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Sub-Saharan Africa: Sovereign Risk – Rising Yields and Weak Recovery Will Require Fiscal Discipline

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Monday, August 28, 2017 1:50 PM / BMI Research

BMI View: The higher cost of financing fiscal deficits on international credit markets will increase sovereign risk across Sub-Saharan Africa over the coming quarters. Limited recourse to external debt will demand a greater degree of fiscal discipline from governments in the region, which will prove challenging, given the lacklustre outlook for economic growth and commodity prices over the coming years.

Recent months have seen a rally in yields on the Sub-Saharan Africa (SSA) region's dollar denominated debt, spurring a dramatic spike in eurobond issuance. However, we believe this rally has largely been a product of improving global sentiment towards emerging and frontier markets more generally, rather than being justified by stronger macroeconomic fundamentals.

With the price of dollar-denominated debt close to historic highs in several SSA markets, we believe risks now lie to the downside for investors. Furthermore, governments across SSA are looking increasingly unable to rely on a recovery in economic growth and commodity prices to improve their fiscal position.

Local debt paints a more varied picture, but ongoing fiscal headwinds in the region and weakening currencies in several key markets will add to sovereign risk. Below we highlight several key themes in SSA sovereign risk.

Low Yields Unlikely To Last Over Coming Months

A decline in global risk aversion over recent months has sustained improving sentiment towards frontier market economies, leaving yields on dollar-denominated debt in regions such as SSA close to their all time lows. This rally has continued despite the recovery in commodity prices stalling in Q217.

However, with increasing signs that the Trump administration will fail to deliver on the package of tax reforms and infrastructure spending that buoyed market confidence, we question whether the high valuations on SSA's dollar debt are justified. Spreads over the risk-free rate have narrowed as real yields in the US have spiked in recent months and we see little scope for frontier market debt continuing to attract the same degree of investor interest over the coming months, as the relative return of riskier assets has declined.

In this environment, we believe yields on the region's dollar-denominated debt will begin to rise, which could soon cause problems for those governments who have looked abroad to finance wide fiscal deficits as the costs of doing so have fallen. Eurobond issuance in 2017 has already been a record year in Africa, with Senegal, Nigeria and Cotê d'Ivoire having all sold debt on international markets this year.

With the cost of raising capital abroad likely to increase in H217, governments will be forced to either rein in deficits or find alternative sources of financing. This will be particularly difficult for those countries that have become increasingly reliant on foreign currency debt, such as Angola, which has a significant portion of its obligations denominated in US dollars falling due over the next ten years.

Lacklustre Commodity Recovery Shifts Emphasis To Fiscal Discipline

With the cost of external debt becoming more expensive, avoiding an increase in sovereign risk will require a greater degree of fiscal discipline among many governments in the region, particularly those that have traditionally relied on commodities for revenue.

The region's three main commodity exports (oil, copper and cocoa) all have a neutral/bearish outlook according to our forecasts. The effect will be exacerbated by a weaker outlook for economic growth in 2017 and the impact this will have on tax revenues. Indeed, since our last review of sovereign risk in Sub-Saharan Africa, we have revised down our forecasts for real GDP in 13 of the 22 countries that we monitor in the region.

While increasing production will offset some of the impact on fiscal revenues from the persistence of low prices, this will be insufficient to prevent large deficits across the region.

The response from various governments to sustained fiscal pressures in SSA has been largely determined by political considerations rather than macroeconomics. In Kenya, for instance, we believe upcoming elections have encouraged a spike in recurrent expenditure over the past six months in a bid to boost the campaigns of incumbent governments.

Kenya in particular has a history of increasing spending in election years as successive governments have looked to shore up support with wage hikes and populist polices. With public debt reaching 54.3% of GDP by 2017 (compared to 40.1% at the beginning of 2014), the country's fiscal picture will become an increasing threat to sovereign risk if the government fails to rein in spending over the coming years (see 'Fiscal Position Becoming An Increasing Risk', February 20 2017).

Other governments appear more willing to buck this trend. For example, we believe the new Ghanaian government under President Nana Akufo-Addo is laying the groundwork to rein in recurrent expenditure while it still enjoys substantial political capital following the election earlier in 2016 (see 'Fiscal Consolidation Risks Modest Uptick In Social Unrest', June 2 2017).

With the cost of external debt set to increase, this commitment to fiscal discipline will be vital in controlling levels of sovereign risk. That said, we will be watching closely for signs of slippage in countries with large debt burdens such as Ghana.

Investors Gamble On Mozambique At Their Peril

Since the Mozambican government first defaulted in January this year, yields on its dollar debt have fallen by over 1000 basis points, suggesting investors are confident they can reach some kind of agreement with the government that would keep them in profit.

There is some logic to this belief; the government's solitary eurobond still yields the highest return on dollar debt in the region and does not mature until 2023, when production of the country's vast gas reserves is expected to come online and offer a substantial boost to the state coffers.

However, although we maintain our core view that both parties have too much to lose by walking away from negotiations, we believe there is an increasing risk that long-awaited discussions between Mozambique's government and its creditors will come to nothing over the coming months (see 'Headwinds To Growth Will Deepen Without Creditor Settlement', June 6 2017).

The government has so far refused to cede any ground to bondholders, who have demanded prioritisation over the country's other creditors, having already undergone a restructuring of their investment in 2016. Indeed, in April the government signed into law the equal treatment of all its creditors, including VTB Bank and Credit Suisse.

The loans from these two banks were hidden from the IMF and the subsequent discovery of the debt in 2016 gave rise to Mozambique's current fiscal crisis. The hard stance adopted by Maputo bodes poorly for negotiations, expected to begin in the coming months.

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