ASHENAFI FANTA: Rethinking financing Africa’s development

Despite the 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 has imposed an unprecedented burden on the economy and society. Though there is no silver bullet to guide Africa out of the dire situation, research suggests  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.

Africa has a large infrastructure gap estimated by the African Development Bank at $130bn-$170bn a year, and the continent will gain significantly by investing in infrastructure. However, an infrastructure financing gap to the tune of $68bn-$108bn is a major setback.

In economies where the financial sector is well developed,  the 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 doing so is expensive or unavailable. The market was created due to regulatory constraints imposing restrictions on the ability of banks to invest in certain asset classes. However, the structured-finance market is not well developed in Africa except in a few countries.

But given that the continent needs funding to meet sustainable development goals that are critical to pulling millions out of poverty through economic transformation, a 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 on the continent.

Macroeconomic and political stability

Stable macroeconomic and political conditions are 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 a 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 assurances that the project will be able to generate the projected cash flow that enables the project company to service the loan and pay a 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 paper.

Securitisation equally depends on stable macroeconomic 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

The structured-finance market provides an 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. The structured-finance market, therefore, serves as an alternative way of raising long-term capital by directly interacting with the investment community.

However, the 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 asset-backed securities as well as future flow securitisations. Asset-backed securities are used in markets where there are banks holding a 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 numbers.

Legal framework to ensure investor rights

Structured-finance transactions fall beyond the operational scope of a single financial institution and hence are concluded based on the strength of the legal and regulatory framework in a country. A strong legal and regulatory system is needed to allow investors to assess the 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 well formulated legal frameworks and clear regulations to organise project finance and securitisation transactions.

The lack of a regulatory framework in many countries in Africa is engendered by a low level of awareness and understanding of the nature of structured-finance transactions. In addition, market participants such as central bankers, security regulatory agencies and 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 an opportunity for regulators and other stakeholders to have first-hand experience of the transactions.

Tax incentives

The provision of tax incentives in the form of exemption for structured-finance transactions will reduce transaction costs and encourage the 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 costs and, as a result, discourages investment in structured-finance assets.

Local ratings agencies and service providers

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

• Dr Fanta is a senior lecturer in development finance at the University of Stellenbosch Business School.