The Poor State of Finance in East Africa

Background paper prepared for the Summit by MAYANK PATEL of KPMG

Special Report
Monday, November 11, 2002 

As was the case for most developing countries, in the past decade, the East African countries have all been through financial sector reforms. In the process, the financial markets have been liberalised, interest and exchange rate controls removed, the relevant legal and regulatory framework have been implemented, regulatory capacity has been strengthened, some state-owned institutions have been restructured and privatised. As a result, everyone would agree that the current financial sectors are more stable and competitive. However, much needs to be done in this area. The major concerns from the private sector now relate to the high costs of borrowing and difficulties in obtaining credit.

In developed market economies, a financial intermediary system takes primary care of channelling savings to those who need loans and can use the funds most effectively. In our region, despite the improvements over the last decade, this intermediation process has not worked to the levels necessary for sustainable growth. 

Therefore, within the East African region, a major hindrance, from the finance perspective, to economic growth and social development, is: 

Inaccessible and unaffordable financial services

A combination of factors contribute to this problem. Nonetheless, the financial sector within the region is seen as a key constraint to growth as opposed to being an accelerator of growth.

The major consequence of financial services being inaccessible and unaffordable by the vast majority of the productive sectors in the region is that demand for financial services far outstrips supply. Whilst we do not have data to demonstrate this, what can be demonstrated by statistics is that the East African countries (together with other sub-Saharan countries) have the lowest level of financial penetration and credit to the private sector. 

Some of the factors which result in the financial services being inaccessible or unaffordable, and thus contributing to the low levels of financial depth and penetration, are:

Macroeconomic environment / policy issues

• Unstable / unpredictable macroeconomic conditions
• Relatively high levels of inflation and interest rates
• Fiscal indiscipline
• High levels of public debt and public sector borrowing
• 'Crowding out' of private sector credit
• Low rates of savings
• Poor investment climate leading to capital outflows

Market structure

• Highly concentrated and fragmented financial markets. The markets are generally controlled by 5-7 large institutions in each country and region.
• There are still a number of state-owned financial institutions that are under-performing and, in some cases, a drain on the economy
• Focus of services in urban areas, ignoring outlying areas, which are home to most agricultural and natural resource production
• Products and services mainly cater for large enterprises, with the local medium, small and micro-enterprises being neglected
• Lack of scale, impacting adversely on profitability
• Poor credit risk management and related high levels of non-performing assets
• High transaction costs, mainly due to poor infrastructure
• Limited scope of activities, products, services and distribution channels
• Underdeveloped capital markets
• Lack of long-term investment and credit products
• Poor corporate responsibility and governance, often leading to mismanagement of funds

Legal and regulatory framework

Various sectors comprising the financial services industry are regulated separately, thus increasing costs of regulation or inefficient regulation and competition.

Prohibitive investment rules e.g. insurance companies only allowed to invest in Government paper.

Universal regulation (therefore, high barriers to entry) for all banking institutions regardless of sectoral or segmental needs. On the other hand, similar financial activities regulated under different acts e.g. Co-operatives and SACCOs gather deposits and governed under their own act, whereas mainstream banks gathering deposits regulated under Banking Acts.

Weak regulation, for instance, under-capitalised banks allowed to continue trading, shareholder involvement in management of banks etc.

Weak legal / judicial system, constraining enforcement of financial contracts, thus exposing banks to legal and credit risk.

Inadequate rules for criminalising certain acts e.g. cheque bouncing

Policy / Tax issues

Hardly any policies / tax incentives for promoting savings, investments, capital markets etc.
 Lack of favourable policies for promotion of certain products e.g. securitisation, leasing. This inhibits access to cheaper sources of funds
 High taxation levels leading to reduced disposable incomes, hence lower level of savings

Infrastructure & Information

Poor infrastructure, particularly in rural areas

Lack of information in relation to financial products and services and financial institutions, disallowing investors in making proper decisions

Lack of information on borrowers

Low use of technology and unreliable telecommunications

In summary, major policy and structural issues require to be addressed if the private sector, together with the governments and regulatory authorities, is to remove the constraints impeding private sector growth as a result of inaccessibility of financial services.

Therefore, the major challenges to the private sector are to create a sustainable environment that:

• Encourages savings domestically and in the region; and
• Enables most efficient deployment of funds to the most productive sectors and areas. In this respect, it is now widely accepted that the medium, small and micro-sized enterprises, which contribute significantly to the economy and employ more than 70 per cent of the labour force, constitute the engine of employment creation and income generation.

What has been done?

In the past decade, all East African countries have undergone reforms in the financial sector in order to make the markets more efficient, stable and competitive. There has been mixed success, and while the financial depth of the markets has improved from the position a decade ago, much as yet to be achieved for sustainable growth in the region. Some of the measures and initiatives undertaken in the region are:

• Restoration of macroeconomic stability, which is a condition for the smooth functioning of the financial markets. In this regard, inflation rates have been brought down to single digits, exchange rates and interest rates are relatively stable, although interest rate spreads have widened. Further, the East African Co-operation is committed to the adoption of policy reform programmes containing largely similar policy packages which has helped to converge macroeconomic policies. Continued efforts will be made to ensure co-ordination of macroeconomic policies and economic reform programme. Priority will be given to harmonisation of macroeconomic policies starting with exchange rate policies, interest rate policies and monetary and fiscal policies. Sharing of relevant budget information on revenue measures and other economic policies will continue to be encouraged to enable convergence of macroeconomic variables.

• Reform of the financial sectors, whereby basic legal framework, institutions and market structures have been put in place as a result of which we have emerging competitive, efficient and sound financial systems.

• Restructuring, recapitalisation and privatisation of state-owned banks, although this is ongoing.

• Establishment of money and capital markets and stock exchanges for mobilising and allocating savings. However, these are largely under-developed.

• Strengthening the conduct of monetary policy and bank supervision role of central banks and complete liberalisation of interest rates

• Liberalisation of insurance sectors.

• In Uganda and Tanzania, Advances Realisation Trusts were formed to address the large portfolio of non-performing loans.

• Establishment of commercial courts, although the problem of legal contract enforceability still remains as a major issue.

• Credit Reference Bureaux have been or are in process of being set in each of the countries for sharing of information on borrowers.

• Policy and legal framework for promotion of micro-finance activities are either in place or in the process of being implemented. Donors have funded the emergence and growth of a variety of micro-finance entities in rural areas.

• Central banks have been pushing smaller banks towards consolidation in order to address the fragmented markets and improve competition.

• Reforms in the retirement benefits area are in process.

• In some countries, legislation for new investment products e.g. collective investment schemes are in place, although the markets have yet to see the products in place.

• Industry associations are in place in each of the countries to address industry issues. In particular, the Association of Microfinance Institutions have been formed to promote  microfinance activities.

Importance to social and economic development

The financial sector is the hub of the economic activities in any country. The financial markets provide the necessary credit facilities enabling investments, local and international trade, which lead to economic growth.

Various researches have now confirmed the direct correlation between GDP growth and financial deepening and penetration. One research over a lengthy period of time and across a number of countries indicates that one should expect a 10 per cent improvement in financial depth and penetration to lead to 0.5 per cent - 1.0 per cent improvement in GDP growth rate.

It is therefore no surprise that the high-income (OECD) countries' ratio of financial assets to GDP is above 100 per cent compared to less than 40 per cent for sub-Saharan countries. 

For the purpose of development, growth, or often for the purpose of simple operation, we have discussed above the important issue of access to external funding. It is typical that enterprises do not self-finance business opportunities. Even though the financial intermediation system is in place, it happens in every country that some enterprises cannot access external funds. The percent of businesses which are not financed by banks is a very important indicator for both the business and financial sectors. In developed market economies it is typically below 10 per cent, while in most developing countries it exceeds 90 per cent. 

Economic growth is the single most important factor influencing poverty. Accordingly, sustained high rates of growth are necessary for social development i.e. poverty reduction. Moreover, growth alone is not sufficient for poverty reduction. Growth associated with progressive distributional changes will have a greater impact on poverty. Such distributional changes in the case of financial markets could include measures to increase the rural smallholders' access to financial services. 

Based on above, making financial services both affordable and accessible to the region is critical to the economic and social development of the region.

Targets already set in East Africa

While no specific targets that may have been set in the region by either the private sector, regulatory bodies or the governments could be obtained, the EAC countries have committed to the following goals:

Co-operation in Macroeconomic Policy

According to the EAC Treaty, co-operation in macroeconomic policy matters aims at establishing stability in these areas within the Community through: 

• Co-operation in monetary and financial matters and maintaining the convertibility of currencies of the Partner States as a basis for the establishment of a single currency; 
• Harmonisation of macroeconomic policies with special emphasis on exchange rate policy, interest rate policy, and monetary and fiscal policies; 
• Partner States shall work towards closer macro economic convergence on the following economic parameters: Real GDP growth rate of at least 7 per cent; Inflation of less than 5 per cent; Lower ratio of current account deficit; Reduction of fiscal deficit to less than 5 per cent; Maintaining reserves at least 6 months equivalent of normal imports; Scaling up the ratio of domestic savings to GDP of at least 20 per cent; Undertake debt reduction initiatives and maintaining the fiscal burden of serving the external obligations to less than 15 per cent.
• Monetary and fiscal policy harmonisation will be pursued with a view to achieving the following: 
• Maintain market determined exchange rate and acceptable level of reserves; 
• Pursue policies which will achieve monetary stability and growth; 
• Complete financial sector reforms to ensure their efficient operation consistent with promotion of savings and investment for growth; 
• Harmonise tax policies. 
• Partner States are determined to create a conducive environment for movement of capital within the Community through: 
• Harmonisation of capital market policies; 
• Promotion of co-operation among the stock exchanges and capital markets and securities regulators; 
• Generating sufficient business in the stock exchange markets in order to facilitate cross-border listing of companies in stock exchange markets; 
• Establishing within the Community a cross-border listing of stocks and rating system of listed companies and an index of trading performance to facilitate the negotiations and sale of shares within and external to the Community; 
• Working towards the establishment of East African Stock Exchange by the three national organisations.
• In the process of establishing an EA Stock Exchange arrangements shall be made to explore possibilities of using the relative strength of the Nairobi Stock Exchange and the Johannesburg Stock Exchange to promote stock exchange activity in the region. More viable companies need to go public by selling shares to East Africans and thus facilitate cross listing. Progress in this direction will be through: 
• Review of policies that inhibit participation of both local and foreign investors in EA stock exchange. 
• Removal of legal impediments that constrain active use of the capital markets or cause fiscal distortion. 
• Commissioning a study to ascertain the exact areas of harmonising the legal frameworks governing the operations of stock exchange markets and facilitate actual harmonisation. 
• Instituting measures to prevent money laundering activities; 
• Speeding-up modalities for implementation of the standardised prudential requirements in licensing of Commercial Banks; 
• Fully liberalising the capital accounts in all Partner States especially Kenya and Tanzania; 
• Putting in place a disclosure standard framework; 
• Fiscal and Monetary Policy Environment followed by government has an impact on capital market operations and, therefore, a study on the areas that impact on capital markets shall be carried out at regional level and make recommendations to governments. The study will also recommend policy incentives needed to attract more companies to list and increase investor participation in capital markets. 
• Public Education and Awareness will be developed and disseminated by East African Securities and Regulatory Authorities (EASRA) for market professionals and public using the most appropriate media e.g. TV, radio and video workshops using the most appropriate language; and 
• With regard to Credit Rating Agencies, East African Securities and Regulatory Authorities (EASRA) will adopt the Credit Rating Agencies guidelines issued by Capital Markets Authority (CMA) Kenya. The role of regulators will be to provide the framework for registrations as well as accreditation of credit rating agencies.
  East African enterprises often rely on international finance. In the transitional period the EADB will be used as a vehicle for raising funds for regional projects while preparations for forming a Regional Development Fund are being made. 
  The size of the challenges at hand is quite obvious when one compares the following measures for East Africa against the developed countries:
• Percentage of financial assets to GDP - East Africa collectively stands at around one-third the rate for developed countries;
• Financial deepening - East Africa collectively stands at around one-third the rate for developed countries;
• per cent of Private sector credit to GDP - East Africa stands at one-sixth the rate for develop countries.

We believe that any actions required will likely involve paradigm shifts and new ways of working to get the region's financial markets to be the accelerator of growth and poverty reduction.

Constraints

While changes within the financial markets can be made through the co-operation of the governments, regulators, financial sector participants and the private sector, there are a number of constraints that are likely to be faceds:

• Lack of human capital and skills necessary for the transformation;
• Poor and inadequate physical infrastructure, particularly in the rural areas;
• Lack of information and information technology in the region;
• Continued high costs of regulation. The multiple regulatory bodies do not assist in the functional objectives of the financial markets either.
• The continued difficulties with enforcement of financial contracts;
• Low investment returns within the region which would dissuade savers from investing in financial products and entrepreneurs from investing in businesses;
• Inability to shift current from current high levels of consumption to savings;
• Continued fiscal mismanagement;
• High transaction costs.