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From this month’s Business Diary Botswana:
Back in late July Bloomberg noted that Botswana, the world’s biggest diamond producer by value and volume, was set to produce 24 million carats of gems in 2010, 36 percent more than last year, as demand recovered following the global recession. Some analysts pointed to the industry’s rapid contraction of output in the face of perceived demand destruction as the root cause underlying the quick turnabout—at the crisis’ peak, for instance, Debswana, the 50/50 joint venture between the government of Botswana and De Beers Group, and then-producer of approximately 33.6 million carats of precious stones per year, said that it would reduce production and reallocate resources accordingly. “The increasing supply shortages forecast for the next decade, coupled with increase in consumer demand, will support industry growth in the long term and enable the diamond industry to bounce back from the short term impact in the global recession,” the company announced in late 2008, though as market value across basically all asset classes sagged in unison worldwide, its fingers were no doubt crossed. Many analysts now maintain, however, that dour predictions surrounding luxury sales were always somewhat exaggerated: what the industry lost to the U.S. turned out to be offset by the rise and relative stickiness of Russian, Chinese and Indian demand, they say. Moreover, this ‘new normal’ in regards to buying habits—a phrase describing the paradigm shift in growth rates and consumption away from developed and towards developing markets put forth by Mohamed El-Erian, CEO and co-CIO of PIMCO, the world’s largest bond investor—is likely to persist going forward, a chief reason why so many industry insiders remained bullish even as prices plummeted. De Beers forecasts that the U.S., which accounted for about half of global diamond consumption pre-crisis (with China and India hovering around 6-7 percent), will fall to 30-35 percent by 2016, while China and India each grow to roughly 16 percent. This shift will translate into overall, annual global jewelry sales growth of 4-5 per cent between now and 2020, according to Freddy J. Hanard, CEO of the Antwerp World Diamond Centre (AWDC), a promoter of Belgium’s diamond industry.
Such upbeat forecasts are certainly reassuring to Botswana’s diamond industry, which began in 1967, the year after Botswana broke away from Britain, upon the discovery of what is still considered one of the world’s largest diamond mines in Orapa, a then-desolate area some 250 miles from Gaborone. It’s also somewhat reassuring to officials startled by this month’s declaration by the IMF that plans to fully balance the country’s deficit (affected in part by falling diamond exports) by 2012-13 were “ambitious.” That said, the indisputable catalyst for Botswana’s economic growth and transformation since its independence (average annual growth rate of 9 percent from 1966-2004) is still the same fuel underpinning its relatively high standard of living and political, social and economic stability across the continent today. In fact, per the Boston Consulting Group’s “African Challengers” research note from June, Botswana was chosen as one of eight “African Lions” (a la the four Asian Tigers—Hong Kong, Singapore, South Korea and Taiwan—all of whom high realized high growth and rapid industrialization between the early 1960s and 1990s) based on a variety socioeconomic factors, but namely GDP per capita rates which as of 2008 exceeded those of any of the BRICs. Yet in Botswana’s case, the sustainability of the accolade may be of more concern than with any of its peers: diamonds currently contribute 50 percent of public revenue, 33 percent of gross domestic product and 70 percent of foreign exchange earnings. And despite persisting rhetoric from government officials insisting that, in the face of various expert opinions that the country’s diamond reserves will be depleted in roughly 20 years and that the economy must therefore diversify away from gems and towards sectors such as mining, tourism, agricultural and even offshore financial services, Botswana remains disproportionately dependent on the precious stones. To that end, the IMF’s recent projection that overall GDP growth will reach 8.4 percent in 2010 is explicitly a function of “the rebound in diamond production” and the overall mining sector’s 16.8 percent y-o-y rebound.
One notable source of potential revenue going forward that, until the past few years, has largely been underdeveloped and overlooked is coal mining , as well as the comparatively environmentally friendly production and use of coal-bed methane (CBM)—a naturally occurring methane gas trapped inside coal that once was considered a dangerous hazard. Admittedly, given that Botswana currently imports 80 percent of its 550 MW power demand, with the majority coming from South Africa—which is dealing with its own shortages and will stop supplying its neighbours by 2012—the matter touches as much on security and sovereignty as it does budgetary concerns. Yet there are roughly 200 billion metric tons of coal reserves (largely located in the eastern Kalahari Karoo Basin, an extension of South Africa’s Waterberg Coal Basin), that theoretically could be a vital source of internal power generating capacity, according to the Ministry of Minerals, Energy and Water Resources, as well as help reduce the country’s dependence on imported power and also be transported for sale not only to South Africa, where Eskom, the government-run utility, still faces a coal shortage due to an inability to meet demand with domestic output—but to an export terminal on Namibia’s Atlantic coast, where ocean-going vessels could be loaded quickly. Until recently, though, the problem has centered on transportation, and at least one analyst (who asked for anonymity) blames the lack of capital stock squarely on the state. “The problem is that Botswana and its coal resources are landlocked. There is no easy way to transport these resources to ports for exports as the country does not yet have adequate infrastructure, and building such infrastructure is associated with great expenses,” he wrote.
But that lack of investment may be a thing of the past, per the Southern Times, which reported in late September that “both Namibia and Botswana are in the midst of courting private companies to build the envisaged Trans-Kalahari Railway line stretching from Mmamabula coal deposits in Botswana’s hinterland to Namibia’s deep water port of Walvis Bay.” Ultimately, proponents say, Botswana coal could be marketed internationally, across Europe, China and India. To date, four private companies have been actively exploring eastern Botswana’s coalfields, including CIC Energy, Kalahari Energy, Aviva, and Saber Energy, part of the Tau Capital group that owns CIC Energy, while a fifth, Australian-listed Earth Heat Resources, will soon join the fray. The companies will be engaged in projects, per a report, “ranging from coal mining, coal to hydrocarbons, a coal-fired power station, CBM production, a CBM-fired power station and the various fuel [spin-off] industries.” Moreover, the government seems keen on attracting further investors, revising its Mines and Minerals Act of 1999 that, while continuing to vest all mineral rights in the State, introduces a new retention license which gives it an option to acquire up to a 15% interest in new ventures on commercial terms, thus abolishing its free equity participation, which previously meant that, for significant minerals operations, it would tend to exercise a legal right to acquire an equity interest of 15% to 25% without compensation.
Finally, the CBM market in particular seems to be drawing a growing contingent of advocates, though its commercial uses is less clear. “Research [has] demonstrated that capturing methane and harnessing it into a productive energy source has the ability to dramatically decrease the detrimental effects on the environment. It has been proven that burnt or used CBM is twenty two times less detrimental to the environment than when it is left to escape un-burnt. It also has twenty one times greater heat trapping value when released into the atmosphere than carbon dioxide. Based on its environmental footprint it is clear that every opportunity should be taken to remove CBM from the atmosphere and one of the best ways to do this is to use it in energy production,” wrote Megan Rodgers of Bowman Gilfillan, a Johannesburg and Cape Town-based law firm. That said, China’s CBM experience—involving convoluted access for suppliers to the pipeline network, and the necessity of subsidies—leaves question marks on the industry’s future feasibility. Such concerns aside, however, Botswana’s energy and diversification push seem on the right track, another step away from diamond dependence.
Per the country’s Central Statistics Office (CSO), Botswana’s gross domestic product (GDP) contracted by 8.4 percent in the second quarter of 2010 compared to the previous three months. However, on an annual basis, growth remained positive at 6.5 percent. Moreover, the contraction was mainly concentrated in the mining sector, where output is estimated to have fallen by 23.5 percent. In contrast, non-mining GDP grew by 1 percent. In the first six months of 2010, overall GDP was 7 percent higher than during the same period in 2009.
The IMF estimated at the end of August that Botswana’s economy should expand by 8.4% this year due to higher diamond demand, adding however that country would need to trim its public workforce and promote private industry in order to maintain high growth rates. During the crisis, Botswana’s central bank cut interest rates by 500 basis points between December 2008 and December 2009, while the government boosted spending to counter the recession. With inflation at 7.0% year-on-year in July (and thut outside of the central bank’s target range of 3-6%), “it will be important therefore to err on the side of caution before proceeding with further reductions in interest rates and to proceed with fiscal consolidation as envisaged,” the organization noted.
Yet some analysts maintain that such measures ultimately make the IMF’s forecast overly optimistic. Motswedi Securities’ Garry Juma, for instance, sees 4-6% growth in 2010 as the mining sector recovers. “We believe the economy is still vulnerable to downside risks and we anticipate the reduction in government expenditure to negatively affect the non mining sector especially sectors dependant on household consumption,” said Juma. Furthermore, because the diamond industry is still overly dependent on de-leveraging advanced economies (though, per the BRICs, this paradigm is under assault and may not hold true in ten years), Botswana needed “to speed up the diversification of the economy away from the mining sector for sustainable growth” post-haste.
One area of diversification remains investments in both infrastructure and more pointedly, in power generation. As I write in October’s Business Diary Botswana, the country’s 200 billion metric tons of coal reserves could be used not only to ween its domestic demand from South African imports, but in turn create an export industry via a coal export terminal in Namibia’s Atlantic coast that could meet the ever-rising demands of China and India. Long-term contracts with those two could generate as much $5.9 trillion, per some estimates.
A rather hectic MBA schedule is once again putting a damper on my blogging. Bear with me for a few more weeks. In the meantime, my April contribution to Business Diary Botswana:
After a relatively nondescript start to 2010, Botswana’s domestic companies index (DCI) rose by nearly 5% in February, making it the month’s best performing market in the Sub Saharan region according to Silk Invest, a London-based, frontier market oriented asset manager. Key standouts during the period included Sefalana Holding Company Limited (+19.40%) and FSG Limited (+14.29%), the former of which flourished notwithstanding what one commentator aptly described as a “challenging macroeconomic environment” that resulted in “lower spending and squeezed volumes and margins.” Despite its status as a diversified holding company—Sefalana’s operations include the likes of Foods Botswana, which mills and produces sorghum, soya and maize based extruded products, malt and diastatic malt; Sefalana Cash & Carry Limited (Sefcash), a distributor of consumer goods and an 88% contributor to the firm’s total revenue in the second half of 2009; MF Holdings (Pty) Limited, which is engaged in heavy construction and farming equipment; and KSI Holdings (Pty) Limited, which produces toilet soaps, laundry soaps, cooking oils and dishwashing liquid soap—none of its subsidiaries, save for Sefalana Properties, proved resilient to consumption contraction. For instance, Motswedi Securities, a local broker, lamented Sefcash’s 4% turnover decline (likely a result of the government’s 30% alcohol levy), as well as its sizeable reduction in cross border trade with both Zimbabwe and Zambia) as reasons behind lackluster reporting. Yet amidst such gloom many analysts remain bullish on Sefalana as a proxy on both demand recovery and future economic growth, a prospect that some observers forecast returning sooner rather than later. To this extent, February’s demand ramp up may have been the market’s collective, psychological embrace of risk in anticipation of a more V-shaped recovery.
Adding credibility to the specter of imminent economic revival, the Bank of Botswana released a report in January touting the fact that the country’s overall business confidence had increased and that businesses were increasingly confident in both impending domestic and international economic conditions. The release validated a Reuters poll taken last fall of nine economists who predicted that Botswana’s economy would grow by 5-6% in 2010 (after an approximate 11% contraction in 2009), and also provided the impetus to those industries, such as consumer goods and agriculture, most sensitive to an economic rebound. For example, in its latest equity research piece, Imara, a regional investment bank and asset management firm, concluded that “Sefalana’s subsidiaries are expected to perform better in the second half of the year,” noting an increase in vehicle sales (through the firm’s Commercial Motors arm) to the public sector, as well as increased production capacity at Foods Botswana. Perhaps most promising to future revenue forecasts, it noted, were Sefcash’s openings of two ‘Shoppers’ supermarkets in 2009—a fraction of the 19 total openings planned over the next three years—as well as its recently established distribution agency in Zambia. Coupled with Sefalana’s modest use of leverage (debt to equity is slated to remain around 5.2%) and strong net cash position (latest figure was P46.16 million), Imara projected that the firm’s net income could be expected to continue its ascent (it doubled from 2008) and allow management to concurrently grow (19% anticipated revenue growth over the next two years) while also paying dividends (6.8% forecast for 2011), a rare recipe in any macro climate.
Distilled to its essence, however, Sefalana’s core business revolves around Sefcash, a wholesale distributor in the fast moving consumer goods (FMCG) industry (and a relatively recent entrant into the retail market through its wholly-owned, Shoppers supermarkets) whose ship Stockbrokers Botswana commented last summer the company had finally righted following a rancorous legal spat in 2006 over management control with its former partner, Met Cash of South Africa. Since then, observers note, Sefalana has overseen the brand’s complete overhaul, boosting profits while branching out to over two dozen outlets, as well as two hyper stores. Yet to the extent that its fortunes are tied to the overall economy’s, Sefcash’s biggest asset in the near term may not be so much in its operations per se, but rather in its geographic diversity and by extension its ability to smooth earnings across varying consumer environments. According to Dr. Keith Jefferis, Managing Director at Econsult Botswana and former deputy governor of the Bank of Botswana, “risks remain,” both internationally and domestically, that could cause demand recovery across a variety of goods and throughout much of the world to become derailed. Pointing to Botswana specifically, he wrote in a Botswana Insurance Fund Management newsletter last December, “much of the [then] recovery in the demand for rough diamonds represents demand from re-stocking rather than buoyant retail demand, and may therefore be short-lived.” Moreover the apparent rebound both in Botswana and across asset markets abroad in 2009 was more a response to debt-driven, government-orchestrated, artificial manipulation than to bona fide health. “[But] at some point the growth rate of government spending will have to slow down, especially with revenues under pressure, reserves declining and debt mounting,” he noted. Finally, of equal importance to the hitherto revival has been household spending. “In contrast to consumers in other countries who are saving more and spending less in response to the global recession, Botswana consumers have been saving less and spending more,” Jefferis lamented. “This cannot go on forever, and as savings decline and the debt burden mounts consumers will eventually have to cut back on their spending.” To Sefcash and its consumption driven business-model, such a pronouncement should warrant pause.
Distribution agencies throughout Zimbabwe and Zambia would at least theoretically help assuage such concerns over future cash flows, though growth prospects in Zambia are admittedly as heavily tied to minerals (copper accounts for one-third of the country’s GDP and 80% of its foreign earnings) as are Botswana’s, while distribution of wealth measurements (two-thirds of the 12m plus population live below the poverty line) and overall quality of living standards seem hopelessly mired in comparison. Zimbabwe, on the other hand, is still riding a crest of economic optimism on the back of finance minister Tendai Biti’s vision for 7% growth in 2010 and beyond based on predicted improved performance in agriculture, mining, manufacturing and tourism. While many pundits point to the nation’s still unresolved political stalemate—The Economist referred in early March to a “power-sharing government plainly going nowhere”—Biti sings the praises of the economy’s untapped potential. “Those who are sitting on the sidelines waiting for politics to completely resolve itself, waiting for what I call the landmine period to blow over, I think they will miss the boat. I think South African capital is ready to move and to move very quickly. We’ve got keen interest from business people in Botswana, in Mozambique and so forth,” he proclaimed last May. Interestingly, however, Biti’s buoyancy isn’t shared by Prime Minister Morgan Tsvangirai, who allegedly “shares” control of the country’s governance with President Robert Mugabe. In an interview with BusinessWeek from late January, Tsvangirai warned that Zimbabwe’s economy had shrunk by more than half in the past decade and probably wouldn’t “come out of the trough” in the next five years. Weak political leadership, a lack of capacity to effectively use development funds and the failure to include affected communities in planning are key reasons why African economies are slow to develop, said Tsvangirai. “It’s not the absence of money. It’s the absence of absorptive capacity.” To that extent, historically-shaky relations between the two countries leaves the solidity of future unfettered trade in limbo, especially when coupled with Zimbabwe’s yet-to-be finalized political landscape. A recent kerfuffle surrounding the detention of three wildlife officials who inadvertently strayed into Zimbabwe while tracking a lion pride ended with exasperated Botswana officials recalling diplomats, while tensions between the two parties are said to still be strained following President Mugabe accusation several years ago that Botswana was training and harboring a secret militia aimed to overthrow him. That said, with over $500 million of IMF aid to be allocated, Zimbabwe is on the mend, literally and figuratively, for the near term at least. And Zambia, while still poverty-ridden, is better situated to improve its lot now than at any other time in its history, argue many economists. If intra-continental trade, rather than the one-time gain that stems from simply exporting resources abroad, is Africa’s optimal outcome, then Sefcash’s realization of a Botswana-Zambia-Zimbabwe triangle of revenue could be a microcosm of grander things to come.
Turbulence continued in Botswana following Moody’s downgrade of sovereign debt last week from stable to negative. The ratings service projected a prolonged decline in demand for diamonds and thus continued pressure on the state’s coffers. Botswana will run a deficit of 12.2 percent of GDP in 2010/11, per its Finance Minister Kenneth Matambo. To that extent, the firm warned that “the government’s ratings would likely be downgraded to A3 upon the failure to stem the deterioration in its net asset position over the medium term,” and that “fiscal consolidation and economic diversification will be ever more vital to preserve the country’s economic strength as the depletion of diamond resources approaches over the coming decades.”
Diamonds once accounted for over $3b (roughly 50%) of annual revenue for the country, with the U.S. and Japan demanding the lion’s share of product. While analysts predict the demand for luxury goods will be restored (though likely aided by an increase in demand from emerging countries rather than a complete bounceback from developed ones), the recovery will take time. Furthermore, Botswana’s government admits that its gem production capabilities may only have another ten years or so of viability. In the meantime, the government is looking to diversify its economy while concurrently attempting to realize growth. Its central bank left benchmark rates unchanged, stating that its four interest-rate cuts last year were adequate to spur economic growth and that forward-looking inflationary pressures were benign.
From September’s Business Diary Botswana:
Derivatives market helps farmers weather storm and smooth returns In “Fool’s Gold,” Financial Times global markets commentator Gillian Tett writes that “versions of derivatives trading have existed for centuries,” citing “rudimentary examples of futures and options contracts found on clay tablets from Mesopotamia dating back to 1750 B.C.” And the relatively modern practice of futures and later options trading to hedge against price volatility–used by farmers in order to lock in the price of a crop as it is planted, and thus negating the risk that prices will drop before it is harvested–began as early as 1849, when the Chicago Board of Trade opened. Yet within frontier markets the use of derivative contracts amongst farmers has been notoriously fickle, despite the obvious benefits that such techniques would bring not only food producers, but ultimately consumers. A 2006 paper published by the University of Pretoria’s Department of Economics, for instance, concluded that “the problems concerning food and income insecurity [would] be reduced if farmers [could] adopt derivative contracting on a large scale, since the producers [would] then be able to produce the staple food on a continuous basis at relatively profitable levels.” In Botswana’s case, a mature derivatives market could ultimately ignite a moribund industry whose waning impact is readily felt even in the face of robust GDP. According to the World Bank, despite the country’s seismic growth rates during the 1990s, the prevalence of hunger actually increased. Since then, the agricultural sector’s output has continued to disappoint, hampered by lackluster farming technologies and practices, sporadic rainfall and rampant disease outbreaks. Such degree of inefficient food production leaves not only consumers vulnerable, but state coffers as well. Per the Ministry of Agriculture, current annual arable production levels are only between 15-20% for cereals, and 45% for fruits and vegetables–meaning that imports must pick up the slack. Moreover, the risk of large-scale calamity due to, say, drought, leaves a given country’s fiscal surplus in a perilous position should wide-scale humanitarian intervention become necessary. And with food inflation a near certainty in the long-run, given a rise in price of major commodities related to food production due to growing world demographics, coupled with an ever-diminishing amount of farmland-per-person and an increasing scarcity of cheap, fresh water, it is no wonder that a lagging agricultural sector is continually singled out by worried Botswana officials.
Facilitating the sector’s resurgence, however, may be the emergence of Bourse Africa, a Pan-African commodities and derivatives exchange that will have a technology hub in Botswana and will link to other exchanges in the continent, and which is expected to be operational this month. The exchange, which in sponsored and coordinated by Financial Technologies India Limited (FTIL), a global leader in creating and operating financial markets that also owns MCX India, the Mumbai-based, world’s 8th largest commodities exchange, will trade contracts for agricultural commodities, oil and metals across Africa with a hub and spoke model centered in Botswana. According to Adam Gross, its Head of Strategy, the exchange will be of greatest benefit to farmers. “[Farmers] will understand the real value of what they produce. They get bad prices on the world market,” he said, noting that they will be taught about market information and how to execute orders and risk management. Additionally, the Exchange notes: “it has been demonstrated in academic literature how exposure to price volatility encourages commodity producers to pursue risk-minimizing strategies with the consequence that investment in production is limited and the cultivation of higher revenue but higher risk products remain off-limits. Whilst this is particularly the case for rural producers and informal sector workers, even a relatively sophisticated private sector enterprise can be critically wounded by sharply rising prices for fuel or essential raw materials, or a significant year-on-year drop in realized prices. Moreover, volatility has particularly damaging effects on poor people in low-income countries whose ability to cope is limited by shallow financial sectors and political and economic constraints that place limits on the type and nature of government interventions.” One specific subset of the agricultural derivatives industry centers around weather risk management. Per research by the World Bank, while international food prices have fallen, local food prices in many countries haven’t followed suit. While below their 2008 peaks, major food grain prices are still above average; maize is 50% more expensive than its average price between 2003 and 2006, and rice prices are 100% higher, for instance. One explanation is that production and supply cannot always be neatly correlated to fit demand; extraneous random variables such as weather patterns have an integral impact on a given crop’s yield. Per one academic paper, “weather is undeniably one of the most important sources of risk in agriculture, and it seems that fluctuations of temperature and precipitation have even increased in the last decade [and will continue to increase?] due to global climate changes.”
Sensing the need to help farmers manage this risk and to reduce the impact of drought in developing countries, the World Bank last year launched a series of financial intermediation services to low-income client countries of the International Development Association (IDA), and added to the range of risk-management tools available to middle-income client countries of the International Bank for Reconstruction and Development (IBRD), to help transfer risks to the financial markets. Such “index insurance” is tied to an objectively measurable indicator (e.g., rainfall, temperature, humidity, crop yields), in lieu of loss. At present, the use of rainfall totals to hedge against drought-related crop loss is the most prevalent derivative found in developing markets. In September 2008, the Bank reported, Malawi became one of the first countries to use a weather derivative financial product–index-based weather derivatives, in which “payments are triggered by adverse weather events according to pre-specified conditions.” In practice, it explained, “the Bank enters into mirroring transactions with the client country and a financial market counterpart. In the event of a severe weather event, client countries receive a payout from the Bank, the total value of which would be based on an index used as an estimate of the financial impact. This would be funded with the payout that the Bank would receive from the mirroring transaction.” In Malawi’s case, the World Bank Treasury acted as an intermediary on behalf of the government to ease and expedite its access to the international weather derivatives market–thus reducing transaction costs. “If there is significant drought in the country, the government will get a payout whose level is determined by the size of the premium paid and the severity of the drought. This payout may be used to help purchase grain to resolve supply shortfalls or to distribute grain from national strategic grain stocks,” commented David Rohrbach, a senior economist at World Bank’s Malawi office. Concurrent with the Malawi deal, the World Bank also began to support weather index insurance initiatives across Thailand, Bangladesh, Senegal, Burkina Faso, Kenya, Jamaica and Fiji. And in Indonesia, per its website, the Bank and IFC are completing a “feasibility study on a crop insurance pilot for maize small farmers.” While not an innovative product per se–weather market and index-based insurance products in agriculture have grown rapidly over the past decade and are widely used by private companies to manage risk–their adoption in developing countries is relatively novel. Skeptics, however, note that the long-term future of weather derivatives will ultimately depend on what improvements can be made to their pricing. “Because weather cannot be traded, that is, the market for weather risk is incomplete, a straightforward application of standard pricing models for financial derivatives is impossible. Actually, the poor transparency of pricing algorithms employed by sellers is considered a major cause of the slow development of weather markets,” stated a paper published last November by the American Journal of Agricultural Economics. That said, proponents such as Rohrbach point to an already burgeoning global industry (which now exceeds some $32 billion, including energy firms that make up roughly 36% of the market) and posit that “as the international weather derivatives market becomes accustomed to these transactions, the World Bank expects [a variety of governments] to begin pursuing such transactions independently.”
The following appeared in the August edition of Business Diary Botswana. Right now I find myself fascinated by the role that securitization and a mature credit derivatives market will ultimately play in frontier economies; as J.P. Morgan once penned, “credit derivatives allow even the most illiquid credit exposures to be transferred to the most efficient holders of that risk.” Despite its perils (notably the lack of respect issuers had for the potential correlation on mortgage defaults), it is my belief that the underlying concept supporting derivatives is a sound one if handled correctly. As wealth continues to flow to developing markets in the coming decades, so too will the management of risk continue to mature.
Back in late March, not long after the S&P registered its ominous 666 low, an understandably seething writer in The New York Times charged that above all, the “key promise” of securitization–a process involving the pooling and repackaging of cash-flow producing assets into tranche-laden (arranged by risk rating), tradeable vehicles that was effectively born in the late 1970s at then Salomon Brothers in relation to mortgage-backed securities–“turned out to be a lie. Banks used securitization to increase their risk, not reduce it, and in the process they made the economy more, not less, vulnerable to financial disruption.” The column raised eyebrows, not only because of its vociferous and encompassing indictment, but because of the man behind it: Paul Krugman, winner of the 2008 Nobel Memorial Prize in Economics. Moreover, the charge ran counter-intuitive to previously uncontroversial financial theory; on its face, the concept of securitization should be a boon to issuers and investors alike. As J. David Cummins, Professor Emeritus of Insurance and Risk Management at Wharton wrote in 2004, “securitization provides a mechanism whereby contingent and predictable cash flow streams arising out of a transaction can be unbundled and traded as separate financial instruments that appeal to different classes of investors. In addition to facilitating risk management, securitization transactions also add to the liquidity of financial markets, replacing previously un-traded on-balance-sheet assets and liabilities with tradeable financial instruments.” In other words, improved market efficiency in the form of an increased rate of capital utilization (asset and liabilities moved off-balance sheet to a special purpose vehicle (SPV) are free of capital requirements and in turn reduce the expected costs of regulatory intervention arising from any deterioration in them), simultaneously lowers transaction costs and spreads risk as once static, embedded cash-flows mired on balance sheets become pliable. In the context of residential mortgages, this meant cheaper sources of funding for a wider pool of applicants. Credit card and corporate loans soon followed.
Yet along the way something went terribly wrong, and it’s this hiccup that so infuriates detractors of the practice like Krugman, who conclude that far from “bringing securitization back to life” through increased scrutiny and regulation, the Obama Administration shouldn’t even try. ‘What went wrong’ is that securitization was effectively hijacked, its role of transferring assets and ultimately shrinking a bank’s balance sheet pirated and replaced en masse by a new form of structured finance that involved a hitherto underutilized credit “derivative” called a credit-default swap (CDS), in which contract buyers are essentially insured by sellers of a given entity’s continued solvency. When J.P. Morgan began to slice, dice, arrange and then sell its burgeoning corporate exposure in order to reduce its corporate-based risk in light of the 1997 Asian crisis, it became the first bank to free up capital not by reducing its balance sheet by selling loans (which would damage client relationships), but rather by expanding it under the guise of having perfectly hedged against the risk of default. The most liquid portion of the market revolved around synthetic collateralized-debt obligations (CDO), in which investors insured against an entire group of loans in exchange for regular premium payments, and banks often kept the (allegedly) riskless, “supersenior” tranches on their own balance sheets with little or no capital in reserve. Over the course of a decade, such “loans” began to be manufactured across Wall Street (“originate and distribute”), and CDOs became increasingly supported by increasingly dodgy borrowers in a vicious cycle as banks succumbed to pressure (by directors, manages and shareholders alike) to continually accelerate returns. The rest is history. But lost in the clamor and media frenzy over the industry’s reckless abandon has been much in the way of level-headed, objective analysis. In particular, little has been concluded as to the broader economic impact of securitization. If you listen to the likes of Krugman (and in a “science” as convoluted and cryptic as economics, you’d almost be foolish not to), the jury is in, and securitization should be ‘out’. Yet as one commentator prudently surmised, “the problem with a lot of what looked like securitization over the past decade was that many banks thought that they’d sold off all their risk, when in fact they hadn’t.” Moreover, there is a growing amount of research that quantitatively supports the model–in its fundamental form at least. A study published in late June by NERA Economic Consulting, for example, assessed the long term impact of securitization, with a focus on the residential mortgage-backed securities market. The study found that: (i) securitization lowers the cost of consumer credit, reducing yield spreads across a range of products including mortgages, credit card receivables, and automobile loans; (ii) increases in secondary market purchases and securitization of mortgage loans have positive and significant impacts on the amount of mortgage credit available per capita, particularly among traditionally underserved populations; and (iii) conversely, declines in secondary market purchase and securitization activities negatively impact the amount of available mortgage credit. Moreover, the study reported, a reduction in securitization activity has a negative impact on all types of lending activity, including but not limited to residential mortgages; as such, it stated, bank lending activity is likely to be significantly and negatively impacted if securitization remains at its current, depressed level. The findings add further support to a seemingly pre-crisis consensus that the practice of trading cash flow streams allows parties to manage and diversify risk, arbitrage, and otherwise invest in previously unattainable classes of risk–all of which in turn enhances market efficiency.
Such rationale cannot be stressed enough if securitization is to continue its spread into developing economies and increasingly illiquid markets. As for African markets, the practice is still in its infancy. “Securitization is a bit more sophisticated than the reality in Africa,” said one asset manager. “The Commercial Paper (a money market instrument) market is where most of this activity is centered.” According to South African investment banker Stephanus de Swardt, aside from both the proper regulatory environment (which “allows for the special capital treatment of securitization bonds”), as well as the right legislative one (in order to “structure the transfer of assets”), securitization also depends on relatively developed capital markets that already feature both a government bond market and at least some form of corporate bond market, as well as “at least partially liberalized exchange controls” already in place. Some countries are naturally ahead of the curve. Botswana, for one, initiated the issuance of government debt in 2003 precisely with its market’s maturation in mind. Said the central bank at the time: “the [government] bond issue is a momentous event as the objective of the issue is not driven primarily by a need to raise revenue or funding but to develop the domestic capital market. The bonds are expected to help Botswana establish a relatively risk free yield curve that will serve as a benchmark for other private sector and parastatal bonds.”
In further happenings, last fall the Botswana Stock Exchange (BSE) hosted a conference on how to change illiquid assets into instruments that can be issued and traded in order to provide corporations a “new and potentially cheap form of funding.” Said a research note, “for banks and finance companies that have successful loan programs but are faced with capital constraint, securitization is a means of removing assets from the balance sheet and freeing up capital to support further lending.” Furthermore, new products may ultimately emerge in such markets even as more traditional ones begin to take root. For instance, as per capita income grows in developing countries, it can be expected than products such as life insurance and annuities will become more in demand. As Cummins pointed out in his 2004 treatise on the subject, the securitization of life insurance and annuity cash flows and risks “can increase the efficiency of insurance markets by utilizing capital more effectively, thus reducing the cost of capital and hence the cost of insurance, for any given level of risk-bearing capacity and insolvency risk. Securitization can accomplish this goal by spreading risk more broadly through the economy rather than by warehousing risk in insurance and reinsurance companies, which have lower capacity and diversification potential than the capital market as a whole.” Finally, securitization may even play a vital role in reducing poverty and improving lives in the SADC region. In a 2008 paper, World Bank Senior Economist Dilip Ratha and fellow economists Sanket Mohapatra and Sonia Plaza estimated that Sub-Saharan Africa could raise up to $30bn a year and further access international capital markets by “exploring previously overlooked sources of financing such as remittances and diaspora bonds, and strengthening public-private partnerships.” Said Ratha: “Preliminary estimates suggest that Sub-Saharan African countries can potentially raise $1 to $3 billion by reducing the cost of international migrant remittances, $5 to $10 billion by issuing diaspora bonds, and $17 billion by securitizing future remittances and other future receivables,” such as remittances, tourism receipts, and export receivables. In this latter form,future foreign-currency receivables are pledged as collateral to a SPV which issues debt to an offshore collection account that the borrowing country can then access. These securities have a higher investment grade rating than “the generally unfavorable sovereign credit ratings” given to Sub-Saharan countries, the Bank reports, which effectively opens them up to new, larger classes of investors.
Botswana Stock Exchange (BSE)-listed junior copper miner, African Copper, announced that it would restart its operations at the Mowana Mine near Dukwi–which it shelved back in January–upon receiving $41 million in funding from mining investment firm Zambia Copper Investments Ltd (ZCI). The firm also reported a pretax profit of 27.7 million pounds ($45.91 million), compared with a loss of 2.6 million pounds last year, for the six months ending June 30.
Copper prices dropped from US$7,000 per ton at the beginning of the third quarter of last year to US$3,000/ton by the end of that quarter. But copper prices have double this year, and according to Zijin Mining Group, China’s largest gold producer, “a recovering world economy and loosening bank credit will bolster copper prices in the second half of the year.” The estimation echoes that of GFMS, a precious metals consultancy, which opined on Thursday that global copper supply was expected to fall increasingly short of demand from next year, which should see prices rising every year to 2012:
“In the short term, copper prices were expected to soften, with inventories reported by the London Metal Exchange (LME) now rising after a surge in Chinese imports earlier in the year while Chinese industry rebuilt depleted stocks. But the increase in the surplus was likely to be brief and a market deficit would become evident early next year,” GFMS said.
The following appeared in July’s Business Diary Botswana:
Speaking at a seminar in October 2006 devoted to the country’s efforts towards economic diversification, Happy Fidzani, Executive Secretary of the Botswana Institute for Development Policy Analysis (BIDPA), warned that the government’s “heavy confidence” in its mining sector–namely rough diamond extraction through Debswana, the joint-venture mining firm operated in partnership with South Africa’s De Beers and dating back to the late 1960s–had created a welfare-like, “parasitic” dependency for revenue upon which the nation’s non-mineral sector was habitually tied. Largely unaware of just how prophetic his words would soon turn out to be, Fidzani told the audience that shocks originating from the mining industry were still “easily felt” across the economy, and that the government, despite its ceaseless rhetoric and campaigning about the importance of diversity, was as reliant as ever on just one resource. Less than three years later in March 2009, and some time into a calamitous and synchronized global recession that left no market or asset unscathed, Moody’s, an international credit rating agency, downgraded its credit (bond) ratings outlook for the country as well as for the currency (pula), citing the downturn in diamond exports to which the central budget is largely tied. This came on the heels of Standard & Poor’s decision to cut its own outlook for Botswana to negative, while warning of worsening public finances. And in June, the African Development Bank announced its biggest ever loan facility–a $1.5bn loan–to Botswana, the country’s first such borrowing from the bank in seventeen years, and in the face of a budget deficit equal to 13.5% of gross domestic product (GDP) in the current financial year and an estimated growth slump this year of 2.6% (2.9% next year), down from 3.9% in 2008. The bank noted that while Botswana was still regarded as “one of the best-managed economies in Africa,” it had not escaped the financial crisis because of falling commodity prices, particularly in diamonds.
So why hasn’t Botswana’s economy yet diversified? The answer is somewhat confounding because, in a sense, it has. Studies done in the early part of this decade by both the Bank of Botswana and by BIDPA, for instance, used the Herfindahl index, which measures the size of firms in relation to a given industry as well as the amount of competition among them, to show that since the mid 1980s Botswana’s economy has markedly reduced its dependency on minerals. Among other findings, the reports showed that mining contributed only one-third to real growth since 1975, and also that the 9.1% growth rate during that same period by the overall economy was matched by the non-mining sectors as a whole, excluding agriculture. Yet their conclusions were muddled. “The foundations of this diversification are lacking in depth and remain fragile, and results in terms of providing employment opportunities have been less than hoped for,” the Central Bank remarked. To date, efforts at diversification have focused on export-oriented industries such as the manufacture of textiles, leather, glass, and jewelry, as well as the establishment of an International Financial Services Center, the promotion of Information and Communications Technology, and tourism. Additionally, the government would like to see the resurgence of agricultural activity, which, outside of livestock, largely remains languid. Increased production would help decrease the need to import from South Africa. When Botswana gained independence in 1966, the agriculture sector contributed roughly forty percent to GDP and ninety percent of total employment in the domestic economy. However, by the mid-1990s, the sector’s share of GDP and employment had fallen to four percent and sixteen percent, respectively. Yet despite all of the economic development and apparent political will to change course, many observers point out that the thrust of diversification still resides within the mining sector—namely, the exploration and extraction of copper, nickel and coal. For instance, according to Kristin Lindow, Moody’s Senior Vice President, “efforts to diversify the economy have been paying off, [although] they mainly led to the expansion of other mineral resources, the prices of which, except for gold, have [also] dropped precipitously [in recession].”
One proposed theory for the dearth of real economic diversity is that from a political standpoint, mining has represented a perpetual haven–a means whereby to grow reserves, subsidize education and health care, and generally sustain and nurture an average quality of life more or less unknown before anywhere on the continent. Oupa Tsheko, an author and professor of economics at the University of Botswana in Gaborone, commented to a UN information network in April that diamonds fund government expenditure. Therefore, he says, declining diamond revenues would have a “huge impact” on the country’s development. And politicians have all but embraced the lynchpin role that diamonds still play. “There can be no doubt that diamonds have played a major part in the transformation of our country’s fortunes and the lives of our citizens,” Botswana’s then president, Festus Mogae, told parliament in 2006. “For our people, every diamond purchase represents food on the table, better living conditions, better healthcare, portable and safe drinking water, more roads to connect our remote communities, and much more.” According to The Economist, a 2008 Growth Commission report identified Botswana as one of just 13 countries (and the only African state) to have achieved sustained economic growth over decades. In fact, the country grew 8.9% annually between 1960 and 2005, making the once third-poorest nation in the world its fastest growing one over that time period, while helping its population realize real per capita income four times that of the SADC average, per a 2002 World Bank report. During that period, diamonds at their peak became the base of over three-quarters of Botswana’s export revenue, two-thirds of the government’s tax revenue, and around forty percent of GDP. Which imprudent elected official would ever jump in front of that train? As Bert Lance, a one-time advisor to U.S. President Jimmy Carter famously said, “if it ain’t broke, don’t fix it.”
Further complicating matters is the position put forth by Chaim Even-Zohar, an analyst for Tacy Ltd., a diamond industry think tank, who opines that the gem’s long-term fundamentals are attractive, especially since global diamond jewelry retail demand is only expected to shrink 10-15% this year, and that demand for rough diamonds will again grow in the second or third quarter of 2010 (he admits concurrently, however, that it may take four years for GDP per capita to rise in the U.S.; said figure is considered a benchmark for measuring diamond jewelry retail consumption growth). Moreover, Even-Zohar argues, given the oligopoly of rough diamond’s supply structure, and the fact that of late annual rough diamond supplies into the value chain have consistently exceeded demand, the “downstream diamond pipeline” (i.e., rough and polished traders, polished manufacturers, jewelry manufacturers, jewelry distributors and retailers) currently holds some $45-50 billion worth of diamonds, or enough to assuage consumer demand for between two to three years. Because of this inefficient glut of working stock, he continues, inventories must now be reduced accordingly. Demand destruction will take its toll across all parts of the supply chain—finally culminating in a 50-60% drop in rough demand this year, per estimates. It’s this “stabilizing” period of adjustment in which stocks, prices and supply and demand find a new equilibrium, that will be the most painful for Botswana’s industry, admits Even-Zohar. “The cutting centers will take the greatest hit, but they will also experience the fastest growth in an upturn,” he concludes. Gareth Penny, Managing Director of De Beers, agrees, and like Even-Zohar, is bullish on the industry’s underlying, bounce-back prospects. “In the long term rough and polished prices will increase,” Penny says. If you look at historical data, it is clear that, immediately following a recession, the [response] in rough diamond prices has been dramatic, and we would expect to see a similar situation soon after the current recession is behind us.
News of the gem’s long-term price and demand viability are welcome news to those pundits who maintain that bona fide economic diversification in Botswana is simply not practical. As The Economist Intelligence Unit glumly noted in February, Botswana’s current economic predicament may indeed be proof that “even when governance and policies are good, it is extremely difficult for a small, landlocked African economy to diversify, especially if it has an industrial powerhouse such as South Africa (whom it is heavily reliant on for imports) on its borders.” Critics maintain that manufacturing is not feasible because of the high cost of imports and exports, and that South Africa already has a competitive advantage in service-based industries. Particularly in the short-to-mid term, observers point out, Botswana will need the revenue from a post-recession, mineral resurgence if it is to orderly pay down or refinance debt that it is assuming in the present. And if the economy is to ever be truly diverse, they maintain, an entire cultural mindset must be transformed and entrepreneurship must be taught from an early age. Such paradigm shifts must be planned, and will take time. In the interim, there is still further scope for the mining sector to provide economic benefits. Plans by De Beers to move its “sight aggregation” (where blending takes place to provide overall consistency) functions from London to Botswana (Penny says the switch is imminent), for instance, will be a further form of diversification, albeit within the same sector. Sometimes, some things are too good to let go.
Imara Holdings, the Botswana-listed, Pan-African investment bank and asset management group, recently launched a niche fund focused on small-to-medium-sized mining and other companies that often remain unnoticed by global funds that typically allocate resources towards more prominent resource firms. Imara, which among other vehicles offers a Zimbabwe Fund, a Nigeria Fund, an East Africa Fund, and a long-only Opportunities Fund that covers a range of countries and sectors, has $135 million in assets under management, and $750m under administration.
The timing of the fund, whose commodity exposure includes gold, platinum group metals, coal, ferrous metals, chrome oil and gas, could hardly be more ideal, explains its manager Bruce Williamson, who has 25 years of experience as a mining analyst. Williamson argues that the year’s commodity rebound is more secular, rather than cyclical based. [Commodities are] not a temporary phenomenon. The long-term fundamentals are strongly positive. [And] the big, long-term upside is among juniors and mid-tier miners,” he explained.
Back in March I analyzed and indeed applauded the Bank of Botswana’s decision to run a fiscal deficit in the face of waning exports. Given the country’s accumulated reserves, as well as then-falling commodity prices, temporarily raiding coffers in order to support domestic consumption—despite the long-term problems posed by such “unorthodox” policy—was a no-brainer for the central bank.
That said, one concern I had (and still have) for Botswana is that the government was underestimating just how grave (prolonged) this global recession would be. While Botswana is actively attempting to diversify away from diamonds, this transformation will take time. Moreover, demand for diamonds from Japan and the U.S., its biggest customers, may never truly return. The extent of the necessary de-leveraging that must take place in the U.S., for example, is staggering.
It appears that at least for the short-term, however, Botswana will have an adequate credit supply, not only from the African Development Bank, but also from the IMF. But these next few years will be crucial. How it chooses to appropriate this debt injection right now may indeed determine its fate for decades to come.
JGW
Frontier Markets 