Sub-Saharan Africa, once written off by all but the most adventurous entrepreneurs, has staged an impressive comeback. However, could plunging commodities prices and risk aversion now threaten that renaissance? Justin Pugsley reports.

Even though African banks largely kept clear of investing in US sub-prime follies, the continent is nonetheless suffering from the effects of the global fallout it has caused. The most obvious impact is that of the global economic slowdown, which is slashing demand for raw materials – Sub-Saharan Africa’s main export.

One of the clearest indications of the rapidity of the slowdown has been the impact on the Baltic Exchange Dry Index (BDI), which has collapsed from a giddy peak of 11,550 to just under 900 at the beginning of December.

This index measures the cost of shipping bulk commodities from iron ore to grains around the world. It is often used by economists as a proxy for measuring the pulse of international trade and economic growth. There’s falling import growth from the US, less US grain exported, slipping iron ore demand from China and lower coal imports by Japan. These factors have certainly had an impact.

However, what has substantially added to the downward pressure is shipping over-capacity. Typically, many owners prefer to run their fleets at a loss rather than have them idling in ports. The Economist Intelligence Unit predicts that shipping, which accounts for around 90% of world trade will probably decline by just 0.5% next year.

Don’t underestimate the effects
Nonetheless, the slowdown in international trade and in the commodities trade in particular does have a big impact on Sub-Saharan Africa.

Indeed, there are concerns that dwindling cashflows from commodities could endanger Sub-Saharan Africa’s recent renaissance. But in fairness, Africa’s revival was also down to improved governance, sovereign debt write-offs, growing infrastructure investment along with an emerging middle class in numerous countries on that continent.

Hopefully, these factors will safeguard these countries from the worst vagaries of the commodities markets long enough for them to enjoy the recovery once the global economy resumes normal service.

In terms of margins and tenors, the really big impact of the US blow-out on the region has been on risk appetites. Some international banks have simply pulled in their horns and are trimming their exposure to emerging markets such as Africa in a headlong rush for safety and to rebuild capital ratios. This drain in confidence has most obviously been felt in the area of project finance, particularly for mining. The big international banks have not only been rocked by the global liquidity drought, but are also concerned about the potential viability of new mining projects.

This is not overly surprising given the performance of copper, for example, which happens to be another bellwether of the global economy. Copper futures on Comex fell from a peak of about US$4.00/lb during the middle of 2008 to around US$1.65 at the beginning of December.

A very substantial fall and who knows whether this market has even bottomed yet? A similar story can be told for other metals, which have also experienced precipitous falls. Many junior mining companies, which were spearheading so many of these projects in Sub-Saharan Africa are now struggling to survive. They’re being shunned both by equity investors and banks, especially if they’re yet to generate any cashflow.

A number are likely to fold with the luckier ones being taken over or merged with cash rich counterparts.

Trade block
However, trade finance, traditionally a much safer aspect of banking, has also been affected, quite badly.

Bankers and corporates are reporting a considerable tightening in margins and a shortening of tenors, but at least deals are still being done. However, some typical buyers of African commodities now can’t even open letters of credit (LCs), such is the risk adverseness of some local banks. For example, they are now much more weary of LC guarantees issued by other banks. It’s as if the glue that holds international trade together is steadily coming unstuck.

Problems with obtaining LCs have been prevalent in China, which until recently had been making deep in-roads into Sub-Saharan African economies via trade and investment. Other countries which have experienced similar problems include Vietnam, Turkey and Brazil. Another casualty is South Africa, although bankers report it is easier to do rand-financed trade transactions than dollar denominated ones.

These problems have predominantly fallen on small-to-medium-sized enterprises (SMEs), which had been a growing source of demand for commodities. However, they are also the hardest for banks to evaluate in terms of solvency, especially in some emerging markets where verifying financial data is more challenging. Back in China, thousands of small exporting manufacturing enterprises, which consume metal among other commodities, have being going broke.

These problems have certainly hit smaller traders as well, which focus on trading commodities out of African into other markets.

“The minute the banks started pulling credit lines, we were affected,” says one commodity trader. “Putting letters of credit together is now much harder and more expensive, yet more people want to use them.”

He is also concerned over the impact of liquidity drought on the viability of some commodity producers. “Falling commodity prices and the credit crunch have increased the risk profile of commodity producers,” says Pit-Haen Ingen Housz, managing director, commodities, Fortis Bank Netherlands.

But even for big multinationals, the cost of financing trade has gone up substantially. However, the big falls in commodities prices does help some traders, although many have lost money speculating in products such as steel.

“Because of the lower collateral value of commodities, traders and buyers of commodities don’t require as much credit as previously, which is potentially positive for their balance sheets,” says A Ganesh, regional head of Africa and Mena for commodities traders and agriculture with Standard Chartered Bank.

Year zero?
Nonetheless, some economists are so worried about these problems that they are openly speculating about the possibility of international trade grinding to a halt if confidence is not somehow restored soon.

Andrew Burns, an economist at the World Bank, recently said global trade may contract by 2% next year, in contrast to what had become normal 5-10% annual increases. Though the percentage seems small, it would be a dramatic reversal in fortune for a segment of global economic activity, which had seemed hitherto relatively safe and predictable.

This is particularly damaging for intra-emerging market trade, which had been a strong growth driver for Africa with booming Asian economies becoming such important clients for its commodities. Even in the US, small businesses are finding it much harder to open letters of credit and get those all important credit guarantees on them.

“There is definitely a squeeze in liquidity going on. Finance margins on maize export deals out of South Africa to nearby African countries have increased 100-250 basis points depending on the buyer and the country,” explains Dean Scoble, commodity finance, South African market, with Standard Bank. “There’s definitely a much lower risk appetite.”

However, tenors on loans relating to corn exports, typically three to six months, have changed little. “These are seasonal items and tenors anyway tend to be quite short,” he says.

However, a growing trend he has noticed is the tendency for banks to temporarily take ownership of the commodities in question and then sell them back to the client. “It helps their balance sheet and overall borrowing profile,” says Scoble.

Another issue says Ganesh is Basel II, which is forcing banks to be more selective in who they lend to. In essence the accord favours strong credits in terms of the amount of capital that needs to be set aside against those loans. This hardly favours emerging market borrowers and increasingly many developed country corporate credits, which are being impact by recession.

Indeed, there are growing calls for Basel II to be revised.

Changing products
The new spirit of caution has also changed the nature of commodity trade finance products. “Loans are increasingly self liquidating lines of credit, rather than the longer terms redeemable after three to five years,” says Ganesh. Not only are those self-liquidating loans of shorter tenors, maybe out to a year, but the margins are higher. On dollar credit lines margins are up by an extra 100-150bp.

Syndicating loans is also much harder now. “You’re tending to see more club deals,” says Ganesh. “Besides, many banks don’t have the ability to keep much of the loan on their books.”

Unfortunately, local African banks aren’t that much help either as they are often too small, especially when it comes to participating in dollar loans. “Though we do try and include them in local currency loans,” says Ganesh.

Even structuring cocoa export finance in countries such as Cote d’Ivoire has become harder, partly because a few international banks have reduced their exposure there. This has helped push up margins by some 150bp. Also, a number of banks, which recently ventured into commodity finance are now pulling back.

Cocoa producers as well are finding funding more difficult. In many cases they relied on credit from traders, which in turn borrowed from the banks. In some ways this was an ideal relationship as the traders know their suppliers intimately and are in a better position to judge the risk involved in lending to them. But with those credit lines now restricted, many traders can no longer act as bankers to local producers.

Another trend picked up by Ganesh is corporates relocating from East African countries such as Kenya, to Dubai. In terms of trade flows nothing has changed.

Kenya still exports tea to the Middle East and Europe and imports petroleum from the Gulf, for example. What has changed is the paper trail. The move is usually due to tax reasons.

Another reason is one of logistics. Dubai is increasingly establishing itself as a regional trade hub and an ideal location for buyers to source commodities. The emirate has seen to it that a trading infrastructure has been established made up of commodity exchanges, a legal framework, certification processes and bonded warehouses.

Mauritius has proved a popular country for East African traders to relocate to as well because of its favourable fiscal climate.

Meanwhile, supply chain finance (SCF) is beginning to make an appearance in Africa. Often it involves large multinationals, which source materials such as cocoa, coffee or tea, from the continent.

Given the problems with obtaining finance, setting up SCF programmes for the benefit of local producers does potentially make sense. “As far as these multinationals are concerned an important attraction of SCF is that the financing can be off balance sheet,” says Ganesh. “This can be structured around special purpose vehicles for example.”

Although there are ongoing discussions about SCF, little has of yet been established. The combination of the credit crunch and multinationals keen to secure their supply chains might spur the roll out of SCF into much of Africa.

Metals meltdown
Mining finance in general has been hammered and it isn’t just affecting projects in Africa. On December 2, 2008, Credit Suisse released a research note detailing some of the latest set backs for mining projects across the world.

The bank estimates that 119 new projects are likely to be deferred, representing around US$193bn of capex over the next five to seven years. That means a big drop in the use of project finance in this area for the time being. “Our companies (those followed by Credit Suisse analysts) are hunkering down, focusing on cash and delaying their growth programmes,” it says in a report.

Credit Suisse goes on to state that its original forecast made on October 27 for US$200bn of capex deferrals now looks conservative if the rate of cancellations continues over the coming months.

What this translates into in real terms is some 559mn tonnes of future iron ore, (66% global seaborne market), 4.5mn tonnes of copper, (25% of global supply), 4.7mn tonnes of aluminium, (12% of global supply), 396,000 tonnes of nickel (28%) and 0.6mn tonnes of zinc (4%) could be deferred for at least two years.

“Nearer-term production shutdowns of existing capacity are also flooding in. So far, 75 closures have been announced that represent 10% of global seaborne iron ore, 4% of copper, 6% of zinc, 29% of ferrochrome, 10% of nickel and some 10% of aluminium,” says Credit Suisse.

The firm goes on to explain that these shutdowns are down to more than just price falls. Demand in many cases has simply evaporated.

“Very few new mines have been financed in Sub-Saharan Africa,” says Judith Mosely, managing director of mining finance, Société Générale. “We remain open to financing sound projects on a selective basis.”

It is this lack of new projects, which makes it difficult to give guidance on issues such as financing terms, margins and tenors. Although, any new project, however sound, would now inevitably face much higher funding costs than it would have done say two years ago.

Also, there are many subsidiary issues related to funding mines in Africa. In the Democratic Republic of Congo, for example, there is some uncertainty over mining laws.

“Although Africa is rich in prospects, there are a lot of other things that need to be considered such as proximity to infrastructure and power supply,” says Mosely. “The cost of having to build this infrastructure as part of a mining project can make it marginal.”

Mosely sees a collaborative approach for potentially getting projects off the ground. This can involve ECAs providing loan guarantees for the supply of mining equipment, which can help a project look more viable.

“Guarantees containing comprehensive cover for commercial and political risk are particularly useful,” she says. “At the same time it can help if the mining company can negotiate future long-term offtake agreements with counterparties with strong credits.”

Setting up the next boom?
Looking forward, the scale of the current freeze in new mining projects and other deferrals must surely be setting the scene for a big rebound in metals prices at some point.

Indeed, Credit Suisse has done some sums on that prospect. It noted that demand is likely to be down anywhere between about 10% for copper and 40% for iron ore for the fourth quarter.

“As the rate of decline in demand begins to slow, the market will eventually reopen the case for supply,” says the report.

So far of the four big mining houses, BHP, Rio Tinto, Xstrata and Anglo American, only BHP is expected by analysts to maintain a good part of its capex programme, while the others defer their projects while waiting for a more favourable economic climate.

Indeed, the preferred route for acquiring new mines during periods of depressed prices is often through the stock market. Namely by acquiring peer mining firms with attractive assets, which the stock market prices at a discount. This is done at the expense of exploring for new metal deposits and developing them, which is anyway time consuming, expensive and risky. Many of these takeovers will come down to share-based transactions.

However, at some juncture when the economic recovery occurs, metals stocks will become run down and supply growth will be even more constrained than during the last five year boom, reckons Credit Suisse.

Depending on the length and strength of that recovery, prices of many commodities could reach even higher peaks than last time. As risk appetites once again increase new mining projects are likely to get restarted across the African continent.

“Consumers of these commodities are looking to keep their stocks as low as possible now,” says Housz. “When the markets come back, a lot of people could be in for a shock when they find that many of these commodities are in short supply.”

He explains that the long-term demand profile for many grain and soft commodities, for instance, is actually quite bullish and that’s not just because biofuels.

“You see changing consumer habits in China and India as they move towards eating better quality food and consuming more meat, which will have a big impact on grain demand.”

For a country like South Africa, the continent’s biggest corn producer, the impact could be considerable. Even the move towards consuming more luxury foods such as chocolate could in time have a big ripple effect on cocoa demand.

In the meantime all eyes will be on the US and its new president, Barack Obama — a man with some Kenyan ancestry. The US is subject to a huge monetary and fiscal stimulus to jump start its spluttering economy. It is likely to be the first major country to resume growth and this will eventually trickle down to the rest of the world.