Africa Finance Forum Blog
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The global financial crisis posed new challenges for policy makers in Africa and around the world. Its scale and complexity lacked precedents that could have guided decision making and the evaluation of potential risks for the region.
On the whole, African banks stayed the course through stormy weather. Most financial sectors were in the middle of a pronounced growth phase when the financial crisis took hold of international financial markets. This expansion peaked as late as the third quarter of 2008, well into the unfolding global crisis. But even during the crisis, average growth in credit to the private sector stayed above 10% per year and is picking-up again. Bank portfolio quality held up nicely, with a couple of important exceptions concentrated in a few countries. Stock markets fell drastically when international investors withdrew from most African markets, but they recovered most losses since then, as domestic and foreign investors are coming back forcefully. So, what happened? Why did the crisis spare African banks? What can we learn about the vulnerabilities of banks and capital markets?
Much of the explanation goes back to lucky historical circumstances. The crisis came at a good time for Africa. Then and now, bank’s balance sheets are underleveraged, capitalization is high and banks have ample liquidity. There is too little, and not too much bank activity in Africa. Limited integration with global financial markets reduced exposure to toxic assets and failing international banks. Governments and banks had only started to enter global capital markets for foreign funding and were not exposed to the risks that come with mismatches between foreign currency borrowing and local currency earnings. This meant that currency devaluations did not have the devastating effects that triggered most financial crisis contagion in the Asian and Latin American crisis of past decades. And, maybe most surprisingly, banks didn’t have much risk exposure to commodity price volatility for the simple reason that African banks do not do much business with commodity producers. These international firms revert to domestic financial markets only for smaller working capital and local currency cash-flow requirements.
But, thinking about the future, all of this is likely to change. Banks will grow and leverage their capital more, put liquidity to work, fund themselves on international markets, integrate with global financial markets and compete with international banks for the big commodity business.
In preparation for this future, we need to draw the right lessons from the crisis. The nature of these lessons might be much more domestic than global. One important domestic lesson is that future financial sector growth needs to be built on strong risk management and good regulatory capacity. The biggest increase in non-performing loans in the past two years were not a result of the global crisis, but of home-grown factors like the collapse of margin loans in Nigeria or fiscal risks in Ghana. The other important lesson of the last two years is that domestic markets proved their potential to fund African development. When global investors withdrew from Africa, governments and firms could reliably turn to domestic financial markets to raise funding in a big way. Domestic resource mobilization - not external funding - should be the base for financing Africa.
Thomas Losse-Mueller joined the World Bank in 2004 where he works as a financial sector specialist focusing on Africa. He has worked on financial and private sector development projects in a variety of African and Eastern European countries, including Nigeria, Kenya, South Africa, Ethiopia, Sierra Leone, Turkey and Serbia. From 2008 to 2010 he led work on behalf of the German Government in supporting the establishment of the Partnership for Making Finance Work for Africa. Prior to joining the World Bank he worked in risk management for Deutsche Bank in London. He holds degrees in economics from the School of Oriental and African Studies and the University of Cologne.
The proposition that dynamic private sector development is essential for poverty reduction holds true especially for less developed countries in Africa. It is argued that small and medium enterprises (SMEs) constitute the backbone of the economy and are seedbed of innovation, thus holding the potential to raise nationwide productivity and create jobs: the comparative lack of competitive SMEs in several African countries, a phenomenon known as the “missing middle”, is therefore a constraint for economic development.
Constraints for SME development in Africa are manifold. Recently, however, there has been a stronger focus on the weakly developed financial systems and the resulting inefficient financial intermediation in several African countries. Empirical research and surveys among SMEs confirm that lack of access to finance is indeed clearly hampering SME development in Africa. This limited access to finance is often referred to as the “mesofinance gap”, the supply gap of finance between microfinance and the financing available to large enterprises.
The increasing efforts of governments, donors and private actors to address the “mesofinance gap” in Africa are therefore a welcome development. Such efforts range from governments’ use of partial credit guarantee schemes to donor-managed funds targeted at SMEs, and have been bolstered by private foundations’ focus on SME finance. These efforts are backed on the global level and most prominently by the G-20 commitment to increase support to improve access to finance for SMEs in developing countries.
As mentioned above, these activities are in general a welcome development. An important critique, however, remains: despite the wide-ranging discussions about SME finance, the debate about a common definition of “SME” continues to be absent, and the role of the sector in economic development is often inadequately understood. Policymakers justify SME policies on the basis of the assumptions described above; yet, when trying to define the target group, different quantitative criteria – ranging from the number of employees to turnover – are used to define SMEs. This quantitative definitions, however, do not tell us much about the competitiveness or the growth potential of specific enterprises in this segment. Addressing the problem of the “missing middle” in Africa does not mean that we need policies that aim at promoting enterprises with a specific number of employees and a specific turnover. The challenge is to promote and make finance available to those enterprises that are innovative, dynamic and competitive. These are the kind of enterprises that currently lack access to finance because of market failures, but can generate jobs and help reduce the productivity gap vis-à-vis the global benchmark.
So, are recent efforts just much ado about nothing? Clearly not. They are based on the important insight that the “missing middle” and the “mesofinance gap” are a serious problem for the socio-economic development of many African countries. Market failures lead to credit-worthy enterprises not being able to get access to the finance they would need for further development. Addressing these market failures is the key challenge for governments, donors and private actors. This is, however, a major challenge, and the risk remains that many current SME finance activities will be at least partly ineffective if they do not adequately deal with the challenge of disentangling the heterogeneous group of SMEs.
Christian von Drachenfels is a Research Fellow at the German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE), Dept. V: "World Economy and Development Financing".