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African economies are at a pivotal moment. The COVID-19 pandemic has crippled economic activity. Africa’s hard-won economic gains over the past two decades, critical to improving living standards, could be undone.
The high level of public debt and the uncertain prospects for international aid limit the possibilities for growth through large public investment programs. The private sector will need to play a greater role in economic development if countries are to experience a strong recovery and avoid economic stagnation. African heads of state made this one of their resounding messages at the recent summit on “Financing African Economies” held in Paris in May.
Infrastructure—both physical (roads, electricity) and social (health, education)—is an area where the private sector could be more involved. Africa’s infrastructure development needs are enormous, averaging 20% of GDP by the end of the decade. How can this be funded? All other things being equal, the main source of funding would be increased tax revenue, which is what most countries are working towards. But, given the magnitude of the needsnew sources of financing will have to be mobilized from the international community and the private sector.
Africa is a continent that harbors immense opportunities for private investors. It has a young and growing population and abundant natural resources. Cities are experiencing massive growth. Many countries have launched long-term industrialization and digitalization initiatives. But significant investment and innovation are needed to unlock the region’s full potential. Recent Research Published by IMF Staff shows that the private sector could, by the end of the decade, provide additional annual financing equivalent to 3% of sub-Saharan Africa’s GDP for physical and social infrastructure. This represents about $50 billion per year (using 2020 GDP) and almost a quarter of the average rate of private investment in the region (currently 13% of GDP).
What constrains private financing today?
Currently, the private sector is not heavily involved in financing and providing infrastructure in Africa, compared to other regions. Public entities, such as national governments and state-owned enterprises, carry out 95% of infrastructure projects. The volume of infrastructure projects with the participation of the private sector has decreased significantly over the past decade, following the fall in commodity prices. The limited role of private investors is also apparent from an international comparison perspective: Africa attracts only 2% of global flows of foreign direct investment. And when investment goes to Africa, it is mainly in natural resources and extractive industries, not in health, roads or water.
To attract private investors and transform the way Africa finances its development, improving the business environment seems essential. Our research shows that three key risks dominate the minds of international investors:
- Project risk. Although Africa presents a wealth of business opportunities, the pipeline of truly “investment-ready” projects remains limited. These are projects that are sufficiently developed to attract investors who do not wish to invest in early-stage concepts or unknown markets. Financial and technical support from donors and development banks can help countries finance feasibility studies, project design and other preparatory activities that expand the pool of bankable projects.
- Risk of change. Imagine that a project generates a return of 10% per year, but the currency depreciates by 5% at the same time, this would eliminate half of the profits for foreign investors. No wonder currency risk is a major concern for them. Prudent macroeconomic policy combined with sound management of foreign exchange reserves can significantly reduce currency volatility.
- Exit risk. No investor will enter a country if he does not have the assurance that he can also leave it by selling his shares in a project and recovering his gains. Thin and underdeveloped financial markets can prevent investors from exiting by issuing shares. Capital controls can slow or increase the cost of exit. And, where the legal framework is weak, investors can get bogged down in legal battles to have their rights recognized.
Encourage private investment
Improving the business climate is important but not sufficient. Development sectors have certain structural characteristics that make private sector participation inherently complicated, even in the most enabling environments. For example, infrastructure projects often have large upfront costs, but their returns accrue over long periods of time, which can be difficult for private investors to assess. Private sector growth also thrives on networks and value chains, which may not yet exist in new markets.
When these problems are acute, governments may need to provide additional incentives to make infrastructure projects attractive to private investors. These incentives, which include various types of subsidies and guarantees, can be costly and entail fiscal risks. But the truth is that many projects in the development sectors will not come to fruition without them. In East Asia, 90% of infrastructure projects with private participation receive government support.
With certain design features, governments can maximize the effectiveness and impact of public incentives, while minimizing risk. Support should be targeted, temporary and granted on the basis of proven market failures. It must also be transparent, leave enough risk to private parties, and display additionality, which means that the incentives must enable worthwhile projects to happen that would not otherwise happen. Finally, their size must be well calibrated to avoid overcompensating the private sector.
Given the limited availability of public funds, African countries and development partners could consider reallocating some resources used for public investment towards financing public incentives for private projects. When this reallocation is gradual and supported by sound institutions, transparency and governance, it could increase the quantity, range and quality of services for people in Africa. More innovative thinking can help realize the transformative potential of infrastructure on the continent.
*About the authors:
- Abebe Aemro Selassie is the Director of the IMF’s African Department. Previously, he was deputy director of this department.
- Luc Eyraud is Advisor and Chief of Mission in the African Department of the IMF. It leads the annual Article IV consultation with WAEMU regional authorities
- Catherine Patillo is Assistant Director of the Fiscal Affairs Department and Head of the Fiscal Policy and Surveillance Division, responsible for the IMF’s Fiscal Monitor. She works on macro-fiscal issues.
Source: This article was published by IMF Blog
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