Category: Finance

Africanising credit – Financing SME’s

Agriculture and SME’s (small and medium enterprises) are the backbone of Africa’s economy and societies. SME’s make up to 90% of all businesses in sub-Saharan Africa[1]. In Ghana approximately 92% of all local businesses are SME’s, providing up to 85% of manufacturing jobs in the country and contributing about 70% to the country’s GDP. In Nigeria, 37 million SMEs employ about 60 million people and account for about 48% of the country’s GDP. In South Africa, there are more than 2.2 million SMEs, about 1.5 million of them in the informal sector. As much as governments around the continent are looking to industrialise through attracting investment in large scale manufacturing, we cannot develop without our SME’s. SME’s provide the livelihoods for a significant number African’s and if they succeed, African economies and development will succeed.

However, SME’s also face an incredibly tough time. In South Africa, the Department of Small Business Development estimates that between 70%-80% of SME’s do not make it past their first year. In Kenya, the National Bureau of statistics found that at least 46% of Micro Small and Medium enterprises do not make it past their first year. What is preventing them from succeeding? Among the multitude of factors (some covered previously on this blog), one of the biggest is credit. The London Stock Exchange estimates that African SME’s face a funding gap of at least $140 billion African businesses find it incredibly hard to access credit, and credit is the fuel of the modern economy. Without credit, there is no safety net for businesses and farmers when things get a little tough. Without credit, it’s hard to fund growth and innovation. Without credit most businesses and farmers are limited to subsistence, to just surviving, because to develop we need those businesses to thrive.

Thus, the policy question becomes what can be done to ensure more credit gets to the SME’s. If the financial sector is not fit for purpose, how do we move beyond traditional definitions of collateral and banking to kickstart credit to these key sectors? The answer for many governments around the continent and development finance institutions (DFI’s) has been to try some sort of SME financing scheme such as giving banks money or guarantees to lend money to SME’s. However, this hasn’t worked, thus what’s needed is a new approach, based on evidence that takes advantage of new trends and technologies and thinks beyond banks. If so, the continent may be able to turbocharge their economies by enabling businesses that actually exist rather than those they hope will be created.

Understanding SME’s financing needs

Knowing that there is a problem and understanding the nature of that problem are two different things. Judging by their rhetoric, African governments understand the importance of SME’s to their economies and are more than willing to make commitments to improve their lot. However, before making promises to SME’s and formulating policies on the basis of those promises it is necessary to understand SME’s needs.

Thus, the first thing that African governments must do as they attempt to unlock the financing problem that SME’s face is to talk to SME’s. Understand whether the majority SME’s need financing to fund their day to day operations (working capital financing), credit to invest and grow their businesses, or trade financing to help fulfil orders or ensure that they have sufficient levels of stock. Secondly, governments need to understand how much money different types of SME’s actually require. Understanding the financing needs of SME’s will enable governments to design or enable solutions that SME’s actually need. Third, is for governments to understand the participants in the SME sector. Such as the nature of formal and informal player, the challenges facing SME’s in different sectors such as manufacturing, agriculture or the arts, the region of the country they are in etc. If the rhetoric of African governments is to become reality and SME’s are really going to be empowered African governments would do well to make a good faith effort to understand them properly first.

Beyond banking

As stated earlier many of the efforts to jumpstart SME financing have involved banks, with governments and DFI’s providing lines of credit or guarantees specifically earmarked for onward lending to SME’s. Around the continent there exist a plethora of government-owned development banks, private banks, and funds whose sole purpose is to lend to SME’s and start-ups. What’s clear is that traditional funding models (a bank loan) are not necessarily meeting the needs of African SME’s a report by the London Stock Exchange Group has placed the funding gap for African SMEs at more than $140bn. The report goes on to point out that among the key hurdles to SME’s accessing finance are:

  • Onerous credit checks from banks (especially foreign banks) restrict SME participation as SMEs often lack the track record and meaningful data inputs required.
  • Credit Bureaus (where defaulters are blacklisted) have, rather than de-risking credit, turned into a negative reinforcement tool as smaller companies run the risk of being ‘blacklisted’ if a single loan repayment is delayed.
  • Prohibitive collateral requirements: lenders seek high levels of collateral to mitigate the high risk associated with lending to SMEs

It may be time to think beyond bank loans when we ask how we can provide African SME’s with viable sustainable credit options. Across the continent, digital and mobile-based lenders are helping to fill the credit gap with innovative and ever-changing credit risk models allows them to better understand credit risk. Allowing them to lend to small business owners, traders and farmers to access short term credit. Often referred to as short term credit, this type of lending allows businesses to meet short-term funding gaps. For example, if an agricultural produce trader wants to stock for the day or week, they are limited to buying only what they can afford at that particular moment in time. However, with access to short term credit they can borrow, buy more produce, sell more produce and at the end of the day after paying the loan back they have made more money. This is not an abstract example it happens every day, especially in Kenya where mobile lending is now common. If banks are not willing to fill this gap, what policymakers and regulatory bodies such as central banks need to do is think about how we can we enable digital lenders to better meet the needs of SME’s. What regulations, consumer protections and standards do we need to put in place that will allow this industry to grow sustainably? Not just lending small traders but also possibly to larger SME’s enabling them to meet their own short-term finance needs.

Secondly, governments should start thinking about investing rather than trying to push banks to give out loans. In a previous post urging a rethink of industrialisation policy on the continent, I talked about the U.S. Governments Small Business Investment Company (SBIC) program to facilitate the flow of long-term capital to America’s small businesses. The SBIC either directly invests or facilitates private capital investment into Small businesses. Crucially these investments are long term giving small business the opportunity, capital and time to grow. Though it has lost money on some investments its investments in companies like Apple, FedEx, and Whole foods outweigh any losses made through the profits, jobs, Intellectual property and innovation that have brought trillions of dollars’ worth of wealth to the US economy. African governments must show the same willingness to invest in African businesses as the private sector (banks and investors) have not done so yet and we cannot sit around hoping it will. Public agencies with a clear mandate to invest or encourage investment in SME’s which show potential for growth will have hits and misses, not every investment is a success. But every investment like this is a positive bet in the future of your country and its citizens, it’s a sign to others that there is a path for them too, but most of all it puts public money where it could do real good not locked in a bank vault.

Making things just a little easier

Teddy Roosevelt once said that “Nothing in the world is worth having or worth doing unless it means effort, pain, difficulty.” The same applies to running an SME in Africa. Business is not for the faint-hearted, nor should it be, but neither should it be filled with potentially moveable obstacles that make It nearly impossible to succeed. Africa’s SME sector is astounding. It has survived natural disasters and the disaster that has been government policy and ignorance of small businesses. If SME’s are to not just survive but thrive it will require governments to adopt policies that make things just a little easier for them outside of the easing of access to credit.

The first of those policies is a tax. Africa’s tax systems tend to be overly complex and burdensome. With businesses often having to pay multiple taxes, that they can ill afford. Simplifying tax systems to be coherent and so simple, so that they can be understood and paid easily should be a priority. If not, many SME’s will either avoid paying taxes or struggle under the burden of being law abiding citizens.

Second, trust. A public register where key information about companies is available to banks, lenders, governments, investors, customers, etc. to have some trust in the credibility and trustworthiness of these companies.

Third would by altering our laws, specifically our employment laws to fit the reality of SME’s and labour in Africa rather than acting as if all employers were large corporations. I have written more extensively on that here.

Finally, is training and networking. Facilitating the training around financing, marketing and tax/regulatory compliance could equip SME’s with tools they need to succeed and enable them to make better use of the funds they do manage to get. Networking is simple, merely using the government’s power to bring people together, to bring SME’s, investors, financiers and potential customers together, and letting them do their thing.

Creating the right environment need not be complex, a few concrete policy actions from the government would act as a stimulus to SME’s and those that may provide credit to them, making things just a little bit easier.

Conclusion

SME’s are the lifeblood of African economies. They provide livelihoods to hundreds of millions around the continent, and alongside agriculture, they are the key that will unlock Africa’s economic potential. To do that they will need access to credit. Thus far efforts to improve credit provision to SME’s on the continent have not been as successful as hoped. This calls for some new thinking; thinking based on a deeper understanding of the challenges facing SME’s. New thinking about how we can move beyond the limitations of banks to harness new technologies and approaches to provide credit to Africa’s SME’s. And to Identify and implement the key policy interventions that governments can make to provide the right environment in which SME’s can thrive.

If we get this right, if we can get SME’s to thrive, then Africa Rising won’t be an old meme but a future reality.

[1] https://www.ifc.org/wps/wcm/connect/REGION__EXT_Content/Regions/Sub-Saharan+Africa/Advisory+Services/SustainableBusiness/SME_Initiatives/

Africa needs taxes not aid

Revenue collection is the one which can emancipate us from begging, from disturbing friends… if we can get about 22 percent of GDP we should not need to disturb anybody by asking for aid….instead of coming here to bother you, give me this, give me this, I shall come here to greet you, to trade with you. – Yoweri Museveni, President of Uganda

In 2014 Zambia exported 59% of its copper to Switzerland, yet a look at Switzerland’s import and export statistics shows that they barely imported any copper and barely anything from Zambia[1], it is likely that most of this copper ends up going to China or other markets. What’s happening is that mining companies operating in Zambia are taking advantage of transfer pricing. Transfer pricing is where a subsidiary of a multinational company from one jurisdiction sells goods or services to a subsidiary of the same multinational company in another jurisdiction. Multinationals will most often use transfer pricing to shift profits into tax havens and low tax countries such as Switzerland. In the case of Zambia’s copper, mining companies such as Glencore sells copper mined in Zambia by its Zambia based subsidiary to the company’s trading arm incorporated in Switzerland at lower than market prices. The Swiss based trading arm then sells on the copper to the world market at market prices. The results of the transaction will mean that Glencore’s Zambia subsidiary will generate lower profits, minimising the tax payable to the Zambian authorities, while Glencore’s Swiss trading arm will generate the majority of the profits from the sale of copper, making these profits taxable in Switzerland, which as stated earlier is a low tax country. This strategy isn’t illegal, but what it does is minimise the taxes that are paid to the Zambian government and maximise the profits that these companies can make.

What happens to copper profits and taxes in Zambia is neither new nor unique. The UN economic commission for Africa High Level Panel on Illicit Financial Flows[2] estimates that “over the last 50 years, Africa is estimated to have lost over 1 trillion dollars in illicit financial flows, this is roughly equivalent to all of the official development assistance received by Africa over the same timeframe.”  Currently, they estimate Africa is losing more than $50 billion annually which is double the aid that Africa receives per year.

Across the continent African governments are once again getting caught in a debt trap (you can read a previous post on that here)  and are struggling to raise revenue and are having to increase taxes on the poor and working classes. In South Africa the latest budget included a 1% rise in VAT among others, Niger is currently experiencing mass protests against new tax raises on common goods, Kenya , Zambia and other nations across the continent are considering or implementing similar tax hikes. These measures will hit the poor hardest as they will raise the prices of the goods such as fuel, food and clothing that they need the most.

Not only is Africa getting bilked of its taxes, African governments are trying to make up the difference on the backs of the poor. This needs to change, multinational corporations and international investors will be a part of Africa’s growth story and they will (or already are) make fantastic profits from it, it is only fair that Africans get their fair share. And now is the perfect time to enact policies that would give Africa a fair share. Across the world tax evasion is key issue, Europe is cracking down on tech companies that use tax avoidance strategies, and three years ago the G20 vowed to fight tax avoidance[3]. Rather than swimming against the tide, Africa would likely have allies in a quest to implement fair taxes.

Tax revenues and profits where they are made

Recently the EU proposed a new technology tax. For several years EU countries have been trying to deal with a tax avoidance problem, like Zambian copper, big multinationals would base their intellectual property in tax havens and have their European subsidiaries pay “royalties” for use the of it, essentially transferring profits made in Europe to tax havens. The most prolific users of this strategy have been the technology companies and thus the EU has decided to propose a 3% tax on the revenue generated made by these companies in the EU as opposed to profits. The main idea behind this tax is that companies should be taxed in the country’s where revenues and profits are made and not in tax havens, providing a simple solution that African countries should adopt.

Make taxes simpler; the Norwegian example

In the 1970s Norway started exporting oil and gas, in the 40 years since this industry has added over 1.1 trillion dollars to the Norwegian economy, which is almost the size of the combined economies of Sub-Saharan Africa. In 1990 Norway established a sovereign wealth fund to invest its oil revenues today it is now worth over 1 trillion dollars. One of the key tools they have used to benefit from their natural resources is tax, in Norway, companies drilling for North Sea oil pay a 78% tax rate on income, though it includes deductions for losses and investment they are simple and easily implemented and assessed by the government. In addition, Norway taxes entities not specific assets, once again this simplifies the system considerably (you can read more about Norwegian petroleum taxes here).

By contrast if you looked at laws or production sharing contracts around Africa on mining or oil and gas, they are complex, and contain different types of taxes levied on the companies, the mineral, the license etc. This complexity allows these tax systems to be gamed and avoided. African policy makers would do well to look at how Norway taxes the companies that extract its oil and gas and consider a similar system. A system that is simple, easily enforced and taxes the extractives industry on our terms. If we did this Africa could finally be in a position to get significant taxes from the extractives industry and like Norway plough those profits back into the continent.

Expand expertise

This policy is simple, but its subject matter is not. The global tax system and strategies used by multinational corporations are incredibly complex. Companies employ armies of lawyers and accountants to look for loopholes and provisions that will allow them to lower their tax bill, and African countries cannot match up. Thus, on this issue African nations need to come together and the AU or Africa Development Bank (AfDB) provides the perfect venue for doing so, to create an African Tax Centre. This is not a new notion, the AfDB already has the African Natural Resources Center, which was created to help African countries build capacity in natural resource management.   The African Tax Centre could have a similar mission consisting of two goals, first to pool African expertise on taxes and assist national governments in identifying and stopping tax avoidance and second to help train and build the capacity of African revenue collection authorities. Over time as the capacity of African countries to administer and collect taxes increases they will be able to close off the avenues used by multinational corporations to avoid African taxes.

More Taxes less dependency

Taxes are a decidedly unsexy topic and bore most of us senseless. However, they are crucially important, the roads, schools, hospitals and police services that Africa needs must be funded somehow. For too long Africa has relied on aid and debt to provide a substantial portion of this funding, but aid comes with conditionalities set by foreign powers and can only be spent on things they deem important, and debt if not wisely used or with a bit of bad luck can be more burdensome than helpful. The only other option is taxes, but African governments must change their tax focus, today most African countries collect their revenues from those fortunate enough to have formal employment and Value Added Taxes, these taxes place their burden on those who can least afford it, meanwhile global corporations and investors are spiriting away over 50 billion dollars of prospective revenue. It is time for Africa to adopt policies that would end these practices, by taxing profits where they are made, reforming extractives taxes to be simpler and more effective and building the expertise needed to close the loopholes.

Africa is the final frontier of the commercial world. Over the last two decades big multinationals have sought to tap into the African market in technology, telecoms, mining, agriculture, healthcare (the list goes on), which are all very profitable now and will only get more so. The world both needs the resources under Africa’s soil and wants to take advantage of one of the world’s last untapped markets, thus the business case for doing business on the continent will not disappear as some people ominously warn whenever the prospect of higher and more efficient taxes are raised.

If Africa is ever to choose its own development path, if it is to decide its own destiny, it will not be done through depending on the generosity of others, it will be through its own money. If there is one policy Africa should be able to get behind it is that Africa needs taxes not aid.

[1]https://wits.worldbank.org/CountryProfile/en/Country/CHE/Year/2016/TradeFlow/EXPIMP/Partner/all/Product/72-83_Metals

[2] https://www.uneca.org/iff

[3] http://www.oecd.org/tax/g20-finance-ministers-endorse-reforms-to-the-international-tax-system-for-curbing-avoidance-by-multinational-enterprises.htm

Ending the African debt trap: A developmental debt policy framework

“We have been indebted for fifty, sixty years and even more. That means we have been led to compromise our people for fifty years and more.” – Thomas Sankara OAU July 1987

In 2005 developed countries wrote off billions in debt accumulated by Highly Indebted Poor Countries many of those in Africa. Debt relief gave many countries some breathing space from crushing debt and structural adjustment programs that saw public services decimated, and development expenditure minimised. Over a decade later much of the continent is walking into the same trap, accumulating foreign currency denominated debt with very vague ideas of how we are going to pay it back (figure 1)[1].

If we are not careful many African nations will find themselves where they were in the 1990s (some like Ghana already have); cutting spending and services to get IMF bailouts so that they can pay their debts.

As Thomas Sankara alluded to in 1987 this is no way to develop a continent, because in the world of international finance, banks and bondholders do not care about your people, they just want to be paid back on time. When it comes time to pay back this current binge of debt of what African nations are accumulating, just like in the 1980s and 1990s it will be the people who suffer, making the claims of leaders justifying this debt in the name of development a cruel joke.

African governments need to learn how to borrow smartly and use the money prudently. In my view African governments need to develop a framework through which borrowing is assessed; based on a set of principles that benefit Africans rather than burden them. Ending the African debt trap doesn’t mean ending African debt, it means making it work for us.

Debt: Bonds, Loans and Guarantees.

Governments in Africa borrow and accumulate debt in three primary ways. First, by issuing bonds, where investors lend money to the government by buying the bond who in turn promise to pay investors back in full, with regular interest payments[2]. Loans are straight forward, and work in the same way as a bank loan you would get. The main sources of government loans are international banks, multinational institutions like the IMF or World Bank and direct loans from individual states. Guarantees are slightly different, the government does not borrow directly but guarantees the debt of a company, usually a state-owned company, so that if it fails to repay its loans the government has to repay them.

Debt is not inherently a bad thing. It allows you to access funding that you do not otherwise have to invest in growth. For companies, debt is used to fund expansion, new machinery, hire more workers etc., to grow it is revenues. For countries debt can be used to fund investments in the country beyond what is available from tax revenue. It gives government the ability to invest in areas such as infrastructure, education, industrial or agricultural initiatives that give people and wider economy a higher capacity for growth and development. Put simply if you use debt to invest areas that create more value than the value of debt then you are fine, as the debt will pay itself back.

The problem with African debt

Debt becomes a problem when you have trouble paying it back. As your debt load increases you start borrowing money simply to pay for earlier debt, like using a credit card to pay off another credit card. Eventually you are forced to ask for help, going cap in hand to your creditors and asking for a bit more time or to the IMF for a bailout and as Africa discovered in the 80’s and 90’s, when that happens your fate is no longer in your hands.

In Africa bad debt falls into 3 broad categories. The first is corruption and misuse, where money borrowed is not even used in any form of gainful investment but essentially stolen. Mozambique was one of the success stories of the last few years with 7%+ growth rates even as it borrowed heavily (Figure 2).

Investors were not concerned with the debt levels because of Mozambique’s huge gas reserves. In 2013, Mozambique borrowed $850 million dollars to invest in a new tuna fishing fleet meant to jumpstart the countries fishing industry. However, Mozambique did not buy fishing boats, it bought gunboats, and shortly afterward it emerged that the government had been hiding an additional $1.4 billion of in loans whose use is shrouded in mystery. By 2016, Mozambique was unable to pay its loans and it defaulted on its debt. Mozambique is now in the arms of it is creditors and the IMF. When its gas fields start producing commercial gas in 2023, the money will go towards paying its loans first before it goes to the people of Mozambique.

The second way African debt tends to get out of hand is through investment in misguided projects, otherwise known as white elephants. These projects are often pursued for political reasons such as being in the part of a country the minister comes from, or connected people getting the contracts rather than development objectives being main goal. Today there is a building frenzy across the continent as governments invest in infrastructure to boost economic growth. This infrastructure is expensive, and governments have to borrow to fund it and it is a large part of the significant increase in debt on the continent over the last few years. If these roads, railways and dams are white elephants and provide little value to communities and countries they are in, Africans will be saddled with debt for vanity projects.

The third way in which governments accumulate debt is through providing guarantees to state-owned companies who take on debt for a variety of purposes. However, many state-owned enterprises in Africa are poorly run, with spotty oversight and take out debt for poorly conceived expansion plans or to fulfil poorly thought-out political directives. Eskom is South Africa’s publicly owned electricity monopoly, but it is in dire condition. Mismanagement, corruption, old power generation plants, expensive construction of new plants and a failure by the government to let it raise tariffs has put Eskom into a precarious position. Eskom has over the years borrowed to cover the gaps using government guarantees. According to figures provided by the power utility, total debt amounted to R359 Billion (29 Billion Dollars). This amount of debt, as the finance minister recently conceded is a threat to the South African economy. And Eskom is not the only state-owned enterprise in South Africa in trouble. Government guarantees to state owned enterprises stood at R467 billion at the end of 2015/16. Standard & Poor’s forecasts they will swell to over R500 billion by 2020 – 10% of South Africa’s current GDP, adding to South African debt that is already worth over 55% of GDP.

The problem with African debt is that too much of it is ill-considered, too much of it is stolen and most of it is not put into smart investments which will improve people’s lives and create value.

The trap closes – International control.

A key feature of international debt markets that puts the continent at a distinct disadvantage is who controls the debt. Creditors are not usually terribly concerned with what governments do with debt as long as it is paid back. Thus, when governments get into tight monetary circumstances, creditors usually demand that actions be taken to ensure that the debts are paid. The vehicle for this is usually the IMF, the multinational institution charged with securing global financial stability and debt defaults are bad for stability. When the IMF comes in to bail out a government it comes with conditions and as Africans found out in the 80s and 90s (and as Greeks are experiencing now) those conditions are painful. They usually involve a mix of cutting government spending and services, raising taxes and cutting subsidies, privatising public services, selling public assets, cutting the number of government employees and limits on development, spending and investment. With African governments piling up more and more debt we are getting closer to being subject to IMF conditionalities again, and the pain and protest seen in Greece will become a feature in Africa.

A Developmental Debt Policy Framework

The question becomes, how do we make sure any money we borrow is good debt. How do policy makers, politicians and the wider public decide what is worth borrowing money for? If Africa is to end the debt trap cycle it must change the way it decides to borrow, if African countries need to borrow money to fund development expenditure, then we must have something that guides that process. This requires a developmental debt policy framework, that is based on a set of principles that guides various actors as they decide whether the government should be borrowing money. The principles upon which responsible developmental debt would be based are simple. It must be sustainable, valuable, and accountable. These three principles would answer the key questions of why we are borrowing, how are we borrowing, can we afford it and will it create value for the country.

Sustainable

Put succinctly, sustainability in debt is about the ability of country to afford the debt. Can the money borrowed, both the principal sum and interest, be paid back by either normal revenues or by the revenues generated project being funded, without requiring extra burdensome measures, such as additional taxes or cutting of existing government services. Ensuring debt meets this requirement of sustainability will ensure that African states can afford the debt they take on.

Valuable

The principle of value is aimed at ensuring that the areas the debt funds have value to the nation. Value can come in two forms. First, value to people, improving the living conditions or opportunities of people. If it can be demonstrated that a policy, initiative, service or project that requires funding will demonstrably improve the lives of the public, it is not money wasted, as fundamentally development is about improving the living conditions and opportunities available to Africans. Secondly, value for money, which is simply, can the project, or initiative generate enough revenue to pay for the money being borrowed. These two forms of value do not limit the options for governments, rather they ensure that the money borrowed will go into something of importance. For instance, improved healthcare is key to improving the lives of millions around the continent and this requires that Africa train and deploy many more healthcare workers, as doctors, nurses, lab technicians etc., but this is an expensive undertaking. However, the training and deployment of a significant number of healthcare workers is not cheap. If the government can develop a program that trains and deploys healthcare workers in a way that benefits the majority of the population, borrowing to fund this can be justified. In terms of value for money this would be aimed primarily at infrastructure projects and guarantees to state owned enterprises, if it can be demonstrated that these projects (e.g. a new railway) or state corporation (e.g. an airline) can reliably pay for itself then borrowing to fund the investment can be justified.

Accountability

The principle of accountability is simple, the public finances must be public. Transparency in public financing creates accountability. Accountability in public debt transactions would require governments to open about what the borrowing is going to fund, the terms upon which the money is to be borrowed, how they plan to pay the debts back and tracking the use of the borrowed funds to ensure that unlike Mozambique’s gunboat tuna fleet, it goes where it is intended.

These three principles are interrelated. Debt that creates value is far more likely to be sustainable and being open and accountable about the terms on which the money is being borrowed allows for sustainability and value to be accurately and properly assessed. Having a developmental debt policy framework based on these three principles, would help ensure that Africa takes on debts that serve a developmental purpose. Furthermore, these principles can be developed into more detailed project and policy assessment frameworks, which policy makers, politicians, civil society and the wider public can use to access the government’s borrowing and hold it to account. Unlike the conditionalities imposed by the IMF or bond holders using these principles to guide African debt would be aimed at development not just paying back the money, they would give Africans agency over their own debt by requiring responsibility on the part of African policy makers. To end the cycle of African debt traps where development and vital services are sacrificed on the altar of fiscal responsibility, will  require Africa to adopt policies that better guide how the continent borrows and what it uses for.

[1] IMF, Regional Economic Outlook Sub-Saharan Africa: Fiscal Adjustment and Economic Diversification, October 2017 https://www.imf.org/~/media/Files/Publications/REO/AFR/2017/October/pdf/sreo1017.ashx?la=en

[2] http://guides.wsj.com/personal-finance/investing/what-is-a-bond/

Interest rate caps could work and be a good thing

Despite what the IMF, World Bank, Kenya Bankers Association and various private sector organisations say (as well as free market logic), interest caps can be a good thing, if done right they could actually give people access to affordable credit, but that can only happen if governments around Africa stop borrowing as much as they have been.

In August 2016 president Uhuru Kenyatta signed into law legislation that capped the interest rates charged by Kenyan banks to 4% above the Central Bank of Kenya’s (CBK) benchmark rate. This means that if you were to go to a bank in Kenya to apply for a loan today the interest rate charged would not be more than 14%, which is 4% above the CBK’s benchmark rate of 10%.

While it was a drastic step, it was a long one coming. Kenyans had long been frustrated by banks charging exorbitant interest rates often 10 or more percentage points above the CBK benchmark rate. The Donde Bill of 2000 similarly capped interest rates but was neutered by the courts, and another similar law was stopped in 2013 because of heavy lobbying by the banks in parliament. In 2016 the public had, had enough and MPs (with an election around the corner) were listening and the bill was passed, somewhat unexpectedly the president signed the law.

The consequences of the rate cap

The consequences of the law have been significant. First and most significant is that banks have severely cut lending to the private sector, with credit growth falling ominously (Figure 1) meaning that borrowers particularly small businesses have been unable to access credit, meaning that not only can they not invest in further growth they also cannot use credit to supplement working capital [1],  while ordinary households have been unable to get mortgages and car loans. This effect has been cited by people like the IMF, World Bank and the Kenya National Chamber of Commerce and industry as a cause of Kenya’s recent economic slowdown.

Figure 1 – growth of private sector growth in Kenya

Secondly, in response to falling profits from interest rates banks have cut costs, significantly. In 2016 banks in Kenya retrenched over 1000 workers (approx. 1.6% of the financial services workforce in the country), and aggressively pushed digital platforms in order to cut down on more expensive physical infrastructure (bank branches, ATM’s etc)

The third and most important thing is how banks have been making their profits. Instead of lending to people and businesses they have been lending to the government. Banks have shifted their money to buying treasury bills, which are short term loans the government takes to cover its expenses on an ongoing basis, and they are making a lot of money while doing it. The logic is simple, why lend to individuals and private businesses, where you have to spend time and money assessing each applicant for their risk and run the risk that they might not pay you back. Its much easier to lend money to the government and though the interest rates may be lower, the volumes are very large and the government will not default, essentially guaranteeing profit. This is all enabled by a government with a never-ending appetite for more and more money, the Kenya governments debts have soared over the last year and here lies the problem.  The rate cap will never achieve the goals it was meant to – making loans cheaper for ordinary Kenyan business and people – if banks can simply lend to the government and still make huge profits. On the back of this there are increasing calls on the government to repeal the rate capping laws to ‘restore’ private sector credit and boost the economy.

This would, in my view, be the wrong approach, it would simply take Kenya back to the position it was in before. Banks would be charging people and businesses blatantly usurious interest rates for loans while continuing to lend to a government with the financial appetite of a black hole, in the process making enormous profits.

Making rate caps work

Repealing the laws would be a step backwards. The focus should be on making the laws do what they were supposed to do, to which the key is stopping government borrowing so much money. The rate capping law has been a godsend for a government borrowing from every willing lender, the law made the banks much more willing to lend to the government and avoid the effects of the law.

If government appetites for borrowing money could be curbed, then the interest rate caps could work. Eventually the banks will run out of costs to cut, without treasury bills as a source of endless profits, they would have to do what banks are supposed to do, lend. Rather than caving to pressure from banks and international financial institutions (again) the top policy makers at the Kenyan treasury need to start thinking about the people the laws were meant to serve and not the accounting books in front of them.

Rate caps around the continent

Kenya is not the only country on the continent facing the problem of how to improve and increase private sector lending. Across the continent, access to credit is a major hurdle faced by businesses (figure 2)

Figure 2 Percentage of Firms Identifying Access to Finance as a Major Constraint[2]

Without credit small businesses are stuck as they cannot get the funds to operate and grow, Africa may talk glowingly about its entrepreneurial spirit but without a finance industry willing to lend to them the reality will never meet the high hopes. If rate caps can be made to work it would stand as a model that other African countries can follow, it will show that with a simple law you can fundamentally change the dynamic in the financial sector that will force banks to serve their customers, something that free market economics has been unable to do. Giving African households, businesses and entrepreneurs access to affordable could be truly game changing and contribute to solving a range of problems from housing shortages to unemployment to the high rate of failures among SME’s. However, for affordable credit to become available lawmakers and policy makers need to be bold and force the financial industry to serve Africans and that will require policy, regulation and law. For these types of laws to work it will require the government to curb its appetite to spend and borrow as much as it can get away with, something we haven’t yet quite figured out how to do.

 

[1] For many businesses flows of income do not exactly match their spending (e.g. salary must be paid monthly but clients have 60 days to pay you)

[2] https://www.afdb.org/en/news-and-events/afdb-calls-on-credit-providers-to-increase-lending-to-meet-demand-by-african-msmes-17138/