Editor’s Note: This is the third in a series of posts that preview the findings of the forthcoming Financing Africa: Through the Crisis and Beyond regional flagship report, a comprehensive review documenting current and new trends in Africa’s financial sectors and taking into account Africa’s many different experiences. The report was prepared by the African Development Bank, the German Federal Ministry for Economic Cooperation and Development and the World Bank. In this post, the authors focus on the challenges and opportunities in providing long-term finance for enterprises, households and governments. Long-term finance is a critical element for financial systems to fulfill their growth-enhancing role.
Despite recent encouraging innovations in banks, contractual savings institutions, and the capital market, we find that lengthening financial contracts remains a challenge for financial systems across Africa. Figure 1 illustrates the short-term nature of African banking; more than 80% of deposits are sight deposits or with a maturity of less than one year and less than 50% percent of loans have a maturity of more than one year. Providers of long-term finance that are well developed in the industrialized world, such as insurance companies, pension and equity funds and venture capitalists are small in most African countries and inefficient in their operation. This goes hand in hand with a limited supply of long-term equity and debt instruments across the continent.
Figure 1: The Maturity Structure of Deposits and Loans across Africa
On the other hand, we document the enormous needs Africa has for long-term finance. The deficit in the availability of long-term financing is most evident in the state of infrastructure across the continent, even compared to other developing regions of the world (Table 1). The cost of addressing Africa’s physical infrastructure needs is estimated at USD93 billion per year, some 15 percent of Africa’s GDP. Similarly, demand for housing, especially in urban areas, continues to rise across the continent as Africa continues to rapidly urbanize (Figure 2). And yet, across the continent mortgage debt outstanding to GDP remains low, averaging around 10 percent, which compares to 70 percent for the US and 50 percent for Europe. Excluding South Africa and the North African countries reduces the ratio of mortgage debt to GDP to only one percent for Sub-Saharan Africa. In those Sub-Saharan African countries where formal mortgage markets exist, such as Burkina Faso, Ghana, Nigeria, Tanzania and Uganda, the number of loans is rarely more than a few thousand and these loans are often limited to the wealthiest segment of the population.
Table 1: Infrastructure: Comparing Africa with Non-African Developing Countries
Figure 2: Annual Housing Needs across Africa
Optimizing the current possibilities for expanding long-term finance
Although commercial banks dominate the financial system in Africa, their participation in long term finance remains limited by a variety of constraints, including the lack of long-term funding, lack of scale, but also regulatory constraints. Despite these constraints, there are some exceptions with some local commercial banks finding ways of overcoming these challenges and providing long-term finance. For example, in Nigeria the Lekki-Epe Express Toll Road reached financial close in 2008 and was able to mobilize a 15 year loan from Stanbic’s IBTC-Nigeria in local currency for NGN 2 billion (US$ 13.4mn) at a fixed interest rate of 13.9% and with a moratorium on principal repayments of 4 years. This deal was also supported by other local banks, which provided a total loan value of NGN 9.4 billion for a tenor of 12 years.
Insurance sectors across the continent are mostly focused on shorter-term non-life business lines, with the notable exception of several southern African countries, where life insurance products are popular, due to—among others—tax reasons. Few countries on the continent have private pension funds, with most relying almost exclusively on public funds, be it in the form of pay-as-you-go or social security funds. For both pensions and insurance, we argue for the need to undertake reforms in such areas as risk diversification, solvency, consumer protection and taxation. More effective supervision will ultimately also increase trust among potential customers. Recently, several countries have undertaken comprehensive pension reforms, which imply a trend toward autonomy among social security organizations. In Kenya, the private pension sector has experienced a significant improvement in performance since the establishment of the Retirement Benefits Authority, which resulted in the introduction of investment guidelines and a shift to private portfolio managers.
Long touted as essential to unlocking the long-term finance paradox by providing a trading platform for equities, Africa’s stock market has not achieved any substantial degree of capitalization—only 2% of world market capitalization as of 2009. As one market practitioner pointed out, “an entire year’s worth of trading in the frontier African stock markets is done before lunch on the New York Stock Exchange.” Capital markets are still constrained by outdated practices, inefficient listing procedures and trading mechanisms, lack of a regulatory framework, and an inefficient market information dissemination process. One option to expand outreach is the establishment of secondary trading boards, such as exist in South Africa, Egypt as well as Botswana, which have lower demands on the issuer in terms of listing fees, track record, size, reporting requirements and float, or minimum number of shareholders. These secondary trading boards might attract medium-sized companies, for whom the regular conditions are too burdensome. While these markets have facilitated firms’ access to stock markets, their limited success suggests they can only partly solve the problem of access to finance.
Most small economies in Africa, however, are too small to sustain a liquid stock exchange. One possible route is toward regional stock exchanges, as in the case of the Abidjan Stock Exchange, which was expanded to become the Bourse Régionale des Valeurs Mobilières to allow enterprises from throughout francophone West Africa to list. An alternative is to allow cross-listing, which permits enterprises to tap additional investor communities and encourages more liquid trading of the shares of enterprises, thereby increasing the efficiency of the price-finding process.
Similarly, corporate bond markets across Africa are also small and illiquid. They are constrained in many countries by cumbersome regulatory structures. Rather than focusing on disclosure, most African countries impose a complex approval process. Rather than allowing the market to assess the financial viability of bond issuers and the risk of the securities, regulators feel compelled to undertake this assessment on behalf of market participants, which leads to inefficiency (because incentives are not aligned), but also opens the door to arbitrary decisions and corruption. High issuance costs are another critical impediment.
Tapping international markets
We argue that where organized exchanges are too expensive, more private structures might be helpful. For Africa, private equity is becoming a growing part of the financial sector, especially for long-term finance. Between the boom years of 2006 to 2008, private equity funds raised in sub-Saharan Africa amounted to approximately US$6.4 billion, while those invested reached US$7.6 billion. The private equity model in Africa seems to mainly target well established medium-sized enterprises at the top end of the market. Notwithstanding these positive trends, the main obstacles continue to be the limited interest from financiers to invest in private equity funds targeting Africa and their excessive risk aversion toward Africa. Investors in Sub-Saharan Africa north of the Limpopo River demand some of the highest risk premiums, with risk premiums in northern African countries only slightly lower. In addition to high risk perceptions, the industry suffers several specific challenges in Africa, most of them related to the institutional environment in which they operate, including regulatory constraints, ownership and foreign-exchange related barriers for foreign private equity funds and taxation-related barriers.
Another potentially significant source of long term funding is Sovereign Wealth Funds (SWF) with strategic interests in Africa, including funds from the Middle East, China and India which have become important players in African infrastructure projects. There is growing appetite to support foreign country mineral and raw material requirements, as seen with China’s successful efforts in locking up deals in the oil and gas sector and also providing substantial transport infrastructure funding. Middle East SWFs are also active in both the physical and social infrastructure sectors. Nevertheless, Africa’s share in foreign SWF investments remains relatively negligible, justified by the weak governance and high volatility of economies in Africa. Here we go back again to the sequencing issue. African countries would have to restructure their governance structures and communicate more about the risk/return profile of financial markets and institutions, before SWF money will follow.
Pushing towards the frontier and beyond – a long-term agenda with some tricky short-cuts
Lengthening financial contracts in Africa requires policy makers to address structural bottlenecks that inhibit the issuance of longer term contracts. At the most fundamental level are market-developing policies, that is, policies that help create the necessary conditions for long-term funds to flow to and stay in Africa and for long-term financing tools and products to emerge. Most African countries have made enormous progress in macroeconomic stability over the past 20 years. External debt has been reduced substantially across Africa, often because of the heavily indebted poor countries (HIPC) initiative. Despite the sustained macroeconomic stability in many African countries, however, the yield curve is still steep in most countries, if it exists at all. This can be explained by the high risk premium on long-term resources, which, in turn, is caused by risk premiums (political uncertainty and uncertainty about the willingness of governments to meet longer-term commitments), which are also reflected in the illiquidity of long-term capital markets.
The informational framework, most importantly accounting and auditing standards, are critical to long-term transactions. While many countries in Africa have taken the first step in advocating for the use of international financial reporting standards, at least for enterprises above a certain size, as well as for financial institutions, more work remains to be done. The emergence of a number of strong national accounting associations and professions on the continent is a welcome development for the industry. Reforms in the contractual framework and corporate governance are another important item on the long-term agendas of policy makers throughout the region, ranging from changes in legal codes to changes in the court systems and building and reforming property and collateral registries.
Beyond the most fundamental level are market-enabling policies that take the current environment as a given and try to maximize the absorption and intermediation of existing resources in the financial system. These policies should be focused on competition—encouraging the entry of new providers—and the removal of regulatory restrictions, as discussed above in the case of equity funds. However, they may also require the application of market-friendly activist approaches that try to crowd in private providers, such as private-public partnerships for infrastructure financing. Most prominently among these have been partial credit guarantee funds as risk mitigation instruments. As so often, the devil is in the detail to achieve a balance between additionality - how many creditworthy borrowers who previously did not have loans have been included because of the scheme – and financial sustainability of such a scheme.
In the context of such market-enabling policies, the debate on government’s role and, more specifically, the role of development finance institutions, is important. We would argue that policy makers would be better served by re-focusing the government’s primary engagement in the financial sector towards policy formulation and wholesale lending activities, and leveraging the private sector to lead in the retail delivery of financial services, including long term financial services. This can include the role of existing development finance institutions in managing donor funds or partial credit guarantee facilities or joint platforms, as NAFIN has been doing for leasing in Mexico.
In conclusion, lengthening the maturity of financial contracts in Africa requires a joint effort of private players and governments. There is a need for new players and new products. While there is not one silver bullet to solve the challenge of long-term finance in Africa, many opportunities await.