Global Financial Crisis: Implications for Africa’s Financial System1 By Victor Murinde, Birmingham Business School, University of Birmingham
Abstract This paper invokes a flow-of-funds framework to scope the implications of the global financial crisis for Africa‟s financial system. The paper argues that because the financial crisis is characterised globally by bank fragility, the contagion effects may impair (through exchange rate and stock price propagation mechanisms) the financial intermediation function of domestic banks in Africa in three main ways: (a) the immediate effect is a reduction in the supply of intermediary capital i.e. a credit squeeze, or credit crunch; (b) a collapse of the prices of real assets (e.g. residential houses), leading to a collateral squeeze; (c) a fall in prices and incentives for attracting deposits, leading to a contraction in the supply of savings i.e. a savings squeeze. The paper then examines the nature of the current crisis, in view of other recent financial crises, and highlights the implications for key players in a flow of funds sense, namely banks, companies, investors (households) and the government. It is noted that although the largest four economies in Africa have undertaken comprehensive financial reforms and achieved a high degree of bank competitiveness and financial intermediation, most African banks and capital markets are vulnerable to contagion effects of the financial crisis. The paper concludes by proposing corrective actions for Africa and by highlighting the main recommendations for Africa‟s financial system during the crisis (immediate and short run actions) and in the post-crisis period (medium term actions).
Correspondence to:
Professor Victor Murinde Birmingham Business School University of Birmingham Edgbaston Birmingham B15 2TT United Kingdom Tel: +44-(0)121-414-6704 e-mail:
[email protected] webpage: http://www.business.bham.ac.uk/staff/murindev.shtml
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This paper is prepared for the European Development Report (ERD) 2009 Conference on “Financial markets, adverse shocks and policy responses in fragile countries”, to be held on 21-23 May 2009, in Accra, Ghana. I wish to thank: (a) the ERD for financial support; (b) AERC who funded the initial work on these ideas; and (b) Philippe Lassou for excellent research assistance. Section 4 is partly based on recent empirical work with Louis Kasekende, Kups Mlambo and Tianshu Zhao (in Kasekende, Mlambo, Murinde and Zhao, 2009). However, for all remaining errors, I carry the can.
“Though the principles of the banking trade may appear somewhat abstruse, the practice is capable of being reduced to strict rules. To depart upon any occasion from those rules, in consequence of some flattering speculation of extraordinary gain, is almost always extremely dangerous, and frequently fatal to the banking company which attempts it.” (Adam Smith, Wealth of Nations, Book V, Chapter 1, part iii).
1.
Introduction
Perhaps, the dictum from Adam Smith is rather belated; perhaps not! The regulation and supervision of banking is still a hot issue, especially with respect to financial innovations such as derivative instruments. Moreover, banks constitute the integral element of Africa‟s financial system. There is already a plethora of good papers on the possible causes and trend dynamics of the current global financial crisis. There is also much heated debate among academics, policy makers and the general public about the size and possible efficacy of the bail out packages that the US and UK governments, among other OECD governments, have put in place to abate the velocity and longevity of the crisis. This paper departs from the aforementioned stream of work and debate. It seeks to invoke a flow of funds approach to analyze the complexity of the financial crisis and its implications for Africa‟s financial system in order to chart the way forward for the continent. It is useful to note that at the outbreak of the financial crisis last year, there was great optimism among leading African economists that because Africa‟s banks and capital markets are not strongly integrated with the global markets, the impact of the crisis on Africa will be minimal, or at least secondary. As we show later, the impact of the crisis on the capital markets of the large economies in Africa has been quite adverse and substantial, almost to the same degree as the perverse effects on the markets OECD economies. This is quite unfortunate because these large economies, namely South Africa, Algeria, Nigeria and Egypt (the SANE), are arguably the dynamo that is propelling growth in the banks, capital markets and company sector in the rest of the continent. Also, the SANE economies are exemplars of good financial sector reforms. Hence, the rest of this paper takes into account the above considerations and is structured into four sections. Section 2 briefly explains the novelty of the flow of funds framework in the context of the financial crisis. In the context of the framework, Section 3 highlights the salient features of the current financial crisis, against the experience of the recent crises and then spells outs the implications of the crisis for banks, companies, investors and governments. The African context is emphasized in Section 4, by evaluating the progress of financial reforms in African economies, focussing on banks and capital markets. It is argued that a fundamental goal of these financial reforms is to enhance the competitive conditions in financial services in African economies, including some important implications, especially in terms of enhancing productive efficiency, with possible positive spillover effects to the rest of the continent, and effective regulation and supervision to enhance financial stability in the face of the global financial crisis. However, it is also argued that even the reformers among African economies cannot afford to be complacent because although banks in some selected African economies are competitive, but both the banks and capital markets in the large SANE economies are still way behind other emerging economies such as Brazil, Russia, India and China. Finally, Section 5 brings together the key aspects of
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the paper by proposing some corrective actions and lessons for Africa‟s financial system now and towards recovery from the financial crisis. 2.
The Flow-of-Funds Framework
We invoke the flow-of-funds framework in order to underpin the role of banks and capital markets in relation to households, companies, the government and externally propelled financial crises, in the sense that a “…main function of the flow of funds accounts is to reveal the sources and uses of funds that are needed for growth …” (Klein, 2000, p.ix). In the context of this paper, we argue that flows of funds arise from the transactions which take place in an African economy, mainly involving exchanges of assets and liabilities. These transactions generate flows of funds from one agent to another and from one sector to another. In Table 1, flow-of-funds accounts show net transactions in financial instruments among the key economic sectors (Green and Murinde, 1998). Each row (i) represents an asset, and each column (j) a sector. Each cell (i,j) in the matrix shows net purchases(+) or sales(-) of asset i by sector j during the unit time period. The row sums of the matrix are zero as net purchases of an asset must equal net sales, and each column (j) sums to the j'th sector's surplus or deficit i.e. its Net Acquisition of Financial Assets (NAFA). When households and companies make consumption and investment decisions, changes in the stocks of assets and liabilities are tracked through identities which state that the current stock is equal to the sum of: the previous period‟s stock, net flows into or out of the stock through transactions (purchases or sales by any given sector), changes in valuation (capital gains or losses), and depreciation of the pre-existing stock. Net flows into or out of a stock correspond to entries in the flow of funds account for any given sector. Entries for non-reproducible assets such as land reflect flows (purchases and sales) which do not enter into the current account. However, one sector may sell land to another so as to augment its funds to purchase other assets. Intangible assets are also included in any complete representation of flow of funds. Flow of funds models are generated by representing the assets and liabilities into identities and then reparameterising some identities into behavioural equations (which include policy instruments such as interest rates and exchange rates). Examples include models to explain the portfolio behaviour of the household sector, the company sector or the banks sector, and the role of flow of funds in interest rate determination.2. In addition, these models seek to explore why agents in a particular sector hold specific assets and why the agents choose to substitute assets within their portfolio. Also, as shown by Moore, Green and Murinde (2006a, 2006b), stochastic policy simulations within a flow-of-funds model can shed light on the type of financial reform policies for influencing outcomes for households, companies, banks and government.3 As Fleming and Giugale (2000) emphasize, a key advantage of the flow of funds is that it imposes internal consistency on analyses and forecasts, and provides an exposition of the complete financial implications of policy or other changes. The framework in Table 1 can be extended so that the entries in the rows and columns reflect asset prices as well as instruments. The important instruments include private non-bank lending, corporate debt and equity. The inclusion of these instruments reflects the growth of non-bank institutions and markets (including stock markets) in most African economies in recent years.
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See, in particular, Tobin and Brainard (1968), Green (1992), Green and Murinde (1998, 2004, 2005). The implementation of flow of funds accounts in official statistics follows the UN System of National Accounts (SNA; United Nations, 1968 and 1993). Two components of the SNA are: the capital accumulation account which represents the transition between the national income accounts and the financial accounts (it shows sectoral savings including a provision for capital consumption or depreciation, capital transfers to or from the sector, and the non-official assets accumulated by the sector); the SNA is the capital finance account, which provides a breakdown of net lending (the balancing item of the capital accumulation account). 3
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In the context of the financial crisis and Africa‟s financial system, the flow-of-funds serves at least three main purposes. First, the framework underpins the sources and uses of funds between the household, company and banks sectors, on the one hand, and the foreign sector, on the other. The banks sector provides financial intermediation from the household sector to the company sector; financial instruments (such as deposit and loan interest rates), financial reforms, and bank regulation influence the size of intermediation. Hence, the framework underpins the centrality of banks in Africa‟s financial system. Because the current financial crisis is characterised by bank fragility, it may impair (through exchange rate and stock price effects) the financial intermediation function of domestic banks in Africa in three main ways: (a) the immediate effect is a reduction in the supply of intermediary capital i.e. a credit squeeze, popularly known as a credit crunch; (b) a collapse of the prices of real assets (e.g. residential houses) and company real assets, leading to a collateral squeeze; (c) price and other incentives for attracting deposits from household sector fall, leading a contraction in the supply of savings i.e. a savings squeeze. Table 1: Flow of Funds Framework (excluding financial prices and policy instruments) Household Company Banks Government Foreign Sector Sector Sector Sector Sector H P B G F 1. Income-expenditure 1.1 Income (Y) YH YP 1.2 Taxes (T) TH TP TG H P 1.3 Consumption (C) C C CG CF 1.4 Investment (I) IH IP IG IF Net acquisitions (S)
SH
SP
SG
SF
2. Assets and liabilities: Balance-sheet accounts 2.1 Capital (K) 2.2 Loans (L) 2.3 Domestic money (M) 2.4 Foreign money (R)
KH LH MH
KP LP MP
KG LG MG RG
KF
Net worth (W)
WH
WG
WF
WP
LB MB WB
RF
Second, the flow-of-funds framework is used to highlight the transmission of the financial crisis from the foreign sector (the rest of the world, or specifically the USA) to the household sector, company sector, banks and capital markets, as well as the government sector. Financial prices, specifically the exchange rate and stock prices, provide the propagation mechanism for contagion effects of the financial crisis. Hence, the early-warning symptoms for contagion effects into African economies are likely to include rapid depreciation of the exchange rate, collapse of the stock market index, capital outflows and potential (or actual) bank run. Third, the role of the government sector in the financial system is important because in most African countries companies require government guarantees to access funds from the foreign sector (international banks and capital markets). In addition, at the early signs of contagion effects, the government sector should react by bailouts to banks and companies or by funding company redundancies. Moreover, the government is centre stage in other supporting functions, including the legal infrastructure.
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3.
The Global Financial Crisis
3.1
After the Mexican, Asian and Russian financial crises
In a flow-of-funds context, banking crises occur when the role of financial intermediation by banks is impaired to the extent that banks become dysfunctional and the corporate and financial sectors experience a large number of insolvency and bankruptcies. To highlight this argument, we briefly review the current global financial crisis in view of the three main financial crises in recent history. The Mexican Peso Crisis broke out on 20 December, 1994 when the Mexican government suddenly announced that the peso was devaluated by 15% (Han, Lee and Suk, 2003). The peso continued to fall as currency traders and investors panicked and sold their peso holdings. At the same time, there was rapid capital outflow and the Mexican stock market (Mexican IPC) fell by 47.94% in one month. The “tequila effect” spread to neighbouring countries, especially Brazil (Sharma, 2001). Hence, the main symptoms of the Mexican crisis were threefold: exchange rate depreciation, fall in stock prices and huge capital outflows. The 1997 East Asian Financial Crisis4 has been attributed to different factors by different researchers; however, there is consensus that the main causes included large external deficits, property market bubbles and stock market bubbles. The main symptoms were the collapse of the exchange rate and stock prices (see, for example, Grouzille and Lepetit, 2008).5 Also, the crisis is attributed to the presence of internal weaknesses in the financial sector, such as traditional banking practices and inadequate bank regulation.6 Inadequate bank regulation and supervision was rampant to the extent that “new banks and finance companies were allowed to operate without supervision or adequate capitalization.” (Radelet et al, 1998:35). Some foreign banks tried to impose some capital adequacy measures; for example, it has been argued that “Japanese banks were the critical actors who triggered the Asian crisis when they reduced their credit, first to Thailand in early 1997, in order to meet capital requirement” (Brana and Lahet, 2008:98).7 In addition, the crisis is attributed to excessive foreign borrowing mainly by the private sector; “firms borrowed heavily to fund plant expansion and acquired unsustainable debt/equity ratios” (Jackson, 1999:6). Various East Asian countries increased a large proportion of their net foreign liabilities. When the crisis arose in mid-July 1997, there were large scope of indebtedness of short-term and un-hedged loans exceeding 50 percent of GDP of Thailand, Indonesia and Philippines. Furthermore, not only was the indebtedness of these countries substantial, they were also held back by the short-term loans which amounted up to 22 percent of their respective GDPs. It is argued by Radelet et al (1998) that many foreign investors assumed that they would be bailed out by host governments in case of repayment problems by companies. Moreover, the literature suggests that premature capital account liberalization was a root cause of the 1997 Asian financial crisis (Wang, 2007). The "double-edged sword" of capital account liberalization was that while the opening up of domestic capital markets 4
The crisis first exploded in Thailand in September 1997 and almost immediately spread to Malaysia, the Philippines, Indonesia and Korea. 5 The Asian financial crisis has also been described as a currency crisis, defined as a nominal depreciation of the currency of at least 30 percent that is also at least a 10 percent increase in the rate of depreciation compared to the year before (Frankel and Rose, 1996). 6 A sound domestic financial system is important. In the case of the Asian financial crisis, Mullineux, Murinde and Pinijkulviwat (2003) show that the standard regulatory instruments of Central Bank of Thailand were inadequate to deal with the financial crisis. Many domestic banks in Thailand were involved foreign high-risk debt in real estate speculation, but these financial institutions lacked strict internal control and the central bank lacked the regulatory and supervisory capacity to deal with foreign bank transactions. 7 Another additional factor is exchange rate overvaluation, which is blamed on governments for maintaining fixed exchange rates and allowing currencies to become overvalued (Jackson, 1999:3).
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greatly increased capital inflows, the same attracted substantial international hot money which was potentially destructive. For example, speculative hot money led by George Soros‟s Quantum Fund was destabilizing to fragile local financial markets in the absence of adequate financial regulation. However, an interesting lesson from the Asian financial crisis is that countries in the regions were not directly vulnerable to contagion effects. According to Jackson (1999), countries such as Singapore and Hong Kong escaped the spread of the crisis in the region because they had stronger financial systems, including adequate bank regulation. In this context, financial reforms which strengthen bank regulatory and supervisory framework may help to mitigate adverse contagion affects of the financial crisis. The 1998 Russian Financial Crisis broke out in August 1998, approximately one year after the break out of the Asian financial Crisis. Russia‟s foreign currency reserves fell sharply, the Rouble rapidly depreciated and huge capital outflows followed. The stock market index fell quickly. The Rouble depreciated further by 34% at the end of December 1998, amid speculative panics that marked the outbreak of the Russian financial crisis. Some analysts have attributed the crisis to economic fundamentals, such as the erosion of federal government revenues and collapse of fiscal discipline, while forced the government to borrow heavily by issuing bonds. Foreign investors holding government bonds started to panic when the Rouble depreciated rapidly (see Sojli, 2007). The global financial crisis was triggered by the US subprime mortgage crisis in the spring of 2006, when the US second-largest subprime mortgage company (New Century Finance) announced it was filing for bankruptcy protection (Mizen, 2008).8 This was followed quickly by announcements of trouble among several big names in banking and investments in the US. Goodhart (2008) categorizes the reason of the crisis as the mis-pricing of risk, the new financial structure, the poor credit rating agencies and insufficient liquidity. Similarly, Mizen (2008) acknowledges the period of exceptional macrostability, the global savings glut, and financial innovation in mortgage-backed securities as the precursors to the crisis. Raynes and Zweig (2009) suggest that the proper valuation of these securities are seen as being crucial to resolving the financial crisis. However, Wallace (2009) argues that fairvalue accounting provides better monitoring of institutions on a long-term basis, and was not a major cause of the economic crisis in the U.S. Hence, the previous financial crises in Asia, Mexico and Russia have some important common element elements. First, these crises, especially the 1997 Asian Financial Crisis and the current global financial crisis, can be attributed not simply to monetary issues or subprime mortgage problems, or any other form of credit crunch, but mainly to the spread of contagion effects due to financial globalization. Second, when the crises occurred, key financial indicators, such as exchange rates, stock prices, short-term interest rates, asset prices, number of business bankruptcies and collapse of several financial institutions, produced very rapid deterioration in the host countries. However, the crises differ in terms of how quickly and to what extent the nucleus of the crisis has spread to the rest of the world. Third, the Asian financial crisis, Mexican Peso crisis and the Russian financial crisis, which occurred in emerging economies, were characterised by uncertainty in capital flows. The main reason is: “In an emerging market financial crisis, an economy that has been the recipient of large-scale capital inflows stops receiving such inflows and instead faces sudden demands for the repayment of outstanding loans. This abrupt reversal of flows leads to financial embarrassment, as loans fall into default or at least are pushed to the brink of default.” (Radelet et al, 1998:4).
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Sub-prime mortgage crisis in the US is attributed to sub-prime lending. This is where customers who are unable to receive a prime level mortgage due to low or no credit ratings. They are therefore given a higher rate subprime mortgage by banks and lenders. U.S. subprime loans are usually classified for borrowers with a FICO score of less than 680. Subprime loans give customers with low credit ratings the opportunity to become homeowners, however, for lenders this is often a risk which is taken on.
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3.2
Implication for banks, companies, investors and governments
The current financial crisis has important implications for banks, companies, investors and governments. In a flow of funds context, the main implication for banks is the centrality of the financial intermediation role, such that there must be a stable source of funding for all types of banks, including commercial banks and investment banks. Hence, it is very important for banks to maintain capital ratios to avoid liquidity and solvency risks. For example, if commercial banks ignore the basic principal of deposits ratio and over-relying on the money market financing, once market confidence is lost, the liquidity crisis of banks may soon appear. The UK bank Northern Rock is a typical case. The main business of Northern Rock is to provide residents with British mortgage buyers. However, unlike most commercial banks, Northern Rock‟s financing primarily relied on borrowing from money market with interbank rate and selling its mortgage securities. When the subprime mortgage crisis broke out in 2007, the loss of market confidence made liquidity extremely difficult. Consequently, Northern Rock could not finance its business, and it ultimately ended up with U.K. government nationalization. The main implication of the crisis for companies relates to executive compensation and corporate government; also sometimes labelled “the fat cat problem” or simply “greed”. The point is that companies should beware of high incentive used in management which led to uncontrollable risks. Research shows that in 2007 the United States executives‟ salary level was 275 times that of ordinary employees. The ratio was only 35 to 1 about 30 years ago (Bloomberg, 2008). Incentives of executives of financial institutions are often linked to short-term securities trading performance. Driven by attractive salary, the Wall Street "elite" in the pursuit of huge short-term returns, one after another test the water "toxic securities" from engaging in financial innovation and financial risk. High incentives which have been out of control, are seen as the initiator and one of the chief culprits for this financial crisis. To this end, the U.S. government rescue plan has included some constraints on incentives and the tax deductibility of their income of executive in order to enhance market confidence and restore stability in the market order. Therefore, it is learnt that companies in any industry should have a reasonable margin of incentives, which must not breach the industry standard and appropriate balance of the principles of social equity. For investors, the main implications of the crisis are at least threefold. The MSCI world index has plunged by more than 45% from its high (1682.35 as of October 31, 2007). More severely, many investors have lost nearly everything in this financial tsunami. Hence, the first lesson investors should bear is that high returns always involve high risk; however, high risk does not necessarily guarantee high returns, at least not constantly. More importantly, investors should be aware of the extra risk they are talking at all time. Secondly, investors should correctly understand and avoid high levels of gearing, especially during such a volatile market condition. Gearing is absolutely a double-edged sword. No doubt, it can magnify investors‟ potential gains, but, it also, and more often results in position closures at a huge loss when the market goes in the opposite direction. The third lesson investors need to remember is the importance of diversification and government bonds in their portfolio management. Investors may head the old aphorism “Don‟t put all your eggs in one basket” by forming a portfolio with diversified stocks. However, they have ignored the importance of „asset classes‟ meaning that diversification is only impactful with relatively „asset classed‟ portfolio. In an event like the current financial crisis where nearly every asset class is sinking, investors‟ investments are vulnerable and even hopeless without optimized portfolio diversification. Is any safe haven left? Absolutely, government bonds have been extremely outperformed during the crisis, therefore, investors have to learn to put this asset class into their portfolios despite yields being quite low most of the time. Governments, in particular, have important lessons to learn from the current financial crisis. First, all governments must be aware of the extensive risks associated with rapid 6
financial innovations, including the likelihood of causing financial bubbles. The ongoing financial crisis has been triggered and spread by the U.S. subprime mortgage losses due to improper uses of financial derivatives, such as securitisation of U.S. mortgage agencies (Fannie Mae and Freddie Mac) into mortgaged-backed securities for sale in the market. Then, investment banks used their financial engineering technology to repackage and trade the securities. Second, governments should beware of the excessive uncertainties and risks resulted from over-speculation. Looking back the history of financial crises, no matter big and small, almost all of them are connected and caused by the excessive speculation ignorance of risk control. Moreover, modern investment banking business is heavily engaged in financial derivatives, which have leverage effects, such that investors can easily enlarge profits (as well as risks) by bearing a small amount of trading margin. High leveraging ratio has made investment banks highly dependent on financing. However, during the credit crunch, investment banks‟ balance sheet deteriorated dramatically, rating agencies (such as S&P and Moody‟s) therefore lowered their rating so that the financing costs increased significantly. The Big Five on Wall Street at the time (Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs, Morgan Stanley) exhibited this problem (Bloomberg, 2008). Hence, in order to maintain the stability of financial markets as well as the whole financial system with sustainable developments, it is absolutely necessary for all governments to take effective measures to curb excessive speculation and prevent the spread of over-speculation (e.g. setting up thresholds of leverage with strict penalties). 4.
Africa’s Financial System: Reforms, Competitiveness and the Financial Crisis
We evaluate progress with financial reforms in African economies, focussing on banks and capital markets; the main drivers of the flow of funds framework. It is argued that a fundamental goal of these financial reforms is to enhance the competitive conditions in financial services, including some important implications, especially in terms of effective regulation and supervision to enhance financial stability in the face of the global financial crisis. But, it is also argued that even the reformers among African economies cannot afford to be complacent because although banks in some selected African economies are competitive, both the banks and capital markets in the large SANE economies are still way behind other emerging economies such as Brazil, Russia, India and China (BRIC). 4.1
The banking sector
Most African economies have undertaken banking sector reforms, including opening up the domestic banking to foreign competition as signatory members of WTO and GATS, as well as privatisation of state-owned banks. However, the reforms have taken various approaches and progressed at different speeds. For example, South Africa represents a case of gradual restructuring of the banking sector, during which time South African banks have spawned the financial services sector in the rest of Africa. Nigeria has bravely designed and implemented a shock-treatment type of banking sector reform, which amounts to a „big bang‟. 9 The banking sector reforms in Egypt give mixed signals in terms of effort and success, which seem to suggest that the country should really go one extra mile now. Algeria is characterised as a slow reformer; arguably it is high time Algeria embraced full financial restructuring, given the efforts it has so far made and considering the need to mitigate the adverse effects of the raging global financial crisis. The key feature of the banking sector reforms in South Africa is the gradual process that has spanned almost two decades, including complementary reforms in the capital market as well as insurance services. The chronological sequence of the major banking sector 9
As stated: “The 89 banks that had hitherto existed in Nigeria were reduced to 25 in 2006” (Achua, 2008, p57).
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reforms is detailed in Table 1. Indications are that South Africa has established a well developed banking system which compares favourably with those in many developed countries and which distinguishes South Africa from many other emerging market countries.10 Table 1: Chronological key banking sector reforms in South Africa Year Specific Reforms Aimed at Banking Sector Competitiveness 1991 Risk based capital requirements, in line with European Union directives, were introduced for banks 1996 Accounting and financial reporting by banks was required to conform to Generally Accepted Accounting Rules. 1998 The South African Reserve Bank (SARB) changed its operational procedures for providing banks with short term liquidity. Repurchasing auction system was introduced where banks tender on a daily basis for liquidity provided by the SARB. 2001 Adopted a new Securitisation Notice, under Basle II. Securitisation broadened to allow banks to act as originator, sponsor or repackager in a securitisation scheme; also, the minimum prescribed capital requirement for all banks and mutuals raised from 8% (as stipulated under Basle I) to 10%. 2002 Bank Act 1990 amended to compel all banks to establish sound risk management and corporate governance; restrict certain investments made by banks (e.g. equity). 2003 Banks to develop a risk matrix to verify clients‟ identities, as per Finance Intelligence Centre Act (FICA) i.e. making effective legislation against money laundering. 2005 The South African banking market was opened up for foreign banks. South African banks, in turn, were allowed to establish branch offices, subsidiaries and representative offices in many countries around the world. 2007 The Banking Association South Africa unveiled a code of conduct, agreed to by all major consumer lending banks, setting out a standard to which banks undertake to adhere with respect to lending practices. 2008 Implementation by the Bank of Phase 1 of the Integrated Cash Management System (ICMS) was launched, to improve the efficiency; also, all South African banks started operating under Basel II. Source: Adapted from Kasekende, Mlambo, Murinde and Zhao (2009).
Figure 1 highlights the relationship between bank competitiveness and the growth of private credit by banks (to GDP) during the reform period in South Africa. This evidence suggests that not only have the banks become increasing competitive during the reform period but also the increase in competitiveness is matched by the ability of the banks to extend credit to the private sector (in the flow of funds sense, households and companies), especially during 2002-2007. In contrast to the gradualist approach to banking reform in South Africa, Nigeria adopted a „big bang‟ type of banking sector reform, aimed at enhancing the competitiveness of banks.11 Specifically, the latest reforms introduced in July 2004 were characterized by raising the minimum capitalization for banks to N25billion by December 2005; phased withdrawal of public funds from banks, with effect from July 2004; and consolidation of banking institutions through mergers and acquisitions. 10
See Mboweni (2004). According to the Central Bank of Nigeria (2008), the main objectives of the reforms include: the removal of controls on interest rates to increase the level of savings and improve allocative efficiency; elimination of nonprice rationing of credit to reduce misdirected credit and increase competition; adoption of indirect monetary management; enhancing of institutional structure and supervision; strengthening the money and capital markets; and improving the linkages between formal and informal financial sectors. 11
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Figure 1: Bank competitiveness and performance in South Africa, 1993-2007
Figure 2: Bank competitiveness and performance in Nigeria, 1993-2007
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Bank regulation in Nigeria was revamped by adoption of a risk focused and rule based regulatory framework; introduction of electronic Financial Analysis and Surveillance System for banks; the establishment of the Financial Intelligence Unit and the enforcement of the anti – money laundering and other economic crime measures; and strict enforcement of the contingency planning framework for systemic banking distress. The reforms also emphasized the liability of the Board regarding failed banks. Figure 2 shows the relationship between bank competitiveness and the growth of private credit by banks (to GDP) in Nigeria during 1993-2007; including the period 20052007, which captures the „big bang‟ period. This evidence suggests that banks have become increasing competitive; also, the increase in competitiveness is matched by the ability of the banks to extend credit to households and companies, especially during „big bang‟. Figure 3: Bank competitiveness and performance in Egypt, 1993-2007
In contrast to South Africa and Nigeria, the Egyptian banking industry is among the oldest in Africa. Banking reform started in the early 1970s but the first stage of the modern reforms occurred in 1990-1996 and was aimed at full liberalisation. Anecdotal evidence suggests that the sector has been revived by the reforms. It appears Egypt has escaped successfully the direct contagion effects of the crisis (IMF, 2008). This view is consistent with the evidence in Figure 3, which highlights the relationship between bank competitiveness and the growth of private credit by banks during the reform period. However, it is shown in Figure 3 that although the relationship between bank competitiveness and the growth of private credit by banks (to GDP) in Egypt is generally positive and increasing, there has been a slow down in this relationship between the two variables since 2001. This is a matter of degree; the general evidence is, during the reform period in Egypt banks have become increasing competitive and banks have enhanced their intermediation role to the private sector.
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Figure 4: Bank competitiveness and performance in Algeria, 1993-2007
Among the SANE, Algeria is a special case. Before 1980, the country pursued inward strategies, which emphasized state ownership of banks and control of the financial services sector. The banking system was segmented, with little competition. Bond and equity markets were virtually non-existent, due to the predominant role of state ownership, and lack of legal basis for capital market activity. The initial round of banking sector reforms covered the period 1986-1996 and had five elements. First, the initial steps in the reform of the financial sector in Algeria involved raising interest rates, in order to achieve positive real interest rates, and by 1990 deposit interest rates were fully liberalized. The ceilings on lending rates were lifted and limits on banking spreads were abolished in December 1995. The second element was to relax the policy of directed credit. This was initiated in 1987 and by 1994 banks were operating on the basis of market-based credit allocations to firms and households. The third element involved prudential regulation and banking supervision in 1997. New banking laws were introduced, which emphasized liberalization and deregulation of financial activities. By 1999, all banks were aiming to meet the risk weighed capital adequacy ratios recommended by the Basle committee. The fourth element was to enhance competition among banks. The key measures included opening the sector to foreign bank entry, allowing banks to pursue market-based lending decisions, and creating opportunities for many types of financial intermediaries. The fifth element was capital account liberalization. In April 1994, foreign exchange controls were removed and foreign investors were allowed to repatriate earnings. Figure 4 highlights the relationship between bank competitiveness and the growth of private credit by banks (to GDP) during 1993-2007 in Algeria. This evidence suggests that it was after stage 3 of the reforms, specifically after 1998, that there was an increase in bank competitiveness matched by the ability of the banks to extend credit to the private sector, hence bank competitiveness and financial intermediation to households and companies increased steadily during 1998-2007. In general, the main banks in Algeria exhibited stable performance during 2005-2007 (see also Table 2). Table 2 presents some key bank performance indicators for selected African economies, for 2000 and 2007. The indicators include the intermediation role of banks 11
(specifically, the ratio of deposit money bank asset to GDP; the ratio of private credit by deposit money banks to GDP; the ratio of bank deposit to GDP; the ratio of bank credit to bank deposit); profitability indicators (for example, net interest margin); bank cost indicators (specifically, the bank cost to income ratio); and the bank market structure indicator (bank Zscore). A sample of 22 African countries is presented, alongside emerging economies Brazil, Russia, India and China (BRIC). There are three main observations from Table 2. First, the data suggest that almost all banks have achieved improved performance between 2000 and 2007; bank costs have also been stable. Second, the big performers were South Africa, Nigeria, Egypt and Algeria; however, these SANE economies fall way behind the performance achieved by the BRICS between 2000 and 2007, hence the main African dynamos have some way to go in terms of other emerging economies. Three, in the light of the above two observations, the sample of 22 African countries will have to undertake further reforms to boost their performance indicators (compare the BRIC), especially in two main reform areas: reducing state ownership of banks; and allowing free entry and exit of foreign banks. In the current global financial crisis, given the bail out packages in UK and US which have involved bank nationalisation and where foreign banks may be perceived to pose a threat of capital outflows, it is important to emphasize that banking reform must not be myopic; it must look beyond the crisis into the post-crisis period where private sector bank ownership, foreign bank entry and bank competitive environment are critical. 4.2 Impact of the financial crisis on Africa’s banking system The above review has given a positive picture of banking sector reforms and the degree of competitiveness in the reforming economies. In addition, African banking assets represent only 0.87% of global banking assets, compared to 58.15% for the 15 countries of the Euro zone and 15.09% for the United States. Africa‟s financial globalization ratio is comparable to Latin America‟s, at 181.3% and 176.4%, respectively, far behind that of Asia at 369.8% and Japan at 495.7% (ADB, 2009). Moreover, few banks in Africa are exposed to off-balance transactions such as securitisation and use of the derivative market (see Figure 5), they are mainly involved in financial intermediation. Also, for some African countries, borrowing from foreign banks is regulated in the context of exchange control regulations such that, in a flow of funds sense, domestic companies can only borrow from the rest of the world by using central bank or government guarantees. Perhaps, altogether these factors explain why Africa has escaped both the sub-prime and banking crises, and specifically why no African government announced a bank rescue plan at the scale observed in the UK and USA. However, there is no room for complacency. Most African economies feature a high degree of foreign bank presence; for example, foreign bank penetration measured by either bank assets or the number of banks is close or equal to 100% in some countries such as Malawi, Mozambique, Swaziland and Madagascar. Hence, it is possible that African banks may be exposed to contagion effects of the financial crisis. However, the flip side of this argument is that if the OECD governments are successful in their bail out plans and averting bank failure of the parent international banks (say, the headquarters in France, Portugal and the United Kingdom), they will have averted the possible failure of the African subsidiaries of these multinational banks. In fact, ADB (2009) argues that the financial meltdown suffered by the parent banks following market capitalization losses was not passed down to their African subsidiaries; rather, some subsidiaries of foreign banks saw a considerable increase in their market capitalization. For example, Swaziland Nedbank, Bank of Africa Benin and Standard Bank of Ghana saw their market capitalization increase between July 2007 and January 2009. Hence, this process has insulated foreign banks operating in Africa from the contagion effects of the financial crisis.
12
Table 2: Bank Performance Indicators for a Sample of African and BRIC Countries Country
Year
dbagdp
Pcrdbgdp
Bdgdp
Bcbd
netintmargin
costinc
zscore
AFRICA Angola 2000 0.01298 0.0113999 0.082887 0.1410684 0.0437426 0.7846 5.385901 Angola 2007 0.1141063 0.0828738 0.1456175 0.6248416 0.0547031 0.4863556 7.409111 Benin 2000 0.1218932 0.1063761 0.1455027 0.7264593 0.0479745 0.7703 7.530338 Benin 2007 0.1767576 0.1637028 0.1928785 0.8255712 0.0390577 0.705475 4.465053 Burkina Faso 2000 0.122437 0.109548 0.1258856 0.885376 0.0530599 0.6906286 4.052681 Burkina Faso 2007 0.1683231 0.1582123 0.1504847 0.9754043 0.056925 1.006217 2.779791 Botswana 2000 0.1582594 0.1402339 0.2394466 0.6466576 0.0816649 0.43954 12.76055 Botswana 2007 0.1983263 0.1925557 0.3895829 0.4843341 0.0524949 0.5325167 13.584 Cameroon 2000 0.1137317 0.0771629 0.1006199 0.7384505 0.0491915 0.42004 1.791221 Cameroon 2007 0.1104576 0.0889258 0.1456715 0.5951371 0.041173 0.4436 3.846551 Algeria 2000 0.3309422 0.0500784 0.2631202 0.2088989 0.0369428 0.5061333 9.557741 Algeria 2007 0.327131 0.1178534 0.4484411 0.2571101 0.06416 0.4581333 8.249224 Egypt 2000 0.7428216 0.4955837 0.6114211 0.8025357 0.0219243 0.4791893 7.872111 Egypt 2007 0.6885228 0.4389142 0.7752722 0.5471236 0.0206347 0.5334111 4.899436 Ghana 2000 0.244856 0.1167303 0.1428723 0.8427166 0.087346 0.6888889 3.858951 Kenya 2000 0.3372778 0.2558717 0.2928965 0.8650879 0.0758007 0.7491956 6.988771 Kenya 2007 0.3223618 0.2244224 0.3128144 0.7089255 0.065178 0.560025 6.156907 Morocco 2000 0.7066067 0.5416967 0.6264918 0.8571895 0.0408469 0.69885 7.48143 Morocco 2007 0.731382 0.6090647 0.7846684 0.809469 0.0314722 0.4827833 6.561341 Mozambique 2000 0.1972999 0.1783876 0.2357677 0.7171342 0.0826016 1.051 1.175422 Mozambique 2007 0.0002114 0.0001282 0.0002475 0.5005448 0.0977826 0.6429667 4.380046 Mauritius 2000 0.6838309 0.5419438 0.7044449 0.7788234 0.0279372 0.3725667 9.722991 Mauritius 2007 0.9465921 0.7161064 0.8871614 0.8193374 0.0220821 0.6000454 6.44448 Malawi 2000 0.0763176 0.0451167 0.1143308 0.40474 0.1214193 0.47618 5.183635 Malawi 2007 0.100141 0.0624729 0.113856 0.5207077 0.0952016 0.5550667 5.925068 Nigeria 2000 0.1551337 0.1041598 0.1264484 0.7808462 0.0845289 0.6153314 3.633079 Nigeria 2007 0.2386036 0.172558 0.1657761 1.175071 0.0543548 0.5475909 11.64483 Rwanda 2000 0.1028799 0.0913224 0.1159588 0.7859192 0.107591 0.6832 9.461133 Rwanda 2007 0.1296608 0.1100322 0.1464657 0.7738923 0.0689108 0.931425 4.56443 Senegal 2000 0.1956 0.1649412 0.1721116 1.004019 0.058269 0.6204833 6.77494 Senegal 2007 0.2413289 0.2076516 0.2470955 0.8244229 0.0386019 1.17785 1.439283 Tunisia 2000 0.5783143 0.5314924 0.4377977 1.259408 0.0326926 0.56734 18.64342 Tunisia 2007 0.6413144 0.5812688 0.4987795 1.146801 0.0330126 0.47609 6.388167 Tanzania 2000 0.0960507 0.044316 0.1280288 0.3315123 0.0784708 0.7634727 3.821567 Tanzania 2007 0.1833186 0.1205845 0.2082987 0.6183706 0.0648704 0.78275 6.808274 Uganda 2000 0.0970715 0.0522789 0.1068569 0.4633085 0.1209824 0.6359769 2.51927 Uganda 2007 0.157474 0.0743961 0.1561529 0.4940975 0.1154707 0.534275 8.357153 South Africa 2000 0.7066234 0.6499596 0.5014361 1.341861 0.046853 0.5793445 9.48406 South Africa 2007 0.8351861 0.7712374 0.6140785 1.261763 0.0721148 0.5523692 5.011918 Zambia 2000 0.12399 0.0671758 0.1634462 0.3888591 0.1202521 0.6883429 6.583335 Zambia 2007 0.1635806 0.1011529 0.1811648 0.5962471 0.091132 0.5401 6.643523 BRIC Brazil 2000 0.6292732 0.2954858 0.4049746 0.7152506 0.1049917 0.8161351 4.19121 Brazil 2007 0.7790918 0.3792121 0.5607813 0.7207646 0.1414659 0.6930909 6.256958 Russia 2000 0.1845852 0.1085859 0.1251994 0.855553 0.0748435 0.8533985 1.910591 Russia 2007 0.3493831 0.3164034 0.2703327 1.195574 0.0599211 0.663348 6.623487 India 2000 0.4113836 0.265622 0.4259725 0.6295348 0.0320951 0.5997281 6.137282 India 2007 0.610773 0.4340944 0.5759916 0.7446511 0.0277039 0.4773531 8.789032 China 2000 n/a n/a n/a n/a 0.0205353 0.6827455 13.73566 China 2007 n/a n/a n/a n/a 0.0255946 0.3974812 15.66249 Key: dbagdp = Deposit Money Bank Asset to GDP ratio; pcrdbgdp =Private Credit by Deposit Money Banks to GDP ratio; bdgdp =Bank Deposit to GDP ratio; bcbd = Bank Credit to Bank Deposit ratio; netintmargin = Net Interest Margin; costinc = Bank Cost to Income Ratio; zscore = Bank Z-Score. Source: Adapted from Beck, Dermiguc-Kunt and Levine (2009).
13
14
4.3
Capital markets
4.3.1 Why the structure of the capital market is important In the context of the global financial crisis, we discuss the capital markets in Africa in relation to the structure of the three components of the global capital market, as shown in Figure 5. The first is the primary capital market, for new capital issues by firms and other institutions, including governments. The second is the secondary market, for the exchange of existing securities. The third is the derivative market, which serves the trading of securities created by the exchange and whose value is derived from the underlying securities. Hence, it may be argued that, by functional classification, capital markets play three main roles. First, long term funds can be raised by companies and governments from economic agents who have funds to invest, such as financial institutions and private investors; capital markets act as primary markets for new issues of equity and debt. Second, capital markets provide a ready means for investors to sell shares and bonds they own, or to buy additional ones to increase their portfolios; in terms of this role, the markets act as secondary markets for trading existing securities. Third, the markets provide mechanisms for trading future and contingent claims, based on the values of the underlying assets; hence the derivatives market, which is implicated in the current financial crisis but is not dominant in African markets. An important part of the structure in Figure 5 is the complementarity between stock markets and financial institutions. Recent evidence suggests that the existence of an active stock market increases the debt capacity of firms; in this context, stock markets and financial intermediaries are complementary such that an active stock market results in increased volumes of business for financial intermediaries (Green, Kirkpatrick and Murinde, 2005a, 2005b). Specifically, initial improvements in the functioning of a developing stock market produce a higher debt-equity ratio for firms and thus create more business for banks (Prasad, Green and Murinde, 2005; Green, Maggioni and Murinde, 2000, and Murinde, 2009). Overall, theory and evidence suggest that a well regulated and properly functioning capital market plays many roles and offers many benefits. Capital markets allow the efficient transfer of funds between borrowers and lenders. Households and investors who are short of funds to take up profitable investment opportunities that yield rates of return higher than the market are able to borrow funds and invest more than they would have done without capital markets. Consequently, all borrowers and lenders are better off than they would have been without capital markets. In addition, market determined stock prices and yields provide a benchmark against which the cost of capital for and returns on investment projects can be judged, even if such projects are not in fact financed through the stock markets. As stock markets are forward looking, they also provide a unique record of the shifts in investors‟ views about the future prospects of companies as well as the economy. In many respects, therefore, a capital market is a vast information exchange, which efficiently reduces transaction costs (Green, Maggioni and Murinde, 2000). However, to play the above roles and attain these ideals, a capital market needs to be effectively organised and operated, with a continuous flow of orders around the equilibrium prices. Few of the capital markets in Africa live up to this ideal. Many are characterised by intermittent trading of relatively few stocks, often held by a relatively small group of investors; thin markets are characterised by imperfections and asymmetric information and hence they cannot adequately perform their information processing and signalling functions. They may be excessively volatile; and at the extreme, are vulnerable to price manipulation by a small group of insiders. Indeed, there is abundant evidence that stock markets are inefficient in certain key respects and may be subject to “excess volatility” and to speculative “bubbles”.
15
Table 3: Capital Market Indicators and Capital Flows for a Sample of African and BRIC Countries Country Year Inslife Insnonlife stmktcap stvaltraded stturnover Listco
Intldebt
intldebtnet
nrbloan
offdep
remit
0.0027696
0.2443523
0.004209
0.0150792
0.2821469
0.0099178
0.001008
0.0712865
0.3177874
0.0285661
0.0431598
0.1043663
0.428921
0.0457862
0.0505459
0.241105
0.2514963
0.0064289
0.140232
0.135099
0.0069037
0.0847231
0.4234449
0.0426768
0.0450542
0.4392721
0.044055
0.0123757
0.1710646
0.2390833
0.0583129
0.0126336
0.0699022
0.2409376
0.0777887
AFRICA 2000
0.1654462
0.0076604
0.0463017
0.0095919
0.4191545
0.009344
0.0222926
16
Botswana 2007 2000
0.001761
0.004102
0.3107006
0.1113799
0.3584799
2007
0.0040283
0.004481
0.912432
0.4143859
0.4541553
2000
0.1442233
0.0020313
0.0140846
2007
0.1861185
0.0071444
0.0383862
1076
Egypt
22
Ghana
2000
0.007137
0.019069
0.1067166
0.0037362
0.0350109
2007
0.0077605
0.016707
0.4223444
0.0446524
0.1057251
2000
0.008419
0.020514
0.3719554
0.03281
0.0882095
2007
0.0097714
0.019611
0.8553718
0.3585976
0.4192301
2000
0.02318
0.016452
0.3353287
0.0168795
0.0503372
2007
0.7306699
0.0579915
0.0793676
2000
0.0782934
0.0057151
0.0729957
0.0308036
0.0623133
57
Kenya
53
Morocco
40
0.0171691
0.0335621
0.3206492
0.7928312
0.0396033
0.0769247
0.0430615
1.491616
4.742743
0.0337891
0.0448868
0.0317885
0.2246169
0.0302673
0.0015663
0.0345575
0.3000074
0.0200899
0.1580763
0.2055092
0.0409396
0.1092757
0.3267269
0.0476586
Mauritius
195
Nigeria 2007
0.0007665
0.0041463
0.3593745
0.1012384
0.2817071
2000
0.001349
0.015099
0.1431607
0.0321808
0.2247879
2007
0.0020845
0.0177328
0.1408193
0.0186265
0.1322728
44
0.0804569
Tunisia 0.1054445
16
0.0023659
Table 3: Capital Market Indicators and Capital Flows for a Sample of African and BRIC Countries (concluded) Country
year
inslife
Insnonlife
stmktcap
stvaltraded
stturnover
Listco
Intldebt
intldebtnet
0.1300224
0.0003429
0.0883687
nrbloan
offdep
remit
0.098333
0.1086883
0.0025587
0.0015097
0.0613803
0.0608802
0.0033347
0.1115085
-0.000027
0.1419043
0.1409198
0.0049094
0.0870442
0.0084554
0.0908406
0.2428689
0.0031761
0.0423781
0.076014
0.0280107
BRIC 2000
0.00356
0.017312
0.3545794
0.1571543
0.4432132
2007
0.0139137
0.0156
0.7934616
0.4451107
0.5609733
0.2163808
0.0782114
0.3614528
459
Brazil
2000
249
Russia 2007
0.0006762
0.0224421
0.9962026
0.5844539
0.5866818
2000
0.016645
0.005154
0.3644097
1.107817
3.040033
2007
0.0402505
0.0061855
1.127215
0.9458412
0.8390953
2000
0.009705
0.0082
0.3810258
0.6020443
1.580062
1.318386
2.375481
1.80181
5937
0.010101
India
1086
0.0244795
0.0028686
0.063276
0.0489135
0.0230578
0.0146502
0.0006692
0.048074
0.1335671
0.00521
0.0104359
0.0003713
0.0354735
0.1140292
0.0078362
China 2007
Source: Selected and adapted from Beck, Dermiguc-Kunt and Levine (2009). Notes: inslife = Life Insurance Premium Volume to GDP; insnonlife = Non-Life Insurance Premium Volume to GDP; stmktcap = stock market capitalization to GDP; stvaltraded = stock market total value traded to GDP; stturnover = stock market turnover ratio; listco_emdb = number of listed companies (EMDB); prbond = private bond market capitalization / GDP; pubond = public bond market capitalization to GDP; intldebt = international debt issues to GDP; intldebtnet= loans from non-resident banks (net) to GDP; nrbloan = loans from non-resident banks (amt outstanding) to GDP; offdep = offshore bank deposits to domestic bank deposits; remit = remittance inflows to GDP.
17
4.3.2 The Capital Markets in Africa: financial reforms and current status There are 23 capital markets in 20 African countries.12 The development of stock markets in Africa tends to show an evolutionary process with various stages characterized by type of regulatory system, trading method and the scope for market participation. In general, most of the main markets in Africa started with no formally laid down rules and regulations; trading activities were based on interpersonal relationship. Formal markets were then established, driven either by the desire of traders to diversify sources of investment funds or by the need of governments to establish a formal market to float their debt stocks. Overall, during the last two decades, formalization and revitalization processes have brought about some necessary changes in the regulatory framework, trading system and composition of market investors. However, there is still a lot of scope for international capital market linkages in Africa. Table 3 presents the main capital market indicators for a sample of African economies, including the SANE, as well as the BRIC economies for 2000 and 2007. The capital market indicators include: stock market capitalization to GDP ratio; stock market total value traded to GDP ratio; stock market turnover ratio; number of listed companies; private bond market capitalization to GDP ratio; public bond market capitalization to GDP ratio; and international debt issues to GDP ratio. It is shown that almost all of the capital markets in Africa, except the Johannesburg Stock Exchange, which is by far the largest and most developed, are characterised by low levels of stock market capitalisation. However, between 2000 and 2007, some markets have exhibited some improvements; for example, Botswana and Kenya. Among the large SANE countries, there has been steady and positive increase in the ratio of stock market capitalisation to GDP in the period 2002-2007, as highlighted in Figure 6. In terms of the number of listed companies, it is shown that the number of companies listed on local stock exchanges in Africa was generally low, even among the SANE, compared to BRIC. In terms of liquidity of the markets, measured by the value traded to GDP, it is shown in Table 3 that the markets in Africa have low levels of liquidity; the exception is the Johannesburg stock exchange which has the highest levels of liquidity, which compares reasonably well with BRIC. However, for the sample of BRIC, it is shown in Figure 6 the trend is clear that liquidity has been steadily increasing since the early 1990s. To enhance their performance, most African countries have revitalised their capital markets by undertaking some key institutional reforms, namely revitalization of the regulatory framework, modernization of trading systems, and relaxation of restrictions on foreign investors. In terms of the reform of capital market regulation, most capital markets in Africa established or empowered existing market regulators during the revitalization process (e.g. NSE, BSE and ESE). The regulators were charged with the responsibility of facilitating the development of an orderly and efficient capital market.
12
These are: Algiers Stock Exchange (ALSE) in Algeria; Abidjan Stock Exchange (ABSE) in Cote d‟Ivoire; Nairobi Stock Exchange (NSE) in Kenya; Casablanca Stock Exchange (CSE) in Morocco; Tunis Stock Exchange (TSE) in Tunisia, Cairo and Alexandria stock exchanges in Egypt (ESE); Zimbabwe Stock Exchange (ZSE) in Zimbabwe; Nigeria Stock Exchange (NISE) in Nigeria; Stock Exchange of Mauritius (SEM) in Mauritius; Botswana Stock Exchange (BSE) in Botswana; Ghana Stock Exchange (GSE) in Ghana; Swaziland Stock Exchange (SSX) in Swaziland; Namibia Stock Exchange (NSX) in Namibia; Khartoum Stock Exchange (KSE) in Sudan; Lusaka Stock Exchange (LUSE) in Zambia; Malawi Stock Exchange (MSE) in Malawi; Dares-Salaam Stock Exchange (DSE) in Tanzania; Uganda Stock Exchange (USE) in Uganda; Maputo Stock Exchange (MPSE) in Mozambique; Johannesburg Securities Exchange (JSE) in South Africa. In addition, there is a regional market (BRVM) for eight countries. The regional market in West Africa, which dates back to 1973, has headquarters in Abidjan; the member countries are Benin, Burkina Faso, Cote d‟Ivoire, Guinea-Bissau, Mali, Niger, Senegal and Togo.
18
Figure 6: Stock market capitalisation to GDP in the SANE 3
SMC / GDP d
2.5 2 Egypt 1.5
Nigeria South Africa
1 0.5 0 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Year
Note: SMC = Stock Market Capitalisation
Figure 7: Stock market total value traded to GDP in the SANE 1.8 1.6
SMTV / GDP d
1.4 1.2 Egypt
1
Nigeria
0.8
South Africa
0.6 0.4 0.2 0
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Year
Note: SMTV = Stock Market Total Value Traded
19
To achieve this objective market authorities aimed to maintain surveillance over the security market, ensure fair and equitable dealings, undertake the licensing of members and protect investors against abuse of insider traders. In terms of the reform of the trading system, the initial informal trading forums shifted from coffee houses to the trading floor and screen trading. For example, NSE shifted to floor trading in 1991 phasing out the coffee house forum. The main objective of the reform has been to reduce the transaction period and increase market liquidity. In general, however, trading days and duration vary across the markets in Africa. The average trading period is two hours a day while the transaction period ranges from T+7 to T+3. Overall, however, the capital markets in Africa are faced with a lot of challenges, especially in terms of the question of free entry and free exit, although some markets have opened their doors to foreign participation in the brokerage activities, which were previously dominated by local participants.13 In addition, efforts have been made to reduce transaction costs including taxation of share trading earnings where for example, capital gain tax has been suspended. Relaxation of capital controls and participation of foreign investors in portfolio investment vary across the markets. However, some capital markets are still constrained by outdated practices, inefficient trading mechanisms, lack of skilled manpower, legal and regulatory framework and inadequate market information. Overall, therefore, as shown in Table 3 and Figures 7 and 7, positive gains have been recorded between 2000 and 2007 in terms of improvements in the key performance indicators, which may be attributed to the reforms, including adoption of advanced trading technology aimed to reduce transaction costs and settlement periods, strengthening of the regulatory system to reduce information asymmetry problem and protect the rights of investors, and relaxation of restrictions on foreign investors‟ participation in the market. 4.3.3 Other components of Africa’s financial system In a flow of funds context, there are important components of Africa‟s financial system apart from banks and capital markets. These include non-bank financial institutions especially insurance services, microfinance institutions which are specifically useful for reducing financial exclusion and increasing access to finance by small and medium enterprises and poor households. It is argued that the direct impact of the financial crisis to these components of Africa‟s financial system is rather minimal; however, the indirect effects of the crisis may be very damaging to this sector. The performance of the insurance sector is reported in Table 3 for a sample of African economies, in comparison with BRIC. Using two indicators (the ratio of life insurance premium volume to GDP; and the ratio of on-life insurance premium volume to GDP), it is shown that in the sample African economies the two indicators are below 10%, unlike the case in the BRIC. However, it is fair to say that some of the sample African economies, especially South Africa, Algeria, Nigeria and Egypt, are implementing reforms in the insurance services sector. In South Africa, the main reforms of the insurance services sector started with the introduction of industry codes of business conduct and ombudsmen procedures to address consumer complaints, in 1985 for life insurance and in 1989 for short term insurance. In 2001, the Friendly Societies Act was passed to allow societies to guarantee benefits the insured; and in 2007, underwritten policies of long-term insurers increased their foreign exposure from 15 to 20 percent. Further in 2008, terms and conditions of insurance instruments were modified.14 These reforms have greatly enhanced the performance of the 13
Evidence supports foreign bank entry in Africa (Murinde and Ryan, 2003; Lensink and Murinde, 2006b). For example, the maximum scales of commission for all insurer-provided savings contracts were modified to ensure: A maximum rate of commission of 5% of premium; no more than half of the commission may be paid up-front, subject to a minimum discount rate and a maximum discount term; and a special provision to cater for small and emerging intermediaries selling low premium business that the maximum proportion of up-front commission may be increased to more than half, subject to a maximum amount of R400. 14
20
insurance industry in South Africa, with spillover effects to Botswana, Namibia, Lesotho and Swaziland, who are synchronizing their insurance services provision with those of South Africa. For Nigeria, the main element of the insurance sector reforms was to increase the minimum paid-up capital of insurance and reinsurance companies. On September 2005, the new recapitalization of Insurance and reinsurance companies was announced to take effect from the 1st of September 2005 for new and intending companies and 28th of February 2007 for existing companies. The capitalization of insurance firms has enabled these firms to expand the range of investment related products offered to policy holders. The insurance market in Egypt was closed to foreign companies until May 1995. A new legislation in 1998 removed the 49% cap on foreign holdings for domestic insurers, abolished the nationality stipulation for executive management and allowed the privatisation of public-sector insurers. Some recent liberalisation of the sector has led to the entry of several major foreign insurance intermediaries. Table 12 confirms the improvement in the insurance sector due to an increase in the life and non-life insurance sectors as well as the premium from June 2006 to June 2008. However, the Egyptian insurance market remains small and underdeveloped due to excessive stamp duties and premium taxes, among other factors. In Algeria, the insurance sector reforms in Algeria involved three types of insurance activity, namely, direct insurance, specialized insurance and international reinsurance. The reforms allowed insurance companies to distribute their products through commercialization via the banks. In 1995, the government instituted a formal auction system through which insurance companies are able to sell and buy treasury bonds. The microfinance industry provides an important role in improving access to financial services in Africa. It is also an interesting sector in the sense that it appears to be insulated from contagion effects which banks and capital markets are exposed during a financial crisis. We highlight example from South Africa and Nigeria. The microfinance industry in South Africa is used to support the private sector strategy on SME development as well as the national poverty reduction strategy. In 2006 the South African Microfinance Apex Fund (SAMAF) was expand the scale of microfinanced services provision. In Nigeria, microfinance and SME activities during the reform period (post-20005) have largely reflected the rapid transformation of the financial services industry. The SME Equity Investment scheme was introduced in 2005 for the promotion of SMEs as vehicles for rapid industrialization, sustainable economic development, poverty alleviation and employment generation. In general, the financial reforms have enabled the microfinance sector to avail financial services to SMEs. 4.4
Impact of the financial crisis on African capital markets
In a flow of funds framework, the main impact of the current financial crisis on Africa‟s capital works through two main asset prices, namely stock prices for company shares as well as the general market index, and exchange rates for foreign exchange transactions. This observation is consistent with the historical experiences of the previous crises in Mexico, Asia and Russia, as reviewed earlier. We examine the impact of the financial crisis on selected African capital markets, namely Cote d‟Ivoire, Egypt, Kenya, Mauritius, Morocco, Nigeria, South Africa and Tunisia by calculating the change in the value of the respective stock market index between a benchmark period of 31 July 2008 and a cut-off period of 12 February 2009. We then compare the loss in the value of the index within that period for each of the sample African markets, compared to the BRIC capital markets on the one hand, and sample OECD markets for the UK, USA, France and Japan, on the other.
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Table 4: Impact of the crisis on selected African financial markets in an international context Losses Value, at end Benchmark during Country/Region Index name Index code week 31.07.2008 financial 12.02.2009 crisis (%) AFRICA Cote d'Ivoire
BRVM Composit Index
BRVM CI
242.54
169.34
-30.18
Egypt
CASE 30 Index
CASE 30
9251.19
3600.79
-61.08
KSE
4868.27
2855.87
-41.34
SEMDEX
1735.77
1005.69
-42.06
MASI
14134.70
10352.81
-26.76
NSE
52916.66
23814.46
-55.00
27552.65
20650.38
-25.05
Kenya Mauritius Morocco Nigeria
Kenya Stock Index Mauritius AllShares Casa All Share Index NSE All Share Index
South Africa
All Share Index
JALSH
Tunisia
Tunis se Tnse Index STK
TUNINDEX
3036.87
3049.60
0.42
Brazil
Bovespa Index
IBOVESPA
59505.00
41674.00
-29.97
Russia
RTS Index
RTSI
1966.68
624.21
-68.26
India
BSE SENSEX 30
BSESN
14355.75
9634.74
-32.89
China
Shanghai Composite
SHANGHAI COMPOSIT
2775.72
2320.79
-16.39
UK
FTSE Index
FTSE 100
5411.90
4189.60
-22.59
USA
Dow Jones Industrial
DJ Index
11378.02
7850.41
-31.00
France
CAC 40 Index
CAC40
4392.36
2997.86
-31.75
Japan
Nikkei 225 Index
N225
13376.81
7779.40
-41.84
BRIC
OECD
Source: Partly from African Development Bank (2009); updated as follows: UK: http://uk.finance.yahoo.com/q/hp?s=%5EFTSE [Accessed 23/03/2009]; Brazil: http://uk.finance.yahoo.com/q?s=^BVSP [Accessed 23/03/2009]; Russia: http://www.rts.ru/en/index/rtsi/ [Accessed 23/03/2009]; India: http://uk.finance.yahoo.com/q?s=^BSESN [Accessed 23/03/2009]; China: http://uk.finance.yahoo.com/q?s=000001.SS [Accessed 23/03/2009.]
The results reported in Table 4 are starting! The loss in the index value for each of the Egyptian market (CASE, -61.08%), the Nigerian market (NSE All Share Index, -55.0), and the Mauritius market (SEMDEX, -42.06), was higher than the loss in any the OECD market of UK, USA, Japan and Finance. Also, loss in index in each of the three African markets exceeded the loss of value in each of the BRIC, with the exception of Russia (-68.26%). These results are at variance with the view that African markets are insulated from the 22
contagion effects of financial crisis because seemingly they are not strongly integrated with world capital markets. On the contrary, the results in Table 4 drive home the message that the main African financial markets, which are relatively liquid compared to the rest in the continent, have been perversely affected by the financial crisis. In a flow of funds framework, the contagion effect may be attributable to the over-valuation of stocks and the outflow of portfolio investments by the household sector and the company sector. As noted in ADB (2009), African investors and Egyptian and Nigerian investors in particular, recorded within six months an average loss of more than half the wealth invested at the end of July 2008, which is higher than the losses recorded on the sample OECD markets in Table 4. The bond market in some Africa countries was also affected by the crisis because of the adverse changes in the spreads in the bond markets. For example, although Tunisia is the only market with positive value in Table 4, it felt the brunt of the crisis in its attempt to issue bonds on the international financial markets, where it was faced with debt spreads estimated at between 45 and 50 basis points, such that it had to increase its offer by 25 basis points to attract entice investors (ADB, 2009). Moreover, according to ADB (2009), the financial crisis amplified the increase in the margin applied to loans in the international financial markets. For Africa and other emerging economies, sovereign debt spreads rose by an average of 250 basis points, while the spread of the JPMorgan emerging countries equity index increased by 800 basis points in October 2008. At the height of bank rescues in the UK and US, the spreads increased by 100 basis points for Egypt and rapidly increased to above 200 basis points for Tunisia, subsequently forcing Kenya, Uganda and Tanzania to postpone plans for selling bonds on the international financial markets. These perverse effects of the financial crisis on Africa‟s financial system have grave implications for direct foreign investment and short term capital flows. For example, in the short term, FDI into Africa is expected to fall during 2009 and early 2010, which will further increase Africa‟s financial marginalization and undermine growth in foreign capital dependent sectors such as natural resources. In addition, remittances, which feed directly into rural credit markets, have fallen since 2007. 5.
Conclusion, Corrective Actions and Recommendations
5.1
Conclusion
The paper concludes with some thoughts on the implications of the financial crisis for Africa‟s financial system. The nature of the crisis is such that the vulnerability of Africa economies is non-uniform, although all economies seem to be currently characterised by distortions in external sector indicators. Even for South Africa and Nigeria, which have implemented financial sector reforms and have displayed evidence of bank competitive, it has been argued that these have been hit by the global financial crisis through their financial links with other world regions, according to IMF (2009, p.3). It is shown that these two economies have suffered from considerable pressure on exchange rates, decline in capital flows, fall in equity markets, and scarcity of foreign finance for companies and banks. Some „fragile‟ countries such as Sierra-Leone, Burundi, Guinea-Bissau, and Liberia are fond vulnerable due to their heavy dependence on concessionary financing. The African Development Bank (2009) has found these impacts limited because of the underdevelopment of the financial markets in many African countries in one hand, and the tight regulation of the foreign borrowing in the context of exchange control in the other. Furthermore, the increase in the sovereign debt spreads have obliged several countries to postpone their recourse to the international financial markets and rather turned to local markets to finance their resource need. Hence, it must be noted that the current eminent threat to the financial services sector
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in African is the global financial crisis, especially because banks and capital markets are vulnerable due to globalisation and contagion effects. However, the message from this paper is that African economies which have undertaken key financial reforms and have competitive banking sectors are likely to recover from the crisis much faster than those countries which are not, hence the immediate policy action lies in strengthening domestic banks and consolidation regional financial networks, which will requires not only changes in legal infrastructure and trading of currencies but more importantly the political will to survive the global financial crisis. 15 In the meantime, African governments need to consider some corrective actions, and put in place an agenda for immediate as well as short run actions. 5.2
Corrective actions for Africa’s financial system
We consider what must be done now during the financial crisis and thereafter as African countries come out of the crisis. We take into account the corrective actions already in force in OECD countries; we then put forward proposals for corrective actions in Africa. These proposals need to be developed further in order to render them operational, which is the next stage after the initial debate in this paper. International bodies such as the Financial Stability Forum and the Basel Committee on Banking Supervision are working hard to find solutions towards reverting to a stable financial environment and for the credit markets to resume lending. These bodies are focusing on “improving the existing regulatory and supervisory approaches. The idea is to refine and strengthen further liquidity and capital adequacy regulations, thereby adjusting them to new products and developments in the financial system.” (Hildebrand, 2008:318). However, for Africa‟s financial system, the current regulation which is already exceptionally complicated; for example, the revisions in Basle II have not adequately addressed the relevance of the regulatory instruments of banks in Africa. Rather, the focus should be on risk management kits which are tailored to the financial services provided by banks in Africa. National governments, especially the US and UK are also looking for remedies. The corrective action undertaken by the US monetary authority has taken the form of a crisis management strategy, according to Goldstein (2008), which has five elements. First, to invoke macroeconomic stimulus to cushion the real economy and strengthen the financial sector. Second, to implement large-scaled liquidity injections by central banks, in order to minimise panic selling and contagion effects such that liquidity problems do not aggravate solvency problems. For example, a bail-out programme as passed by the United States Congress in 2008 has the potential to provide market liquidity: “The U.S Treasury will create a market, and therefore a market price, through its Troubled Assets Relief Program.” (Allen, 2008:11). This is comparable to the measures undertaken in the UK in the case of Northern Rock in early 2007, where the Bank of England‟s Financial Stability Report for April 2007 identified the increasing wholesale funding of banks as a potential risk if markets became less liquid. It is to be noted that in the previous financial crises, emergency IMF bailout packages were given to Mexico, Argentina and East Asia, as shown in Radelet et al (1998:70). Third, by attracting capital injections into the weak financial institutions and by increasing transparency and disclosure, in order to repair the damage caused to financial systems. The idea is to prevent contractions of balance sheets in weak financial institutions. Fourth, the housing sector has been targeted for assistance, so that the size and scope of the problem of foreclosure is reduced and hence reduce the downward pressure on housing 15
It may be argued that more competiiton may further excebate banks risk taking incentives. However, both the theoretical and empircal literature suggest that competition is a strong stimulas for an efficient financial system and in the case where liberalization and competition have resulted in fragility, this has been mostly the consequence of regulatory and supervisory failures (Beck, 2008).
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prices. Fifth, introduction of regulatory tolerance in order to reduce capital requirements and increasing lending operations, this aims to provide liquidity and support to the weak mortgage market and other sectors. African governments need to work out a contingent plan for banks that are rendered fragile by the crisis, because the banks and capital markets in Africa are still exposed to the contagion effects of the financial crisis, judging by the two main financial prices that provide the propagation mechanism of the contagion, namely exchange rates and stock prices (see Table 4). But, because of the large size of bank assets relative to GDP in each African country (see Table 2), the contingent plan for fragile banks must be co-ordinated at a regional level through the existing regional networks to ensure that bail out plans are not restricted to cash injections or loans but also to such actions as management-buy-in-management-buy-out (MBIMBO), and mergers and acquisitions (M&A). Hence, for Africa the corrective actions, for banks which are rendered fragile by the crisis, have also to be collective. Meanwhile, in OECD countries, debates on the choice of appropriate policy instruments continue, among researchers and policy makers. For example, deposit insurance has always been debatable (see Okeahalam, 2003). However, at the moment proponents of deposit insurance are advocating for its use by national governments, at least during the recovery stages as banks resume full credit operations. It is argued that deposit insurance is needed because it is impossible to avoid the obligation to protect depositors. A scheme of deposit insurance is beneficial if it can clearly state who is protected and to what extent they are protected. In practise, this scheme should protect depositors 100 percent up to a limit of US$30,000. The case for deposit insurance in Africa‟s financial system during and after the financial crisis is equally compelling in order to safeguard the “sanctity” of financial intermediation and provide a safety net for the household sector. Moreover, policy makers in Africa should also watch the business cycles; the business cycle argument is that these crises come and go, such that we should learn to adjust our expectations. Looking back over the last four crises reviewed, it is argued that although it has been necessary always to quickly implement remedial policy measures, it is important to note that each crisis seems to have exhibited some “self-correction” mechanism; when the crisis abates globally, Africa‟s financial system should also recover, and that‟s why the corrective actions in Africa must take into consideration the global corrective actions. Finally, in Section 3.2 of this paper we highlight the implications of the financial crisis for banks, companies, investors and governments. The relevant point here is that for Africa‟s financial system, it is important for governments to beware of the excessive market risks arising from system disorders. An orderly market is only based on the rule of law and regulation, free of corruption and political risk; a challenge that African governments must address at this crucial hour. But also, governments have role in the context of the dictum by Adam Smith (cited in the preamble of this paper): once banks and capital markets choose to ignore the regulatory constraints and the rule of law, in order to freely indulge in actions of excessive pursuit of profit and blind competition, the market slides into disorder, which aggravates the financial crisis. 5.3
Recommendations for Africa’s financial system
The above corrective actions for Africa cover three main areas: regulation and supervision of financial institutions and markets; bail out packages to rescue banks when they are rendered fragile by the crisis; and government policy instruments. Below, we highlight the main recommendations for Africa‟s financial system during the crisis (immediate and short run actions) and in the post-crisis period (medium term actions).
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The immediate and short run actions are:
Move swiftly to establish African regional or pan-African networks of national finance ministers and central banker governors. The remit of these networks is troubleshoot banks which are rendered fragile by the crisis, in order to generate resolution mechanisms for impaired assets and liabilities of these banks. The regional or pan-African effort is emphasized in order to enable small African states to leverage on the large countries (for example, our earlier discussion of the dynamo role of the SANE on the continent). Watch daily movements of the main financial prices that provide the propagation mechanism for contagion effects, namely exchange rates and stock prices. A simple early warning model is useful for this purpose, such that when trigger threshold points in exchange rate movements and stock price movements are hit, the authorities spring into action. It is necessary to mobilise adequate financial resources to ensure confidence in the foreign exchange market as well as stock market (e.g. for vulnerable companies). Specifically with respect to banks that may be rendered fragile by the crisis, mobilize timely liquidity of sufficient magnitude to restore market confidence, especially to enable banks resume lending such that companies can access working capital finance and households can access consumer credit. How can African governments raise these funds very quickly? Floating government bonds on local or regional capital markets? The role of regional development banks, specifically the African Development Bank? African governments must pull together and form an important part of the international partnerships involved in ongoing initiatives for reconstructing the new international financial architecture. There is no “one-size-fits-all” prescription, so it is important to monitor the trend of the financial crisis as well as developments in banks and capital markets, in order to adjust these immediate measures. The medium term actions are:
Aggressively regulate and supervise financial systems to ensure that banks manage risks prudently; to ensure there is accountability, transparency and responsibility in banking operations. The African regional networks should aim to improve the existing regulatory and supervisory approaches in order to refine and strengthen further liquidity and capital adequacy regulations, thereby adjusting them to new products and developments in the financial system in Africa. The idea is that African central bankers and regulators must now concentrate continental or regional efforts in view of the ongoing work on the global framework. Related to the above, strengthen the legal infrastructure to guarantee the security of ownership of assets (the security of ownership of securities) in Africa. Financial securities are by design legally binding instruments, companies are legally corporate bodies and governments issuing bonds because they are legally binding. To what extent do the country-specific legal infrastructures in Africa safeguard property rights, rights of appeal and arbitration in financial transactions? This nexus between law and finance poses a serious challenge to capital market development in Africa, given the history of abuse of these rights. Undertake financial reforms to Improve bank competitiveness as well as to enhance mechanisms for crisis prevention, management and resolution at the regional or continental level. Fortunately, advances in research has made it possible to generate metrics for monitoring bank competitiveness at bank level, industry or country level, per year (see, for example, Kasekende, Mlambo, Murinde and Zhao, 2009). 26
Erect an incentive structure for sound corporate finance to avoid high leverage ratios and excessive reliance on foreign borrowing (Prasad, Green and Murinde, 2008, on corporate tax measures). Revamp deposit insurance provision in Africa. Deposit insurance is needed because it is impossible to avoid the obligation to protect depositors. A scheme of deposit insurance is beneficial is it can clearly state who is protected and to what extent they are protected. In practise, this scheme should protect depositors 100 percent up to a limit of US$30,000. This would protect up to 90 percent of depositors in Africa. Continue to develop strategies to enhance the complementarity and substitutability between the financial intermediaries and capital markets in Africa. For example, to monitor and promote the extent to which the capital markets are able to meet initial capital as well as additional capital required by listed firms, especially in the form of initial public offerings (IPOs) and venture capital. The new financial architecture in African economies must seek to develop and formalize the role of microfinance institutions and rural financial markets, because these are capable of offering more outreach than commercial banks and capital markets. This requires developing legal frameworks for the financial transactions in these institutions and markets. Develop clear guidelines regarding the use of derivative market, which serves the trading of securities created by the exchange and whose value is derived from the underlying securities (i.e. the third component of the structure of capital markets in Figure 5). South Africa is already advanced in this area and should offer lessons for the rest of the continent.
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