Wednesday, July 25, 2007

Traditional Methods of Investing in Africa

As mentioned in the previous blog, the next step in my progression was to show how new ideas could be used to invest in Mali. However, I thought it would be a good idea to first discuss how investors currently approach the African market.

Traditionally investment in Africa is made in the form of relief funds, humanitarian effort and debt financing. These types of investment are made because of a lack of formal equity markets and large corporations, and because the return on investment is known ahead of time. In the case of foreign aid and humanitarian work the return is often a sense of helping and improving the local environment. In the case of debt investment there is no guesswork with projected earnings the expected return is denoted by the terms of the debt instrument. To further ensure return, foreign debt is often issued in a foreign currency so that the lenders do not bear the currency risk associated by African nations. From the perspective of the African borrower the value of domestic currency often exhibits great volatility. This means that there is an increased likelihood that borrowers will be unable to repay, and therefore face higher rates of borrowing to compensate lenders for the additional risk. Recently investors have looked at new methods of investing in local currency debt in Africa. Lending on terms to be repaid in local currency reduces the risk of default by the borrower due to currency risk. Unfortunately, the borrower then increases their exposure to currency devaluation. In the extreme case the borrower could make all payments in a currency worthless to the lender. A potential solution to this problem is to diversify lending across countries by pooling the funds made available by lenders. A fund administrator then distributes lending across countries and all lenders benefit from diversification of funds across a number of countries.

A detailed explanation of this process can be found in Up From Sin: A Portfolio Approach to Financial Salvation a paper written by Randall Dodd and Shari Spiegel, January 2005 (No. 34 in a series of g-24 discussion papers for the United Nations). The paper draws on research (Haussman, 2001, 2002) that concludes developing nations are more able to cope with the negative effects created by shocks and policies errors, on ability to repay debt, if they borrow in their own currency. Dodd and Spiegel note:

“ The market risk, which consists of the uncertainty of domestic interest rates (i.e., interest rates in local currency assets) and exchange rates of each local currency security, is often significant. From 1994 to 2003, the average volatility of individual country returns on local currency debt instruments was nearly 16 per cent. At the same time, yields on local currency debt were also high, at 13.7 per cent on average, but not high enough to compensate for the risk. Hence investing in any one local currency market was not attractive.Combining the returns on individual country securities into a portfolio, however, does produce desirable results. As we will show below, returns on a diversified portfolio range from 8.10 per cent annually while the risk of a diversified portfolio drops substantially to approximately 5.5 per cent (which is in line with United States investment grade bonds).” – Dodd & Spiegel 2005

Although Dodd & Spiegel focuses on investment in debt instruments I thought their line of thinking could be applied to an equity portfolio as well. My hope was to use portfolio theory to show that the risk of investing in a company in Mali was balanced by that investments effect on the expected variance of a portfolio. The difficulties I encountered while attempting to make this connection lead me to change my course of action to steer investment to Groupe Zirasun.


Frederic Renet said...

"To further ensure return, foreign debt is often issued in a foreign currency so that the lenders do not bear the currency risk associated by African nations."

Actually it would be the reverse for US dollar versus FCFA. As the Dollar is sinking and the FCFA is tied to Euro the value reimbursed in FCFA is greater once converted in $US.

Whichever way there is always a risk.

Since the early 80 with the constant price decrease of natural resources we are used to see the constant devaluation of money of the developping countries. But for few years the prices of natural resources rose again and with it the value of the currency of exporting countries.

For the next few years I think it would be better for a lender to have its money back in a currency supported by a real product (oil, coffee beans...) than by faith.

Ian Howard said...

Fred, I think that you are correct in the case of FCFA, used in Mali, for now... it is expected that the FCFA will have to be readjusted sometime soon, as the rising Euro has required it to increase to unsustainable exchange level. The last time the FCFA devalued, it was halved, this is likely to be the case again. Most had predicted that this would have happened by 2007, but here we are... By lending in FCFA, the lender bears the risk, though true, as long as the dollar depreciates versus the Euro, what the borrower owes is discounted (favourable as long as the FCFA isn't devalued). I think that Rob's suggestion that loaning in local currency is still the safest choice for the borrower.