Blended knowledge - Long-term Local Currency

Long-term local currency financing is key to economic development in Africa

Solomon Quaynor, Vice-President, Private Sector, Infrastructure and Industrialization at the African Development Bank (AfDB), provided GuarantCo with his views on local currency financing, the importance of developing local capital markets and what the AfDB is doing in respect of encouraging greater local currency financing in Africa.

Long-term local currency financing is key to economic development. When the financial sector mobilises domestic resources and allocates them efficiently, everyone benefits – individuals have several options for savings and investments, and the private sector and governments can fund their investment needs without currency exchange risk. In particular, financing for long-life assets such as infrastructure, industrialization and housing where the user payments are in local currency and are therefore better financed by long-term local currency financing. This view is supported by precedence as we also know that economies that rely mainly on local currency financing for both sovereign and private sector transactions, such as Japan, USA, the UK, fare better in economic development, and are also more resilient to global shocks such as we have witnessed with the COVID-19 global pandemic. It is for these key reasons that long-term local currency financing in Africa is a priority for the AfDB, and the reason as an example, that we partnered with GuarantCo and provided capital to InfraCredit Nigeria, amongst other initiatives, including the Co-Guarantee Platform, that we have pursued with several partners for similar objectives.

Local currency financing is increasingly gaining momentum

The AfDB has a track record of issuing AfDB bonds in local African currencies. We therefore (i) facilitate the development of Local Currency Bond Markets through the issuance of AfDB local currency bonds; and (ii) assist the AfDB’s clients to mitigate foreign exchange risk from projects financed by the AfDB through the use of hedging instruments.

We have been active in the South African Rand offshore market since 1998. In 2007, AfDB obtained the consent of the South African authorities to issue in the domestic market and became the first supranational to launch a bond in the domestic rand market. Since then, the Bank has issued 3 bonds in the domestic rand market to raise ZAR 3.2 billion that has supported AfDB financing of projects in the Power, Gas and Transport sectors in South Africa.

Since 2006, we have also issued local currency indexed bonds in Botswana, Kenya, Tanzania, Ghana and Nigeria. We are very encouraged by the broadly positive response from international investors. We continue to issue in these currencies and other African currencies and intend to extend maturities to help these countries build true yield curves.

We have also helped clients to access the local currency bond markets, including indirect support  to power sector projects worth Nigerian Naira (NGN) 31.5 billion (~USD 85 million) in Nigeria, and the first 15-year local currency corporate green bond issued in that market.

Overcoming the main challenges for local currency financing

The African financial sector must mobilise and allocate significantly more resources and do so more efficiently to improve the availability of long-term local currency financing.

  • The lack of a diversified and active base of domestic institutional investors is a key challenge. These investors (pension funds, insurance companies, etc.) mobilise long-term savings and should allocate them to support investments in the real sector. However, despite significant growth in assets under management by domestic institutional investors in some of Africa’s key markets, we have not seen the expected increase in real sector investment.  On the other hand, these key markets tend to have deep government bond markets with significant portfolio flows.
  • Whilst regulation plays a role in terms of portfolio allocation of domestic institutional investors, it is not enough. Capital market operators and project sponsors need to develop products that meet the specific risk / return expectations of these African institutional investors, which are quite different from those of other investors. At the current stage of development of domestic institutional investors and the savings culture, greater risk aversion exists and hence higher allocation to investment grade fixed income securities tends to happen, which is one of the reasons for depth in the government bond markets (i.e. governments are perceived to be the best local AAA issuers).
  • Allocating these resources more efficiently means developing the hard and soft market infrastructure to support a wide range of products for different investor needs and risk appetites.
  • High interest rates on government paper are also an impediment to the development of long-term local currency finance in Africa, which results in governments crowding out private sector investment.

The AfDB seeks to broaden the supply of domestic local currency capital through tailored interventions to: (i) promote reforms that develop long term investors (e.g. pension funds, insurance companies, Caisses des Depots), (ii) encourage the development of the mutual fund industry and the development of innovative structures like guaranteed bonds, green bonds, social bonds, diaspora bonds, (iii) promote risk mitigation structures (credit enhancements, mobilization, etc); and, (iv) policy, regulatory and institutional reforms of the domestic capital markets. In addition, the Bank can also leverage its international AAA credit rating to credit enhance Special Purpose Financing Vehicles sponsored by institutional investors that crowd-in other investors into capital markets products such as infrastructure bonds. Finally, we are also able to structure securitisation mechanisms to help investors to take more risk in long term financing, especially for pools of projects in energy and infrastructure. However, supporting governments in better macro-economic management, and leading to less budget deficit financing by these institutional investors and lower yields on government bonds, will subsequently lead to a crowding-in of institutional investors into the productive sectors such as energy, infrastructure, industrialization and housing.

Closing the infrastructure financing gap in Africa

The African Development Bank estimates the African infrastructure financing gap to be between USD 68 billion and USD 108 billion per year; which must have widened since Covid-19 struck. This is the market we are talking about for infrastructure investment. However, to realize this potential and attract the necessary financing, there are a few economic governance bottlenecks to be removed. These could be addressed at multiple levels:

  • Enabling environment for more private sector and PPP infrastructure investment to flow: These country specific constraints are generally referred to as – pull factor, which includes reforms necessary to improve investment climates in countries necessary to attract in particular private and PPP capital. Just to cite few of the pre-requisites that will be needed: a credible contract enforcement mechanisms in place to reassure private sector in the event of any dispute; PPP policies and laws to provide much clearer visibility to investors about which sectors and how they can invest; transparent public procurement rules to ensure value for money; good tax incentives policies aiming at further de-risking investments; and strong counterparty public sector administration to negotiate with.  These basic good governance mechanisms are paramount to attracting the calibre of investors for the transformative infrastructure needed to transform the African economy and boost trade. As the premier continental development bank, the AfDB is providing the much-needed assistance to realise this transformation. Whilst progress has been made in bridging the financing gap of African infrastructure projects, there are still a number of challenges affecting a meaningful public private dialogue to critically address the growing infrastructure financing gap in Africa and these include:
    • Weaker governance and institutional capacity: While policies, laws and regulatory frameworks to support infrastructure investment may exist in many African countries, lack of confidence in the stability and predictability of legal and regulatory frameworks or in the decisions of the regulator, increase considerably the risk to investors and therefore the risk premiums they require. These weaknesses in the system may also lead to more disputes and/or renegotiation of contracts during implementation. The Bank is supporting countries to provide certainty and security in this regard with targeted reforms and sustained country dialogue.
    • Weaker technical capacity: Many African countries usually have weaker technical capacity to prepare, evaluate, bring to market, implement and supervise projects and to engage private sector. Evidence suggests that a public private business are affected directly and substantially by the capacity of the public agency to effectively engage.  In this case, a strategy needs to be in place to acquire or build institutional, administrative and technical capacity before undertaking more complex operations with private sector. The AfDB has instruments in place and is supporting in addressing that in particular in low income and fragile countries.
    • Enabling policy reform – The Bank recognizes the need to deepen its policy dialogue in the area of infrastructure to support member countries in (i) tackling policy and institutional reforms, (ii) ensuring sustainable infrastructure financing including private sector financing, PPP and blended finance, as well as (iii) addressing important issues such as fostering economic/development corridors, tariff and subsidies policies, smart infrastructure, and quality infrastructure, amongst others. These will help to enable the environment for investment therefore facilitating the large and sustainable financing required to bridge the infrastructure financing gap.

The need to innovate further

The traditional means of public financing of infrastructure and pursuing limited private concessions will be difficult as most African governments have limited fiscal space and hence limited ability to borrow from the MDBs and also the international capital markets.  Infrastructure PE Funds are not raising the levels of funding achieved in the past during the height of the Africa Rising narrative.  There is therefore a need to innovate further in the new Africa Recovering narrative. These include:

  • Project preparation and development – we need to find new ways and to deepen old ways to develop a robust pipeline of bankable projects. The AfDB is active in this space with the NEPAD-Infrastructure Project Preparation Facility which supports African countries to prepare regional infrastructure projects in energy, transport, ICT and transboundary water. Since its inception in 2005, the facility has mobilized downstream investments of US 24,1 billion. We also work closely with Africa50, an investment platform which the AfDB and partners established for the purpose of early stage infrastructure project development to improve bankability of key infrastructure projects across Africa.
  • Increasing adoption of PPPs – this is critical to overcoming some of the challenges to the infrastructure financing gap in Africa. To further strengthen its intervention in this area, which is critical in mobilising private sector financing into infrastructure, the AfDB is currently finalising its internal PPP strategy and implementation plan, that will guide our intervention and encourage governments to adopt PPPs more and more.
  • Infrastructure Asset Recycling –. Infrastructure investments should be a key part of the continent’s recovery plans, and asset recycling (“AR”) can help unlock capital currently tied down in state-owned brownfield infrastructure assets by offering all or a controlling stake to credible private institutional investors willing to pay a fair price to government. Then governments can recycle all or part of this unlocked capital to fund new PPP infrastructure projects.  We are working with Africa50 to implement demonstration projects across Africa in short time frames, so that this can be a key mechanism for unlocking government resources to stimulate new PPPs in infrastructure.  In addition, the 5% Infrastructure Investment Agenda for African Institutional Investors, is intended to also advocate infrastructure asset recycling through a pact between African institutional investors (pensions and sovereign wealth funds) and African governments, endorsed by the African Union Heads of State.  AfDB is supporting the Continental Business Network (CBN) on this campaign.
  • Replicate InfraCredit Nigeria or similar vehicles –. NSIA (Nigeria’s SWF), with the support of GuarantCo, developed and established InfraCredit Nigeria.  Since then, AfDB and PIDG (parent of GuarantCo) have invested Tier 2 capital and common equity, respectively.  InfraCredit Nigeria is a mono-line credit guarantee agency in Nigeria that credit enhances infrastructure bonds issued by private corporates and potentially federal and sub-national governments, so as to attract pension and other institutional investors to finance the productive sectors.  There is potential to replicate this or a variation of this across Africa in markets where we have material long-term local savings pools and an increasing portfolio and pipeline of infrastructure projects.