Which policies can reduce the cost of capital in Southern Africa? OECD Development Centre Seminar: "Cheaper Mo

1. Which policies can reduce the cost of capital in Southern Africa? OECD Development Centre Seminar: "Cheaper Money for Southern Africa - Unlocking Growth" 7 October 2004, Paris Martin Grandes (American University of Paris and OECD Development Centre, Paris) Nicolas Pinaud (OECD Development Centre, Paris)

2. This presentation: • Aim and scope: - What policies can reduce the cost of capital in Southern Africa, whereby promoting investment and growth in the region? Focus: local-currency denominated capital costs - Focus on CMA countries (Namibia, Swaziland, Lesotho, SA) + Botswana: 1992-2004 • Policy relevance Post-Monterrey agenda, NEPAD Capital Flows Initiative (CFI), NEPAD-OECD Africa Investment Initiative, OECD Development Centre-sponsored meeting in Johannesburg (March 2004) • Policy recommendations - Why is the real cost of capital relatively high in CMA countries? - What can be done about it?

3. Why a lower cost of capital is key to boosting investment and growth in less developed countries? • What is the cost of capital for a company? Two pivotal concepts: 1) WACC = weighted average cost of capital (debt or equity) = cost of the debt/equity blend raised by the company

4. Why a lower cost of capital is key to boosting investment and growth in less developed countries? • More specifically, what is the cost of capital for an emerging country’s company? Debt Cost

5. Why a lower cost of capital is key to boosting investment and growth in less developed countries? • More specifically, what is the cost of capital for an emerging country’s company? Equity Cost

6. Why a lower cost of capital is key to boosting investment and growth in less developed countries? • What is the cost of capital for a company? Two pivotal concepts: • 2) The hurdle rate • EVA = Return on investment – WACC (cost of capital) • (EVA: Economic value-added) • Hurdle rate = breakeven rate: EVA = 0 • The higher the EVA, the more incentive for investment • Increase the returns on investment or... • Lower the hurdle rate, i.e. the WACC • - Bring the total risk premium down or… • - Await a US monetary loosening cycle

7. Financing costs: Where do CMA Countries Stand? • South African rates set the floor and the tune for CMA countries’ interest rates • CMA a hybrid between monetary union and currency board (PB p.9) • Consider, for instance the cost of debt for a CMA country • Interest rates or bond yields in CMA should converge, unless there is a significant country premium….

8. Why is the real cost of capital relatively high in CMA countries?

9. Why is the real cost of capital relatively high in CMA countries? • South African rates set the floor and the tune for CMA countries’ interest rates • CMA countries’ interest rates are high compared with in OECD countries

10. Why is the real cost of capital relatively high in CMA countries? • South African rates set the floor and the tune for CMA countries’ interest rates • CMA countries’ interest rates are high compared with in OECD countries • Why? Because so are South African financing costs! • Equity costs for an ungeared South African company: - About 15%: South African RFR: 10% (incl. Intern. RFR 4%) Equity risk premium (ERP) of 5% - By comparison, US: 8% = RFR of 4% + ERP of 4% • Debt costs: Rand currency debt costs for companies are even higher because of little appetite of South African investors for bonds… • High debt and equity costs → high WACC → low investment

11. Then, why is the real cost of capital so high in South Africa? • Some elements of the macroeconomic policy framework implemented since the mid-1990s might have had some adverse impact on the real cost of capital in South Africa: • Structurally low savings; taxation policies not conducive to higher surplus • Monetary and exchangepolicy developments • High and volatile rand premium

12. Then, why is the real cost of capital so high in South Africa? • South African spread on local currency denominated bonds has been essentially driven by the rand currency premium • It’s the “Rand Premium” which accounts for high levels of interest rates differentials in CMA countries.

13. Then, why is the real cost of capital so high in South Africa? • Some elements of the macroeconomic policy framework implemented since the mid-1990s might have had some adverse impact on the real cost of capital in South Africa: • Structurally low savings; taxation policies not conducive to higher surplus • Monetary and exchangepolicy developments • High and volatile rand premium: - “peso problem”? - “Zim effect”? • Specific features of the local financial industry + liquidity premium On the demand side, little appetite for risks On the supply side, restrained scope for diversification

14. High real cost of capital in Southern Africa: what can be done about it? Macroeconomic and financial policies in South Africa • Why making the case for cheaper local currency denominated resources...after all? • A pivotal prerequisite: to carry on with the “good” macroeconomic management which has prevailed since the mid-90’s Fiscal (Ahmed, 2004)and monetary indicators (Grandes, Peter & Pinaud, 2003) are found the main determinants of the SA sovereign and currency premium respectively. South Africa, a “no original sin country”

15. High real cost of capital in Southern Africa: what can be done about it? Macroeconomic and financial policies in South Africa • Why making the case for cheaper local currency denominated resources...after all? • A pivotal prerequisite: to carry on with the “good” macroeconomic management which has prevailed since the mid-90’s • However, further bold policy steps are required to lower capital cost in South Africa: • To enhance the development of the domestic bond market • To prop up domestic savings • To complete structural reforms • Decoupling from risks of political instability in the region (e.g. Zimbabwe)

16. High real cost of capital in Southern Africa: what can be done about it? Macroeconomic and financial policies in South Africa • Why making the case for cheaper local currency denominated resources...after all? • A pivotal prerequisite: to carry on with the “good” macroeconomic management which has prevailed since the mid-90’s • However, further bold policy steps are required to lower capital cost in South Africa • Issues remaining open to debate: • Residual exchange control regulations on South African residents • The inflation targeting regime • The exchange rate policy

17. High real cost of capital in Southern Africa: what can be done about it? The Johannesburg financial centre as a regional “financial hub”: relevance, impediments & challenges ahead • Resource gap on the African continent to meet NEPAD growth objectives & MDGs requirements • Developments in capital flows to Africa over the period 1995-2002 do not bode well for the future

18. High real cost of capital in Southern Africa: what can be done about it? The Johannesburg financial centre as a regional “financial hub”: relevance, impediments & challenges ahead • Rationale & relevance • Political willingness in South Africa (see Mr. Manuel statements, FT) • Liquid and sophisticated financial markets unrivaled on the continent; • A reliable, stable and comparatively business-friendly legal and political environment; • A unique position of ”No-Original Sin” country enjoyed by South Africa: potential benefits for CMA countries

19. High real cost of capital in Southern Africa: what can be done about it? The Johannesburg financial centre as a regional “financial hub”: relevance, impediments & challenges ahead • Impediments • Remaining capital control regulations in South Africa re: the access of foreign (excl. CMA countries) entities to SA financial markets • Lack of opportunities and risky lending activities in neighboring countries. Only bank lending, despite excess of liquidity • Risks: regional financial integration might reinforce the role of South Africa as a magnet for neighboring countries’ capital seeking investment opportunities South Africa’s Net Foreign Asset position with Africa (source, Thomas, 2004)

20. High real cost of capital in Southern Africa: what can be done about it? The Johannesburg financial centre as a regional “financial hub”: relevance, impediments & challenges ahead • Challenges ahead • Still, South Africa’s capital pool is shallow and narrow by G-7 standards. • Strengthening of local financial systems in neighboring countries with a growth-enhancing view (Aziakpono, 2004). More and profitable investment opportunities are wanted! • Removal of remaining capital controls to non CMA residents in South Africa. Would foster market liquidity but caution with potential heightened volatility • Reduce the “Rand Premium” • Channeling resources through a financial hub located in Johannesburg alone will be no miracle recipe