Tackling the cost of African financing

Vera Songwe
By Vera Songwe

Executive Secretary of the United Nation's Economic Commission for Africa

Posted on Tuesday, 21 December 2021 18:01

Executive Secretary of the Economic Commission for Africa Vera Songwe arrives at the UK-Africa Investment Summit in London, Britain January 20, 2020. REUTERS/Henry Nicholls - RC2NJE9CPU2S

Africa's development challenge is not the effects of too much globalisation. It is the fact that the continent is not globalised enough.

Africa receives an average of around three per cent of global flows of Foreign Direct Investment (FDI). The continent’s GDP amounts to just under 2.7% of the world’s total, a share per capita that has fallen by 50% over the last 60 years.

Africa’s share of total export is less than three per cent. Africa needs to undergo a dramatic shift in how it engages with global markets, mobilises and spends resources domestically, and the transparency with which it does all of this.

Change is possible – and is imminent. The triple crisis demands it.

The announcement of the Liquidity and Sustainability Facility (LSF) by the United Nations Economic Commission for Africa (UNECA) at the COP26 Summit is a hallmark development in this direction. This facility has the potential to fundamentally alter Africa’s economic trajectory. The LSF provides African governments with a vehicle through which they can promote prosperity at home while prioritising sustainability.

Change is needed – beginning with the continent’s own repo system and greater facilitation of sustainable investments”

Africa needs increasing amounts of liquidity to finance its recovery from the Covid-19 crisis. The IMF estimates this figure as high as $425bn.

The LSF is a bold and ambitious attempt at levelling the playing field on access to financing for Africa’s emerging economies. This required learning, consultation from those who have done this before and finally innovation.

By engaging with numerous central banks including the Bank of England, European Central Bank, Bank of France (Banque de France) and the Bank of Canada, UNECA has been able to understand and apply best practices on how to create a liquidity facility that meets the demands of both sovereigns and lenders. Thus creating a facility that will enable Africa to achieve this system-wide capital market deepening, development and provide a win-win situation for all keen to engage in sustainable green investments.

African governments have until now used two mechanisms to generate capital: taxation and borrowing. The former has not been a particularly effective mechanism for many governments on the continent due to small – and in some cases shrinking – tax bases.

With an average tax-to-GDP ratio of 16.5% in 2018 compared with 23.1% and 34.3% in Latin American and Caribbean countries and the OECD respectively, many governments on the continent have struggled to finance key development projects. The alternative has been to rely on external financing.

Since the establishment of the Bretton Woods Institutions in 1944, African governments have regularly secured loans from the likes of the IMF and the World Bank Group. Over time more bilateral resources have become available. However, all these resources remained constrained by availability.

With a desire to accelerate their development, African economies turned increasingly to capital markets to raise more resources, debt. The Eurobond markets, especially offer countries an alternative funding source from traditional lenders. Today 40% of African debt is held by private creditors.

This has proven to be a double-edged sword for many African economies. In 2021 alone, for example, $11.8bn worth of Eurobonds were issued by African sovereigns.

The issue for many African governments is not debt; it’s the cost of paying it back. Indeed, the current yield to maturity for African Eurobonds can reach as high as 100%. Since 2003 African countries have issued $162bn of sovereign Eurobonds. Of that amount, ten per cent has been repaid at maturity.

 

Repurchase agreements – or more commonly referred to as “repos” – have served as the linchpin of global markets for many years. The simple act of exchanging one’s securities (i.e. bonds) for cash with the condition of repurchasing them for a higher price, has proven extremely popular in developed economies and led to more liquidity and lower borrowing costs. Yet this has to date eluded many African economies.

A major downside to buying African bonds is that they cannot be recycled – or made liquid – as easily as other bonds. This is partly due to the absence of well-developed repo markets.

For example, if you were to buy US Treasury Bonds at 09:00 when the market opens, you could easily repo them by midday get the cash and go back into the market.

This is not possible for most African bonds and where there are repo markets it is extremely limited and expensive. When an investor purchases African bonds, they must be prepared for limited ability to repo and much more limited liquidity which means it can be time-consuming and expensive to transact. This has costs for both the investors and the sovereigns. Because of the poor liquidity and lack of well-functioning repo markets, investors demand higher compensation and pass these costs onto the sovereigns.

In addition, this issue of liquidity has ultimately shunned a significant portion of the global market from investing on the continent which has further increased the cost of borrowing for African sovereigns. The cost of Africa’s illiquid paper is added to Africa’s borrowing cost. As a consequence, African sovereigns could pay anywhere from 100-300 basis points more on their debt than they would need to pay if repo markets operated as they do in most developed markets.

The illiquidity premium is fortunately easy enough to solve. Developed countries such as the US have long enjoyed the existence of large repo markets for their government bonds, facilitating the creation of stable and additional funding sources. This is one reason why US bonds are so popular for global investors.

Africa needs a similar repo market to reduce costs and increase liquidity in an affordable manner. This is what the LSF aims to provide.

Quite simply, the LSF will allow private investors to exchange their African bonds for cash. The LSF will look to source this cash through a variety of institutions including foreign central banks and the IMF’s Special Drawing Rights (SDR).

The LSF will commence with its maiden transaction next year through a $200m fund from the African Export-Import Bank. Given that African bonds will become more secure due to their liquidity, there will be increased interest and participation from the private sector which in turn will increase demand, reduce costs for borrowers, and ultimately mobilise more private sector capital to help close Africa’s funding gap. It is estimated that the LSF could bring about cost of debt savings (yield compression) of 15% for Investment grade, 25% for BB and 40% for B/CCC African sovereign Eurobond issues.

The second core pillar of the LSF is to promote and facilitate sustainable financing across Africa. With a global green bond market of an estimated $539bn, Africa only accounts for a meagre $8bn, thereby missing key investment opportunities.

This is where the LSF will serve as a vehicle for channelling funds from investors towards investments that are not only risk-adjusted and designed to deliver attractive returns, but also beneficial for the country in which they are invested.

The ability to tailor these investments will see the LSF focus funds towards other areas which look to accelerate development such as ICT and rail infrastructure. If we can therefore invest these newfound resources in revenue-generating assets such as roads and ICT infrastructure, then we are able to foster a business environment that will enable more businesses to formalise their work and in so doing, pay their taxes. This will then equip us with the requisite resources to pay back the debt.

Bottom line

The positive knock-on effects of the LSF will also be felt elsewhere across African economies. Greater flows of capital through the repo system will lead to the deepening of capital markets. Through this repo facility, governments can stimulate greater flows of liquidity throughout domestic markets. This also spurs on the creation of domestic rating agencies, and stronger insurance systems.

Africa is at an inflection point. Not only has Covid-19 highlighted the many inequalities throughout the world, but COP26 has also brought the crisis of sustainability centre stage. For Africa, business as usual cannot deliver the change it needs; inequalities cannot be remedied through the current system of borrowing, nor can sustainability be achieved without significant investments towards projects which prioritise the wellbeing of people and planet.

The launch of the LSF at the COP26 is a major step towards integrating the continent into global capital markets and enabling the emergence of a prosperous Africa funding must follow to accelerate impact.

Dr Songwe is United Nations Under-Secretary-General and Executive Secretary of the Economic Commission for Africa

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