The new silk road

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The New Silk Road: Afro-Eurasian investment
June 2014 Dr. Paul Kielstra
Deutsche Asset
& Wealth Management
S5
SPECIAL ISSUE

The New Silk Road: Afro-Eurasian Investment
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Deutsche Asset & Wealth Management’s Global Financial Institute asked the Economist Intelligence Unit to produce a series of white papers, custom articles, and info-graphics focused specifically on global capital market trends in 2030.
While overall growth has resumed, and the value traded on capital markets is astoundingly large (the world’s financial stock grew to $212 trillion by the end of 2010, according to McKinsey & Company) since the global financial crisis of 2008, the new growth has been driven mainly by expansion in developing economies, and by a $4.4 trillion increase in sovereign debt in 2010. The trends are clear: Emerging markets, particularly in Asia, are driving capital-raising; in many places debt markets are fragile due to the large component of government debt; and stock
Introduction to “Global Capital Markets in 2030“ markets face weakening demand in many mature markets.
In short, while the world’s stock of financial assets (e.g. stocks, bonds, currency and commodity futures) is growing, the pattern of that growth suggests that major shifts lie ahead in the shape of capital markets.
This series of studies by Global Financial Institute and the Economist Intelligence Unit aims to offer deep insights into the long term future of capital markets. It will employ both secondary and primary research, based on surveys and interviews with leading institutional investors, corporate executives, bankers, academics, regulators, and others who will influence the future of capital markets.

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About the Economist Intelligence Unit
The Economist Intelligence Unit (EIU) is the world’s leading resource for economic and business research, forecasting and analysis. It provides accurate and impartial intelligence for companies, government agencies, financial institutions and academic organisations around the globe, inspiring business leaders to act with confidence since 1946. EIU products include its flagship Country Reports service, providing political and economic analysis for 195 countries, and a portfolio of subscription- based data and forecasting services. The company also undertakes bespoke research and analysis projects on individual markets and business sectors. The EIU is headquartered in London, UK, with offices in more than 40 cities and a network of some 650 country experts and analysts worldwide. It operates independently as the business- to-business arm of The Economist Group, the leading source of analysis on international business and world affairs.
This article was written by Dr. Paul Kielstra and edited by Brian Gardner.
Dr. Paul Kielstra is a Contributing Editor at the Economist Intelligence Unit. He has written on a wide range of topics, from the implications of political violence for business, through the economic costs of diabetes. HIs work has included a variety of pieces covering the financial services industry including the changing role relationship between the risk and finance function in banks, preparing for the future bank customer, sanctions compliance in the financial services industry, and the future of insurance. A published historian, Dr. Kielstra has degrees in history from the Universities of Toronto and Oxford, and a graduate diploma in Economics from the London School of Economics. He has worked in business, academia, and the charitable sector.
Brian Gardner is a Senior Editor with the EIU’s Thought Leadership Team. His work has covered a breadth of business strategy issues across industries ranging from energy and information technology to manufacturing and financial services. In this role, he provides analysis as well as editing, project management and the occasional speaking role. Prior work included leading investigations into energy systems, governance and regulatory regimes. Before that he consulted for the Committee on Global Thought and the Joint US-China Collaboration on Clean Energy. He holds a master’s degree from Columbia University in New York City and a bachelor’s degree from American University in Washington, DC. He also contributes to The Economist Group’s management thinking portal.
Introduction to Global Financial Institute
Global Financial Institute was launched in November 2011. It is a new-concept think tank that seeks to foster a unique category of thought leadership for professional and individual investors by effectively and tastefully combining the perspectives of two worlds: the world of investing and the world of academia. While primarily targeting an audience within the international fund investor community, Global Financial Institute’s publications are nonetheless highly relevant to anyone who is interested in independent, educated, long-term views on the economic, political, financial, and social issues facing the world. To accomplish this mission, Global Financial Institute’s publications combine the views of Deutsche Asset & Wealth Management’s investment experts with those of leading academic institutions in Europe, the United States, and Asia. Many of these academic institutions are hundreds of years old, the perfect place to go to for long-term insight into the global economy. Furthermore, in order to present a well-balanced perspective, the publications span a wide variety of academic fields from macroeconomics and finance to sociology. Deutsche Asset & Wealth Management invites you to check the Global Financial Institute website regularly for white papers, interviews, videos, podcasts, and more from Deutsche Asset & Wealth Management’s Co-Chief Investment Officer of Asset Management Dr. Asoka Wöhrmann, CIO Office Chief Economist Johannes Müller, and distinguished professors from institutions like the University of Cambridge, the University of California Berkeley, the University of Zurich and many more, all made relevant and reader-friendly for investment professionals like you.

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Investment in Africa’s Frontier Markets: Frothy portfolio gains and long-term opportunities
The next big thing?
Frontier markets are currently hot news for portfolio investors. The term, originally created by the World Bank’s International Finance Corporation, has been around for two decades. It refers to those economies which are at an earlier stage of economic development than emerging markets but which seem capable of moving toward that status. Thus, frontier markets are typically riskier, less liquid, and have lower market capitalisation than emerging ones but hold out the possibility of rapid, prolonged growth.
As developed countries have struggled with stagnation and the BRICs have delivered less dramatic growth, the profile of frontier markets has risen. Funds composed of equities from these countries are delivering substantial returns, albeit after sharp losses in the aftermath of the Global Financial Crisis. More specifically, Africa is the current darling of buyers taking a chance on such investments: from the start of this year to the end of May 2013, the MSCI Africa Frontier Market Index is up by 26%, following on a 52% gain in 2012. Some individual markets are seeing even more dramatic rises. The All Share Index of the Nigerian Stock Exchange gained 34% between January and May after a 35% rise in 2012 and the Ghana Stock Exchange soared by over 50% in the first five months of this year. Debt markets are also becoming more attractive: in September 2012 a Zambian sovereign bond offering raised $750 m and was oversubscribed by 24 times. Foreign investors are taking note.
A story of growth
Africa has much to spark the interest of investors, beginning with resources – both natural and demographic: it has over 10% of the world’s oil, 40% of its gold, and 80% of its platinum. According to UN estimates, Africa’s current population of roughly 1bn, can expect to rise by about 50% by 2030 and to be more than double today’s figure by 2050. At the same time, the proportion of those who are working age will go from 54% currently to 58% in 2030 and 62% by 2050. In other words, Africa is set to reap the demographic dividend many emerging markets have already enjoyed.
The continent has always had resources, though, and youth is an economic blessing only when combined with employment opportunities. On this front African economies have been expanding strongly in recent years aided by governments addressing the overarching business environment. As then World Bank vice-president for Africa Obiageli Ezekwesili said in 2012, “In the last decade... Africa...made peace with the concept of macroeconomic stability as being fundamental for growth.” Reforms have been widespread: according to the World Bank’s Ease of Doing Business data for 2013, of the 15 countries that have seen the most improvement over the last five years, seven are from the continent. Governments have also been addressing debt: an Ernst & Young study of 15 sub-Saharan states calculated that average foreign state indebtedness as a proportion of gross national income fell from 120% in 1994 to just 21% in 2011. Though this is largely a result of debt forgiveness, better economic management plays an important role.
These efforts are being rewarded: Economist Intelligence Unit figures indicate that eight of the 20 fastest growing economies in the last five years are African and nine of the 20 that will see the greatest growth in the next five years are also forecast to be from the continent. At a regional level, for most of the last decade, sub-Saharan Africa and North Africa have seen growth comfortably above the global
A Global Financial Institute research paper written by the Economist Intelligence Unit
June 2014
Written by

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average. Looking ahead, the IMF predicts that economies in sub-Saharan Africa will grow at around 6% annually over the next two years, well surpassing the global figure of 4%. To 2030, CitiGroup has forecast that, the continent’s share of global GDP will go rise from 4% to 7%.
Michael Lalor, lead partner at Ernst & Young’s Africa Business Centre, notes two important attributes of this growth. The first, he says, is that “the progress we’ve seen has been sustained over a decade. It is not just one or two years of growth.” Second, although “natural resources remain a key driver of growth and investment, the extent of diversification is often overlooked.” Only about a third of the continent’s growth has been commodity-related. Manufacturing, telecoms, and local services, are all seeing marked activity. Consumer spending, meanwhile, accounts for over 60% of sub-Saharan Africa’s GDP and is also rising substantially according to the World Bank. Indeed, domestic growth and low levels of debt have helped to cushion African states from the economic difficulties facing much of the rest of the world.
That is not to say doing business in Africa is trouble free. Simplistic comparisons with emerging giants are problematic as the continent’s 54 countries fragment markets not only through diverse regulatory regimes but also in terms of cultures, tastes and languages. Corruption remains endemic in sub- Saharan countries, including Nigeria and Kenya which are tied for 139th place (out of 174) in Transparency International’s Corruption Perception Index. Moreover, although regulation is improving, progress according to Mr Lalor remains, “uneven and moves at what sometimes feels like a frustratingly slow pace.” Indeed, for Weyinmi Omamuli – a sub-Saharan African economist– it is the slowness in reforming political and regulatory structures that is the greatest threat. Failure to provide policies that allow further growth and the development of necessary infrastructure will undermine the ability of Africans to earn and spend further. “Consumer growth,” she explains, although substantial “is still pretty vulnerable.”
But where is the frontier?
Africans have frequently, often justifiably, complained about the extent to which writers generalised bad news to create a distorted, monolithic image of a highly diverse continent. Those discussing the current positive economic story should avoid the same mistake. To begin with, much of the current good news – population prospects, economic reforms, and resultant growth – applies largely south of the Sahara while political and social changes are taking a toll in North Africa. South Africa, the largest economy in the region, has also not kept pace with its sub-Saharan neighbours; in 2012 its 2.5% GDP growth kept down the broader regional figure of 4.3%.
In considering frontier capital markets, though, the problems facing these parts of the continent are of only indirect import because South Africa and the major economies of North Africa are already considered emerging markets. The difficulty is deciding just which countries are members of the frontier club when looking at portfolio investment. Growth alone is not sufficient: in the last five years Rwanda has had the fourth fastest rising GDP in Africa and recently issued a $400m bond on world markets, but with an entire economy worth just over $6bn it lacks depth for potential investments.
In practice, frontier portfolio investment in Africa revolves around a handful of countries and is dominated by the purchase of Nigerian securities. Although no universally agreed list of frontier markets exists, most include only a few African states. Nigeria is inevitably one. MSCI’s African Frontier Markets Fund – a frequently cited index of the performance of these markets – includes equities from there, as well as Kenya, Tunisia and Mauritius but has very few holdings in the latter two. A close look at other African funds usually shows that, beyond a single investment or two in any given country, most money goes into these countries as well as, sometimes, Ghana with the large majority headed to Nigeria. Among all investors, the bias toward that country is even more marked. The EIU estimates that net portfolio investment into sub-Saharan Africa (excluding South Africa) rose from $5.1bn in 2011 to $10.9bn in 2012. The equivalent figures for Nigeria are $3.5bn and $10.3bn, or 94% of the total in the latter year.
These are net figures. The only other frontier country seeing inward portfolio investment on the same scale as Nigeria is

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Mauritius but even more money – as far as can be pieced together from different data sources – then flows out from some of the 27,500 holding companies controlling $400bn in assets located in this tiny tax haven. African portfolio frontier investors, then, may point to the potential opportunities across the continent, but in practice most are really sending hot money to Nigeria and one or two other places, while others use Mauritius as a base to control their holdings, often in India.
The implications for investment
Capital markets are supposed to link those looking for better returns with firms looking to grow. The narrowness of portfolio investment in African frontier markets, however, arises because they are currently still too thin to perform this function to any large degree. The total market capitalisation of firms on Nigeria’s exchange is roughly $70bn – about equivalent to eBay, the 45th largest American company. Kenya, the next most liquid, has a market capitalisation of only around $20bn. However, MSCI, basing its assessment on both on the value of shares and their availability to trade, estimates that the free-float adjusted market capitalisation of the major exchanges in Nigeria, Kenya, Tunisia, and Mauritius are collectively below $30bn. Given the market size, resources and population of sub-Saharan Africa, this leaves significant potential for growth as yet untapped.
Debt markets are also small at the moment. According to the IMF, government and corporate bond market capitalisation as a proportion of GDP in sub-Saharan Africa outside of South Africa is among the lowest in the world. The corporate figure is just 1.3%, compared to 23% in China, 46% in Europe, and 99% in the United States.
For those looking to cash in on rapid index growth in the short term, market size clearly presents a problem. As the Economist commented in February, currently “There are not enough listed African firms to absorb even a fraction of the ignorant money itching to flow south of the Sahara.” Overall, Mr Lalor explains, “Outside of South Africa, capital markets are clearly still very immature.” Those very few African frontier firms that can tap into capital markets may enjoy very cheap access to capital as long as current investor interest in the continent remains strong and a flood of hot money does not create a bubble. Nevertheless, investors are likely to struggle to find such opportunities as so many businesses remain outside of listed exchanges.
Should all this worry Africa’s frontier? Probably not. First of all, frontier economies almost by definition have thin capital markets. As economies grow over the long term, so should market capitalisation. This has already been happening. According to World Bank data, between 2002 and 2012, total market capitalisation in sub-Saharan Africa (excluding South Africa) rose by a total of 4.1 times – more than double the rate in high income OECD states (1.9 times). If the continent follows the path of Asia’s emerging giants, this accumulation will accelerate: India and China saw total market capitalisation rise by factors of 9.6 and 8.0 respectively during the same period. The factors described above which bode so well for African economic growth should thus help with capital accumulation in the equity markets, although investors should be prepared for plenty of bumps along the way.
To move growth along, notes Mr Lalor, “There is a strong case to be made for their regional consolidation: this will help to create critical mass and accelerate the development process”. Authorities are certainly looking at the idea. January 2013 saw the first meeting of the West African Capital Markets Integration Council which has been established by the Economic Community of West African States. The body, made up of the heads of local exchanges and securities commissions, has been established to help create common regulatory standards and a common trading platform across the region. Meanwhile, in August 2012, the East African Community founded the East African Securities Regulatory Authority which has been looking at joint supervision of companies cross listed in national exchanges and mutual recognition of licenses of capital market professionals. The slow progress of the Southern African Development Community’s Committee of SADC Stock Exchanges (CoSSE), which has been promoting integration since 1997, shows that good intentions alone will not be enough. It has had some success in harmonizing regulation, but adoption of common technology has not occurred and, as Beatrice Nkanza, CEO of CoSSE wrote last

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year, “Robust cross-border trading between the region’s stock exchanges is not yet the norm.” Nevertheless, if better ties can be established between markets it should help increase overall market depth and liquidity. At the same time, common regional regulations would improve transparency, especially in smaller markets.
The development of the region’s debt markets, on the other hand, may not be so straightforward. Ms Omamuli points out that many sub-Saharan countries, as a condition of their debt relief from international lenders, have accepted limits on their future level of commercial borrowing under the Debt Sustainability Framework, which regularly assesses countries’ debt burdens over a 20-year horizon. “You will see more countries coming onto the market but what people forget is really that the amount they can borrow is very limited.” If those countries, as a result, do not tap into debt markets at all, it can have a knock-on effect on corporate borrowing. Without a sovereign debt rating against which to benchmark themselves, companies in a given country rarely move onto debt markets.
For many countries in the region, the current size of capital market is less of a focus than their overall investment inflows. Mr Lalor notes that “While the capital is no doubt welcome, the risk with portfolio investment is that it is often short term in nature, and can create volatility. Clearly developmental policies cannot be shaped around these shorter term capital flows.” At this stage, the region needs long term capital but opportunities exist for those with a high risk tolerance and a willingness to venture in for the long haul.
Nor are all Africans, entirely comfortable with the dangers of foreign portfolio investment. Nigeria’s Central Bank, for example, has highlighted the short-term nature of rapid rising foreign portfolio investment – which in the last quarter of 2012 was double the value of FDI – as a threat to external account stability. Renaissance Capital, an investment bank specialising in emerging markets, has even speculated that Nigeria might re-impose capital controls in some form to prevent the rapid reversal of portfolio investment and the attendant disruption that could cause. (The issue may resolve itself. The EIU, citing lower expected oil revenues available to drive economic growth, predicts that foreign portfolio investment in Nigeria will drop to between $5bn and $ 7bn annually for the next four years. This will bring down the sub-Saharan figure to the same range over that period.)
Instead, direct investment – be it greenfield or acquisitions – seems the much more likely way for those with money to benefit from Africa’s growth in the short and medium term. Foreign direct investment has risen substantially in recent years: E&Y reports that since 2007 the value of greenfield FDI projects in sub-Saharan Africa outside South Africa has grown at a compound annual rate of 22%. Meanwhile, even as the EIU sees foreign portfolio investment dropping to a lower plateau in these countries, it is projecting a slight increase in overall FDI in 2013. FDI is also much more widespread among countries, with Angola, Nigeria, Ghana, Equatorial Guinea, and the Republic of Congo each receiving over $2bn in inward FDI in 2012 and Zambia projected to join this group in 2013. Even Liberia is seeing a $3bn investment in plantations spread over several years by Sime Darby, a Malaysian multi-national. As Mr Lalor says, “It is obviously important to develop capital markets with depth and resilience. However, equity flows/investment are arguably less important at this point in Africa’s relative development than investment in infrastructure and greenfield projects.”
Asian investment
A broader look at FDI leads to another leading investment story in African that has been attracting attention recently: the source of the investment. A recent UNCTAD report showed that, although France and the United States still provided the most inward FDI in 2011 for the continent, the next three countries were Asian: Malaysia, China, and India. These states also have the 4th, 6th, and 7th largest overall African FDI stocks. Much of the Indian and Malaysian investment goes to Mauritius which likely sees at least some investments routed elsewhere. Chinese investors use the island less as a tax haven and their growing stake in the continent may even be under-estimated. Despite such caveats, the UNCTAD data are consistent with the growing presence of Asian companies on the ground, including such notable activity as the $10.7bn purchase by India’s Bhati Airtel of the African mobile phone networks of Zain.

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Asian investment is often mischaracterized as no more than an attempt to ensure access to the continent’s raw materials. However, according to UNCTAD, the majority of such investment, whether measured by value or deals, is in services or manufacturing. Only about a quarter of the money from the BRICS went toward investments related to primary goods. One example of the broader extent of investment is Industrial and Commercial Bank of China’s 2007 acquisition of 20% of Standard Bank for $5.5bn. This wider focus, believes Ms Omamuli, will help make the current growth cycle more sustainable. In previous eras, commodity demand in developed countries usually drove rises or falls GDP. Now lower cost labour and growing consumer markets are allowing African countries and Asia’s emerging economies “to form a different type of relationship based on mutual interests, not just resource transfer.”
African economies have strong prospects for growth and, alongside this, capital markets are likely to develop and mature. However, they are too small to channel the funds of those interested in these frontier markets into African development. Dramatic index gains may simply reflect too many buyers chasing too few securities. Foreign investment will nevertheless play an important part in Africa’s future, but for the foreseeable future it will take the form of direct investments by those with the patience to see through the inevitable ups and downs of frontier market development. These funds whether from the East or the West, can also help reshape Africa’s role in the world economy, as it transforms from a purveyor of raw materials to an economic partner and market in its own right.

Disclaimer
Deutsche Asset & Wealth Management represents the asset management and wealth management activities conducted by Deutsche Bank AG or any of its subsidiaries. Clients will be provided Deutsche Asset & Wealth Management products or services by one or more legal entities that will be identified to clients pursuant to the contracts, agreements, offering materials or other documentation relevant to such products or services. This material was prepared without regard to the specific objectives, financial situation or needs of any particular person who may receive it. It is intended for informational purposes only and it is not intended that it be relied on to make any investment decision. It does not constitute investment advice or a recommendation or an offer or solicitation and is not the basis for any contract to purchase or sell any security or other instrument, or for Deutsche Bank AG and its affiliates to enter into or arrange any type of transaction as a consequence of any information contained herein. Neither Deutsche Bank AG nor any of its affiliates, gives any warranty as to the accuracy, reliability or completeness of information which is contained in this document. Except insofar as liability under any statute cannot be excluded, no member of the Deutsche Bank Group, the Issuer or any officer, employee or associate of them accepts any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this document or for any resulting loss or damage whether direct, indirect, consequential or otherwise suffered by the recipient of this document or any other person. The opinions and views presented in this document are solely the views of the author and may differ from those of Deutsche Asset & Wealth Management and the other business units of Deutsche Bank. The views expressed in this document constitute the author’s judgment at the time of issue and are subject to change. The value of shares/units and their derived income may fall as well as rise. Past performance or any prediction or forecast is not indicative of future results. Any forecasts provided herein are based upon the author’s opinion of the market at this date and are subject to change, dependent on future changes in the market. Any prediction, projection or forecast on the economy, stock market, bond market or the economic trends of the markets is not necessarily indicative of the future or likely performance. Investments are subject to risks, including possible loss of principal amount invested. Publication and distribution of this document may be subject to restrictions in certain jurisdictions. © Deutsche Bank · June 2014
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