USB News

Rethinking financing Africa’s development

        • December 2021
        • Tags Development finance, Africa, poverty, economy, politics
        • Author Dr Ashenafi Fanta

SHARE

Despite important strides many African countries have made in reducing poverty and improving quality of life over the last decade, recent years have seen reversals in the trends engendered by a pandemic that imposed unprecedented burden on the economy and society. Although there is no silver bullet to guide Africa out of the dire situation research suggests that investment in infrastructure such as transport, energy, water, and ICT is likely to help in economic recovery by boosting private sector activity as well as attracting foreign direct investment. The fact that Africa has a large infrastructure gap estimated by the African development bank at US$130-170billion a year, the continent will make a significant gain by investing in infrastructure. However, infrastructure financing gap to the tune of US$68-108billion is a major setback.

In economies where the financial sector is well-developed, domestic financial market provides most of the funding for infrastructure projects. In those markets finance can be raised using traditional sources such as syndicated loans and infrastructure bonds as well as innovative techniques such as structured finance. The structured finance market emerged as an alternative avenue to raise funding when so doing is expensive or unavailable. The market was created due to regulatory constraints imposing restriction on ability of banks to invest in certain asset classes. However, the structured finance market is not well developed in Africa except in few countries.

But given that the continent needs funding to meet sustainable development goals that are critical in pulling millions out of poverty through economic transformation, concerted effort is needed to develop the market. We highlight in the ensuing paragraphs requisite conditions that must be created for the development of structured finance market in the continent.

 

Macroeconomic and political stability

A stable macroeconomic and political condition is important for doing business in general because instability in these sectors is likely to turn a promising project into a commercially worthless venture. They are even more important for the development of structured finance market because adverse developments in the economy and politics can lead to significant loss in the value of a project or asset backed security. In project finance markets, sponsors and financiers require assurance that the project will be able to generate the projected cash flow that enables the project company to service the loan and pay dividend. Where there is no macroeconomic and political stability, financiers and investors require credit guarantee schemes from national governments and international agencies. Absent a guarantee, promising development projects will remain on a paper.

Securitisation equally depends on a stable macro-economic and political conditions because a securitised asset will fail to generate the stream of cash flow needed to pay investors if conditions are not suitable. A significant shortfall in cash flow may cause a chain of events similar to the one that led to the 2007/8 global financial crisis triggered by default in the sub-prime mortgage market.

 

Development of the financial sector

Structured finance market is providing alternative way of raising finance that is unavailable in the financial markets and institutions. Banks that dominate the African financial sector are not ideal for raising long-term capital because they hold deposits that mature over the short-term. Structured finance market therefore serves as an alternative way of raising long-term capital by directly interacting with the investment community. However, development of the financial sector serves as a bedrock of project finance as well as securitisation transactions. For instance, well-capitalised banks can act as arrangers in project finance transactions by facilitating a project finance deal where they provide a line of credit to the project company when additional funds are needed.

In addition, adequately funded institutional investors such as pension funds and insurance companies can participate in project finance deals by investing in project assets. Similarly, these institutions are critical as investors in assets backed securities as well as future flow securitisations. Asset backed securities are used in markets where there are banks holding pool of assets such as mortgage loans, vehicle loans or credit cards. Securitisation is unlikely to succeed in markets where banks have a few assets in their portfolio because securitisation like insurance works based on the law of large number.

 

Legal framework to ensure investor rights

Structured finance transactions fall beyond operational scope of a single financial institution and hence they are concluded based on strength of the legal and regulatory framework in country. A strong legal and regulatory system is needed to allow investor to assess risk of the investment venture as well as ensure protection of lenders and investors rights. In addition, investors draw confidence from the strength of the legal system for resolving disputes as they arise. Arrangers need a well formulated legal frameworks and clear regulations to organise project finance and securitisation transactions.

Lack of regulatory framework in many countries in Africa is engendered by low level of awareness and understanding of the nature of structured finance transactions. In addition, market participants such as central bankers, security regulatory agencies, regulators of institutional investors need to develop a common understanding of the nature, risks, and economic benefits of structured finance. Experience from past transactions in Africa, suggests that demonstrative structured finance transactions are likely to pave the way for building regulatory capacity because they provide opportunity for regulators and other stakeholders to have first-hand experience of the transactions.

Tax incentives

Provision of tax incentives in the form of exemption for structured finance transactions will reduce transaction costs and encourage participation of investors in the market. In project finance transactions, some countries provide SPVs a tax holiday to entice sponsors and financiers to participate in transactions with paramount economic significance. A levy on the other hand increases transaction cost and as a result discourages investment in structured finance assets.

Local rating agencies and service provides

Rating agencies play pivotal role in the structured finance market particularly in selling asset backed securities by vouching independently on the quality of a structured asset. In the securitisation market, less sophisticated investors heavily rely on the rating of the agencies in the investment decision while more sophisticated ones use the rating as a complement to their independent assessment of valuation of the asset. Three rating agencies, namely, Standard and Poor, Moody’s, and FITCH, dominate the global rating market. Local rating agencies that understand the local conditions are needed.

Join the Stellenbosch Business School Management Review community

Subscribe to receive an email alert for new content on Stellenbosch Business School Management Review.

SUBSCRIBE NOW

Related articles

Join the Stellenbosch Business School community

Receive updates on the latest news, events, business knowledge and blogs at Stellenbosch Business School.

SUBSCRIBE NOW