Where Do Funds to Finance the African Debt Market Come From?

By MEFMI Executive Director, Caleb Fundanga (PhD)

This article was first published in The Banker – an IMF World Bank publication – in September 2012.

African economics have recently performed well. Real gross domestic product (GDP) growth over the past three years has been robust and projections show that in the next five years the majority of the ten (10) fastest-growing countries in the world will be in Africa. This is a far cry from the 1980s and 1990s and also from when Africa was labelled “the hopeless continent” by The Economist a decade ago.

The African turnaround has mainly been attributed to improved economic management and the Highly Indebted Poor Countries (HIPC) initiative, although high commodity prices in recent years have also played a part. HIPC imposed fiscal management criteria on all those countries that sought access to debt forgiveness. But the debt cancellations under HIPC created fiscal space, which in turn enabled African countries to invest in vital infrastructure. Policy reform also required governments to withdraw from running businesses. In the 1970s and 1980s, most sub-Saharan economies were dominated by state-owned enterprises, the bulk of which were poorly managed and needed subsidies to exist. These subsidies contributed to high borrowing by governments.

One positive outcome of the recent improvement in economic management has been the accumulation of foreign currency reserves by African central banks. Good management has required that every central bank maintains enough reserves to sustain imports of four to six months.

Reserves are a necessary cover against export earnings volatility, given the dependence of many African countries on one or two commodities, such as oil, metals or agricultural produce.  According to the World Bank’s development indicators, foreign currency reserves have been growing rapidly in the past decade, although they dropped in 2010 due to the negative impact of the Arab Spring on North African countries. In 2011, African reserves stood at $461bn. These reserves are mainly kept at and managed by European and US institutions.

Africa’s central banks have developed very prudent investment policies over the years. These have been guided mainly by safety and liquidity. Safety has required that reserves be invested in the paper of institutions with a high credit rating, thus reducing the prospect for loss. The need for liquidity has necessitated investment in instruments with short tenors. It has been argued that these two attributes cannot be found in African counterparties, hence the need to look to developed economies for the investment of reserves.

Credit Rating Drive

Accompanying the rapid African growth of recent times has been the need for increased investment. More resources are required to finance infrastructure, such as roads, schools, hospitals and electricity. Funds are also required to finance private sector activities, including manufacturing, mining and trade. Traditionally, African governments have met their financing needs through grants provided by developed countries, loans from multilateral development institutions and loans from commercial banks.

This financing framework was sometimes criticised as it tended to be controlled by dominant Western interests that were accused of imposing conditionality on borrower countries, including requiring access to their resources. With hindsight, some of the conditions were perhaps necessary given the record of poor economic management in the past.

Until recently, African countries could not access international finance through bond issuance as few were regarded as sufficiently creditworthy. This is now slowly changing as more states improve macroeconomic management and subject themselves to sovereign credit ratings.

African multilateral financial institutions, which are rare, are dominated by the African Development Bank (AfDB), the only AAA rated institution on the continent. But they also include the African Export and Import Bank (Afrexim) and a host of regional banks, such as the East Africa Development Bank, PTS Bank and Ecowas Bank. In recent times, more financial institutions have started to subject themselves to credit ratings, including Afexim and PTS Bank. Although these ratings are not AAA – Afrexim is rated BBB – by Fitch – this has nevertheless opened new financing opportunities for them.

Debt Market Funding

The key question has always been: where do funds to finance the African debt market come from?  Theoretically, the funds come from developed countries. African central banks refuse to take on African debt instruments and prefer to invest their money in developed country institutions where perceived risk is low. But with the recent opening up of markets for African bonds and treasury bills, it is possible that some of the money used to buy the African debt market could come from the continent itself. It is also possible that some of the demand for AfDB bonds could be African.

One has to ask what the consequences of today’s funding model have been. Starting with the subprime crisis of 2008 and now the euro crisis, the global debt market has been in turmoil. The cost of borrowing for Africa’s entities has shot up. The AfDB, which could sometimes borrow below Libor before 2008, now has to borrow at several hundred basis points above Libor.

The global crisis now appears to be affecting African entities more negatively than the countries that started it. Any issuance of debt investments by Africa sovereigns is likely to face a similar fate. In fact a number of African countries that should have gone to the market recently have had to postpone their funding programme because of uncertainties about the cost in these difficult times. It appears that Africa is being punished for the vices of others. With the good performance of African economies in recent times, one would have expected a more favourable pricing of African debt.

Yet while the current crisis has increased the cost of borrowing for African entities, the same crisis has drastically reduced the yields on investments of Africa’s central banks. Current yields on some of the investments stand at below 0.2%. This can be contrasted with 2% to 3% in the pre-crisis period. This has led to a situation where income from investments of African central bank reserves is coming to almost nothing at a time when those reserves are at historical high.

Africa’s opportunity

It is clear that Africa has resources to meet the financial requirements of its development. If one was to concentrate only on the annual borrowing requirements of its multilateral financial institutions – leaving out the sovereigns – perhaps less than $30bn would be needed,  a small fraction of the $400bn – plus reserves.  And such sums would not jeopardise the central banks’ need for liquidity. As such, it is this segment of the market that should be the first target of an effort to develop the African capital market.

The main issue would be the credibility of the counterparties. For the envisaged market to develop, it is important that all potential participants go through a rigorous credit rating process. Only entities attaining a certain threshold should participate. This would also create new opportunities for the rating business.

Africa financial entities need to be rated to determine their creditworthiness. Although credit agencies lost a lot of their shine in the wake of subprime and eurozone crises, their work still has a lot of relevance when properly done and supervised.

But there is also the need for the promotion of local rating agencies with better local knowledge. International rating agencies should partner local

agencies to help develop capacity.

If the reserves of the central banks were put towards African debt instruments, the yields would certainly be much higher than the sub-0.2% levels they currently get in the developed world. Similarly, if African development finance institutions borrowed the reserves of African central banks, the cost of such borrowings would certainly be lower than the current levels. This is undoubtedly a win-win situation. Both borrowers and investors would be better off.

To address the problem of some of the counterparties having poor credit ratings, the AfDB (with its AAA rating) could guarantee the borrowings of some of these institutions. African development would be the real winner.

The case for Africa using its own resources for its development is getting stronger. Already the use of local currency loans by development entities such as the World Bank and AfDB is providing popular and helping to reduce the foreign exchange risk faced by borrowers. And the growth of stock exchanges in Africa, with money coming in from local investors, is opening new funding avenues for African entrepreneurs.

In a similar manner, the use of African central bank reserves to finance African development finance institutions would mean utilising a huge pool of local resources hitherto targeted at developed countries. The real challenge is to establish institutions that can help to make this possible.