Amid great fanfare 44 African countries signed the long-awaited African Continental Free Trade Area (CFTA) earlier this year. The bloc is expected to boost intra-African trade – pegged at less than 20 percent – by eliminating import duties and scaling back tariffs.
If fully implemented, a market of 1.2 billion people with a combined GDP of US$2.5 trillion will be created.
Efforts to create a free trade grouping date back to the establishment of the African Economic Community under the Abuja treaty in 1991. In this context, therefore, the CFTA should be celebrated.
Nonetheless, it remains more of a beginning than an end to overcoming intra-African trade barriers.
“The political act of signing the free trade area will not, on its own, promote intra-African trade,” says Benedict Oramah, president of the African Export–Import Bank (Afreximbank).
On this note, Moody’s, an international credit ratings company, argued shortly before the deal was signed that the CFTA may improve the region’s credit profiles but “Africa’s under-developed infrastructure, non-tariff barriers and finance constraints will limit the potential benefits.”
A 2017 report by the African Development Bank (AfDB) estimates an annual US$90bn trade finance gap on the continent. If enterprises with cross-border trade ambitions struggle to access finance then the objectives of CFTA may not be properly met.
Trade finance constraints
As it stands banks support about one third of total trade in Africa. However the share of bank-intermediated trade finance devoted solely to intra-African trade stands at a modest 20 percent, according to AfDB.
Of this percentage, well-known and large corporates take the lion’s share, but small to medium-sized enterprises (SMEs) and first-time applicants face significant challenges in accessing trade finance facilities from banks.
For the financiers there are a number of associated risks. Saad Sheikh, head of private investments and portfolio operations at TLG Capital, a private investment firm in Africa, points to the lack of robust credit rating systems. This makes it hard to appraise a client’s credit risk and means that defaults are met with very few consequences. “In Europe if you renege on a contract as an entity or country then your credit rating gets impacted,” he says. “In Africa your credit rating doesn’t hold that much importance.”
Egypt, for example, has been attracting investment despite its rating six levels below investment grade by Moody’s – one level below Nigeria, which has attracted far less.
In such a manner credit ratings in Africa may not be a useful framework on which investors can base their decisions and the ratings will struggle to hold those who default to account.
On the other hand, investors and banks are hesitant to back cross-border partnerships due to a lack of publicly available information about the African private sector as a whole.
“The challenges have always been that counterparty information is not easily available,” affirms Benjamin Mugisha, a senior underwriter at the African Trade Insurance Agency (ATIA). “In most markets there is no obligation for corporates to be transparent about their operations and so we are not sure whether they honour their agreements or not.” Creditworthiness is therefore difficult to ascertain and finding a credible counterpart can be difficult.
Mugisha believes this can be overcome as Africa’s pan-African banking infrastructure continues to develop and achieve greater penetration.
“We have seen a rolling out of financial institutions like Ecobank and United Bank of Africa which is part of the process of increasing financial inclusion,” he says. As Africa’s ever-increasing financial framework gains sophistication and depth, corporates will follow suit.
The lack of specific investor information also feeds into the larger African phenomenon of countries being unaware of neighbouring trade opportunities. “Kenya imports certain kinds of leather for manufacturing shoes that Burundi exports to Europe,” says Oramah. “People are unaware that the market that best meets their expectations is the market across the border.”
This, for Oramah, is a hangover from the colonial-era where African economies were geared up to export raw materials to metropolitan powers. This goes a long way to explaining why 80 percent of Africa’s trade finance is in support of extra-continental trade.
Quite simply financial backers will feel uneasy about backing a trade route previously unknown to them – no matter how financially viable.
Currency is a perennial obstacle to trade and trade finance in Africa. Financiers are worried about retrieving money from a country in which they don’t operate; either because they may get less than they put in or because the money may get “stuck”. Devaluations and political or economic instability may cause a currency to drop and a resulting loss on the exchange rate; or, a lack of foreign reserves may result in a lack of payment.
The possibilities of not getting paid also create harsh collateral requirements for cross-border traders looking to get loans from banks. Collateral requirements are the amount a loan applicant must have in reserves in case of any shock or transactional failure.
The collateral requirements for trade finance in Africa may be as high as 100 percent of the value of the traded goods, presenting significant problems for SMEs and entrepreneurs whose lack of capital lead them to the bank in the first place.
Finally political risk and sovereign risk is amplified when investing in cross-border trading activities. “In the case of Africa you have internal political risks which are unlike other economies,” says Mugisha.
“Whether it’s uncertainty about peaceful transition of power from one administration to the other, or with regard to a change in tax laws and licensing requirements, all these make Africa risky from an investor or trader perspective.”
By minimizing border tariffs the CFTA will help open the space for trade finance as traders and investors stand to make larger margins on their exports. Yet, for reasons given, substantial problems stand in the way of trade finance being able to support the level of intra-African trade envisaged in the CFTA. If the free trade area is the machinery of Africa’s trade revolution then trade finance is surely the grease.
Large development banks such as Afreximbank and AfDB and insurers like the African Trade Insurance Agency are working to minimize some of the risks. They do so largely by providing guarantees and credit rating backings for those looking to trade across borders.
Guarantees work by promising to cover the possibility of a trader defaulting on a loan. A bank is more likely to offer trade finance if the loan is backed up by a larger bank who can cover the repayment in the event of the trader defaulting. In this vein AfDB has recently approved a US$50m risk participation agreement with Frankfurt-based Commerzbank AG.
The partnership allows both banks to cover the risk of some of Africa’s smaller banks looking to expand their trade finance operations. The facility is expected to support around US$700m of trade on the continent within three years. Afreximbank is involved in similar projects. “Last year we launched Afreximbank guarantees for those who are worried about the country risk of other African countries,” says Oramah.
Credit insurers, like the African Trade Insurance Agency, also have an important role to play. Mugisha explains how the agency’s top S&P credit rating is carried forward to their clients so that those clients can then mobilise finance on the basis they will be able to repay loans.
Indeed, insurers function in much the same way as guarantees do in that they guarantee repayments on loans.
Efforts like these are crucial to unlocking trade finance on the continent as only by providing financial bulwarks against Africa’s associated risks will the dream of a fully developed trading bloc be realised.