African economies are at a turning point. The COVID-19 pandemic has crippled economic activity. Africa’s hard-won economic gains over the past two decades, essential to improving living standards, could be reversed.
The high level of public debt and the uncertain outlook for international aid limit the possibilities for growth thanks to large public investment programs. The private sector will need to play a greater role in economic development if countries are to benefit from a strong recovery and avoid economic stagnation. African heads of state made this one of their resounding messages at the recent “Financing African Economies” summit 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 – on the order of 20% of GDP on average 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 revenues, which most countries are working towards. But, given the magnitude of the needs, new sources of financing will have to be mobilized from the international community and the private sector.
Africa is a continent with 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 digitization initiatives. But significant investments and innovations 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 funding equivalent to 3% of sub-Saharan Africa’s GDP for physical and social infrastructure. This is around $ 50 billion per year (using 2020 GDP) and almost a quarter of the region’s average private investment ratio (currently 13% of GDP).
What is holding back private financing today?
At present, the private sector is not much 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 percent of infrastructure projects. The volume of infrastructure projects with the participation of the private sector has declined significantly over the past decade, following the fall in commodity prices. The limited role of private investors also appears from an international comparison perspective: Africa only attracts 2% of global foreign direct investment flows. 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 crucial. Our research shows that three key risks dominate the minds of international investors:
- Project risk. Although Africa presents a plethora of business opportunities, the pipeline of truly “ready-to-invest” projects remains limited. These are sufficiently developed projects to attract investors who do not wish to invest in early stage concepts or unfamiliar 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 earns 10% a year, but the currency depreciates by 5% at the same time, which would wipe out half of the profits of 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.
- Risk of exit. No investor will enter a country if they do not have the assurance that they can also exit by selling their stake in a project and recovering their earnings. Thin and underdeveloped financial markets can prevent investors from exiting by issuing stocks. Capital controls can slow or increase the cost of exit. And, when 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 enough. 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 accumulate over long periods of time, which can be difficult for private investors to assess. Private sector growth also thrives through 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 grants and guarantees, can be costly and carry fiscal risks. But the truth is that many projects in the development sectors will not happen without them. In East Asia, 90 percent 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 must be targeted, temporary and granted on the basis of proven market failures. It should also be transparent, leave enough risk to private parties and display additionality, which means that the incentives should enable worthy projects that would not happen otherwise. 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 might consider reallocating some resources used for public investment to financing public incentives for private projects. When this reallocation is gradual and supported by strong institutions, transparency and governance, it could increase the quantity, range and quality of services for African populations. More innovative thinking can help realize the transformational potential of infrastructure on the continent.