Cost of Equity (COE)

Along with changes in the supply of capital and investable opportunities, another factor that influences the prices at which assets change hands is the perceived risk and rewards of a particular investment. Cost of equity (COE) represents investors’ estimate of a fair rate of return required for an investment based on the risk. To estimate the changes in the risk exposure perceived by investors, we have estimated an average cost of equity for each market.

Most countries showed a decrease in the cost of equity from December 2018 to December 2019. Most notable is Egypt’s 3.35% decline, which can be attributed to reduced investment risk as Moody’s upgraded the country’s long-term foreign and local currency issuer ratings from B3 to B2. Moody’s decision stems from the expectation that the ongoing Egyptian fiscal and economic reforms will steadily support real GDP growth. Moody’s expects that the maintained primary budget surpluses, combined with strong nominal GDP growth will reduce the country’s vulnerability to financing shocks.

However, in May 2020 the rating agency affirmed the country’s rating with a stable outlook on the back of a track record of economic and fiscal reform implementation and Egypt’s demonstrated capacity to manage significant shocks, which reduce the likelihood of a global financial market disruption severely affecting the country.

South Africa experienced an increase in COE levels from December 2018 to March 2020, which is mostly attributable to the deterioration of the country’s fiscal strength and structurally low growth. Moody’s argues that South Africa’s debt burden will rise over the next five years under any plausible economic and fiscal scenario and that further downgrades are possible if poor growth, high fiscal deficit, and rising financing costs persist.

From December 2019 to March 2020, an increase in the COE was experienced in all countries. These increases include significant markets such as Ghana, Kenya, and Nigeria, where COE increased by 2.96%, 2.34%, and 2.59%, respectively. The COE increase is attributable to a universal increase in risk due to the global impact of COVID-19.

Several African economies are very dependent on the export of commodities. For example, Nigeria, a large investment market, is highly dependent on the export of oil. The collapse in international crude prices following the pandemic caused massive shockwaves throughout these economies. The heightened fiscal risks and uncertainties stemming from the disruption have also contributed to the increase in COE levels.

Ghana and Nigeria have had larger increases than Egypt and South Africa, which experienced COE increases of 1.08% and 0.74%, respectively. Egypt and South Africa are the only African countries that are classified as emerging markets and are therefore considered to have far more robust capital markets, possibly resulting in smaller increases in COE levels. Another factor contributing to the lower movement in the Egyptian COE level is the country’s decline in currency risk. According to Fitch Solutions, Egypt’s long-term inflation has been revised downwards as price growth is expected to moderate as inflationary pressure stabilises. As such, Fitch Solutions expects inflation to average 5.7% over the coming decade, compared to a peak of 29.6% in 2017 and 9.4% in 2019.

The worsening macroeconomic environment has driven a significant increase in COE levels in Zambia. The Zambian economy has been plagued by weak governance, policy uncertainty, and an undiversified trade portfolio that is heavily dependent on commodity exports. Moody’s and Fitch have both downgraded Zambia’s long-term foreign-currency bonds, citing grave concerns regarding the country’s ability to meet debt obligations.

From March 2020 to June 2020, COE has reduced for most markets under review, except for Ethiopia. The overall movement in COE from December 2019 to June 2020 for Ethiopia can be mainly attributed to a change in its currency risk. According to Fitch Solutions, the Ethiopian monetary policy is considered uncoordinated as the National Bank of Ethiopia has elected to increase the money supply in a relatively high inflationary environment to boost public investment. Along with imported price pressure, this increase in money supply is expected to drive Ethiopia’s inflation to an average 12% per year between 2020 and 2029.

The sovereign credit default spread is a quantitative measure of each country’s sovereign risk. This measure is used to calculate the COE of each country. The graph, “Credit default spreads from Jan 2018 – June 2020”, illustrates how the credit default spreads have changed from January 2018 to June 2020 for a selected group of African countries.

Overall, we have seen a sharp increase in sovereign credit default spreads from December 2019 to March 2020. This is mostly attributable to the global risk-off environment ignited by the devasting economic impact of COVID-19, with investors moving away from riskier emerging and frontier markets towards safer, more developed markets. As African markets are classified either as frontier or emerging markets; this impact was heavily felt on the continent.

Movements in credit default spreads from December 2019 to March 2020 for countries such as Nigeria and Ghana were far more significant than for other African countries. This may have been caused by the additional risk of commodity dependence in these economies. The movement in credit default spreads from March 2020 to June 2020 represents the stabilisation of markets as global economies recovered from initial lows, as well as the impact of world-wide quantitative easing.