Financing SMEs in Africa: The Case for Establishing an African Guarantee Fund

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Financing SMEs in Africa The Case for
Establishing an African Guarantee Fund

• Pietro Calice
• Senior Investment Officer, Private Sector
  Operations
• Danida Development Days, Copenhagen
• 8-9 June, 2009

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Introduction

• The AfDBs Strategy Update for Private Sector
  Operations approved in January 2008 acknowledges
  the fundamental role of SMEs in the process of
  poverty-reducing economic growth. Accordingly,
  supporting SMEs is one of the key strategic
  priorities.
• The AfDB channels its support to SMEs indirectly,
  through financial intermediaries, providing
  financial products often combined with grant
  resources for technical assistance and capacity
  building.
• One of the core financial instrument for
  assisting SMEs are PCGs. To date, the AfDB has
  approved 5 PCGs. However, given mounting external
  and internal constraints there is a need for
  scaling up assistance and overhaul the current
  operational approach.
• The purpose of this presentation is to propose
  the establishment of an African Guarantee Fund to
  ease access to credit for SMEs.

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This presentation is organized in three parts

• Background
• The Role of Partial Credit Guarantees
• The Proposal

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In the first part of this presentation

• Background

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SME development is paramount for achieving the
MDGs

• Economic development during the last decade has
  lifted millions of African people out of poverty.
  Yet Africa faces important challenges in meeting
  the MDGs given the current global economic
  context.
• Private enterprises are the most important engine
  of growth and poverty reduction. Any national
  strategy to meet the MDGs must include a
  framework for domestic private sector growth.
• Within the domestic private sector, SMEs play a
  fundamental role in the economies of every
  country in the world. They account for most of
  output and total employment.
• The presence of SMEs is associated with overall
  productivity improvements. They are very
  important in testing new ideas, introducing new
  products and intensifying competition.

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SMEs in Africa The Missing Middle

• Africas private sector consists of mostly
  informal micro-enterprises operating alongside
  large firms. SMEs are very scarce and constitute
  a missing middle.
• SMEs are weak in Africa because of small local
  markets and difficult business conditions
  including poor infrastructure, dubious rule of
  law and unfavorable tax and regulatory regime.
• Large firms have the means to overcome legal and
  financial obstacles. They have bargaining and
  lobbying power, and they depend less on local
  economies for their production inputs.
• One of the greatest obstacles to the emergence
  and growth of SMEs in Africa is the limited
  access to formal external finance, particularly
  to bank credit.

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Restricted Access to Investment Finance

• Credit markets in general are characterized by
  market failures leading to credit rationing.
• Credit markets for SMEs are further characterized
  by high transaction costs, high risk perception
  and lack of collateral.
• A further constraint is represented by the
  regulatory framework for banking intermediation
  (Basel) and by its inherent procyclicality.
• Given the extent of the global economic and
  financial crisis and its impact on Africa, the
  procyclicality of bank regulatory capital will
  likely translate into a credit crunch for SMEs.

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In the second part of this presentation

• The Role of Partial Credit Guarantee Schemes

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The role of PCGs to ease access to credit for SMEs

• There is a clear economic and social case for
  scaling up public financial support for SMEs. The
  problem is to select the most appropriate
  instrument.
• Need for minimizing market as well as public
  failures complementing private market for
  credit consistency with the consensus on private
  sector development.
• PCGs fit these criteria. They align incentives so
  that banks share in the default risk of the
  borrower, perform independent screening of loan
  applications and are charged fees high enough to
  give up using the guarantee for loans that do not
  need it.
• There is also some historical evidence that PCGs
  play a fundamental countercyclical role, ensuring
  support for projects in an economic downturn,
  when banks reduce their level of activity with
  SMEs.

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The experience of the AfDB with PCGs

• PCGs have been identified as a core financial
  product to mobilize financial resources for
  economic and social development in RMCs since the
  AfDB was established art. 14 (1) (d) of the AfDB
  Agreement.
• In 2004, the AfDB approved the Bank Policy on
  Guarantees, which represents a comprehensive set
  of operational and financial guidelines.
• To date the AfDB has approved 5 PCGs for easing
  access to finance for SMEs 2 GOWE in Cameroon
  and Kenya, respectively (10mn each) 1 Export
  Oriented Program in Ghana (24mn) 1 PCG to CRDB
  Bank in Tanzania (8mn) and 1 PCG to Zambia
  National Commercial Bank (8mn). The latter three
  are in partnership with USAID.

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Basel II poses stiff challenges to PCGs

• The potential of well-designed PCGs can be
  affected by external factors, including the
  regulatory framework.
• While Basel II is expected to make credit for
  SMEs both more rationed and costly, it also
  provides a regulatory recognition for credit risk
  mitigating techniques including PCGs and
  counter-guarantees.
• The majority of existing PCGs in Africa will not
  be compliant with Basel II thus undermining
  banks incentives to cooperate. This is
  especially due to their relatively poor credit
  quality.
• The AfDBs PCGs will be affected too. The
  implementation of Basel II at the AfDB means that
  there will be a reallocation of private sector
  operations towards the higher-end of the rating
  scale.

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Summing up

• A strong and vibrant SME sector can make a
  significant contribution to the achievement of
  the MDGs in Africa.
• Yet African SMEs find it difficult to access
  external sources of finance, particularly bank
  loans. This hampers their growth and development.
• There is a clear case for increasing financial
  support for SMEs and PCGs seem to be the most
  appropriate instrument, also given their
  regulatory recognition for capital relief under
  Basel II.
• While scaling up aid is a fundamental condition
  for achieving the MDGs, aid effectiveness must
  increase as well. This is all the more important
  in the context of shrinking aid in the coming
  years.

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In the final part of this presentation

• The Proposal

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AGF Initial Design

• AGF will be explicitly required to conduct its
  operations so as to generate appropriate returns
  on its resources.
• This market-oriented approach will ensure that
  AGF achieves self-sustainability while
  maintaining a financial profile in line with the
  desired rating category.
• AGFs performance and results will be
  periodically evaluated as it will be the
  financial and economic additionality spurred by
  the fund.
• Product portfolio Loan portfolio guarantees and
  counter-guarantees Portable guarantees Capacity
  development for financial institutions Capacity
  development services for SMEs.

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AGF Governance

• Set up as an incorporated legal entity offering
  shares in three types of risk tranches a lowest
  ranking (first loss) tranche, a mezzanine tranche
  and a senior tranche.
• The first loss layer will be funded through
  grants provided by donors, DFIs will primarily
  invest in the mezzanine tranche. The senior
  tranche will be designed to attract commercial
  financial institutions .
• Investors in the lowest ranking tranche and in
  the mezzanine tranche would hold the absolute
  majority. This is a necessary condition to
  achieve a high credit rating from international
  rating agencies .
• AGF will be governed by a Board representing the
  ownership interests of the equity investors with
  a weighting towards either the lowest ranking
  (first-loss) or mezzanine share classes.

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Overview of AGF
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Justification for the AfDB involvement

• Strategic alignment AGF will be consistent with
  PSO Strategy and aligned with Country Strategies.
• Commercial viability The fund will be explicitly
  mandated to conduct its operations so as to
  generate appropriate returns on its resources.
• Development outcome AGF will help mobilize
  significant financial and technical resources for
  SME development. For example, a capital of 500mn
  with a leverage of 3X and a coverage of 50 could
  mobilize 3bn of SME loans and a total 20bn of
  SME investment (1.5 of African 2008 GDP).
• Additionality and complementarity The fund will
  contribute to ease the problem of access to
  credit for SMEs. It will also help develop and
  deepen local currency bond markets by investing
  its liquidity in sovereign debt.

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Action Plan

• Undertaking detailed feasibility study in six to
  eight countries, drafting Information Memorandum.
• Setting up a Working Group to lead the process
  and consult with potential partners.
• Presenting the Information Memorandum and getting
  shareholders approval.
• Finalizing design of AGF (statutes, management
  and organization, operational guidelines,
  recruitment).
• Starting operations (expected June 2010).

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• THANK YOU