Commodities: Curse or Cure for Africa?
Recent years have been tough for commodity-exporting countries, companies involved in the production and trading of commodities, and investors into such countries and companies alike. The Bloomberg Commodity Index, a widely followed benchmark tracking 21 commodity futures contracts traded on major exchanges, declined by 49% since its peak in May 2011. The index only declined by 10% between May 2011 and June 2014, when the bear market in commodities accelerated on the back of the free fall in energy prices.
While energy has the largest weight in major commodity indices, such as the Bloomberg Commodity Index or the S&P GSCI Index, other commodity markets, particularly base and precious metals, fared not much better. Since May 2011, copper fell by 44%, gold by 25% and platinum by 46%. While cocoa stood out with a decline of only 5% during the same period, other agricultural commodities got hammered. Coffee fell by 61% and raw sugar by 35%.
As can be imagined, shares of listed commodity producers and traders came under pressure as well. Since the beginning of 2013, shares of BHP Biliton, the world’s largest mining company, fell by 45%, those of Anglo-American, the world’s largest producer of platinum, by 70%, and shares of Glencore, the world’s largest commodity trader, by 68%. While the decline in value of those companies does primarily affect large shareholders, the bear market in commodities sealed also the fate of whole economies.
The value of local currencies against the US Dollar is a good proxy to demonstrate the devastating macroeconomic effects on (mostly developing) nations which rely on commodity exports. Since January 2013, the Brazilian Real depreciated by 89%, the Russian Rouble by 105%, the Australian Dollar by 31% and the Chilean Peso by 43%. Commodities, which are valued and traded in US dollars, can be considered real currencies of countries depending on their export, with their (fiat) currencies a derivative of the US Dollar price of respective export commodities.
The current bear market in commodities is driven both by demand and supply. Chinese demand for commodities, particularly base metals and energy, had multiplied in the last two decades, driven by yearly GDP growth rates of 8% to 10% in the world’s most populous country. Investments as a percentage of GDP were regularly above 40%, due to fixed capital formation and a boom in construction. During that time, China has not only accumulated substantial currency reserves, but also built huge reserves of strategic commodities.
The rapid growth of the Chinese economy has led some observers to declare the advent of a “super-cycle,” with China slowly taking over the role as the centre of the global economy from the United States. To put the scale of the commodities bull market into perspective, the S&P GSCI Index is still up by 73% since January 2000, despite a decline of over 50% since May 2011.
Chinese demand for commodities had a last acceleration during the global financial crisis of 2008/2009. A massive government-driven investment programme into infrastructure and residential real estate, on the back of substantial declines in exports to developed countries, fuelled Chinese demand for iron ore over copper to coal and petroleum products. As the utility of many investments turned out to be questionable, while liabilities of many local governments and state-owned companies soared to unsustainable levels, the Chinese government embarked on a transformation programme for the economy, away from investments and exports towards (private household) consumption. This transformation is going hand in hand with reduced GDP growth rates, and China is fully aware of this effect. In turn, Chinese demand for (industrial) commodities has waned.
On the supply side, commodity producers have ramped up production capacities during the heydays of the commodity boom. No project was too complex and no region too risky for not investing into new mines or wells, as retained earnings and easy access to cheap debt capital drove capital expenditure, while demand from China was extrapolated into perpetuity.
In the energy sector, the United States again proved its unparalleled capability for innovation, as it fine-tuned existing extraction technologies for domestic shale oil and gas, in turn eliminating energy imports from overseas.
With demand for commodities down across the board, production capacities have to be cut, until supply and demand find a new equilibrium. Given the scale of the preceding boom, this adjustment process can take years, moreover if overall demand remains sluggish.
Dependency of African countries on commodity exports
While much has been said about the huge potential of the African consumer and the emerging African middle class, it has to be acknowledged that commodity exports still play a decisive role for the economic well-being of many African countries. I would even argue that the emergence of a middle class in some African countries is mostly due to the commodity boom seen in the 2000s, and its multiplication effects on income.
Table 1 shows the dependency of selected African countries on commodity exports and five broad macroeconomic indicators: current account balance, fiscal balance, debt/GDP ratio, currency reserves and the performance of local currencies against the US Dollar. I have eliminated re-exports as far as possible, to capture only commodities genuinely extracted or grown in the respective country. Data sources are estimates from the IMF World Economic Outlook database, national statistic offices of the respective countries and own calculations.
Table 1: Commodity Exports and Macroeconomic Indicators of African Countries
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Current and future exploration projects have to be taken into consideration as well, as volatility in commodity prices can affect investment programmes in the countries where reserves of commodities are discovered. Oil and natural gas exploration projects in Kenya, Uganda, Tanzania and Mozambique were expected to attract considerable foreign direct investment. In the case of Mozambique, natural gas will possibly become the country’s primary export commodity at some point. That said, with the sharp decline in oil prices, many projects have been put on hold, in turn depriving those countries of an important source of foreign currency inflows in the meantime.
Botswana is standing out in the first group of African countries. The country will generate a current account surplus in 2015, while debt levels remain very low and the expected fiscal deficit for 2015 is negligible. No other African country has comparable currency reserves to cover imports. Prudent management of public finances and political stability are certainly important ingredients for the success of Botswana.
Also, diamond prices have suffered compared to those of other commodities, as high-end retail demand from the United States and Asia remained overall robust in recent years. But Botswana has also extended the value chain from simple extraction of raw diamonds to cutting and polishing. In 2012, Botswana agreed with De Beers, the major diamond miner in the country, to relocate diamond cutting and polishing functions to the country. This formula has created jobs and increased value addition, and it can serve as a blueprint for other countries overly relying on exports of raw commodities.
The endowment with rich natural resources has been a cure in the case of Botswana. On the other side of the spectrum, Nigeria, the largest economy in Africa since 2014, can be considered an example of the famous “resource curse”. In 2015, Nigeria is expected to post a current account deficit for the first time since 1998. The large drop in oil prices has not only weighed on export earnings. It has also depleted currency reserves and reduced foreign direct and portfolio investments during the last 18 months. Nigeria is virtually importing everything, including most of the foodstuff consumed, and importers find it increasingly challenging to procure foreign exchange to pay for goods bought abroad. The country finds itself on the brink of recession in 2015.
The deteriorating economic situation in Nigeria was one of the reasons the former government was swept away in peaceful democratic elections in March 2015. Another reason was a population tired of apparently widespread corruption. Once elected, the new president Buhari dismissed the top management of the Nigerian National Petroleum Corporation, the parastatal body which allegedly helped corrupt politicians and bureaucrats to embezzle billions of US dollars in oil revenues during the reign of the former government.
Again, extension of the value chain in the oil and gas sector is an important aspect of the current policy response in Nigeria. Refining of crude oil shall be enhanced in the years ahead, to keep the premium on refined petroleum products in the country. Also, the vast natural gas reserves shall be increasingly used to fire power plants, as Nigeria, like many African countries, is suffering from chronic blackouts. But all those measures take time, and there are of course risks to proper execution of the projects, as well as question marks on the political will to change the way of doing business. Even with the best intentions, Nigeria will face an uphill battle to transform its economy when oil prices are hovering around 50 dollars per barrel.
Strategy of patronage
Oil is also playing a prominent role for Ivory Coast and Ghana (the second group of countries highly dependent on two or more commodities). The former started to produce (offshore and shallow water) oil already in 1980, while the latter took more than a decade longer. Offshore oil reserves have recently led to a dispute between the two neighbours, as both countries lay claims on the TEN oil field. Ivory Coast and Ghana are also the largest and second largest producers of cocoa in the world. In addition, Ghana is one of the largest gold exporters in Africa. Both countries have reached lower middle income status in recent years.
Despite living through short periods of civil war in 2002 and 2011, economic development in Ivory Coast has recently surpassed its neighbour. The country will be one of the fastest growing African economies in 2015. Value addition in the oil and cocoa sector has traditionally exceeded the capabilities of Ghana. Ivory Coast avails of oil refineries and processes a part of its cocoa bean harvest to cocoa paste and butter.
Since its accession to lower middle income status in 2011, economic development in Ghana has slowed down considerably. One of the main reasons are ballooning fiscal deficits and external debt levels, as the government lost control on current expenditure. The rise in current expenditure was mostly driven by generous increases in salaries for public sector employees. This strategy of patronage has been applied time and again in Africa by incumbent governments, with the obvious goal to buy support.
Zambia is another example where both headcount and salaries of public sector employees has risen substantially in recent years, as copper rallied from levels around $2,000 per metric tonne in 2003 to $10,000 per metric tonne in 2011. Bull markets in export commodities are usually accompanied by rising tax and/or royalty revenues, providing incentives to politicians to run such patronage schemes. The unintended consequences of this approach become apparent once prices for export commodities go down: government revenues contract but current expenditure remains.
In the case of Ghana, large fiscal deficits are going hand in hand with unsustainable deficits in the current account, rising levels of external debt and depletion of currency reserves. In turn, the International Monetary Fund had to support the struggling country with an ‘Extended Credit Facility’ in April 2015 to prevent a balance of payment crisis. Ghana received $3.7 billion in debt relief under the Highly Indebted Poor Country initiative in 2002, which led to a decline of its debt/GDP ratio to 22% in 2006, from over 100% at the beginning of the new millennium. In less than a decade, the country managed to more than triple its debt and has been forced to go cap in hand to the IMF. And this despite record prices for its primary export commodities gold, oil and cocoa during that period. While one can always argue that things might be even worse without them, abundant natural resources have not really helped Ghana during the last years.
For the third group of African countries with more or less diversified economies, price action of export commodities does not, by definition, play a decisive role for the overall economy. As all of those countries are importers of petroleum products, the sharp decline in oil prices has on the contrary generated windfall gains. In this context, consistent current account deficits of 5% across these countries are somewhat surprising, though some such as Mauritius are estimated to narrow the deficit substantially in 2015, albeit from unsustainable levels. Persisting current account deficits in this group are, however, driven by idiosyncratic factors not specifically related to commodities.
Political leadership, a decisive factor
In principle, African countries can take pride on their rich natural endowment. Commodity reserves give countries a head start over those which depend on their import. Unfortunately, commodity reserves regularly turn out to be a curse, not a cure, for one major reason: corrupt and/or incompetent politicians at the helm of government and public sector institutions. Arguably, international commodity producers and traders have successfully exploited both greed and incompetence of politicians in the past. But the stereotypical African dictator is becoming increasingly a relic of the past: it is now up to the people in most African countries to decide on political leadership. In addition, governance and corporate social responsibility standards of many multinational companies have dramatically changed, mostly due to pressure from different stakeholders, including large institutional shareholders.
The extension of the value chain is certainly a good strategy for commodity-exporting countries in Africa. In 10 years’ time, African oil exporters might market gasoline and kerosene to other African countries, and African natural gas might fire power plants across the continent (if no technological quantum leap renders fossil fuels completely obsolete), while countries like Ghana or Ivory Coast might manufacture chocolate bars and export such products worldwide. But even if African commodity exporters are able to extend the value chain, they remain more vulnerable to external shocks as their economic fate is still intrinsically linked to the volatility of commodity prices. African countries which successfully manage both the creation of a manufacturing industry around their natural resources and the diversification of their economies across additional sectors, such as light manufacturing, technology and services, will be the future winners on the continent. It should be clear that political leadership will be a decisive factor.
By Philippe Koch
The author holds a Masters degree in business administration, the CFA charter and FRM designation. The opinions and views expressed in this article are of personal nature.
Courtesy: Conjoncture - Bilingual Journal of PluriConseil.