The African financial sector is desperately in need of a shot in the arm as it continues to grapple with the legacy of banking systems and financial markets. Development of this sector can play a key role in providing a much-needed engine of domestic growth. Discussions during the African Development Bank’s 2015 Annual Meeting, from May 25-29 in Abidjan also focus on SMEs contributions to growth, especially on increasing private sector involvement in creating wealth. AfDB’s Financial Sector Development Director, Stefan Nalletamby, has analyzed constraints and opportunities for the financing of SMEs in Africa. Excerpts.
Could you give us a brief overview of financial sector development in Africa and give us two concrete cases of successful projects where the Bank has been an advocate of development for this sector?
Stefan Nalletamby: Africa’s 54 financial systems are as diverse in depth, breadth, robustness and complexity as its economies. When you look at the size of the banking system and financial markets relative to GDP, you realize that Africa’s financial sector is small, but developing, relative to other regions. Over here, financial systems tend to be highly fragmented; the range of institutions is narrow, and a significant proportion of the population has no access to basic payment services or savings accounts.
That said, Africa’s financial sector has been strengthened by a wave of reforms over the past decade. Financial systems in many African countries have begun to diversify their activities, deepen their lending, and increase their reach with new products and new technologies. The commercial banking sector has also become stronger, with lending of close to US $600 billion and customer deposits of US $800 billion which represents a rise of more than 20% in the last 10 years. In the public markets, sovereign bond issuance in 2014 hit a record high of about US $25 billion, with new borrowers entering the market to take advantage of historically low yields and strong investor interest. Also, over 20 African countries had credit ratings issued by international agencies, more than double the number a decade ago. FDI flows in 2014 rose for the fourth year to an estimated US $80 billion, making Africa one of the few regions registering year-on-year growth. What’s important to note is that Africa’s financial sector is growing.
As the premier pan-African development financial institution, the African Development Bank is already applying several innovative approaches to strengthen the continent’s financial sector. One example is our Africa SME program, which seeks to channel long-term funding to SMEs through SME-focused Financial Institutions (FIs) across Africa, thereby enhancing financial inclusion and reducing the SME financing gap. With this program, we intend to avail US $125 million through multi-currency Lines of Credit (LoCs), mainly in local currencies, along with about US $4 million of Technical Assistance (“TA”) financing for capacity building support to approximately 25 financial institutions. Another novel project is the African Fundamental Bond Index (AFBI), which is a ranking of African local currency bond markets. The index will provide the basis for designing a strategy for African bond markets deepening and also act as a barometer for identifying priority reform measures in each market segment.
Despite the importance of SMEs and their potential contributions to the economic development of African countries, these SMEs suffer from many constraints that hinder their ability to grow and contribute substantially to inclusive growth. What is your analysis of constraints and opportunities for the financing of SMEs in Africa?
Stefan Nalletamby: We need to distinguish between the constraints that hinder the growth of SMEs and the issues affecting access to finance for SMEs. With regards to the first question, constraints hindering growth are well known, and also part of the World Bank’s Doing Business indicators. They include: red tape, corruption, difficulty in obtaining and renewing licenses, high taxes for companies operating in the formal sector, limitations in physical infrastructure, limited access to foreign exchange, and of course limitations in management skills and financial.
In terms of constraints for the financing of SMEs, the limitations in financial infrastructure i.e. credit bureaus, collateral registries, access to capital markets, etc., are important. The cost of financing can also be an important constraint. Access to financing for MSMEs remains very high in Africa, in part because of generally high interest rates, but also because of risk-based pricing margins. The situation is changing though and access to microfinance has improved a lot. Credit bureaus and collateral registries are also being established everywhere. SME financing is still a challenge.
With regards to opportunities, there are a number of innovations in SME financing taking place. Some banks are increasingly adopting a SME client service approach to be able to maintain close relationships while offering more appropriate combination of products. Mobile banking and branchless banking offer opportunities to reach out to larger MSME communities as well – some financial institutions have been very successful with this. In fact, the AfDB is already exploring innovative solutions in mobile payment systems with a view to scaling them up across regions.
SMEs also need other products like insurance for health, agriculture, etc. Increasingly, financial institutions are beginning to incorporate these in their portfolios thanks to re-insurance companies. These are good successes. Financial institutions also require support to reduce the risk of financing SMEs. Various guarantee mechanisms now exist to support financial institutions. This helps. Value-chain financing and franchising as a business model are other examples of financing whereby financial institutions may or may not play a role, but which facilitate access to finance for SMEs. Of course, SME quasi equity funds have come up to select ‘winners’, and recently a number of impact investment funds have been established. There are a lot of tested but also untapped opportunities in all these areas.
The capabilities of SMEs need to be strengthened. How do you think the decision-makers and political authorities can help those businesses seeking to increase productivity through innovation?
Stefan Nalletamby: Enterprise support or Business Development Services (BDS) are often available, but the difficulty for SMEs is the information gap that exists; it is often difficult to establish which service is good and whether it provides value for money. Governments have mostly failed in providing such services and their role should probably be that of a facilitator and not provider, given that civil servants are not entrepreneurs and do not usually understand what businesses need. Assisting in the certification or accreditation of good proven BDS services can be a good method to reduce market inefficiencies. Voucher schemes set-up with Government support have been used in various countries, with differing success. Other enterprise services such as information on business opportunities and markets, services to provide quality standards and product certificates to promote exportation of local products are also very essential and are often not accessible to SMEs. Government authorities can also establish export promotion agencies that actively support local SME product providers.
Many African countries are planning to reach emergence within the near future. Do you consider that to attain this objective, the private sector and its innovative capacity can be instrumental?
Stefan Nalletamby: Africa is emerging as an important growth centre, similar to a number of East-Asian countries a couple of decades ago. Now, the drivers of growth vary across countries, but the general trend is that growth on the continent has largely been driven by: (i) large public spending on major infrastructure investments; (ii) increased Foreign Direct Investment (FDI) inflows; and (iii) improved economic management and business climate.
We have a unique advantage – Africa can learn from past successes and mistakes of more developed regions. This presents us with the opportunity to leapfrog the development process by harnessing scientific and technological progress and accumulated innovations to increase productivity, protect our environment, and conserve scarce resources. In order to do so, however, African countries will have to significantly strengthen their technological capacity and invest substantially more in research and development (R&D). In the context of private sector development, there will be significant opportunities for entrepreneurs, investors and enterprises – both local and foreign – to prosper in individual countries and across regions. Already, the private sector in Africa supports about 90% of total employment and generates 80% of Africa’s aggregate economic output. This is significant. Africa’s private sector is coming of age, and it is poised to serve as the engine of economic growth and poverty reduction.
What are the obstacles facing the private sector enterprises in African countries when trying to innovate?
Stefan Nalletamby: African countries have considerable opportunities for private-sector-led innovation. However, before those opportunities can be unleashed, there are major obstacles to eliminate. They include:
(i) Firstly, the high cost of doing business. I think this is the most important factor shadowing the investment and business environment in Africa. The factor that is most responsible for this is bureaucratic red tape.
(ii) Secondly, there is a short supply of essential support services such as credit, financial services, and affordably priced business technical services.
(iii) A third factor is inadequate legal and regulatory frameworks, weak institutional capacities, and entrenched corruption. Generally, the laws of the land are yet to catch up with the pace of innovation on the continent.
Finally, another factor is inadequate supply of labour in a range of modern skill categories. Competency of modern skills is essential to be able to master rapidly changing technologies and processes.
Some believe that the financial services offered by commercial banks to SMEs are considered a panacea that allows these companies to solve their financing problems. What is your view?
Stefan Nalletamby: I think it is widely known that the biggest constraint for SMEs is access to finance, as well as the cost of finance. However, a number of businesses may not be deserving of credit as they are often too risky or badly performing. In other continents the prime source of finance is also internal working capital, family savings, etc. That said, well-run SMEs in Africa are increasingly accessing financing where needed, although they financing is often short term.
It is also important to consider other forms of panacea which are not necessarily of a financing nature. For example, simplifying licensing requirements, establishing SME stock exchanges, facilitating the establishment of credit bureaus, simplifying and reducing tax payments for SMEs, supporting sustainable incubator models, as well as SME business development support services are all solutions that would prove useful in enhancing the growth of SMEs.