Financing Costs and the CFA Franc: a Promise yet to be Fulfilled Nicolas Pinaud

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Financing Costs and the CFA Franc a Promise
yet to be FulfilledNicolas Pinaud
"Macroeconomic Policy in the Franc Zone What can
the European Central Bank learn from
Africa?" February 21, 2006 Paris
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Cost of Capital in the CFA Area Expected Benefits

• A peg is conducive to a more stable real
  effective exchange rate (REER)
• Fixed nominal exchange rate
• Lower inflation

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Cost of Capital in the CFA Area Expected Benefits

• Reduced currency mismatch lower solvency risk
• The bulk of ODA provided to UEMOA/CEMAC
  countries, and therefore the greater part of
  their external debt, are denominated in SDR,
  and

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Cost of Capital in the CFA Area Expected Benefits

• A lower (if not zero) currency-risk premium on
  local-currency denominated financing
• Breakdown of debt cost for a borrower in local
  currency on the local bond market

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Cost of Capital in the CFA Area Expected Benefits

• A lower (if not zero) currency-risk premium on
  local-currency denominated financing
• Fixed nominal exchange rate supp. of foreign
  investment (esp. from euro-zone investors in the
  CFA Zone) in LC denominated assets no currency
  risk
• Low inflation theoretically conducive to higher
  domestic savings

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Cost of Capital in the CFA Area Expected Benefits

• A limited transfer risk (principle of free
  transferability)
• Lower the solvency risk premium charged to
  non-sovereign entities
• Makes it easier, in principle, for WAEMU / CAEMC
  corporations to "pierce" the sovereign ceiling
• Transfer risk is usually a strong deterrent to
  foreign investment

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Cost of Capital in the CFA Area Expected Benefits

• Potentially, since 1999, an even larger capital
  pool accessible to CFA-zone entities the
  Euro-zone
• Quasi local-currency financing for CFA zone
  entities no currency mismatch, i.e. lower
  solvency risk and default premium
• One of the world broadest and deepest financial
  centre high liquidity (no liquidity premium) and
  high appetite for risk
• Top legal standards no jurisdiction premium

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Cost of Capital in the CFA Area Mixed Outcome

• UEMOA countries' sovereign short term bond issues
  are gaining in importance (together with
  declining coupons)
• State-owned companies BOAD, Port Autonome de
  Dakar, Communauté Electrique du Benin
• ? Average maturity of 7 years, 5.35 - 6.5
  coupons
• Large UEMOA corporations are also issuing debt at
  relatively low cost Nestlé (Ivory Coast),
  TELECEL (Burkina) and SHELTER Afrique (Senegal)
• ? Average maturity of 5 years and coupon between
  6 and 7.25

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Cost of Capital in the CFA Area Mixed Outcome

• However, local financial systems remain extremely
  shallow
• Low domestic saving rates
• Limited competition in the banking sector,
  limited role in the financing of the local
  economy

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Cost of Capital in the CFA Area Mixed Outcome

• However, local financial systems remain extremely
  shallow
• Illiquid financial markets
• BRVM very small Market Cap
• Velocity of circulation on the BRVM equity market
  is the lowest in Africa (1.8 in 2004 / 47 in
  the JSE)
• Hardly any bond trading, no real secondary bond
  market

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Cost of Capital in the CFA Area Mixed Outcome

• However, local financial systems remain extremely
  shallow
• Illiquid financial markets

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Cost of Capital in the CFA Area Elements of
Explanation

• Is the peg really credible?
• On the face of it, yes it is (guarantee of the
  French Treasury, de facto currency board)
• However recurrent rumours of devaluation the
  1994 devaluation has set a precedent
• Is there an implicit currency premium? Apparently
  not

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Cost of Capital in the CFA Area Elements of
Explanation

• WAEMU CAEMC sovereign still perceived as
  fragile obligors by foreign investors
• Poor track record
• Structurally flimsy public finances (limits of
  the HIPC initiative) and low ratings (Fitch
  SPs)
• From CCC (Cameroon)
• to B at best (Senegal / Benin)
• No investment grade
• High country risk in general (Ivory Coast as a
  case-in-point)

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Cost of Capital in the CFA Area Elements of
Explanation

• Little developed corporate sector
• Limited liquidity of debt instruments /
  preeminence of commercial loans
• The very few bond issuances can be underwritten
  locally
• Poor legal and business environment in the WAEMU
  and CAEMC high jurisdiction premium requested by
  foreign investors
• Poor corporate governance / Stringent listing
  requirements and expensive fees in the euro-zone
  for bond issues

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Cost of Capital in the CFA Area Conclusion

• The peg is potentially a useful instrument to
  reduce capital costs in the CFA franc zone
• Yet, the other components of the country risk
  premium tend to nullify the benefits of the peg
• ? The CFA peg is no "magic bullet" to deepen
  WAEMU and CAEMC financial systems and to reduce
  capital costs in the region