013, SSA countries were able to raise more than $5 billion. The following countries issued 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 relatively favorable 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). However, as a result of this recent rush to the international bond market, 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 relatively low-priced, compared to domestic rates (but high compared to more mature markets), a number of risks remain, from the point of view of all investors, domestic and foreign, including thecountries’ lack of liquidity and underdeveloped financial markets, making exiting challenging. From the point of view of countries, the main challenges are (i) capacity for utilizing the borrowed funds for growth enhancing outlays and (ii) being able to refinance the debt, if needed, on more favorable terms.
With the rise of interest rates in advanced economies, the 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 have a silver lining as the use of borrowed funds is likely to be more carefully scrutinized at home, although debt distress from recent debt accumulation is a future threat.
Q: 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 return to safety and normalization of monetary policies triggered some instability in emerging economies. The reduction or even reversal of capital flows induced sell-offs in emerging-market assets, accompanied by the implicit devaluation of local currencies making imports more expensive. As the risks associated with foreign investment increased, investors have been paying greater attention to economic fundamentals. There is of course no, one-size-fit-all solution for emerging or frontier economies, given the considerable diversity of structures and performance. To shield African bond issuers from possible negative effects of tapering, policy makers need to assess their vulnerabilities and the types of shocks their countries may be exposed to when setting their policy options. Still, a range of policy options is available, including a mix of monetary and fiscal policies, foreign exchange intervention, capital account management, and targeted prudential measures, etc. The appropriate responses will always depend on country-specific situations and the availability of policy buffers. On balance, emerging markets are expected to benefit from the recovery of the more advanced countries, which is expected to raise aggregate demand and increase global trade.
Q: What advice would you give to specific African countries (i.e. South Africa) that are facing the impact of the US quantitative easing?
Given South Africa’s greater integration into global financial markets and the capital inflows received during the QE, it is more exposed than other African countries to the effects of the Fed’s tapering. South Africa’s vulnerability also stems from certain features of its economy, particularly its still considerable dependence on commodities, as opposed to manufactures, in its trade, the large current account deficits, limited foreign currency reserves, and official partiality for low interest rates.
South Africa needs to adopt macroeconomic policies and structural reforms to reduce its current account deficit. In order to stabilize its currency which weakened during the QE tapering, it raised its policy rate. Moreover, higher and more liquid foreign currency reserves could 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.
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.
More broadly, the sharp depreciation of the South African rand and the Ghanaian cedi in recent months notwithstanding, most African currencies have emerged from the global capital sell-off following the QE largely unscathed. Still, countries with wide current account deficits and large external debts need to stay vigilant and may need to intervene in their forex markets. Over the longer term they may also need to improve their fundamentals.
Q: 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 PRG (partial risk guarantee), helps well-performing low-income countries with low risk of debt distress to 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.
Q: Due to 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?
It is expected that countries that received the largest amount of capital inflows during the period of ultra-loose monetary policies in the West are likely to be affected more severely by the tapering process than those that did not. South Africa and Ghana are among the more vulnerable African countries in this regard. They have witnessed large capital outflows and sharp weakening of their currencies.
In the short run, African central banks could use 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 appropriate policy buffers in the event of currency shocks, and at the same time diversify their reserve currencies, thereby reducing exposure to a single source, such as the 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. However, ultimately there is nothing that matches good policies and institutional soundness in addressing external shocks.
Q: What key lessons should Africa take from this QE exercise as more nations look to tap into international capital markets whilst also trying to develop their domestic markets?
A major feature of the world economy is the rapid 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 recent experience is that financial markets could create favorable conditions for domestic access to capital, which however, could be reversed through external developments such as the QE. This could inadvertently disrupt their currencies, exports and inflation levels. Policymakers in developing countries need to develop contingent plans and strategies to address these developments, as they are bound to occur from time to time, and countries will not be able to shield themselves entirely. Apart from temporary policy measures that can be used in response to QE-driven boosts and tapering-induced declines as discussed above, African countries should also consider long-term measures such as economic diversification and greater regional integration to build resilience to external shocks.
Put differently, in the situation of greater global risk aversion, investors are now looking more carefully at countries’ economic fundamentals. Therefore, structural reforms that would raise economic flexibility and resilience will be a crucial undertaking for many African economies.
1. Other non-standard approaches to monetary policy included an enhanced credit support, credit easing, quantitative easing, interventions in foreign exchange and securities markets, and the provision of liquidity in foreign currency.