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«WP/09/182 Understanding the Growth of African Financial Markets Mihasonirina Andrianaivo and Charles Amo Yartey © 2009 International Monetary Fund ...»

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Despite the problems of small size and low liquidity, returns on African markets have generally been high. Senbet (2008) shows that after controlling for risk (Sharpe ratio) returns are similar to those realized in Latin America and Asia even when the results are converted into dollars. Therefore, these markets represent unexploited opportunities for international investors. They are diversification opportunities that are minimally lowly correlated with the global system and its risk.

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Private equity is a broad term that refers to any type of investment in an asset in which the equity is not freely tradable on a public stock market. In fact, private equity refers to how the funds have been raised—on private rather than public markets. 2 Following the trend of increases in capital flows and investments in emerging markets, there has been a significant boom in private equities in the last few years in Africa. According to the OECD, investments in private equity reached US$2.3 billion in 2006, and there has since been the buyout of Celtel, Africa’s third largest mobile operator, for US$3.4 billion (OECD, 2008). In 2007, Pamodzi Investments Holdings in South Africa announced a US$1.3 billion pan-African fund, backed by American financial institutions, after Rennaissance Capital launched its US$1 billion pan-African investment fund.

With African stock markets small and illiquid, private equity is another way for investors to take advantage of the opportunities in African emerging economies. According to the South African Venture Capital Association, although international conditions have pushed money into riskier but more profitable investments, nevertheless risk premiums in Africa decreased from 8.9 percent in 2006 to 6.7 percent in 2008. 3 Private equity investments are generally made through funds. Typically, the funds raise equity at the time they are formed and raise additional capital when investments are made. This additional capital usually takes the form of debt when the investment is collaterizable, as in buy outs, or equity from syndication partners when it is not, as in a start up. The typical private equity fund has a relatively long investment horizon (at least 5-7 years), and is often active in the operation or restructuring of acquired firms.

Because in the U.S. and Europe competition for good deals became fierce as the amount of capital available increased, managers went looking for alternative investment destinations.

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Source: EMPEA Private equity funds in Africa are small by international standards. There are currently about 31 fund managers active in Africa and about seven private equity funds are dedicated to infrastructure (Ndiaye, 2008). 4 South Africa dominates the African equity market with a share of 80 percent of sub-Saharan African private capital, and Nigeria has another 10 percent (Santiso, 2007). South Africa’s private equity market compares favorably with those in developed countries. Total funds under management were roughly 2.8 percent of GDP in 2007—higher than the global average of 2.1 percent and the European average of 1.9 percent (KPMG and SAVCA, 2008).

Funds for private investment in Africa come from a variety of sources. The United States provides 50 percent of the capital of private equity funds in Africa. South Africa is second with 25 percent, of which a third is raised from pension and endowment funds (Santiso, 2007). Europe contributes about 9 percent of the capital, primarily from public funds of European development finance institutions such as Proparco (France) and CDC (UK). China also recently bought a 20 percent stake in Standard Bank, the largest bank in South Africa, for US$56.5 billion.

A better macroeconomic environment characterized by high growth and low inflation has been a primary factor in the growth of private equity. Even though the absence of systems and institutions to ease deal flows and the exit of private equity funds, poor governance, and political instability militate against market development, foreign investment is attracted by the high returns in African markets over the last five years due to cheap labor, little competition, low rents, and therefore higher margins. The institutional environment and the quality of regulation are important to the proper functioning of the private equity market in Africa (Yartey, 2007b).

AIG African infrastructure Fund, EU Africa Infrastructure Trust Fund, Pan African Infrastructure Development Fund, China-Africa Fund, Comesa Infrastructure Fund, Emerging Africa Infrastructure Fund, Southern Africa Infrastructure Fund.

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The market for long-term debt is the least developed segment of Africa’s capital market, attracting only a small proportion of total financial system assets. Much of the momentum for the growth in nonintermediated debt markets in Africa has come from the government sector.

Corporate debt markets (including issues by government-sponsored enterprises) have generally lagged the government bond market. However, evidence from seven sub-Saharan African countries (Botswana, Ghana, Kenya, Mauritius, Nigeria, Tanzania, Uganda, and Zambia) shows a marked increase in the volume of nongovernment domestic debt, from US$91 million in 2001 to US$801 million in 2006. Nevertheless, the corporate debt market is underdeveloped in most African countries mainly because the government debt market, which is expected to provide the foundation for a number of hedging instruments, is itself developing slowly.

Foreign currency debts dominate the debt market in Africa mainly due to a reliance on concessional multilateral and bilateral funding and the fact that domestic markets are rudimentary (Sy, 2007). Some countries have, however, been able to access international capital markets or develop domestic debt markets. Local currency debt is mainly short- term with maturities usually less than a year; maturities of 3 to 6 months are the most popular.

Local currency markets have been used extensively for recapitalizing banks, setting benchmarks for the pricing of financial assets and risk management tools, and helping governments to finance their deficits. Commercial banks use these opportunities to increase their profits by transferring their excess liquidity held in reserves at the central banks into government bills.

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Source: Financial structure database- Beck et al. 2008 Issuers on the local currency debt market differ by country; they include governments, regional development banks, and corporations. Issuance of local currency debt is erratic and small in volume, leading to problems in developing fungible and liquid instruments and benchmarks. Domestic market infrastructure, including clearing, settlement, and systems, is underdeveloped. Local commercial banks and institutional investors account for about 70 percent of outstanding debt. This reflects weaknesses in commercial bank lending and in some cases excessive requirements to hold government securities (Blommestein and Horman, 2007). Institutional investors like pension funds are vibrant in some countries, promoting more diverse ownership.

Nonresident holdings of domestic debts are typically low, but several countries have managed to issue debt securities in their own currency to foreign investors. At the end of June 2007 foreigners held about 11 percent of Ghana’s domestic currency government debt (more than US$400 million) and 14 percent of Zambia’s (Linn and Nagy, 2008). In 2007, Ghana and Gabon entered the international capital market. To fund new public infrastructure spending, Ghana issued US$750million in bonds and Gabon issued US$1 billion (Linn and Nagy, 2008).

Market microstructure problems—small size, low liquidity, lack of long-term maturities, and limited investor base—pose challenges for bond market development and debt strategy in Africa (Blommestein and Horman, 2007). These problems have led to the lack of reliable yield curves, pricing benchmarks, and financial products to hedge risk. Mitigating the risks requires sound macroeconomic policy and a stable political environment. Building up market infrastructure, including trading, information dissemination, clearing and settlement systems;

incentives that reinforce good market participation; and developing a yield curve would also be beneficial.


The relationship between financial development and economic growth has been the subject of extensive research. Financial intermediaries emerge mainly due to informational problems and transaction costs. Studies of finance and development can be traced back to Schumpeter (1911). Recently, endogenous growth models have been used to explain how the financial system can affect steady-state growth. The usual result is that financial development promotes economic growth. Levine and Zervos (1998), for instance, show that stock market development affects growth through capital accumulation and improvement in productivity.

While the question of whether financial market development promotes growth has gained considerable attention in academic and policy discussions, there is little work, theoretical or empirical, on what determines financial market development in developing economies.

Understanding the determinants of financial market development is crucial to understanding the finance-growth relationship. The small number of studies has divergent views on crosscountry differences, ranging from time-invariant fixed factors, such as historical factors or country characteristics, to macroeconomic policies and institutional development.

The initial endowment hypothesis argues that the initial endowment of a country, such as colonization, shapes institutions that can retard financial development and long-run growth (Acemoglu, Johnson, and Robinson, 2001). Geography variables, such as latitude or isolation (landlocked, for instance) and natural resource endowments, also influence financial development from the demand side (see Huang, 2005, for a review). Other country characteristics, such the degree of ethnic fractionalization and differences in culture measured by differences in the religion and language practiced by the majority of the population, also affect financial development even though the impacts are less robust (Stulz and Williamson, 2003).

The law and finance view argues that the origin of a country’s laws affects the degree of financial development (La Porta et al., 1997): a common law basis is more conducive to the development of capital markets than a civil law basis because the flexibility of common law legal system allows for protection of small investors. 5 In fact, Djankov, McLiesh and Schleifer (2007) show that legal origin is an important determinant of creditor rights and private credit, and creditor protection also has an independent effect on private credit. They distinguish two broad views on private credit determinants: the power of creditors and creditinformation-sharing. They argue that lenders, who can more easily force repayment, attach collateral, or gain control over a firm will be more willing to lend, as will those who know borrower credit history and debts to other lenders. 6 There are two opposing views about openness and access to international capital markets.

The sequencing literature advocates that domestic systems need first to be developed to a certain level before they can profit from financial liberalization. In other words, trade openness should come first, followed by financial liberalization, and finally capital account liberalization (McKinnon, 1991). Rajan and Zingales (2003a, 2003b), however, argued for the simultaneous opening of both trade and the capital account because this reduces interest groups opposition to financial development: the new opportunities brought by both trade and financial openness can outbalance the losses from greater competition. Baltagi, Demetriades, and Law (2008) show that both trade openness and financial openness are important, but they only find partial evidence that they have to be simultaneous. Chinn and Ito (2002, 2006) show that greater financial openness contributes to financial development, but only when the legal system and institutions have reached a certain level.

Finally, favorable economic conditions are also important for financial development. For instance, inflation above a certain level brings adverse consequences (Azariadis and Smith, 1996; and Khan, Senhadji, and Smith, 2001), whereas income level and savings are positively related to financial development.

Common-law-based systems have evolved to protect private property, whereas civil-law-based systems were developed to enhance state powers and to address corruption.

Mc Donald and Schumacher (2007) find such evidence for Africa.

On the specific question of stock market development, Calderon-Rossell (1991) developed a partial equilibrium model of stock market growth. This model represents the most comprehensive attempt to date to law the foundation of a financial theory of stock market development. Recent works tend to focus on the role of financial liberalization. Mishkin (2001) argued that financial liberalization promotes transparency and accountability, reducing adverse selection and moral hazard. It thus tends to reduce the cost of borrowing in stock markets, which eventually increases the liquidity and size of the stock market.

Garcia and Liu (1999) examined the macroeconomic determinants of stock market development in a sample of Latin American and Asian countries. They found that GDP growth, domestic investment, and financial intermediary development are important factors.

El-Wassal (2005) investigated the relationship between stock market growth and economic growth, financial liberalization, and foreign portfolio investment in 40 emerging markets between 1980 and 2000. He found that economic growth, financial liberalization, and foreign portfolio investments were the leading factors in emerging stock market growth.

The literature also demonstrates that stock market development has a nonlinear relationship with banking sector development: stock market development is initially supported by banking sector development through trade intermediation. However, as stock markets develop they begin to compete with banks in financing investment (Yartey, 2008b).

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