Do African Stock Markets Provide a Window of Opportunity to the International Investor ?

8/9/2019 Do African Stock Markets Provide a Window of Opportunity to the International Investor ?

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- 1 - 2009 PK Mwangi Global Consulting

Abstract:

This research looked at the concept of market efficiency in the weak-form and tested these in a sample of African stock

markets- the Johannesburg Securities Exchange (JSE), the Egyptian Stock Exchange (EGX), the Kenya Nairobi Stock

Exchange (Kenya NSE) and the Nigeria Stock Exchange (NSE) - selected as representative of the continents stock

markets. The FTSE/JSE Africa All-share index, the Hermes Financial index (HFI), the Kenya NSE-20 index and the

Nigeria All-share index respectively were used as proxies for these markets.

In the study non-linear modelling (runs test and the Wilcoxon Signed Rank test) was used so as to avoid deriving

erroneous results due to the assumptions on linearity made under linear modelling. In addition in order to capture the

real return generating process in these markets weekly returns were collected in an international currency- the US

dollar.

The aim of the study was to present the international investor with practical and relevant evidence on the efficiency

levels of African stock markets, an area that has become of keen interest to the international investor seeking to

diversify his portfolio and earn higher returns. To venture into these markets the investor needs the assurance that

stocks are correctly priced to facilitate maximum return on the allocation of resources. Any predictability and

autocorrelation in return series would compromise such efficiency in pricing and it was the intention of this study to

test these efficiency levels in the weak-form.

On the basis of this research all four markets were found to be weak-form inefficient in particular due to liquidity

issues that contributed considerably to detected autocorrelations. These results were further confirmed by semi-strong

form efficiency tests on stocks randomly selected from the relevant indices.

By adopting a triangulation approach in arriving at the study results the robustness of these results was confirmed.


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1: Introduction

1.1: Research Rationale:

In light of the recent turmoil in the world financial markets, investment portfolio diversification across region and asset

classhas become all the more critical to the success of the international investor. More and more international investorsare looking to emerging markets to diversify their risk and earn higher than average returns. In particular, previous

research (Ayadi et al., 1998 p.24) has shown that African stock markets are decoupled from other major stock markets

thereby creating the potential to earn positive returns since correlation is a factor in determining the cost of capital.

Lower correlation validates a lower discounting of future expected returns from a particular investment opportunity

thereby encouraging the allocation of resources in that direction. (Christofi and Pericli, 1999 p.79)

Not only emerging stock markets in Asia, the Middle East and Latin America, but also emerging African stock markets

have seen tremendous growth in the last decade and an increasing focus by international investors. According to

Standard and Poors(2008a), a leading publisher of financial research and analysis literature, international gross

portfolio inflows into Africa, excluding South Africa, increased from almost nil to $23 billion between 2001 and 2006

while gross foreign direct investment increased from $15 billion in 2001 to over $20 billion by 2006. In addition total

market capitalisation on the continent quadrupled between 2002 and 2007 from US$ 250billion to almost US$1.2

trillion (see Appendix IV) while between 1997 and 2004 five key African stock indices grew by in excess of 100 %. 1

This is a clear indication, not only of the recognition of opportunity in emerging Africa by international portfolio

investors, but also the increased economic activity that will be spurred by the massive FDI inflows which should

further spur stock market development in these economies and boost the international investors confidence. The latter

may be wary of the risks involved in venturing into underdeveloped and inefficient markets. The figures also give a

clear indication of the return generating potential these markets hold for the international investor. However, the key

question is whether these markets are efficient enough to allow the international investor to exploit this potential.

In early 2008 Standard and Poors launched three new benchmark indices the S&P Africa 40

index, the S&P Africa Frontier index and the S&P Pan Africa index to track the performances of

leading companies and equity markets on the African continent. The indices are meant to provide the international

investor with tangible evidence of areas into which to diversify his portfolio and are a clear indication of the growing

importance of the continent to investors seeking an alternative or expanded horizon for their investments. (Reuters,

2008a)

In accessing the return potential of these markets and their ability to allow a diversification of the international

investors portfolio a valid indication of their real return generating process is critical. Most previous research on

1 Between 1997 and 2004 the Botswana Domestic Composite Index grew by 298%, the Egyptian CCSI by 239%, the Ghana GSE All share index by 198%, the

Nigeria LSE All share index by 264% and the South Africa JSE All share index by 114% (Yartey and Adjasi, 2007 p.6; Chukwuogor, 2008 p.375)


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market efficiency on African stock markets has measured returns in domestic currency2ignoring the implications oftheir usually high inflationary environments (see Appendix III) and weak exchange-rate regimes. Exchange rates of

African currencies against major international currencies like the US dollar, Euro or British pound are particularly

volatile and even where returns (measured in local currency) are high, the benefit may not be apparent when the returns

are measured in an international currency like the US dollar. Thus this study attempted to fill this gap in the literature

by using an international currency in testing the efficiency in these markets and hence deriving a more accurate

assessment of the return generating process.

Without going into the complexities involving the exchange rate movements in the individual currencies of the

countries involved, this research approached the issue of real returns by measuring them in US dollars as a proxy for

the international currency. The obvious advantage here was that the use of an international currency in tests of

efficiency would dampen any bias towards autocorrelation where local currencies were used as evidenced in Karemera

et al. (1999 p.183)3. It is this real return generating process and the identification of efficiency using such returns that is

critical to the international investor in assessing whether the African stock markets represent a worthwhile window of

investment opportunity.

As widely documented in the literature ((Fama, 1981 p.545; Kaul, 1987 p.255) inflation and real return are negatively

correlated. Rising inflation in most African economies reduces the return based on local currencies i.e. as a result of

inflation a higher expected return is needed to yield a similar return to that before the incidence of inflation. To the

international investor, inflation in these African markets means a depreciation of their local currencies.

Measuring returns in the local currency will therefore give an inaccurate assessment of real return where these are not

adjusted for inflation. By measuring returns in the international currency, the international investor is able to capture

the true nature of the return generating process, as the inflationary component is eliminated through the exchange rate

mechanism. This is illustrated in Table I below. Thus the international investor is able to reach a better informed

decision about his investment plans

2 This includes the works of Magnusson and Wydick (2002), Appiah-Kusi and Menyah (2003), Jefferis and Smith (2004, 2005) andBillmeier and Massa (2008) among others.

3Returns from selected emerging markets measured in international currency are more consistent with RWH. When the same results aremeasured in local currencies for the same markets there is a higher rejection of RWH.

Do African Stock Markets Provide a Window of Opportunity to the International Investor ?

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