Debashis Dey, Partner at White & Case LLP helps paint a picture of the different challenges being faced by various African economies, and discusses the potential for Islamic finance and infrastructure funds in reshaping the investment landscape.
What do you see as the main drivers of credit activity across the African continent this year and how are the different regions’ markets faring?
North Africa, Sub Saharan Africa and South Africa, East Africa and French speaking Africa are all quite different. The part of Africa that is deeply tied to commodities is struggling, whether mining or oil. But places like South Africa, Morocco, Tunisia and Egypt have a completely different mindset when it comes to political instability and market challenges that aren’t driven by commodities or similar economic concerns. South Africa, which is the most diversified and more closely aligned with the western economies, is struggling on currency and political fronts.
North Africa does link itself to the production of oil. Egypt, Tunisia, and to a much lesser extent Morocco, have some ties to commodities, which are all around oil. But one could argue that with the depreciation of oil as a whole, and the consequential deflation of their local currencies to the US dollar, one of their challenges is to think about how they continue to maintain their balance of payments as well as the subsidies they have given to the local populations. The challenge that they’ve had is a significant round of political change and instability. If they can maintain stability, the credit driver for some of the largest economies is diversification into what is effectively a vertical economy.
Egypt is a great example of the potential here: it has a population of over 80 million people, a diverse set of sectors including a service economy, and it’s a giant when compared to South Africa, which doesn’t have the same population or economic diversity. In the next couple of years, Egypt could be a growth story compared to the rest of the continent. It is starting from a low base; it has the potential for both domestic and non-domestic consumption of its services and goods; and because it’s already in Africa it is essentially a gateway to the rest of the continent – there are already a range of regional banks in Egypt that regularly lend into the continent, and they understand African risk better than many. But their challenge has been that for the last two or three years, the country has experienced significant political instability.
If you look at a place like Tunisia, the story is very different. It’s a small country that has some links to oil production. The Arab Spring was meant to stabilise things but it has done the opposite to some extent. There are a number of countries like Tunisia on the continent that are still trying to find their way in a world that sees much lower oil prices. The country is going to struggle in terms of trade, and if it can form a trading block and align itself with development in Egypt it may yield some success in diversifying its economy.
If you look at Sub Saharan Africa, you have the French and English side. Here, the story is largely dictated by the link between commodities, agriculture, oil and mining. With countries like Kenya, Nigeria, and Ghana, as well as many of the French speaking countries in the region, the main drivers have been the strength of their ability to export raw commodities, or in some cases agricultural products, and that has been driving their credit strength. But we’re reaching a situation where commodity prices are significantly down, mines are being mothballed because it’s not financially viable to keep them open, and the price of oil is putting severe pressure on many of them. Coupled with that, many of these economies have borrowed extensively from international markets. So their biggest challenge is the extent to which they can service the conventional debt given their budgetary restraints and currency depreciation, and be in a position to deal with new debt.
South Africa’s markets have the most depth in the region, but it is struggling from currency depreciation, political uncertainty and a stalling economy. There are different ways of thinking about South Africa, but some have put their challenges down to the way the economy is being managed. So what the country is experiencing has less to do with the its fundamentals and more to do with the fact that it has challenges managing the economy.
None of this necessarily means there won’t be any financing, but that the financing will likely be of a limited recourse nature. Institutions will lend, but only if they have security, a contract where they can see good cash flow projections, and a strong link to hard assets. That puts us firmly into the infrastructure space, where the idea of building roads, rail and power generation is important because these are the areas where there is genuine need, even in the lower liquidity environment.
A good proportion of financing demand in Africa is fuelled by the need for infrastructure. How does sukuk measure up to other asset-based forms of financing in that context in terms of structure, available liquidity, and the regulatory landscape?
These kinds of projects lend themselves well to not only project finance but Islamic finance – because many of these kinds of projects involve elements Islamic finance investors are looking for, like the funding of hard assets. Sukuk works extremely well here because what we have is an instrument typically deployed around ownership of an asset, and the funding of that asset by actually acquiring it.
The challenge we have is that to date, you don’t really see Islamic finance in this space – other than in a few small banking or sovereign deals. When you consider sukuk, they are all typically found in the unsecured investment grade space, and they are not backing hard infrastructure in limited recourse financing. The reason why it isn’t likely to happen anytime soon is because sukuk investors today are largely financial institutions in the GCC region that don’t want to hold instruments with a longer tenor, or hold true asset risk; they still largely focus on balance sheet risk. That doesn’t translate well in a stressed credit environment.
These challenges are largely investor driven. It is extremely difficult to move the investor base off shorter tenor, investor grade balance sheet credit. We are further hampered by the fact that if you look at the conventional project finance world, some of the buyers of these bonds are some of the larger municipalities, or pension funds, or long-term investment holders – people who are looking for something that is relatively stable and can deploy money over a 20-year horizon or similarly long tenors. We don’t have these large Islamic pension funds, or Islamic insurance companies – instead we have a very specialised group of Islamic finance institutions, which are typically banks, that don’t want the kind of asset risk and ownership associated with projects.
The thing that might change this is if we started to see more Islamic infrastructure funds. If we moved away from investors like banks, which are re-packaging their deposits into sukuk investments, and instead saw more Sharia compliant funds that are on the hunt for power or other infrastructure assets, that would make a big difference. They would be looking for ownership, they wouldn’t have a regulatory capital problem, they would be looking for long term returns, and they’re typically buy and hold investors. People buying into these funds typically want both the upside and asset risk because they get paid a better return and better value. These kinds of funds could really change the dynamics of the market.
What kinds of risks or challenges do you see African issuers of project-based sukuk encountering?
The legal framework in a country is often one of the biggest challenges here. Are you confident that if you take security over something, those rights will be respected? And the further away you get from those questions, the further away investors will be. Then there’s the Islamic question: can I pay those funds free of any tax withholdings? Is it recognised that the Islamic instrument is tantamount to something similar of what a project bond would require? In most jurisdictions the reality is that there isn’t any clarity or legislation being published on the Islamic financing front. That would be a challenge for investors, but the fact of the matter is all of it will be challenging, whether you do a conventional or Islamic trade.
What alternative forms of financing are available to fund Africa’s infrastructure pipeline?
The ECAs and international DFIs are the ones that are fearless in terms of going in and funding these types of projects, because they are able to assess credit risk in a different way. They look at themselves almost as an insurance policy in some ways – many lenders find it too difficult to get into these projects because it might be too difficult from a credit perspective. For many, that’s the glimmer of hope and what we’re seeing in places like Egypt and Nigeria. The other aspect is these unique infrastructure funds – if these funds can get off the ground it could make big inroads in the region, as the demand for projects is clearly there.
We shouldn’t dismiss balance sheet funding where you have a strongly rated credit of a corporate entity. Telecoms providers, utilities providers, and nationally linked entities like airlines may take a stab at Islamic finance because the reality is we are running out of supply in the conventional space. The other is in the project finance space, but whether we see any big moves in the next two years is harder to tell because these kinds of deals take much longer to mature. There will be a slowdown simply because of the nature of the economic situation in Africa generally. That’s where places like Egypt are important. Because the country’s economy is picking up, it could move quite rapidly into doing infrastructure finance as well as Islamic finance for corporates and banks. The country has been working on legislation to make the latter easier, adding to hopes the country can unlock new pockets of liquidity and help fuel growth.