Reasons for the trade finance gap in Africa

This post is a continuation of my exploration of the trade finance gap in Africa.

To recap, I had wanted to learn about why there was such reticence on the part of financiers to fund trade with African buyers.

Smallholder traders at the Rwanda-Congo border with Congo-bound jerrycans of cooking oil

The main reasons I identified for this gap in trade finance capital in Africa are:

Lack of verifiable historical financial information on borrowers

There is a lack of historical financial information on borrowers in these markets. Traditional risk assessment methodologies from developed markets (e.g. Altman-Z models, FICO scores, etc.) have limited utility in frontier markets, as these methodologies hinge on integrity and completeness of financial data, which cannot be assumed in frontier markets. Lenders in those markets therefore cannot rely on traditional risk assessment tools to decide on financing deals.

Lack of credit history information (leading to lemon markets)

Lenders in frontier markets therefore have to make assessments based on other factors, such as credit history of the borrowers. This is arguably the most important factor in assessment of the risk a borrower presents.

This is a “chicken and egg” situation as absence of trade finance renders it difficult for an SME to develop a credit history — a vicious cycle. Lack of credit history is often given as a key reason for rejecting trade financing requests[1].

In a market without such credit history information, bad actors can make a surplus by being unfaithful once they are given financing. The information gap also means lenders don’t have the ability to identify and avoid such bad actors. This causes a market dysfunction that rewards bad actors as they are able to benefit at the expense of lenders. This results in the lemon market problem, which is referenced in Kommerce’s White Paper that will be released in the coming weeks.

Lack of information as to reliability of logistics providers

Domestic African logistics is highly fragmented, with no dominant player across the continent. With the hodgepodge of providers, and without information on the reliability of these providers, trade financiers and insurers cannot accurately determine risks of loss in transit.

Lack of confidence in domestic legal systems

The ability to enforce a contract depends on the presence of effective legal counsel, a body of law covering security and enforcement, and a fair and effective domestic legal system that does not discriminate (formally or in practice) against foreign-sourced funding and foreign entities. The lack of lender confidence in the domestic legal systems across much of Africa contributes to the unwillingness of lenders to commit trade finance capital in these countries.

Limited domestic financial infrastructure

Structural constraints in Africa’s financial infrastructure are also responsible. Domestic banks often have relatively small balance sheets and limited capital; there is also a chronic lack of US dollar availability; and international endorsing banks often grant insufficient correspondent limits to African banks. The net result is that international payment transfers, which in the developed world can be instant, take at least five to seven days in much of Africa, and substantially longer in countries that maintain hard currency or capital controls.

Changes in global banking regulations

Changes in capital adequacy requirements and liquidity ratios for banks under Basel 3 rules mean that money deployed on trade finance requires higher reserves to be retained by the deploying banks[2]. The ability to aggressively fractional-bank (where banks lend out money against a tiny fraction kept in reserve) has also been curtailed by these rules. This reduces the profitability of trade finance as an activity for banks to engage in, and increases the opportunity cost; the additional money required to be kept in reserve cannot be deployed to make a return elsewhere. Developed markets are already seeing a pullback from trade financing and commercial or merchant banking as a result. This suggests that trade finance availability from banks in developing markets will similarly erode. Given the need for most banks in such markets to strengthen capitalization, their willingness to continue with trade finance is thrown into doubt.

Lack of public institutions supporting lending

EXIM banks that support export and import financing are not a regular feature of the African landscape. Such institutions have supported growth in many countries but their role on the African continent is limited.

In summary, there are strong reasons why financiers avoid financing in these markets. It’s not enough just to tell a financier that they should finance. What’s needed is to show them how they can successfully finance. Any solution that seeks to kickstart trade finance in Africa must address all, or a majority of these reasons.

With my team at Kommerce, I sought to do this.

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Notes:

[1] World Trade Organization, Trade Finance and SMEs [2016] at 21

[2] See explanation in Finextra blog at https://www.finextra.com/blogs/fullblog.aspx?blogid=5151 and a more extensive discussion in the thesis by Bc Jana Malesova, The Impact of Basel III on Trade Finance, Charles University in Prague, Faculty of Social Sciences, Institute of Economic Studies (Masters Thesis, Acad. Year 2015/2016), at page 27