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Africa: Africa Finance Profile


If we can draw one major conclusion from the events of the completed year, it is that, while an underlying economic problem can be temporarily covered up, financial markets will always end up exposing it from presently on. Despite massive amounts of quantitative easing by central banks worldwide, financial market participants remain sceptical of the beneficial effects of such monetary policy on the economy and inflation. We expect that low interest rates will continue to dominate capital markets in 2016.

One of the major themes reviewed in this Outlook is the shift in focus of financial markets to emerging economies. In somewhat oversimplified terms, we could national that the West, in pursuing highly expansionary monetary policies, has exported its financial crisis – or at least some of the consequences of this crisis – to the rest of the world. This has led to a significant increase in gross public and private deficit (a portion of which is denominated in foreign currencies) in these nations, most notably China (see Figure 1).

Race is far from over

We expect China to devalue its currency in 2016
The Fed will raise interest rates ... the ECB is additional likely to reduce them
The dollar will therefore become stronger, but the euro/dollar pair weaker
Despite the scarcity in deficit instruments created by the ECB’s purchasing programme, the improved economic conditions are an argument for slightly higher capital market rates

China – in particular its exchange-rate policy – could end up having a significant impact on currency markets in 2016. This as well marks a new stage in the world currency war, since central banks across the industrialised world, which had been expecting to finally be able to adopt a additional hands-off approach, are presently compelled to respond from presently on again. This raises the question as to what extent the Fed can raise its policy rate and what other measures the ECB could implement to prevent the still-vulnerable eurozone from fighting a rear-guard action in this world currency war. Governments and their central banks have long abandoned the world policy coordination introduced in 2008, the reassuring words heard at the completed few G20 summits notwithstanding. It would seem that, where currency markets are concerned, nothing is certain but great volatility, to paraphrase the famous words of Benjamin Franklin.

More debt in BRICS and developing countries

Devaluation of renminbi inevitable?

Given the size of China’s current account surplus, it is not surprising that the real effective exchange rate of the renminbi has appreciated by additional than 25% since 2009 (see Figure 2). However, with Chinese deficit snowballing over the completed five years, a stagnating economy and an ongoing confidence problem, the outlook for the renminbi suddenly looks completely different. We will expand on this in better detail in Box 1 and will, for presently, merely conclude that capital outflows will outpace inflows and that recent expansionary monetary policies are exerting downward pressure on the renminbi. This will from presently on require China to make one of the following choices: (i) continuing to intervene in the currency market in order to keep the exchange rate stable and accepting the resulting negative fallout; or (ii) liberalising its exchange rate in earnest and allowing the currency market to find a new equilibrium, thereby putting a halt to capital outflows.

We expect the Chinese government to decide – possibly sooner than anticipated – in favour of the second option, which is the least painful and the majority market-oriented. Back in 1998 and again in 2008, at the same time as China was still strong enough to carry the weight of the world’s problems, there was no need for it to devaluate its currency. But we believe the tables have since turned, with China itself having become the problem. The Chinese government is aware of the need to transform its increase model (see as well Outlook on the International economy), but their decision to create bubbles in the housing and equity markets in order to accelerate this process is likely to backfire. We therefore expect the renminbi to depreciate further against the dollar in 2016. A sudden and substantial depreciation/devaluation of 10% cannot be ruled out, but, given the difficult timing issues involved with this, we presume that it will occur at a additional gradual pace, with the USD/CNY exchange rate increasing from the current price of 6.36 to 7.50 in the course of 2016.


Box 1: Capital outflows drive renminbi exchange rate

Downward spiral; erosion of trust
Of the many measures the PBoC has introduced in recent times to ward off the economic decline, the one that has had the most significant knock-on effects on the rest of the world was without a doubt its decision, announced on 11 August 2015, to let the exchange rate of the renminbi be determined to a greater degree by the market. This effectively involved a 2 to 3 percent devaluation of the currency, coupled with a change in the way the exchange rate is determined. In practice, this increased the significance of interventions in the currency market and immediately and painfully exposes the underlying problem: is the PBoC truly in favour of ceding more control to market mechanisms? Diminished confidence in its policy stance has made foreign investors wary and results in an increase in net capital outflows. The PBoC intends to counter the downward pressure this exerts on the renminbi by selling foreign reserves, resulting in an unwanted liquidity shortage in the domestic money market. When it attempts to offset this, in turn, by creating additional domestic liquidity, this inevitably drives down the exchange rate. As long as the Chinese authorities are unwilling to accept a substantially lower exchange rate, foreign reserves will continue to steadily decline.

Critical limit for foreign reserves is not at zero
It is currently commonly believed that China will be able to pursue this approach for some time yet, although we have our doubts whether this is indeed the case (see Every, 2015). While the Chinese foreign-exchange reserves remain substantial (USD 3,514 billion as of September 2015), the actual room for manoeuvre is significantly smaller. We continue to view China as an emerging market, and foreign-exchange reserves are necessary in order to maintain financial stability. If we were to follow a set of generic guidelines for countries with fixed exchange rates (IMF, 2011), the minimum reserves needed would be in the order of USD 2,800 billion. In August 2015, Chinese foreign-exchange reserves fell by USD 94 billion, only to drop further by USD 43 billion in September, following the introduction of new, more stringent capital controls. However, this latter measure is at odds with China’s long-term objective of liberalising its financial account, internationalising its currency and obtaining a special SDR status from the IMF. We are also under the impression that China’s policy of currency interventions have shifted over the past two months from the spot market to the forward market (Every, 2015), causing the interventions to become less visible in the short term. However, even if it were to see its foreign reserves shrink at a rate of USD 43 billion per month, China would still reach the ‘critical’ level of USD 2,800 billion in only twelve months (see Figure 3). However, ultimately what matters is not only the amount of the reserves but also the negative signal that is being sent out by such capital outflows – and the question is whether China is willing to let things go that far.

 Strong rise in trade-weighted euro since PBoC decision of 11 August

Effects on world currency markets

Unless the ECB takes countermeasures, a significant depreciation of the renminbi is bound to have an impact on the eurozone, as evidenced by the volatility in the currency markets since 11 August 2015. Figure 4 shows the effect of a (limited) depreciation of the Chinese renminbi on the trade-weighted exchange rate of the euro in the ensuing weeks. With China playing such a dominant role in the region, other Asian countries may have no choice but to follow its policies, at least to some extent. This will cause other Asian currencies to further weaken against the dollar and the euro (De Groot, 2015). Secondly, the markets are almost certain to conclude again that China’s economy is struggling even more than initially assumed, which may cause commodity prices to fall further.

This, in turn, will lead to weaker currencies in other (commodity-producing) countries – including Brazil, Russia, South Africa, Canada, Australia and New Zealand (Foley, 2015). Figure 5 shows how closely these currencies have followed commodity prices in recent months. Thirdly, in this case a decrease in capital flows to emerging economies (or even an outflow of capital) as a result of growing risk aversion among investors will boost the US dollar in a more general sense. However, this latter argument also applies to the euro and other developed-market currencies, such as the yen and the pound sterling.

Lower commodity prices, weaker commodity currencies

Euro-dollar exchange rate to depreciate further – but different developments are possible
China does not represent the only challenge as far as the outlook for the euro-dollar exchange rate is concerned: overall, both the US and the eurozone are affected by slower growth in other parts of the world and by the knock-on effects of such a slowdown. It is difficult, however, to predict at this point how the balance is going to tip. One factor which has a far greater impact on the EUR/USD exchange rate is the extent to which the policies pursued by the Federal Reserve and the ECB will diverge and how the market is positioned. This past spring, it was widely expected that the Fed would be able to increase its policy rate as early as mid-2015, while the ECB’s asset-purchase programme was boosting carry trades at the same time.[2] When it became apparent that the Chinese growth slowdown would have a global impact, doubts about a US rate hike grew and the euro-dollar exchange rate climbed back up to 1.15, having previously traded at around 1.05.

Looking ahead to 2016, we must take into account continued risk aversion and decreasing (net) capital flows to emerging markets, which will continue to support the euro, since investors continue to maintain net positions (carry trades) based on expectations of a weaker euro. Furthermore, the Fed is unlikely to aggressively increase its policy rate in the short term. Nevertheless, we do believe the euro will continue to fall against the dollar. For one, viewed from a fundamental perspective, there remains a wide gap between the stages in the business cycle in which the US and the eurozone respectively currently find themselves (see also our Outlook on the International economy). Secondly, the ECB is not likely to give up the battle against deflation any time soon. Assuming that it may even decide to step up its current asset purchase programme, we expect that the increase in the ECB's balance sheet continues to drive down the euro (see Figure 6). A third factor is that the deflationary forces generated by lower commodity prices apply to both regions, and the market has already largely adjusted its expectations to a very gradual hiking path in the US.

A weaker euro will, however, likely require additional policy efforts on the part of the ECB.
The global currency war we are currently witnessing and on which we have reported extensively over the past year (see, for example, Every, 2015 and Rabobank, 2015), is ultimately a zero-sum (or even negative-sum) game. Yet individual countries cannot afford to remain on the sidelines and take the moral high ground; if they do, they will inevitably end up paying the price.

We see the EUR/USD exchange rate trading at around 1.05 over the next 6 months, while in the slightly longer term a level slightly north of parity rate remains realistic (our 12-month forecast is 1.04). Overall, we expect the euro to also further depreciate against the pound sterling. The in-out referendum on Britain’s membership of the EU, which is scheduled to be held before the end of 2017, will cause its share of volatility, but the Bank of England is significantly closer (our estimate is August 2016) to a first rate hike than the ECB. However, with the Bank of Japan it is much more of a neck-and-neck race in terms of who is most willing and able to push through further quantitative easing, and we expect the EUR/JPY exchange rate to remain stable overall in 2016.

Fed hesitantly heading towards the finish line

As we posit in our Outlook on the International economy, the US domestic economic outlook has steadily improved in recent years, which means we are inching closer toward the first rate hike. The Fed has set itself the requirement that before increasing rates it must have “reasonable confidence” that inflation will return to its 2-percent target in the medium term. Up to November of this year, the majority of the members of the FOMC (Federal Open Market Committee) seemed confident that the first rate hike could be announced by the end of 2015. We expect them to maintain this position, although the US will also be confronted with the effects of the growth slowdown in emerging economies and the lower commodity prices. Financial markets are as yet somewhat sceptical of the FOMC’s intentions for a December rate hike and have priced in only a two in three chance of a 25 basis point increase.

We believe it is far more important what measures the Fed will take after its first hike and how it will communicate these measures, since this will also determine the market’s reaction. We expect the Fed to increase its policy rate more slowly in the coming years than it did during the decade leading up the financial crisis, while the hiking path will also be less steep than the FOMC members predict in their “dot plot”, which is released every quarter (see Marey, 2015). There is a larger amount of slack in the labour market than it might appear, while wage growth and inflation are still low, the latter caused in part by the strong dollar. But it is also likely that the natural rate of interest has further declined in recent years[3], which means the end point of the Fed’s hiking cycle will also be lower (Figure 7). The risks here, too, mainly pertain to the lower end of expectations, and we certainly do not rule out that the Fed will eventually need to reverse its earlier rate hikes. While the Fed may act as though it is mainly considering the domestic situation, the fact is that its policies have significant knock-on effects on the rest of the world. This is due not only to the role of the dollar as a reserve currency, but also to the increased dollar-denominated debt worldwide. Increasing the interest rate too quickly will ultimately backfire on the Fed if emerging markets end up struggling even more as a result of its rate hikes and the stronger dollar. Our current estimate therefore is that the policy rate will be increased in two hikes of 25 basis points each in 2016 and in four hikes of 25 basis points each in 2017.

 Lower commodity prices, weaker commodity currencies

Box 2: What exactly do we measure with the 5-year/5-year forward inflation expectation rate?

ECB President Mario Draghi emphasised the significance of the five-year, five-year forward inflation swap (“5Y/5Y”) in the speech he gave at the Fed’s annual economic symposium in Jackson Hole, Wyoming on 22 August 2014. Technically speaking, this 5Y/5Y forward represents the average expected inflation rate over five years, starting five years, as priced in by the market. It constitutes key information for the ECB – alongside surveys conducted among businesses and households – regarding long-term inflation expectations. However, it cannot be considered an unequivocal indicator of future developments in inflation.

In recent years, this 5Y/5Y inflation swap shifted in tandem with changes in commodity prices (see Figure 8). This isn’t necessarily self-evident, however, if you operate based on the assumption that commodity prices mainly affect inflation rates in the current and following years, but have no impact on inflation five years from now. One explanation for this is that the inflation swap is not an unequivocal way of measuring inflation expectations, as it is influenced by liquidity and other risk premiums. It can also be affected by the specific framework in which professional investors operate (e.g. pension funds hedging inflation risk) (see also D. Elliott et al., 2015). Another explanation, however, is that the 5Y/5Y inflation swap reflects factors which have an impact on both commodity prices and the long-term inflation outlook. If there is a persistent growth issue, for example, the 5Y/5Y inflation swap may well be an indicator of the level of confidence in the central bank’s policy.

Earlier this year, the increase in inflation swaps appeared to derive in part from ‘pure’ QE effects, as we demonstrated in a recent study (Cardon and De Groot, 2015), but this effect was largely cancelled out during the period from July to September. Overall, this suggests that central banks should not blindly rely on these measures, but that a more in-depth analysis must be made of the drivers underlying them. If they fail to do this, there is a risk that the central bank will conclude, based on the wrong reasons, that more quantitative easing is required.

More quantitative easing by the ECB

As carefully as the Fed may have been treading of late, the contrast between its policies and those pursued by the eurozone remains significant. The ECB will continue its current asset-purchase programme until September 2016, but it has already hinted at its intention to initiate a new round of quantitative easing (see De Groot, 2015). However, the positive outcomes of previous policy measures – improved credit and consumption growth – are likely to be eclipsed by the negative effects of the growth slowdown in the emerging economies, including lower commodity prices.

While the ECB may have hopes that the resulting disinflation will boost consumer spending, lower commodity prices could also indicate a global drop in demand. In addition, the lower inflation rate increases the risk of a deflationary spiral, which also further decreases inflation expectations.
One of the indicators monitored closely by the ECB is the five-year, five-year forward inflation swap (see Box 2), which fell to just 1.55% in early October (although it has since recovered slightly). Earlier this year, this low level prompted the ECB to announce its asset purchase programme.

In the ECB’s press conference of 22 October 2015, ECB President Draghi also referred to the option of further reducing the rate it pays on its deposit facility. This would indicate that the ECB’s Governing Council had already concluded beforehand that a substantial expansion of the QE programme was likely to present some problems, possibly because it will want to distribute the purchases among the member states as evenly as possible.

In concrete terms, we expect that the ECB will further reduce the deposit rate as soon as December of this year (by 15 basis points to -0.35%) and will announce an expansion of its asset purchase programme. We envision a combination of an extension of the duration of the programme (until mid-2017, for example), an increase in monthly purchases (i.e. in excess of the current amount of EUR 60 billion per month) plus an expansion in the asset classes the Eurosystem is authorised to purchase. We believe that the two most obvious asset classes are debt issued by state-owned companies and regional governments (McGuire, 2015). As far as the first option is concerned, the ECB has already added nine state-owned companies to its list, while technically there is also a large amount of quasi-government debt, which is spread across the eurozone, available (estimated at approximately EUR 1,150 billion, although far from all of this will satisfy the ECB’s criteria). Regional government debt is not spread to the same extent and would create more room for purchases in Germany in particular (EUR 193 billion outstanding to German Länder). However, it is also likely that the ECB will absorb a portion of the larger monthly purchases through additional government bonds. In June, the ECB Governing Council decided to increase the issue limit for government bonds (where possible) from 25% to 33%, which, according to our calculations, would facilitate an additional purchase of a total of approximately EUR 300 billion in government bonds.

Although there is growing evidence that unbridled quantitative easing is subject to the law of diminishing returns (see elsewhere in this Outlook for details), we anticipate that additional measures will need to be implemented in 2016. We believe the euro exchange rate will remain a key guideline in setting the policy. Particularly in light of our outlook for the PBoC’s exchange rate policy and the Fed’s cautious interest rate policy, the ECB cannot afford to let the euro appreciate to any significant extent. With what has become a massive pool of excess liquidity in the European financial system (more than EUR 564 billion as at mid November 2015) and a deposit rate which will likely be reduced, interbank money market interest rates (see Figure 9) will likely fall to new historic lows across the board in the course of 2016. At a deposit rate of -35 basis points, an Eonia rate of -25 basis points is not outside the realm of possibility, which means a 3m Euribor rate of between -15 basis points and -20 basis points seems possible as well.


ECB asset purchase program pushed excess liquidity higher and money market rates


So how will this affect capital market rates?

It is less likely that an expansion of the ECB’s asset purchasing programme will also automatically result in lower capital market rates or bond yields (a notion which was commonly held for some time and may still be prevalent today). Long-term interest rates fell sharply during the first four months of 2015, both in the run-up to the programme and in the first few months of its implementation.

In fact, the German 10-year bond yield fell to only 7 basis points above zero, while the yield curve flattened substantially (which is to say that the 30-year interest rate fell even more sharply). It was widely believed that the additional demand created by the Eurosystem – i.e. the liquidity effect – would drive up bond prices (and thereby drive down interest rates). This was compounded by a gradual reduction in the issuance of new bonds as a result of an improvement in public finances. This was particularly evident in the case of German government bonds, which were at risk of becoming relatively scarce because a part of the yield curve traded below the ECB’s deposit rate (making the bonds in that segment ineligible for purchase by the Eurosystem), while Germany could rely on an estimated budget surplus in 2015-2016.

If the ECB asset purchase programme is indeed expanded, it would seem likely that the liquidity effect or scarcity effect will further drive down long term rates in the eurozone. However, the willingness to hold bonds also depends on three fundamental factors: (i) inflation expectations, (ii) the appeal of alternative investments and (iii) any improvement (or lack thereof) in the real economy. In more general terms, we posit that a (successful) policy of quantitative easing results in higher interest rates and a steeper yield curve, since the primary impact of QE is higher inflation expectations, which are achieved through an expansion of the central bank balance sheet and a concomitant fall in the exchange rate. We saw a similar pattern of QE pushing up long term interest rates during the asset purchase programmes launched by the Fed and the BoE (McGuire, 2015). This pattern was confirmed in May-June of this year, when two sell-offs in the Eurozone government bond market brought an end to the major discrepancy which had opened up between trends in market rates (lower) and those in fundamentals characterised by stronger growth and higher inflation expectations (see Figure 10). This resulted in a significantly steeper yield curve.

Ultimately, it’s not liquidity but the fundamentals which drive interest rates
Based on the perspective provided by a weaker euro, the tentative upward trend in the eurozone economy in 2016 and increasing inflation, long termrates in the eurozone should eventually start increasing again. However, this is being complicated by uncertainty with regard to the fundamental factors described above. For one, QE does not provide a solution to structural problems affecting the economy. It is no coincidence that we are currently witnessing a global currency war, with the “more debt equals more growth” paradigm having reached its limit in many countries. As we argued in our publication Outlook on the International economy, it remains to be seen whether the US has what it takes to serve as the world’s growth engine. There is also the fact that the Fed’s rate hikes may remain below expectations, particularly if wage growth in the US also continues to fall short of expectations over too long a period. In this case, capital market rates in both the US and the eurozone will continue to fall.

The second – related – factor, again, is the role of capital flows and investors’ risk appetite. The US S&P 500 Index is only 4% removed from its all-time high, and, to the extent that the liquidity result of QE has raised valuations of high-risk assets, the risk of anxiety part investors has as well grown, which could create an additional request for ‘safe’ investments. Moreover, a new outflow of capital from developing nations to the industrialised world could result in lower bond rates.

We note that this runs counter to the common fear that the large-scale sale of foreign reserves by central banks in emerging markets will drive up US and European capital market rates (McGuire, 2015). If this is motivated by a desire on the part of these central banks to stabilise their currency (as is the case with China), this is likely to point to an outflow of capital. This, in itself, is the result of weaker increase in these economies, which could as well occur in conjunction with lower commodity prices. In this case, capital market rates in the eurozone could in fact end up falling. Figure 11 shows the positive correlation between shifts in world reserves and fluctuations in long-term bond yields in industrialised economies.

We expect long term interest rates to increase somewhat in general in 2016 in both the US and the eurozone, but believe there are various factors at play which will curb this increase. On a 3-month horizon, we expect a 10-year swap interest rate in the eurozone of approximately 0.8% (slightly below the current rate), while a rate of 1.3% would seem realistic based on a 12-month horizon.

We believe quantitative easing by the ECB will continue to boost request for peripheral government bonds. However, since spread levels for Italy and Spain are currently close to 100 basis points, potential profits are limited – unless the eurozone nations decide to develop an active strategy for pooling government deficit next all. We should note here that peripheral bonds, impacted by the current low spreads, have become additional vulnerable to political factors, as evidenced by the recent elections in Catalonia (see McGuire, 2015).

Does selling of world currency reserves really lead to higher long-term interest rates? \"FigureSource: Macrobond

Corporate bonds: a balancing act
These same arguments largely apply to European corporate bonds as well. Spreads on corporate bonds may recover somewhat next the weakness of the market in recent months due to risk aversion on the part of investors (Figure 12). Corporate bonds (excluding those issued by national-owned companies) are not likely to be included in the ECB’s investment purchase programme, but they nevertheless stand to benefit from its liquidity effects. However, volatility will remain at a higher level, and we reckon that there is a risk of spread widening in 2016. On the investment side of the balance sheet, we see corporates being relatively advanced in terms of their refinancing plans, inclunding extended maturities and stronger balance sheets. Mergers and acquisitions are expected to boost the issuance of new bonds, which will significantly exceed repayments of existing deficit in 2016, as was the case in 2015 and 2014.

An environment characterised by low interest rates, a weak euro and low energy prices improves the profitability of businesses, while request for new bonds remains. At the same time, however, European corporates are as well faced with the impact of the increase slowdown in emerging economies, the fact that investors request higher credit spreads for new issues (which has a negative result on the secondary market) and the higher level of event risk involved. In general, we believe that shareholders will be prioritised over bondholders, which could, for instance, end up having a negative result on leverage.