At an Abuja roundtable for financial industry regulators in April, a representative from the pension regulator was asked why all but a small proportion of the large pool of pension capital in Nigeria was funding government deficits rather than productive economic activity and infrastructural development. Unfortunately, this is a question that could be asked across almost all of Africa.
Africa is often described as having capital constraints and being in need of foreign capital to finance public services, infrastructure and development. Yet this narrative deviates from an observed reality; across the continent, domestic capital pools are growing rapidly. Pension assets are getting larger, insurance pools rising, and in many markets banking system liquidity is strong and sovereign reserves robust.
The issue therefore is not the absence of investment capital – but how that capital is deployed. Capital exists but it is not reaching productive sectors in full and not catalysing growth at scale; rather, it is locked in government securities and short-term instruments. The capital is financing government budget deficits.
Structural imbalance
While holding sovereign debt and short-term instruments may reflect rational portfolio management choices, given liquidity considerations and risk constraints – especially in emerging markets – the high proportion of total capital kept in such instruments is an indicator of some structural imbalance. The fact that a larger proportion of capital is being channelled towards financing government rather than financing investment in industry, corporate expansion and infrastructural development means that it drives public sector spending rather than broad-based economic growth.
The allocation of African pools of funds to sovereign securities is influenced by a set of structural, often unintended, incentives. In many countries on the continent, these securities offer a great combination of high yield, safety and liquidity. From a fund manager’s point of view, this makes a lot of sense in markets where corporate securities and alternative assets are often illiquid or not traded and therefore difficult to price. Also, infrastructure and other long-term projects are often constrained by weak project pipelines, limited credit enhancement arrangements and shallow secondary markets.
Investors have to bear risks they may be ill-equipped to manage
In addition, risk management and hedging tools, such as financial derivatives, are often underdeveloped, meaning that investors have to bear risks that they may be ill-equipped to manage. In such an environment, the preference for sovereign investments is rational but leads to markets and economies where capital is preserved but not deployed to productive economic activity. Therein lies the paradox, because no other continent on the globe needs capital to support economic growth and development more than Africa.
Inefficiency ripples
This allocation to sovereign assets leads to a persistently high cost of capital for private-sector organisations, as they are crowded out of the debt markets. They therefore have to borrow at rates that make many projects non-viable. This allocation also means that most infrastructure must be funded by governments even though they have proven less efficient than the private sector at providing such infrastructure. This inefficiency ripples through the continent’s economies, slowing development and economic growth.
On a practical level, in many African markets, the mechanisms that should channel savings into productive investment are underdeveloped, making price discovery and risk-sharing somewhat difficult. This drives players in the finance industry towards activities that are easier to execute than those that promote economic transformation, which is again rational. The result, however, is a system that is stable on the surface but largely ineffective at deploying capital to support growth.
Credit guarantees and blended finance structures must be put in place
To address this problem, the role of financial markets in the economy must be brought into focus. Markets must be designed around the core idea of transforming short-term savings into long-term investment in development-supporting areas. They must have functioning mechanisms for price discovery, risk transfer and liquidity.
New incentive structure
Efforts need to be made to change the incentive structure for asset allocation. Investable instruments, such as infrastructure bonds, pooled investment vehicles and asset-backed securities, which channel long-term capital to productive sectors, need to be created. Credit guarantees and blended finance structures, which can help mitigate downside risk, have to be put in place to help crowd in private capital. Also, robust credit assessment frameworks and more active secondary markets have to be in place. Reliable benchmark rates and functioning repo markets will also support more efficient asset allocation.
For finance professionals, this has to mean building capacity in the creation and use of derivatives and structuring financing options that solve real problems. They must create instruments tailored towards directing finance to where it is most useful for the economy. Accountants also have a role in supporting these structures and must build capacity in that area, too.
In the final analysis, the challenge facing African economies is not one of capital scarcity, but of capital effectiveness. The growth of capital pools is a structural advantage that, if properly harnessed, could provide the capital needed for economic growth and infrastructural development on the continent. If this is to be achieved, the right systems, instruments and incentives must be put in place.
