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FINANCIAL SECTOR REFORMS IN AFRICA Perspectives on Issues and Policies*

Lemma W. Senbet University of Maryland

USA

Isaac Otchere University of New Brunswick

Canada

Current Version February 2005

* Prepared for the Annual World Bank Conference on Development Economics (ABCDE), Dakar, Senegal, January 2005. We wish to acknowledge comments and suggestions from the conference participants, Mthuli Ncube, and Solomon Tadesse.

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FINANCIAL SECTOR REFORMS IN AFRICA Perspectives on Issues and Policies

INTRODUCTION Most African countries, particularly those in Sub-Saharan Africa, have recently undergone extensive financial sector reforms. The reform package includes interest rate liberalizations, removal of credit ceilings, restructuring and privatization of state-owned banks, introduction of a variety of measures to promote development of financial markets, including money and stock markets, and private banking systems, along with bank supervisory and regulatory schemes. A particularly interesting outgrowth of these financial sector reforms has been a surge of interest in the establishment of stock exchanges and their rapid proliferation in the recent years. The number of stock markets in Africa currently exceeds twenty (see Table 1 for listed companies and growth in listing) - Botswana, Cote d'Ivoire, Egypt, Ghana, Kenya, Malawi, Mauritius, Morocco, Mozambique, Namibia, Nigeria, South Africa, Swaziland, Tanzania, Tunisia, Uganda, Zambia, and Zimbabwe. An important byproduct has been an emergence of a regional market in 1998, which is domiciled in Abidjan – Bourse Regional des Valeurs Mobiliéres (BVRM). The regional market serves as an anchor for the CFA countries - Benin, Burkina Faso, Cote d’Ivoire, Guinea-Bissau, Mali, Niger, Senegal and Togo.

Table 1 [Listing of Firms on African Stock Exchanges] Regionalization is an important and welcome development in view of the thinness and illiquidity of the individual stock markets, and the Abidjan-based market is bound to serve as a positive role model for other regions of Africa. It is encouraging that already the Anglophone countries of West Africa are contemplating forming a regional stock exchange under the umbrella of the ECOWAS. Similarly Kenya, Tanzania and Uganda can be natural partners in forming a regional stock exchange in East Africa. Moreover, the Southern African Development Community (SADEC) stock exchanges have proposed the idea of a regional stock exchange. Increasing development of capital markets and accelerated financial sector reforms are vital avenues for integrating Africa in the global financial economy and attracting international capital. In fact, a recent encouraging development has been the growing attention that Africa has received from international investors, although still at a very low level. The Africa-oriented investment funds, which are now trading in New York and Europe, approach eighteen in total. The positive attention that Africa has attracted recently is primarily driven by economic fundamentals and economic systems that increasingly empower private initiative. It is tempting to view Africa’s embrace of globalization and openness as merely the fashion of the day, which would dissipate due to dramatic financial crises recently witnessed in East Asia and Latin America. However, this view is misguided. Africa has little choice but integrate into the global economy. Financial sector reforms and developments are a crucial channel for global integration and keeping Africa at the cutting edge of best international practices.

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Table 1

Listing of Firms on African Stock Exchanges

1992 - 2002

Country Number of Listed Firms in

1992 or before

Number of Listed Firms

in 2002 Growth Rate (%) Annualized

Growth Rate (%) Algeria 2 3 50.00 10.67 Botswana 11 19 72.73 5.09 Cote d'Ivoire 27 38 40.74 3.16 Egypt 656 1151 75.46 5.24 Ghana 15 24 60.00 4.37 Kenya 57 50 -12.28 -1.18 Malawi 1 8 700.00 34.59 Mauritius 22 40 81.82 5.59 Morocco 62 56 -9.68 -0.92 Namibia 3 13 333.33 14.26 Nigeria 153 195 27.45 2.23 South Africa 683 472 -30.89 -3.30 Swaziland 3 5 66.67 4.75 Tanzania 2 5 150.00 20.11 Tunisia 17 46 170.59 9.47 Uganda 2 3 50.00 14.47 Zambia 2 11 450.00 23.75 Zimbabwe 62 77 24.19 1.99 Total 1780 2216

Source: Emerging Market Handbook, Liquid Africa and authors’ calculations

Over the period 1992-2002, most countries experienced growth in the number of firms listed on the exchange except South Africa that had 683 firms listed in 1992 but only 472 firms in 2002, a fall of 31% and an annualized growth rate of -3.3%.

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The serious financial sector reforms, along with development of capital markets and regional integration, are welcome developments. However, the performance outcomes have not been as encouraging. The deeper and politically sensitive issues of institutional development, such as contractual and legal systems, accounting and disclosure rules, and regulatory and supervisory mechanisms are still incomplete. Thus, despite the extensive financial sector reforms that have taken place in terms of interest and price liberalizations, Sub-Saharan African financial systems face severe inefficiency, illiquidity, and thinness. Moreover, despite a surge of global investor interest in the 1990s, Africa has been bypassed by massive international capital that flew to developing economies. The aggregate private capital flows have been rapidly exceeding official development assistant flows since the 1980s. By contrast, Africa remains the only developing region, which continued to experience development assistance flows in excess of private capital flows. In fact, the aggregate development assistant flows declined during the same period that private capital flows went up dramatically to the developing economies. The mal-functioning and ill-developed financial systems are impediments not only to mobilization of global capital but also to domestic savings mobilization. In fact, Africa continues to experience high levels of capital flight. It is consistently estimated that Sub-Saharan Africa has the highest proportion of private wealth held abroad of any other region (estimates ranging from 30 to 40%, versus estimates for Latin America and East Asia as 8 and 3%, respectively). The irony is that the stock of capital flight estimates is even larger than the stock of Africa’s external debt! In addition, informal savings channels are prevalent in view of the grossly inadequate formal financial systems. All these factors – dearth of private international capital, low level of domestic resource mobilization, capital flight, and untapped resources in the informal sectors, lead to considerable financing gap, with adverse consequences on growth and poverty alleviation in Africa. This paper provides an analysis of the recent financial sector reforms that have taken place in Africa and provides some policy guides to alleviate the challenges in developing and building capacity of the financial systems. It takes a functional perspective and wholistic approach. It catalogues multiple functions that the financial systems provide beyond serving as a mere conduit for savings mobilization. The savings mobilization function is incomplete, although it has been a popular view of the dominant development thinking. However, the other functions of financial systems – information production, price discovery, risk-sharing, liquidity provision, promotion of contractual efficiency, promotion of governance, and global integration – are vital and go to the heart of ingredients for a well-functioning system. Understanding these functions is crucial in providing proper diagnostics of the existing systems and serving as guides for policy prescriptions. Moreover, this wholistic approach recognizes important complementarities between the development of banking systems and capital markets. This same functional perspective is to provide a catalogue of policy guides for developing and building capacity of the financial sector in the context of Africa, with particular focus on Sub-Saharan Africa.

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The policy prescriptions pertain to both the banking sector and capital markets. Capital markets are viewed more broadly to include markets for stocks, bonds, and other financial instruments. The paper discusses various measures intended to improve the functioning of the banking sector, such as an appropriately designed deposit insurance scheme, capital regulation, market-based and incentived regulation, etc. Regarding policy guides for capital market development, the focus is on the fledgling stock markets in Sub-Saharan Africa and supporting institutions. The guides include measures for the development of non-banking institutions, which also foster competition in the financial system and mitigate the adverse consequences of oligopolistic banking systems prevailing in Africa. Then a more comprehensive development agenda is considered for the stock markets, at the core of which are measures for promotion of public confidence, provision of informational efficiency, provision of liquidity, cultivating synergy among regional stock markets, and global integration. The paper is organized as follows. The following section provides foundations of financial sector reforms based on paradigms in finance. It takes a functional perspective with a catalogue of multiple functions of the African financial systems. These functions (e.g., liquidity provision and price discovery, governance) provide a channel for a linkage between financial sector development and economic development, and they constitute a basis for diagnosing the features of the current African financial systems. Using this functional perspective, we also take a closer look at the prospects for financial globalization of Africa based on mutual gains for global investors and the region at large. This section will be followed by another that provides the features of African financial systems, beginning with packages of the financial sector reforms that have taken place and then the constraints faced by these systems in achieving the desired outcomes of savings mobilization and financial stability. In particular, the malfunctioning features of both the credit/banking systems and the African stock markets have been identified. This then becomes a basis for us to provide a series of policy prescriptions, which are taken up in the final section. These prescriptions are targeted toward developing more efficient financial systems and building their capacity.1 FOUNDATIONS OF FINANCIAL SECTOR REFORMS: Functional Framework The dominant development thinking, which has viewed the financial sector as a mere conduit for capital mobilization, has inspired financial liberalization/reform programs in developing countries, including Africa, with undue emphasis on the development of the banking sector. This perspective, focusing on the savings mobilization role of the financial system, is shortsighted. In an economic environment characterized by uncertainty, capital markets provide functions beyond capital mobilization and allow for risk allocation and risk sharing among market participants. For instance, risk sharing allows high risk, yet high return, projects to be 1 This paper has benefited from prior work: Senbet (1998) “Globalization of African Financial Markets”, UNU/AERC conference (Tokyo) [also in Asia and Africa in the Global Economy, UNU Press,2003], Senbet (1998) “Global Financial Crisis: Implications for Africa”, AERC plenary conference (Nairobi) [also in Journal of African Economies, 2001], and Aryeetey and Senbet (1999) “Essential Financial Market Reforms,” World Bank 21st Century project conference (Abidjan). The current paper provides an extensive update (data), particularly regarding African stock markets and financial globalization, as well as new analytical perspectives and updated policy prescriptions.

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undertaken; otherwise, such projects would be rationed out of the market, and hence leading to value destruction and ultimately decline in economic performance. In this section we will first provide a vital linkage between financial sector development and economic development based on the available evidence. It is important that we gain a deeper appreciation of the multiple functions of a financial system, since these functions serve as a channel for the system’s impact on economic growth. These functions are stated in the context of an agency-based paradigm in finance. A. Financial Sector Development and Economic Development

The ultimate consequence of a well-functioning financial system is economic development. The available empirical evidence is that well-functioning financial markets, along with well-designed institutions and regulatory systems, foster economic development. The channel for the linkage of financial system development and economic development is the functions that the system performs. For instance, in the case of the stock markets, studies have found that functional features, such as liquidity, turnover, efficiency of pricing of risk, are positively correlated with current and future economic growth and productivity improvements. A liquid financial market, which is characterized by active trading among a large number of investors and firms, provides an exit strategy both for investors and issuing firms. Thus, liquidity is a crucial feature of financial sector development. It also provides a channel for more efficient corporate governance and resource allocation, whereby resources are allocated to the most productive and innovative firms. The linkage between liquidity and economic growth is supported by the existing empirical evidence in that countries with liquid markets experience faster rates of capital accumulation and subsequently greater productivity gains. See the stylized facts in Table 2, which are consistent with the latest evidence provided by Tadesse (2004) on the linkage between liquidity and economic performance.

Table 2 [Liquidity and Economic Performance]

The empirically supported positive linkage between financial sector development and economic development provides a strong case for the development of a well-functioning financial sector. The implication for African economies is particularly encouraging, since it suggests a linkage between financial sector development and poverty alleviation, as well as employment creation. The central question is how to develop a well-functioning financial sector and build its capacity so as to exploit its potential contribution to economic development.

B. Multiple Functions of a Financial System

Given the evidence for the positive linkage between financial sector development and economic development and the channel for this linkage being the functionality of a financial system, it would be appropriate to catalogue the multiple functions of such a system. The functional perspective departs from the dominant development thinking that focuses on savings

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Turnover Ratio

(TURNOVER)

Log (Per Capita GDP)

Low Income Countries Bangladesh 0.0327 5.234 India 0.4261 5.78 Indonesia 0.1855 6.315 Pakistan 0.1413 5.794 Zimbabwe 0.0653 7.876 Average 0.17018 6.1998

Middle Income Countries Chile 0.0661 6.086 Colombia 0.0863 7.711 Egypt 0.0636 10.085 Jordan 0.1571 7.008 Malaysia 0.2392 7.73 Mexico 0.5394 7.975 Peru 0.163 7.524 Philippines 0.2161 6.566 Sri Lanka 0.0694 9.344 Turkey 0.5041 7.88 Venezuela 0.1275 9.949 Average 0.2029 7.9871

High Income Countries Australia 0.2923 9.704 Austria 0.4422 9.856 Belgium 0.1202 9.791 Canada 0.3084 9.899 Denmark 0.2086 7.096 Finland 0.2019 10.081 Germany 1.0394 9.963 Greece 0.1218 8.968 Israel 0.6492 9.287 Italy 0.2986 9.757 Japan 0.4329 9.966 Korea 0.8502 8.527 Kuwait 0.2363 9.632 Netherlands 0.3656 9.786 New Zealand 0.1854 9.444 Norway 0.3265 10.179 Portugal 0.1537 8.69 Singapore 0.3254 9.422 Spain 0.2695 6.496 Sweden 0.2984 10.123 U. K. 0.3783 6.984 U.S. 0.5379 9.654

Average 0.3656 9.2411

Table 2

Capital Market Development and Economic Performance Stock Market Liquidity Measures: Selected Countries by Income Categories

Annual Averages 1980-1995

Source of Data: International financial statistics (IMF), Emerging Market Database (IFC)

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mobilization of a financial system (McKinnon 1973; Shaw 1973), and it recognizes a more comprehensive and wholistic approach. There are two fundamental considerations. First, an environment characterized by risk and uncertainty calls for a financial system that provides efficient risk sharing and diversification. Under uncertainty, risk allocation and sharing are vital functions of financial markets beyond mere savings/capital mobilization, which has inspired financial liberalization/reform programs with undue emphasis on the development of the banking sector. Consequently, both the quantity and quality of capital need to be considered in the functioning of financial markets. The traditional view is guided primarily by the quantity of capital mobilized in an economy (Haque, Hauswald, and Senbet 1997).

The second major dimension to consider in studying a financial system is its role in an imperfectly informed environment characterized by agency problems, such as those prevailing in African economies. In this environment, there are incentive problems among various stakeholders to an organized enterprise, particularly among management and capital contributors (shareholders and bondholders), and potential conflicts between capital contributors and the society at large (non-financial claimholders, such as employees and customers).2 See Figure 1. A well-functioning and liquid financial system serves as a vehicle for efficient contracting among conflicting parties and for disciplining of corporate insiders. For instance, a well-functioning financial system allows for active contests for corporate control so that resources are controlled by those who create the most value for the stakeholders, and ultimately for the society at large.

Figure 1 [The Firm as a Nexus of Contracts]

We now take a functional perspective in studying the characteristics of African markets and understanding the constraints to financial market reforms in African. We categorize the principal functions and discuss them briefly as follows:3

1. Mobilization of domestic financial resources: Capital providers may often desire

liquidity (ability to exit on short notice), along with attractive returns commensurate with the underlying risk exposure. However, entrepreneurs need to commit capital for long-term investments. Capital markets resolve this divergence through risk pooling and through provision of alternative instruments to facilitate diversification, and allow for maturity transformation. This risk pooling and maturity transformation allows entrepreneurial firms to invest and grow, leading to private sector development which is an engine of economic development. 2. Allocation of risk: diversification, insurance, and hedging: High return, yet risky investment projects, may not be undertaken simply because they could be too risky for any particular investor to bear. At the same time, risk sharing in the form of diversified

2 See Barnea, Haugen, and Senbet (1985) 3 See Haque, Hauswald, and Senbet (1997) for more detailed developments of the multiple functions

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Figure 1

The Firm (Corporation): A Network of Contracts

Firm Other Stakeholders (Product and Factor Market)

Outside (New) Equityholders

Government/ Society

Debtholders

Classes of Agency

Excessive Perquisites Underinvestment Overinvestment

Risk Shifting Asymmetric Information

Bankruptcy and Financial Distress

Management Debtholders, Stakeholders

Government/Society Debtholders, Government

New Equityholders Debtholders, Stakeholders

Adapted from John and Senbet (1998)

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investments means that each investor presumably owns only a partial stake in any given project. Hence, risk sharing arrangements imply the separation of ownership and control in the sense of separating providers of real investment from the providers of risk capital. This separation between real investment and risk bearing, in turn, allows specialization in production activities according to the principle of comparative advantage (Merton and Bodie 1995).

3. Production of information and Price Discovery: Price has an information content and hence signals scarcity and value, thereby allowing allocation of resources to their best use. A major limitation of the traditional development thesis, anchored around resource (savings) mobilization, has been the suppression of price signals so as to channel savings toward politically guided investment priorities. Repressing price signals (or, equivalently, returns) has often led to a misallocation of capital with adverse consequences for economic welfare and a country’s well being.

4. Promotion of corporate governance: Capital markets promote efficient governance and control of an organized enterprise by exerting external pressure and discipline on its operation. The market serves as a signal for managerial performance. The governance role of the market, through the pricing mechanism, is particularly important in an environment of uncertainty characterized by incentive conflicts and imperfect information. In this environment, contractual parties cannot easily observe or control one another, and enforcement mechanisms are costly. The market can provide a price-based monitoring mechanism for sub-optimal behavior through transmission of negative information and hence putting pressure on management to take corrective action. As an example, the market price information uncovers target firms for takeover and provision of active trading for actual transfer of control. Inefficient management may then be removed through takeovers, whereby raiders accumulate shares in the open market and take control of the firm. Often, the very threat of such a control transfer serves as a disciplining mechanism for management. Further, the internal and external monitoring mechanisms that accompany capital market development, such as structure of corporate boards and system of disclosure rules, improve transparency and boost investor confidence. Industry-level data from various studies have shown there is a positive relationship between market-based governance and improvements in industry efficiency. Industry efficiency is important because it promotes economic growth.

5. Improvement in the design of incentive contracts: In a private economy with incentive conflicts among contracting parties (stockholders, debtholders, management, etc), such as in Figure 1, capital markets facilitate the design of incentive compatible contracts that promote alignment between management, shareholders, and bondholders. In the case of managerial agency conflicts, for instance, incentive compensation structures can align management with capital contributors. Such incentive features include equity participation by management, executive stock option plans that link incentives to fortunes of companies that are being managed. A liquid market can deliver a pricing benchmark for the valuation of such incentive schemes, as well as for the assessment of these incentive contracts on corporate investments.

6. Mobilization of global capital and promotion of global integration: Well-functioning markets can position a country competitively in markets for global capital. This promotes inflow

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of international capital and subjects a country to international discipline. Further, accessing global markets for capital reduces reliance on foreign aid. In the next subsection we will take a closer look at the ingredients and prospects for globalization of African financial systems.

7. Summing up: multiple functions as guides for capital market development: Thus, capital markets perform multiple functions as discussed above. Policy makers need to be aware about multiple functions of capital markets in designing mechanisms for efficient functioning of these markets. The depth of the capital market reform and development must be judged on the basis of the efficiency with which the various functions of capital markets are carried out. For instance, the mere establishment of stock exchanges is inconsequential, if the environment is hostile to risk-sharing opportunities and liquidity provision. Stock markets, which are devoid of liquidity and information production, are malfunctional. By the same token, the mere existence of banks is of little value, if what they do is to mobilize deposits and use them primarily for the purchase of government securities at the detriment of credit to the private sector. The dearth of commercial and private lending prevents banks from serving as informed agents or intermediaries and build vital information capital for efficient allocation of resources. This pattern of financial dis-intermediation or dysfunctional intermediation is widely observed in Sub-Sahara Africa. Thus, it is imperative to use the multiple functions of capital markets as a guiding principle in building capacity of African financial systems and coming up with measures for integrating the region into a global financial economy. C. Ingredients and prospects for financial globalization of Africa As discussed above, promotion of global capital is an important function of a well-functioning domestic financial system. This also helps promote integration of a country into a global financial economy. It would be useful to look at the essential ingredients for successful financial globalization of Africa.

1. Africa was left out of massive international capital flow

There has been a massive flow of private international capital to developing countries resulting from the opening up of the world economy in the 1980s. Accompanying this has been a radical shift in the pattern of capital flows, with the fast growing components being portfolio flows (equities and bonds). Sub-Sahara Africa was left out of the dramatic portfolio flows. Moreover, although development finance flows have declined over time, Sub-Sahara Africa continues to account for the largest and growing proportion of development finance. In fact, since the mid-1980s, aggregate private capital flows to developing nations have rapidly outpaced official development assistance flows. This is a welcome development and positive trend in view of shrinking development flows. Unfortunately, Sub-Saharan Africa is the only region (except South Africa), which continues to face development assistance flows in excess of private capital flows. See Figure 2.

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Figure 2: Official Assistance Flows versus Private Capital Flows, with South Africa excluded

from Sub-Saharan Africa, 2000

0%

20%

40%

60%

80%

100%

Sub-Saharan Africa (South Africa excluded)

East Asia and Pacific

South AsiaLatin America and the Caribbean

Europe and Central Asia

Middle East and North Africa

(regions)

(per

cent

)

OfficialPrivate

Figure 2a: Official Assistance Flows Versus Private Capital Flows, with South Africa excluded

from Sub-Saharan Africa, 2001

0%20%40%60%80%

100%

Sub-Saharan Africa (South Africa excluded)

East Asia and Pacific

South AsiaLatin America and the Caribbean

Europe and Central Asia

Middle East and North Africa

(regions)

(per

cent

)

OfficialPrivate

On the other hand, foreign direct investment was relatively stable and actually experienced upward trend through the 1980s and 1990s. Overall, though, FDI has been the dominant component of private flows to Sub-Saharan Africa. However, it is highly concentrated, with the bulk being channeled to the four resource rich countries - South Africa, Nigeria, Angola, and Ghana.

Source: Global Economic Prospects, World Bank, 2003 and 2004

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Figure 3 [Composition of Portfolio Flows to Sub-Saharan Africa: To be completed] Portfolio equity flows to Sub-Saharan Africa were non-existent prior to 1992, but they have emerged slowly over the years, although are still small, relative to other emerging markets. The positive development in portfolio equity is a window of opportunity for financial globalization of Africa as is also evidenced by the introduction of global investment funds targeting Africa. There are now about 20 Africa-oriented funds trading in Europe and America (e.g., Africa Investment Fund – Morgan Stanley, Africa Investment Fund – Citibank). Thus, with guarded optimism for further development, it is now appropriate to look into prospects for globalization of African financial markets.

2. Globalization: Mutual Benefits for International Investors and Africa Financial globalization is a two-way street, and successful globalization is characterized by mutual gains for both global investors and emerging economies in Africa. The competitiveness of Africa in attracting international capital depends on its role in improving the global risk-reward ratio faced by global investors. Why is Africa of potential interest to global investors? What does Africa gain from financial globalization?

a. Sources of Potential Benefits for Global Investors in Africa It is only rational that international investors take a global view in their holdings of portfolio investments. Consequently, they evaluate their investment portfolios on the basis of global risk-reward ratio.

(i) Benefits from global risk diversification: At a more fundamental level, the benefits

from global risk diversification arise from diversity in the economic cycles of countries. Take the case of US investors, for example. They would benefit from diversifying their investment portfolios globally, since the US economy does not move in tandem with the economies of the rest of the world. It is unwise for the US investors to put all of their “eggs” in the same “basket”, so to speak. This can be illustrated using Wall Street data (Figure 4).

Figure 4 [Potential Benefits of Global Risk Diversification: To be updated]

The average annual return for an investment portfolio is measured along the vertical axis, and risk is shown along the horizontal axis. There is a frontier (hyperbolic) with the extreme right point represented by non-US equities, and the curve bends backward in the left with the last point represented by the US stock market. Investors with a 100% allocation faced (during the sample period) a reward of about 13% but with correspondingly high level of risk exposure (standard deviation of 23%). Those with a 100% allocation in the US market faced a much lower return (11-12%) but with correspondingly much lower risk exposure (standard deviation of 16%). Consider now a combined strategy of investment in both non-US equities and the US market. This strategy generally dominates investment in the US market alone. This is because the US market and non-US markets do not move in tandem due to relative diversity in the underlying economic cycles. For instance, an allocation with 64% in the US market and 25% in the non-US markets offered a higher return but with the same level of risk as the US. Indeed, the efficient diversification strategies should plot along the frontier, beginning with the minimum risk allocation, and the US market is dominated by any of these strategies.

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The foregoing illustration makes it clear that the optimal investment strategies are global. This is also supported by growing evidence that such global strategies should include emerging markets, and even pre-emerging markets, such as those in Africa (e.g., Diwan, Errunza, and Senbet, 1993). To the extent that Africa’s economies do not move in tandem with those of the advanced economies, there are opportunities for international investors to benefit from inclusion of African financial markets in the global portfolio. Consequently, the competitiveness of a pre-emerging region, such as Africa, in attracting international capital depends on its role in improving the global risk-reward opportunities available to global investors. In fact, the available evidence points to a low correlation between Africa and those of the developed counties, and hence generating potential for beneficial global diversification. See Table 3.

Table 3 [Stock Return Correlations among Selected African and Non-African Countries]

The actual portfolio holdings are nowhere near the optimal global strategy, suggesting considerable potential for further globalization of emerging markets as the world becomes more integrated. While emerging markets are under represented in the global portfolios, Sub-Saharan Africa is under represented even in the emerging markets portfolio. Thus, with increasing economic and financial reforms, Africa is bound to participate in the growing allocation of global investments to emerging markets. ii. Potential bargains from African stock markets: The potential benefits of the Africa portfolio go beyond its contribution to global risk diversification. The other dimension of global strategy is investment reward for an acceptable level of risk. In the 1990s very low price-earnings multiples were observed in the African stock markets, and suggesting high undervaluation, given an acceptable range of emerging market risks. In 1997, for, for instance, shares of some solid companies, such as Zambia Sugar, Standard Chartered Bank (Ghana), and Delta Corporation of Zimbabwe were trading in 1997 at 2 1/2 times prospective earnings (D. Gpoinath, 1998). This was indicative of gross undervaluation for an acceptable emerging market risk. By and large, this reflected an extraordinary level of perceived risk characterizing the Sub-Saharan African markets. To put things in proper perspective, the US broad market index traded at around 28 times earnings in 1997. However, the P/E multiples have picked up more recent years. See Appendix 1, for instance, for the December 2003 figures, although they are still generally low despite the more recent price run-ups in many of these markets. Another indicator pointing to untapped value potentials for global investors is the recent return performance of various stock markets in Sub-Saharan Africa. The Sub-Saharan stock markets have outperformed the emerging indices of the IFC by a substantial margin. See below for further discussion of outlook for financial globalization of Africa (section 3).

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Figure 4: Illustration from Wall Street

Benefits of International Portfolio Diversification:

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b. Benefits to Africa from Integration into the Global Financial Economy

So far we have motivated globalization from the standpoint of benefits to international investors (or suppliers of capital) and the need for competitive positioning of Africa in global markets in response to investor desires. However, there are considerable benefits to Africa as a recipient of global capital and its integration into the global economy. These benefits are as follows:

(i) Diversified source of external finance: In contrast to heavy reliance on sovereign debt and its attendance crisis and official aid flows, which are already shrinking, financial globalization allows access to more diversified source of external finance.

(ii) Global sharing of local equity risks: In contrast to the syndicated bank lending of

the 1970s, international investors can share in the riskiness of local capital markets, especially through equity investments.

(iii) Reduction of cost of capital for local companies: Financial globalization allows

for local securities market risks to be shared internationally. Greater sharing of risks in the local capital markets through global holdings of local shares leads to reduction in the cost of capital for local firms. This leads to enhanced liquidity of the local market and capital mobilization by firms in response to the reduced cost of capital. The spillover effect here is an improved economic performance as projects, which previously were foregone due to excessive risk exposure, would now be adopted [see Errunza, Senbet, and Hogan, 1998, for the evidence]. Thus, the potential benefits of financial globalization to Africa go beyond mobilization of international capital flows to improvement in the liquidity and functioning of the local market as well growth of local firms.

(iv) Reversal of capital flight: Financial globalization helps reverse capital flight (often

an initial capital inflow and source of privatization capital), The evidence from other regions, such as Latin America and East Asia, suggests that financial globalization leads to large reversals of capital. Here it is important to recognize that the very measures that retain domestic capital are also those that help reverse capital flight. Given that Sub-Sahara Africa experiences the largest share of stock of capital flight (relative to other regions), there is a potential for significant reversal, if the region is sufficiently integrated into the global financial economy. (v) Promotion and validation of capital market institutions: Financial globalization enhances validation of the credibility of domestic capital market institutions (custodial, clearing, settlement, and brokerage services, information and accounting disclosures, etc. and regulations), as foreign investors demand world-class services. Governments will be under greater pressure to strengthen the rule of law, enforce contracts, and increase the growth of available information in response to international investor demands. Thus, globalization exposes African stock markets to the best practices and standards, and in turn puts pressure for reforms of the local stock markets. The focus on the development of the banking sector precludes opportunities for building up informational technology unique to risk capital (e.g., disclosure and accounting standards). This informational discipline has a positive externalty over the entire financial sector, including the banking sector. It is, therefore, important that African countries do not put counterproductive restrictions in place by stacking odds against outside investors.

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Table 3: Panel A

Correlation Coefficients Between Weekly Market Returns in Local Currency Terms During January 1988 - May 2000a

Correlation Coefficients

for the Common Sample During November 1997 - May 2000

Aus

tral

ia

Bel

gium

Can

ada

Fran

ce

Ger

man

y

Japa

n

Net

herl

ands

UK

US

Bot

swan

a

Gha

na

Ken

ya

Mau

ritiu

s

Nam

ibia

Sout

h A

fric

a

Belgium

0.212 b

Canada 0.427 c 0.404 c France 0.461 c 0.551 c 0.677 c Germany 0.474 c 0.562 c 0.609 c 0.848 c Japan 0.388 c 0.185 b 0.233 b 0.278 c 0.289 c Netherlands 0.439 c 0.665 c 0.634 c 0.836 c 0.845 c 0.334 c UK 0.420 c 0.614 c 0.527 c 0.738 c 0.710 c 0.258 c 0.743 c US 0.455 c 0.413 c 0.791 c 0.682 c 0.611 c 0.213 b 0.649 c 0.653 c Botswana 0.019 0.136 0.092 0.132 0.104 0.016 0.126 0.001 0.079 Ghana 0.077 0.154 -0.015 0.077 0.031 0.043 0.108 -0.063 -0.064 0.224 b Kenya 0.093 0.002 -0.021 0.013 0.016 -0.158 0.049 0.057 -0.017 -0.220 b 0.031 Mauritius 0.097 0.136 0.073 0.122 0.081 -0.014 0.173 a 0.069 0.113 0.109 0.289 c 0.037 Namibia 0.279 c 0.182 a 0.355 c 0.368 c 0.445 c 0.205 b 0.387 c 0.336 c 0.369 c 0.050 0.049 -0.068 0.022 South Africa 0.431 c 0.289 c 0.635 c 0.566 c 0.555 c 0.272 c 0.549 c 0.552 c 0.552 c 0.032 0.062 0.039 0.017 0.609 c Zimbabwe 0.148 0.023 0.114 -0.001 0.011 0.132 0.011 -0.056 0.026 0.115 0.016 0.155 -0.013 0.196 b 0.133

17

Table 3: Panel B

Correlation Coefficients for the Common Sample Period from

February 1991 - May 2000

Aus

tral

ia

Bel

gium

Can

ada

Fran

ce

Ger

man

y

Japa

n

Net

herl

ands

UK

US

Bot

swan

a

Ken

ya

Mau

ritiu

s

Belgium 0.171 c Canada 0.394 c 0.297 c France 0.329 c 0.490 c 0.511 c Germany 0.415 c 0.479 c 0.500 c 0.729 c Japan 0.288 c 0.142 c 0.240 c 0.268 c 0.244 c Netherlands 0.414 c 0.566 c 0.533 c 0.730 c 0.785 c 0.272 c UK 0.401 c 0.458 c 0.463 c 0.648 c 0.614 c 0.250 c 0.681 c USA 0.411 c 0.361 c 0.721 c 0.518 c 0.511 c 0.222 c 0.567 c 0.545 c Botswana 0.011 0.008 0.032 0.081 0.067 0.010 0.066 -0.019 0.022 Kenya 0.003 -0.002 0.053 -0.029 -0.020 0.001 0.011 0.017 0.011 -0.083 Mauritius 0.074 0.077 0.071 0.006 0.028 0.022 0.071 0.073 0.055 -0.057 0.174 c South Africa 0.370 c 0.219 c 0.516 c 0.379 c 0.447 c 0.243 c 0.423 c 0.405 c 0.393 c 0.029 0.032 0.033

a Significant at the 0.10 level. b Significant at the 0.05 level. c Significant at the 0.01 level. Source: Lamba and Otcherie (2001)

18

Table 3a Risk-Adjusted Performance of African Stock Markets*

This table shows the Sharpe measure for the African countries. The measure is based on mean stock return and mean risk free (Treasury bill) rates of return from 1992-2002. The measure is calculated for the countries for which data are available.

Country

% Mean Returns

(1992-2002)

Risk-Adjusted: Sharpe

Measure Botswana 28 0.53 Cote d'Ivoire -6 -1.21 Egypt 20 0.36 Ghana 41 0.14 Kenya 9 -0.21 Malawi 15 -0.77 Mauritius 11 0.05 Morocco 12 0.28 Namibia 1 -0.26 Nigeria 32 0.39 South Africa 13 0.04 Swaziland 8 -0.08 Tanzania 52c - Tunisia 4 -0.36 Uganda 3c - Zambia 13 -1.20 Zimbabwe 75 0.57

c Returns are available only for one year. * See footnote for further explanation.

19

3. Outlook for Financial Globalization of Africa There are encouraging forces in place for the prospects for Africa’s integration into the global financial economy. First, there is growing integration of world capital markets, including those in emerging economies, with increasing capital mobility. Barriers to international capital flows have been reduced (e.g., elimination of fixed commissions, deregulation of financial markets). Moreover, there are rapid advances in information technology, which facilitate capital flows, research and international investing. On the real sector side, MNCs have expanded global operations and have taken advantage of global capital markets. Thus, investors seeking the benefits of global diversification are now better able to access markets. It turns out that African markets are also joining this wave of global integration and the evidence is reported by Lamba and Otchere (2001). The evidence is indicative of African markets being increasingly integrated with the other world capital markets. Also, see Table 3 (Panels B and C), which is consistent with this evidence. Financial sector reforms have contributed to this development. Globalization of capital flows has led to growing relevance of emerging capital markets. Increasing integration of African markets with the other capital markets will encourage the flow of investments into these countries as investors seek to capitalize upon the potential diversification benefits. As these markets become increasingly integrated with the worlds market, they may be able to provide significant diversification benefits and allow Africa to achieve the benefits of globalization as listed above. The second encouraging element for increased prospects for Africa’s financial globalization is due to recent performance of the African stock markets (relative to those in the other emerging economies). Stock market outlook for the African markets appears to be improving. In the last five years, the cumulative returns in US dollar terms for sub-Saharan African has been 4.3% in comparison to -3.9% for the S&P 500 and -15.5% for the UK FTSE 100 index (UNDP 2003). African stock markets were among the best performers in 2003. According to Databank, the average African stock market returns in 2003 were 44%. This compares favorably with the 30% return associated with the Morgan Stanley Capital International (MSCI) Global index, 32% for the MSCI-Europe index, 26% for the S&P Index and 36% by the Nikkei Index. In particular, stock markets in Ghana, Uganda, Egypt, Kenya, Nigeria and Mauritius performed phenomenally with a return over 50%. The Ghana stock market exchange was the best performer with a return over 144%, outperforming 61 markets that were surveyed by Databank Financial Services. Moreover, the the 2002-2003 period, the Ghana stock market led the World with a compounded return of 256%. Databank attributes this superior performance to improving macro economic conditions, improved corporate sector performance and perhaps the base line low equity valuations. 4 The foregoing data suggest that African equity markets represent largely unexploited opportunities for international investors. Moreover, the potential exists for benefits from diversification by investing in these markets. Despite this potential, Africa has received a scant portion of capital flows to emerging markets as global equity funds have maintained a low exposure to Africa. Africa’s portion of global emerging equity portfolios is just about 8%, but the bulk of this exposure is South Africa (Mensah, 2002). Why is Sub-Sahara so marginalized in the global financial economy? The following sections deal with the challenges and constraints facing African financial systems and the policy prescriptions to help alleviate those.

4 Table 3a shows risk-adjusted returns, but they are preliminary. More work is being done using country returns adjusted for foreign exchange fluctuations and comparing them with the other emerging countries on a risk – adjusted basis.

20

FEATURES OF AFRICAN FINANCIAL SECTOR REFORMS: Constraints and Opportunities for Further Reforms Financial sector reforms have been and continue to be among the key pillars of structural adjustment programs (SAP) in Africa. In the past two decades, African countries have embarked upon financial sector restructuring involving deregulation and the gradual opening up of the financial sector to foreign participation, interest rates and exchange rate liberalization, removal of credit ceilings, bank restructuring and privatization, introduction of measures to promote capital market development. This has been a major reversal of policies of the post-independence era during which African governments intervened in the financial sector. The menu of intervention was quite extensive and it included nationalization of private banks, establishment of entirely new state banks and non-bank financial institutions, imposition of quantitative restrictions on the allocation of credit and restriction of external capital flows. Although the intentions of government intervention in the financial sector might have been benevolent in the sense of mobilizing capital needed for investments and allocating capital to priority sectors, the actions were counterproductive and produced utterly dysfunctional financial systems. Moreover, the intended goals of capital mobilization and allocation of capital to growth areas were not realized. In fact, the repressive era produced a lost decade for Sub-Saharan Africa (1980s) whereby the region marched backwards while the rest of the world, particularly the emerging countries in East Asia and Latin America, moved forward. The recent financial sector reforms were intended to reverse the adverse consequences of the repressive financial policies of the post-independence era, although the pace and the extent of policy reform varied across countries. As we discuss below, though, the performance outcomes of the financial sector reforms have not been encouraging, and even, not that dissimilar across countries which have varied in their pace of reform. For instance, although Ghana’s removal of lending restrictions was much more rapid than that of Tanzania, the evolution in interest rates and spreads has been similar (Nissanke and Aryeetey 1998). In this section we wish to examine the extent to which the financial sector reforms have produced the desired outcomes and identify the constraints against achieving those outcomes. We take a functional perspective in identifying these constraints and use those as a foundation to come up with policy guides as detailed in the next section. A. Elements of Financial Sector Reforms in Africa

Table 4 provides the essential elements of financial sector reforms that have taken place in Africa. The table shows similarities and variation in the extent of financial sector reforms across the countries. At a broader level, there is no doubt that a more liberalized financial environment has emerged as a result of these reforms. A major feature of interest rate and credit market liberalization was elimination of monetary policies that involved direct determination of lending and deposit rates. These rates are now by and large left to market conditions. Moreover, indirect monetary control policy emerged as a viable option over its direct counterpart. Thus the interest rate liberalization, along with removal of credit ceilings and quantitative controls, constituted an important element of financial sector reforms. Restructuring and recapitalization of banks was another major element of financial sector reforms. As shown in Table 4, banking restructuring included privatization of state-owned banks in about a dozen in

21

Sub-Saharan Africa. Moreover, regulatory and supervisory schemes were introduced in conjunction with these bank restructurings and privatizations. B. Challenges to Reforms of Credit and Banking Systems We take a functional perspective in studying the characteristics of African financial systems. In particular, we look at the effectiveness of financial intermediation, banking regulation and supervision, diversity of financial instruments, and depth and capacity of stock markets. While there may be some diversity in the outcomes of the restructuring efforts in various economies, the differences are not very significant. Essentially, the functions of savings mobilization and financial intermediation have not fully recovered since reforms were initiated (Nissanke and Aryeetey 1998; Haque, Hauswald, and Senbet 1997). Even in those countries, such as Ghana and Malawi, where reforms were relatively orderly, most banking institutions have not developed the capacity for efficient risk management and control. As also witnessed in such countries as Ghana and Uganda, the allocation of bank lending portfolios targeted either the lowest risk category (e.g., buying up government securities) or recklessly targeted excessively high-risk clients (Aryeetey and Senbet, 1999). In Ghana sixty per cent of bank asset assets have government exposure, including state-owned enterprises. In Uganda a third of bank assets are held in government securities. This is despite the fact that Ghana and Uganda have been among the most progressive and reforming countries in the Sub-Sahara region. 1. Financial Deepening and Credit to the Private Sector The performance outcomes for the financial sector reforms have been discouraging or at times outright perverse. The desired effects on savings mobilization and credit allocation have not materialized. The financial deepening measures, the M2/GDP ratio, and the measures of private credit, the private credit/GDP ratios, did not show clear upward trend in most countries. See Table 5 – Panel A for financial deepening and Panel B for credit to the private sector. On both indicators, African countries generally lag behind their Asian counterparts. South Africa is, of course, an exception.

Table 5 [Effects of Reforms on Financial Deepening and Credit to Private Sector]

2. Banking Instability and Dysfunctional Intermediation

The problems of the banking systems in Africa remain severe after financial sector reforms. Many economies are characterized by banking systems with a heavy concentration of their assets in the short end of the market and excessive liquidity (Nissanke and Aryeetey 1998). Moreover, the portfolios of banking institutions continue to be dominated by an extremely high incidence of non-performing loans and excess liquidity. The information and enforceability problems, along with prevalence of financial distress and bank failure, have serious consequences. In particular, they result in adverse selection, where weak banks attract disproportionately high risk and weak enterprises (e.g., state-owned companies), which see no downside in borrowing at high interest rates and bet on a small probability of good outcomes. Such a weak banking system breeds instability and even undermines government policies, such as the conduct of monetary policy (Camen, Ncube, and Senbet 1996). a. Banking Incentive Issues and Ill-designed Safety Nets: A major objective of monetary and financial policy-makers is the stability of a nation's payments system. Explicit or implicit deposit insurance is used to reduce the risk of systemic failure of banks and hence stabilize the payments and financial system. However, deposit insurance is socially counterproductive, if the system is not appropriately structured.

22

Table 4

Financial Sector Reforms and Establishment of Stock Exchanges in Sub-Sahara Africa

Year of Liberalization of Reform Interest rates and Restructuring Privatization Establishment of (SAP) credit market of Banks of Banks Stock Exchanges

Benin - 1989 - - - Botswana 1991 1991 - - 1989 Cameroon - 1990 - 1998 - Cote d’Ivoire - 1989 - 1999 1976* The Gambia - 1986 - - - Ghana (1983) 1983 1988 1989 1997 1996 Kenya (1989) 1989 1991 - 1989 1954* Madagascar - 1994 - 1999 - Malawi (1987) 1987 1988 1990 - 1996 Mauritania - 1990 - - - Mauritius (1983) 1983 1993 - - 1988 Namibia 1992 1991 - - 1992 Nigeria 1987 1987 1990 1992 1960* Tanzania (1985) 1985 1991 1991 1994 1998 Uganda (1987) 1987 1988 - 1996 1998 Zambia (1991) 1991 1992 - - 1994 Zimbabwe (1991) 1991 1991 - 1997 1946c* Source: Inanga and Ekpenyong (2004); Reinhart and Tokatlidis (2001); Chirwa and Mlachila (2004) ; World Bank Privatization database *Prior to embarking on structural adjustment program, Kenya and some other Sub-Saharan African countries had stock markets although they were relatively inactive. c A new exchange was established that year. .

23

When deposits are guaranteed, depositors themselves face no risk. However, risk due to the incentives of the banker is transferred to an insuring agency. Bank owners have an incentive to gain by choosing excessively risky asset portfolios by engaging in high risk lending. Thus, in an ill-designed deposit insurance system, public mismanagement of the system and private incentive incompatibility problems can actually work to increase the systemic risk and instability of a banking system Cull, Sorge, and Senbet (2004) study the impact of deposit insurance schemes on financial development and stability of a variety of countries around the world. The desired outcomes are achieved in those countries with high quality of regulation, but deposit insurance schemes turn out to be counterproductive in those countries with weak legal and regulatory regimes. The weak financial systems become even more unstable. The lesson for Africa is to devise efficient and incentive compatible regulatory systems in the face of provision of safety nets, such as explicit or implicit deposit insurance schemes. Otherwise, ill-devised schemes lead to instability of the African financial systems.

The basic idea of moral hazard and excessive bank risk taking can be formalized along the lines of John, Saunders, and Senbet (2000). Bank owners, left alone and inefficiently regulated, would seek to adopt excessively high-risk portfolios (e.g., speculative real estate lending) hoping for big payoffs under favorable economic conditions but transferring losses to the insuring agency (and the society at large) when projects fail. Consider Figure 5, which characterizes the investment incentives of a banking system. A bank is endowed with an opportunity for portfolio of risky assets (loans). These investment opportunities can be depicted by their rewards, along the vertical axis in Figure 5 (a schedule of bank values) and their risks (volatilities) of the terminal cash flows, along the horizontal axis. Following the agency tradition, let us assume that bank asset or lending risk choices by corporate insiders (bank managers) are imperfectly observed by outsiders (depositors and regulators). The agency problem arises, because bank owners make investment and risk choices to maximize the value of the bank equity currently outstanding, rather than maximizing the total value of the bank assets. In the absence of bank leverage (or bank deposits), bank equity and bank value maximization decisions are identical. The first best solution is represented by the value-maximizing level of risk for the investment opportunity. There is a unique value-maximizing level of risk for unimodal structures, at the apex of the concave production curve in Figure 5.

Figure 5 [Moral Hazard and Excessive Risk-Taking]

With undercapitalization or with sufficiently high level of debt (deposit financing), bank insiders deciding on behalf of bank owners) depart from the first best risk outcome. Thus, the investment implemented will be affected by the amount of capital in place and its complement, the level of debt financing. Bank owners will invest at a point of asset risk choice above the first best level of risk (along the right hand side of the value maximizing point), so as to maximize the value of their equity holdings. The distortion in risk choice depends on the level of bank capital, as well as the investment risk characteristics. However, the risk distortion effect decreases with the level of bank capital. This provides a rationale for capital adequacy requirement so as to minimize the instability brought about by moral hazard and excessive bank risk-taking. When capital adequacy measures are weak banks are more likely to become distressed.

c. Supervisory and Regulatory Failure: As discussed earlier, there have been serious efforts to improve banking regulation and supervision in several African countries in order to achieve financial stability and high quality intermediation. However, supervision and regulation

24

Table 5: Panel A

FINANCIAL DEEPENING

M2 to GDP RATIO

Country 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 % Growth

Annualized Growth (%)

Algeria 0.49 0.55 0.49 0.40 0.36 0.39 0.46 0.45 0.41 0.49 .. 0.65 32.46 2.59

Botswana 0.30 0.23 0.22 0.22 0.22 0.23 0.29 0.34 0.29 0.34 0.30 0.30 1.97 0.16

Cote d'Ivoire 0.28 0.28 0.28 0.29 0.27 0.24 0.23 0.22 0.22 0.23 0.29 3.24 0.29

Egypt 0.85 0.85 0.85 0.80 0.79 0.78 0.77 0.76 0.77 0.82 0.88 0.97 15.05 1.18

Ghana 0.21 0.20 0.23 0.22 0.21 0.24 .. .. .. .. .. .. 16.16 2.53

Kenya 0.37 0.37 0.41 0.44 0.48 0.48 0.45 0.44 0.43 0.40 0.41 0.40 10.23 0.82

Malawi 0.21 0.22 0.26 0.19 0.16 0.14 0.17 0.16 0.19 .. .. .. -11.11 -1.30

Mauritius 0.69 0.70 0.71 0.77 0.74 0.77 0.76 0.81 0.79 0.80 0.83 0.84 21.07 1.61

Morocco 0.60 0.63 0.62 0.66 0.62 0.73 0.71 0.78 0.83 0.87 0.89 0.92 53.00 3.61

Namibia 0.28 0.32 0.33 0.37 0.40 0.38 0.38 0.41 0.41 0.37 .. .. 31.77 2.80

Nigeria 0.23 0.28 0.29 0.16 0.13 0.15 0.18 0.21 0.21 0.23 2.68 0.32 35.23 2.55

South Africa 0.50 0.47 0.49 0.50 0.51 0.54 0.57 0.58 0.56 0.59 0.62 0.64 27.41 2.04

Swaziland 0.34 0.32 0.29 0.25 0.25 0.26 0.26 0.26 0.22 0.21 0.21 -36.83 -4.09

Tanzania 0.22 0.24 0.19 0.20 0.17 0.17 0.16 0.17 0.17 0.18 0.22 -0.92 -0.08

Tunisia 0.47 0.46 0.46 0.46 0.46 0.49 0.48 0.52 0.55 0.57 0.57 0.56 20.65 1.58

Uganda 0.07 0.10 0.11 0.11 0.12 0.13 0.14 0.14 0.16 0.16 0.19 0.19 165.87 8.49

Zambia .. 0.14 0.15 0.17 0.18 0.17 .. .. .. .. .. 20.10 3.73

Zimbabwe 0.17 0.23 0.23 0.27 0.25 0.29 0.24 0.21 0.25 .. .. 54.06 4.92 Source: World Development Indicators (various) and Authors’ calculations

25

Financial Deepening and Credit to Private Sector

0

20

40

60

80

100

120

1995 1996 1997 1998 1999 2000 2001 2002

% o

f GD

P

Credit to Private Sector (ex SA & Mauritius)Financial Deepening(ex SA & Mauritius)Credit to private sector (SA & Mauritius)Financial Deepening (SA & Mauritius)

Financial Deepening and Credit to Private Sector (Sub Saharan Africa ex South Africa and Mauritius )

0

5

10

15

20

25

30

1995 1996 1997 1998 1999 2000 2001 2002

% of GDP

Credit to Private Sector Financial Deepening

26

Credit to Private sector as a percentage of GDP

Country 1995 1996 1997 1998 1999 2000 2001 2002 % Growth

Annualized Growth (%)

Algeria 5.2 5.5 4 4.6 5.5 6.1 8 6.8 30.77 3.41 Botswana 13.2 11.1 9.9 11.9 15.2 16.1 16.2 18.4 39.39 4.24 Cote d'Ivoire 20.2 19.7 19.4 18.6 16 17.2 15.9 14.8 -26.73 -3.81 Egypt 47.1 41.5 46.6 54 59.7 59.3 61.6 60.6 28.66 3.20 Ghana 5.2 6.6 8.2 9.4 12 14.1 14.1 12 130.77 11.02 Kenya 33.8 34.6 34.9 30.3 30.5 30.1 24.6 23.4 -30.77 -4.49 Malawi 7.8 4.2 3.9 6.1 5.6 6.2 6.8 4.1 -47.44 -7.72 Mauritius 48.3 44.7 50.5 59.2 58.5 26.7 62.7 61.3 26.92 3.02 Morocco 48.9 45.8 33.5 50.4 54.6 58.6 54 54.4 11.25 1.34 Namibia 56.9 50.5 52.6 51.2 49.2 44.7 47.3 48.4 -14.94 -2.00 Nigeria 7.8 10.6 8.2 9.1 13.8 13.9 17.8 17.8 128.21 10.86 South Africa 130.6 137.1 135.7 118.9 136.3 141.9 148.5 131.7 0.84 0.10 Swaziland .. .. .. .. .. 14.2 13.1 14.3 0.70 0.23 Tanzania 8.9 3.4 3.9 4.7 4.6 4.6 4.9 6.3 -29.21 -4.23 Tunisia 68.4 63.5 64.5 50.8 65.1 66.2 67.9 68.6 0.29 0.04 Uganda 4.1 4.7 4.3 5.2 5.9 6.3 5.9 6.7 63.41 6.33 Zambia 7.2 9.3 8 6.8 7.4 9.5 7.2 6.2 -13.89 -1.85 Zimbabwe 35.3 35.4 37.6 38.8 27.2 25.2 25.8 37 4.82 0.59 Sub-Saharan Africa .. 68.1 65.1 57.9 66.2 66 65.2 53.5 -21.44 -3.39 Developing nations .. 18.7 47.2 50.2 52.7 55.3 52.1 55.9 198.93 16.93 World .. 107.7 109.7 103.1 109 119.5 120.7 118.1 9.66 1.33

Table 5: Panel B

Source: World Development Indicators (The World Bank) 1997-2004, authors’ calculations. Definitions: Credit to Private Sector refers to financial resources provided to the private sector-such as through loans, purchases of non-equity securities, and trade credits and other accounts receivable-that establish a claim for repayment. For some countries these claims include credit to public enterprises. Financial reforms are usually associated in the increase in the credit to the private sector. For most of the countries, there was an increase in credit to the private sector.

27

have remained grossly inadequate, and the quality of financial intermediation is either reflective of excessively high risk (leading to bank distress) or excessively conservative (leading to dearth of

credit to the private sector). Even when the regulatory structure looks efficient on the books, it may not be properly implemented. This requires a well developed and coherent legal environment that forces regulators to faithfully and obediently implement and enforce regulation. In the absence of such supporting institutional arrangements (i.e., bad governance), the consequences of agency conflicts between society and regulators can lead to suboptimal regulatory outcomes (Hauswald and Senbet 1999). Nigeria is often cited to be in this category of regulatory failure. Regulatory failure may also occur at the level of managing bank insolvency. For instance, it would not be in the best interests of bank regulators to “fail” an insolvent bank whose assets are insufficient to meet the debt obligations (Kane and Rice 1998). In particular, regulators facing short decision horizons would find it in their interest to “recycle” bad loans of troubled banks. In this environment, an insolvent bank can stay in business, and even raise more deposits, so long as it does not face severe liquidity problems that would eventually lead to disclosure of its insolvency.

d. Bank Concentration: The size and scope of financial service activities in most African financial systems have often been limited by policy. There is dominance of state-owned

Figure 2: Bank Investment Opportunities

Bank value

Risk ( )

Value under bank asset risk-shifting

V1*

V1

1* 1

Bank 1

Bank 2

Figure 5: Bank Investment Opportunities and Risk

Taking

28

banks and the banking sector is oligopolistic. Bank oligopoly is particularly worrisome. For instance, in Uganda 4 foreign-owned banks account for 75% of deposits and assets. Similarly, 4 banks account for 65% of market share in Ghana, with Ghana Commercial Bank being one of them. In Tanzania, 4 foreign banks account for 49% and 3 local banks account for 49% market share. This highly concentrated banking structure observed in Sub-Sahara Africa allows only for very limited deposit and lending competition. Hence, this leads to reinforcement of high lending and deposit spread environment that is discussed above (Haque, Hauswald, and Senbet 1997). Governments, which practice issuance of large quantities of high yielding securities/bills to meet their fiscal requirements, only exacerbate the problem. The financial sector reforms have lead to the decline in the public share of domestic credit, but government and public enterprises continued to enjoy the largest proportion of bank credit in many countries (See Table 5). e. High Interest Rate Spreads: Financial liberalization could put upward pressure on the gross interest margin since competition in the credit market resulting in the reduction in the barriers to entry of foreign and domestic competitors increases slowly relative to that of deposit market. The readjustment of bank cost structure may materialize only slowly. Thus, under the reform programs, an initial increase in the spread between lending and deposit rates would be expected. But then with more efficient banking practices, the spread should narrow. Moreover, financial liberalization should be accompanied by a reduction in the reserve requirement, which in turn should increase loanable funds, putting downward pressure on the cost of funds. These developments should reduce the spread or the interest rate margin (the gap between the lending rate and the deposit rate). However, in most countries, lending rates did not only rise sharply during the reform years; they rose much faster than deposit rates. In many cases, the spread continued to widen (see Table 6).

Table 6 [Interest Rate Spread and Dysfunctional Intermediation]

The good news is that financial sector reforms yielded a desirable outcome of positive real interest rates (as expected). However, the exorbitantly high real interest margins (spreads) are particularly disappointing and remain another African puzzle. Coupled with a failure to produce the desired results of increased investments and savings, the high spreads constitute a devastatingly negative outcome of financial sector reforms in Africa. This phenomenon points to dysfunctional financial intermediation as well as grossly inadequate competition in the African financial systems. In particular, these systems are characterized by the oligopolistic behavior of a few commercial banks and state dominance. Financial sector competition remains very limited in a large number of counties including Botswana, Malawi, Morocco, Mauritius, Swaziland, South Africa, Zambia and Zimbabwe, where gross interest rate margins have rather increased. Most of the countries where financial sector competition has been limited are in Southern Africa. Table 6 also shows improvements in the most recent years suggesting growing competition in the financial system as well as enhancement of contract enforceability in the credit markets. The interest rate margins have been declining recently for most countries including Algeria, Egypt, Kenya Mozambique, Namibia, Nigeria, Tanzania and Uganda. Over the 1992-2003 period, for instance, the gross interest margin in Tanzania declined by over 37%, with an annualized fall in gross interest rate margin of 5%. Looking ahead, countries, which build institutional capacity with multiple financial institutions and increasing availability of non-bank finance, can foster competition in the financial systems and experience declining spreads as well as better quality financial intermediation. The introduction of the stock market is one way to foster such an outcome (see below).

29

Table 6 Interest Rate Spreads

Gross Interest Rate Margin

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Growth (%)

Annualized Growth (%)

Algeria 4.00 3.00 4.50 2.75 2.50 2.50 2.50 3.25 3.25 2.75 -31.25 -3.68

Botswana 1.50 1.43 3.49 4.31 4.07 4.83 4.81 5.17 5.24 5.60 5.66 6.10 306.67 12.40

Egypt 8.30 6.30 4.70 5.60 5.10 4.00 3.60 3.80 3.70 3.80 4.50 5.30 -36.14 -3.67

Kenya 15.20 16.20 13.53 11.09 12.83 14.24 13.03 12.96 12.44 -18.16 -2.20

Malawi 5.50 7.75 7.00 10.06 19.00 18.04 18.61 20.37 19.88 21.21 285.64 14.45

Mauritius 7.06 8.18 7.88 8.58 10.04 9.84 10.64 10.71 11.16 11.32 11.12 11.47 62.46 4.13

Morocco 6.20 7.10 8.10 8.30 8.60 8.80 41.94 6.01

Mozambique 16.13 11.77 9.34 7.63 8.72 12.54 -22.26 -4.11

Namibia 8.85 8.41 7.87 7.67 6.60 7.48 7.78 7.66 7.89 7.74 6.03 5.94 -32.88 -3.27

Nigeria 6.72 8.41 7.39 6.70 6.78 10.63 8.07 7.48 9.58 8.18 8.10 6.49 -3.42 -0.29

South Africa 5.13 4.66 4.47 4.36 4.61 4.62 5.29 5.76 5.30 4.40 4.98 5.20 1.36 0.11

Swaziland 5.43 6.46 6.71 7.61 7.59 7.50 7.58 7.56 7.47 7.10 7.23 7.04 29.65 2.19

Tanzania 18.20 20.38 18.44 15.41 14.14 14.19 15.45 13.14 11.43 -37.20 -5.04

Tunisia

Uganda 12.00 9.00 9.53 9.50 12.82 13.08 14.19 13.54 9.09 -24.25 -3.04

Zambia 6.07 24.42 15.29 11.65 12.21 18.72 20.25 18.56 22.82 21.87 18.62 206.75 9.79

Zimbabwe 6.88 8.11 8.81 12.65 13.95 13.00 16.88 18.04 24.07 18.10 61.37 792.01 22.01 Source: World Development Indicators (various) and authors’ calculations

30

3. African Bank Privatization and Performance There has been a wide spread privatization of state-owned banks in Sub-Sharan Africa in the wake of the extensive financial sector reforms that have taken place in the region. This is particularly welcome given the available evidence that privatized firms generally outperform state owned enterprises. Consequently, the conventional wisdom for state ownership of banks is being challenged. The convention is that state owned banks serve underserved markets, particularly rural areas and small enterprises. On the other hand, it is often alleged that private banks tend to concentrate their lending, particularly to urban areas and large enterprises, while simultaneously being prone to costly banking crisis. On the contrary, the growing evidence is that state ownership is associated with less financial development, less growth, and less bank performance, and less financial stability (Barth, Caprio and Levine 2001). In recent years there has been sharp decline in the state ownership of banks in developing countries, including Africa, although some countries (e.g., Ethiopia) continue to resist bank privatization. Africa experienced the sharpest decline in state ownership during the 1999-2002 period (Clarke, Cull, Shirley, 2004). Using the data from the World Bank Privatization database for the list of privatized banks in Africa and the share issue dates from the supplemental appendix to Megginson (2000), we examine the pre- and post-privatization operating performance of the privatized banks relative to that of the rival banks. The measures of performance are asset quality, management efficiency, earnings ability, and labor (employment levels and productivity). As we can see from Table 7, there was deterioration in the asset quality of the privatized banks. Loan loss provision also increased significantly in the post privatization period. Moreover, the profitability of the privatized banks worsened in the post privatization period; so was the performance measure in terms of return on equity (ROE). However, the privatized banks were more profitable than their rivals, although the difference was not statistically significant. In terms of operating efficiency, we do not observe any perceptible change in the efficiency of the privatized firms vis-à-vis the rivals. Overall, the post privatization operating performance for the privatized banks in these African countries did not improve but actually worsened.

Table 7 [Bank Privatization and Performance]

The evidence from capital market data is also consistent with the worsening performance effect of bank privatization in Africa. The results presented in Table 7a (bank privatization and stock market performance) show that the privatized banks realized negative abnormal returns. Investors who bought the shares of the privatized banks on the first day of trading and held them for 5 years lost 27% of their wealth. The performance of privatized firms worsened after year four. However, the returns are not statistically different from those of the rival banks. The poor operating and stock market performance of the privatized banks in Africa suggest that there have not be gains from bank privatizations. This is contrary to the overall evidence presented for other regions (Clarke, Cull, and Shirley, 2004). A couple of factors may be at work here. First, the privatization data is based on share issuance, and African countries have malfunctioning (as discussed below) stock markets with limited capacity for monitoring. Megginson, et al, (1994), for instance, suggest that capital market monitoring that accompanies privatization elicits post privatization performance improvements. Moreover, a well-developed and active

31

Table 7 Bank Privatization and Performance

This table contains the median operating performance measures for the sample firms the operating performance measures analyzed include Asset quality, Management efficiency, Earnings ability and Labor (employment levels and labor productivity). The z-statistics for the Wilcoxon signed rank test of the difference in median ratios between the two samples are presented in Panel C. The median ratios

and z-statistics are reported where enough observations exist to compute the z-statistic.

Panel A: Asset Quality Ratios: Provision-Loan-ratio (Gross) Impaired Asset-Loans Ratio

Year Privatized Banks Rivals Difference (Priv-Rival) Privatized banks Rivals Difference -1 2.38 (0.89) - - - -

- - - - - - 0 3.06 (1.34) 0.27 (1.36) 2.79 (1.74)*

- - - - - - 1 1.97 (1.89)* 1.43 (2.61)*** 0.54 (0.80)

5.73 (0.01) 7.33 (1.90)* -1.6 (0.59) 2 3.69 (1.89)* 1.42 (3.60)*** 2.27 (1.33)

31.61 (0.89) 6.45 (2.62)*** 25.16 (1.06) 3 2.00 (2.10)** 0.94 (4.19)*** 1.06 (0.80)

6.33 (1.34) 7.29 (3.03)*** -0.96 (0.51) 4 2.54 (2.10)** 1.31 (4.61)*** 1.23 (0.57)

20.25 (1.34) 7.25 (2.77)*** 13.0 (1.27) 5 1.04 (1.64)* 1.21 (3.97)*** -0.17 (0.33)

15.26 (0.89) 6.08 (1.70)* 9.18 (1.15) Pre-mean 2.83 (1.86) - - - - - - - - - Post-mean 3.05 (2.72)** 1.44 (15.10)*** 1.61 (1.43)

21.64 (2.40)* 9.34 (6.58)*** 12.30 (1.35) Difference (Post-pre) -0.22 (0.12) - - - -

Panel B: Profitability

Return on Assets (ROA) Return on Equity (ROE)

Year Privatized banks Rivals Difference Privatized banks Rivals Difference -3 3.41 (0.89) - - - -

28.19 (0.89) - - - - -2 4.27 (0.89) - - - -

27.55 (0.89) - - - - -1 3.53 (1.34) - - - -

12.52 (1.34) - - - - 0 4.23 (1.33) 1.89 (1.90)* 2.34 (0.30)

16.25 (1.33) 33.25 (1.90)* 17.0 (1.19) 1 3.56 (1.64)* 2.43 (2.10)** 1.13 (0.96)

16.52 (1.64)* 29.24 (2.10) -12.72 (1.39) 2 1.24 (0.54) 2.05 (3.55)*** -0.81 (0.63)

13.94 (0.54) 21.77 (3.44)*** -7.83 (2.11)** 3 2.22 (0.25) 2.32 (4.07)*** -0.10 (0.60)

12.58 (0.59) 16.86 (3.58)*** -4.28 (0.59) 4 1.49 (0.51) 1.88 (3.77)*** -0.39 (0.33)

15.35 (0.71) 16.19 (4.02)*** -0.84 (0.62) 5 2.22 (1.10) 1.70 (2.05)** 0.52 (1.19)

21.97 (0.93) 15.89 (1.83)* 6.08 (1.00) Pre-mean 3.23 (2.36) - - - -

21.47 (1.84) - - - - Post-mean 2.55 (1.62) 1.84 (5.40)*** 0.41 (0.69)

10.45 (1.23) 10.60 (2.80)*** -0.15 (0.17) Difference (Post-pre) 0.68 (0.22) - - - -

11.02 (0.63) - - - -

32

Panel C: Efficiency:

Cost-to-Income Net interest Margin

Year Privatized banks Rivals Difference (Priv-Rival) Privatized banks Rivals Difference -1 80.85 (0.89) 73.92 (1.66)* 6.93 (0.69)

3.10 (0.89) - - - - 0 70.03 (1.64)* 65.66 (1.90)* 4.73 (0.12)

12.36 (1.34) 4.40 (1.66)* 7.96 (1.95)* 1 73.17 (1.65)* 66.20 (2.61)*** 6.97 (0.08)

7.09 (1.34) 3.20 (1.90)* 3.89 (0.01) 2 83.04 (1.89)* 68.54 (3.60)*** 14.5 (1.18)

2.67 (1.88)* 7.05 (2.61)*** -4.38 (0.27) 3 81.03 (2.10)** 71.85 (4.19)*** 9.18 (1.48)

3.52 (1.89)* 3.20 (3.60)*** 0.32 (0.55) 4 85.04 (2.09)** 72.08 (4.36)*** 12.96 (1.98)**

2.32 (2.10)** 4.10 (4.27)*** -1.78 (2.10) 5 70.55 (1.65)* 73.46 (3.81)*** -2.91 (0.61)

3.10 (1.64)* 3.03 (3.71)*** 0.07 (0.43) Pre-mean 80.35 (5.63) 75.64 (8.85)*** 4.71 (0.30)

3.10 (1.56) - - - - Post-mean 80.61 (20.39)*** 83.65 (13.87)*** -2.91 (0.24)

4.10 (5.81)*** 5.08 (11.53)*** -0.90 (1.01) Difference (Post-pre) -0.26 (0.03) -8.01 (0.47) - -

-1.00 (0.62) Panel D: Changes in Employment

Growth in staff levels Year Privatized banks Rivals Difference 1 -1.21 (0.01) 0.12 (0.01) -1.33 (0.61) 2 0.70 (0.01) 2.66 (1.94)* -1.96 (1.03) 3 -1.22 (0.27) 2.66 (2.87)*** -3.88 (1.21) 4 1.54 (0.51) 0.87 (1.95)* -0.67 (0.59) 5 -2.06 (1.01) 1.10 (3.39)*** 0.316 (0.38) Post-mean -4.67 (1.00) 1.33 (2.69)** -6.00 (3.14)*** Difference (Post-pre) (1.35)

33

Table 7a: Bank Privatization and Performance from the Stock Market

This table contains mean and median long run returns for the privatized banks and their rivals. The returns are market-adjusted buy and hold returns (BAHR). The BAHR are the returns accruing to investors who bought the shares on the first day of trading and held the stock for 12, 24, 36, 48 and 60 months. The figures in parentheses are t-statistics for mean returns or z-statistics for the median returns or percentage positive. ***, **, * Indicates significance at the 1%, 5% and 10% level respectively.

Privatized Banks (N=7) Rival banks (N=27) Difference

Event period Mean

Return % Positive Median Return

Mean Return % Positive

Median Return

Mean Return

Median Return

1-12 -0.08 0.00 -0.08 -0.01 50 -0.01 -0.07

(-1.16) (-1.41) (-0.89) (-0.50) (0.00) (0.55) (-0.96) (-0.69) 1-24 -0.06 50 -0.02 -0.01 50 -0.01 -0.05

(-0.82) (0.00) (-0.55) (-0.30) (0.00) (-0.44) (-0.60) (-0.16) 1-36 -0.02 57 0.09 0.11 69 0.15 -0.13

(-0.13) (0.38) (0.08) (2.58)** (1.96) (2.29)** (-0.74) (-0.55) 1-48 -0.05 56 0.04 0.09 64 0.13 -0.14

(-0.30) (0.33) (0.01) (1.31) (1.57) (1.38) (-0.75) (-0.67) 1-60 -0.27 40 -0.26 -0.17 38 -0.17 -0.10

(-1.68) (-0.63) (1.43) (-2.57)** (-1.37) (-2.19)** (-0.57) (-0.71)

34

capital market allows the newly privatized firms greater access to capital needed to finance profitable projects. Second, the poor post privatization performance could be due to the fact that the sample firms are partially privatized. As shown in appendix 1, about 89% of the privatized banks in Africa are partially privatized, with the governments owning about 65% of the privatized banks. This leaves banks vulnerable to government intervention and the available evidence is that privatization performance improves with less government retention of shares (D’Souza, Megginson and Nash, 2001). This was corroborated by more recent evidence suggesting very limited privatization gains even when the government held a minority stake (Clarke, Cull, Shirley, 2004). This is not surprising in the face of the state’s multiple objectives which are politically driven and which detract from efficiency. The morale of the bank privatization experience in Africa is, thus, two-fold: (a) there is a need for the elimination of continuing government intervention and partial ownership of the privatized banks, and (b) there is a need to cultivate a deep and well-functioning financial system that can lead to proper gains from bank privatization. We will be taking the latter issue of the functioning of the African financial markets in the following sections.

C. Functionality of African Stock Markets The extensive financial sector reforms undertaken by African countries have produced a rapid increase in the number of the stock markets in Africa. The number grew from 10 in 1992 to 24 in 2004. The phenomenal growth was registered particularly in Sub-Saharan Africa exclusive of the established markets in South Africa (Johannesburg Stock Exchange) and Egypt. Actually the latter were established in 1880s. The African stock markets have emerged as a real potential basis for integration of the continent into the global financial economy. Already we have witnessed numerous Africa – based funds trading in New York and Europe. A particularly striking feature of capital market development has been an emergence of a regional stock market domiciled in Abidjan. This happens to be the only regional stock exchange in the world linking eight Francophone countries in West Africa. However, the markets remain the smallest of any region in terms of capitalization, except South Africa and are very illiquid (Senbet 1997). The issue of liquidity and functionality of the capital markets will be taken up in the next section.

Table 8 [Post-Reform Capitalizations of African Stock Markets]

1. Stock Market Liquidity and Depth Beyond mere capitalization, it is the functional efficiency of financial systems that contributes significantly to economic growth as discussed in the earlier section. African stock markets, thus, should be judged on the basis of their efficiency in carrying out these functions. Although the growth in the number of stock exchanges has been impressive, their existence alone is not consequential to economic growth. Judged on the basis of functionality as a guiding principle, these markets have been malfunctional. Except for the South African stock market, pre-emerging stock markets in

35

Table 8 Post-Reform Capitalization of African Stock Markets

(US ‘$000s) Country 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 % Growth Annualized

Growth (%)

Algeria - - - - - - - 306 303 199 145 -52.61 -17.03

Botswana 295 261 377 398 326 614 724 1,052 978 1,269 1,717 2,131 622.37 17.91

Cote d'Ivoire 483 414 428 866 914 1,276 1,818 1,514 1,185 1,165 1,329 1,650 241.61 10.78

Egypt 3,259 3,814 4,263 8,088 14,713 20,830 24,381 32,838 28,741 24,335 26,245 27,073 730.71 19.29

Ghana 84 118 1,873 1,649 1,492 1,138 1,384 916 502 528 740 1,426 1597.62 26.62

Kenya 637 1,060 3,082 1,886 1,846 1,824 2,024 1,409 1,283 1,050 1,676 4,178 555.89 16.97

Malawi - - - - 15 110 148 161 212 152 107 156 940.00 34.01

Mauritius 424 842 1,578 1,562 1,693 1,754 1,849 1,643 1,335 1,061 1,324 1,955 361.08 13.58

Morocco 1,909 2,651 4,376 5,951 8,705 12,177 15,676 13,695 10,899 9,087 8,319 13,152 588.95 17.45

Namibia 21 28 201 189 473 689 429 691 311 151 201 308 1366.67 25.08

Nigeria 1,221 1,029 2,711 2,033 3,560 3,646 2,887 2,940 4,237 5,404 5,989 9,494 677.56 18.64

South Africa 103,537 171,942 225,718 280,526 241,571 232,069 170,252 262,478 204,952 139,750 182,616 267,745 158.60 8.24

Swaziland 111 297 338 339 471 129 85 95 73 127 146 127 14.41 1.13

Tanzania - - - - - - 236 181 233 398 695 398 68.64 9.10

Tunisia 814 956 2,561 3,927 4,263 2,321 2,268 2,706 2,828 2,303 1,810 2,464 122.36 6.89

Uganda - - - - - - - - 37 34 52 36 -2.70 -0.68

Zambia - - - 19 195 705 301 280 236 217 231 217 1042.11 31.08

Zimbabwe 628 1,433 1,828 2,038 3,635 1,969 1,310 2,514 2,432 7,972 11,689 4,975 380.63 15.34

Total Africa 113,423 184,845 249,334 309,471 283,317 281,251 225,772 325,419 260,777 195,202 244,672 337,485 197.55 9.51 All Emerging Markets 981,617 1,664,045 1,822,103 1,893,625 2,223,895 2,133,165 1,775,267 2,948,429 2,608,486 2,243,446 1,871,265 1,836,748

87.11

5.36

Developed Markets 9,950,909 12,353,880 13,233,217 15,894,462 18,028,762 20,983,312 25,148,563 33,180,126 29,614,264 29,945,774 25,690,523 21,522,735

116.29

6.64

World Total 10,932,526 14,017,925 15,115,320 17,788,087 20,252,657 23,116,477 26,923,830 36,128,555 32,222,750 32,189,220 27,561,743 23,359,484

113.67

6.53

Africa/ Emerging Markets 11.6% 11.1% 13.2% 16.3% 12.7% 13.2% 12.7% 11.0% 10.0% 9% 13% 18%

Africa/ World Total 1.0% 1.3% 1.6% 1.7% 1.4% 1.2% 0.8% 0.9% 0.8% 1% 1% 1%

Source: S&P Emerging Markets Handbook 1997, World Development Indicators (various) and authors' calculation.

36

Stock Market Capitalization (US$billions)

00.5

11.5

22.5

33.5

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Year

US

D bi

llion

s

Total Africa All Emerging Markets

Relative Market Capitalization of African Capital Markets

0.00%

5.00%

10.00%

15.00%

20.00%

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Rel

ativ

e si

ze (%

)

Africa:Emerging Markets Africa:World Total

37

Africa are by far the smallest of any region, both in terms of number of listed companies and market capitalization. Thus, thinness is a major characteristic of the SSA markets. Moreover, the trading activity is minimal . As seen in Table 9, the stock turnover is extremely low in most countries, suggesting extremely low provision of liquidity and exit strategies. . Thus, the stock markets have been inactive and malfunctioning in terms of liquidity provision and information production. International investors are not investing in Africa. Most of the capital raised through IPOs or seasoned offering comes from African institutions and individual investors (UNDP 2003). The low liquidity (rather illiquidity), more than market size, should be of great concern to Africa in light of the earlier evidence linking market liquidity to economic growth.

Table 9 [Liquidity of African Stock Markets] It should be recognized that the inefficiency of the secondary market is a barrier to raising capital in the primary market when companies seek to make initial public offerings. This is a partial explanation for a dearth of new listings in African stock markets. Companies will also find it too costly in their secondary offerings (i.e., new issue of seasoned shares) in malfunctioning stock markets. The dysfunctionality of the stock markets is also reflected in their operational inefficiency. There are poor brokerage services and slow settlement and operational procedures where, in some countries, it takes months to execute a single transaction. This is partly due to problems in the design of market microstructure and lack of quality personnel.

2. Sources of Macro Risks

a. Macro-economic and Political Instability: Research has shown that country risk, by implication, macro-economic risk, is the predominant source of variation in stock returns across countries (as opposed to industry-specific shocks). High macro-economic and political instabilities lead to high volatility in the financial markets. Further, investors would be concerned about a source of political risk stemming from the odds of adverse changes in government policies. As is often said, the best policy is no change in policy. Unfortunately, Africa is abundantly endowed with abrupt changes in government policies and political climate. These abrupt changes have adverse consequences in financial markets. A case in point is the dramatic price swing in the Zimbabwe stock market. The Zimbabwe market, which rose phenomenally in 1996 (89.5%), moved down by more than 50% during the final quarter of 1997 in the wake of those dramatic government farm and pension policies5 (D. Gopinath, 1998).

b. Foreign Exchange Fluctuation: Hard currencies are readily hedged. High currency exchange

volatility is endemic to African economies, creating an impediment to foreign investments. In view of the dearth of hedging mechanisms through derivative markets (forward, futures, and options), an indirect approach would be to increase the number of export-oriented companies on the stock exchanges. In particular, those with exposure to hard currency exports should be targeted, so as to provide substantial hedging against local currency devaluation.

Table 10 [African Currencies and Changes in Values; also see Appendix 3 ]

The preliminary regression results in Appendix 3 show the adverse impact of currency depreciation on the performance of African stock markets.

5 The two policy changes are: (a) land reform to take over 1500 commercial farms - mostly white, and (b) a decision to pay $240 million in pensions to disgruntled veterans of the Zimbabwe independence war.

38

Table 9 Liquidity of African Stock Markets

Stock Market Liquidity (Turnover %)

Country 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Average 1990 Average

2000 Average

Algeria 0.3 1.7 1.5 - 1.2 0.3 1.4

Botswana 5.1 7.7 8.2 9.5 9.5 9.6 9.7 3.6 4.8 5.1 3.6 7.0 7.9 5.1 Cote d'Ivoire 0.8 1.4 2.8 1.6 2.1 1.9 2.1 5.6 2.8 0.7 1.2 2.1 2.3 1.7

Egypt 6.0 4.5 17.8 8.4 16.7 28.1 20.6 27.5 38.7 16.0 28.1 19.3 16.2 25.5

Ghana 4.2 4.0 1.3 1.1 4.3 4.3 2.7 2.0 2.5 2.9 2.9 3.2 2.6

Kenya 1.9 1.3 2.0 3.4 3.6 5.8 3.9 5.3 3.7 3.8 2.1 3.4 3.4 3.2

Malawi 6.8 3.7 4.2 13.8 2.8 6.3 5.2 6.8

Mauritius 2.4 4.6 5.4 4.4 4.8 8.1 5.6 4.7 1.8 10.3 4.5 5.1 5.0 5.4

Morocco 3.7 18.8 18.0 40.8 5.0 8.6 8.9 18.5 10.0 10.7 11.1 14.0 15.3 11.5

Namibia 9.0 1.6 8.7 3.5 3.0 3.2 7.1 5.3 64.2 11.7 4.8 22.1

Nigeria 1.1 1.0 0.7 0.7 2.0 3.6 5.5 4.9 6.2 9.2 8.1 3.9 2.4 6.9 South Africa 7.5 7.6 6.9 6.1 11.3 19.3 34.3 27.8 34.0 49.9 42.1 22.4 15.1 37.1

Swaziland 0.6 0.0 0.4 5.4 0.0 0.0 0.0 7.9 0.0 33.5 1.1 2.4

Tanzania 3.9 17.2 2.0 2.7 6.4 3.9 7.1

Tunisia 4.1 4.8 11.6 16.9 6.6 11.2 8.3 1.6 22.1 13.7 38.9 12.7 8.1 21.9

Uganda 1.9 1.9 - 1.9

Zambia 1.5 1.1 1.0 4.3 3.4 24.4 0.9 5.2 2.0 8.5

Zimbabwe 3.2 3.7 9.6 7.4 7.0 27.4 14.2 9.0 11.5 19.2 1.1 10.3 10.2 10.5 Total Africa 7.2 7.5 7.2% 6.8 10.9 19.0 29.1 26.3 35.0 39.6 35.1 20.3 14.3 32.5

LIQUIDITY –One measure of stock market liquidity is the Turnover Ratio = Total Value of All Market Transactions / Total Stock Market Value.The evidence presented in Table – shows that African stock markets are illiquid. The average stock in Africa has turned over 20 times a year.Some of the emerging markets have very low turnover ratios especially the smaller markets (Algeria, Cote d’Ivoire, Ghana, Uganda, Tanzania and Zambia.). The larger markets have higher turnover (South Africa and Egypt).

39

Table 9-cont’d Liquidity of African Stock Markets

Stock Market Liquidity (Turnover %)

Country 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Average 1990 Average

2000 Average

Sub-Saharan Africa .. .. .. .. .. 23.1 8 19.9 23 22.5 23.8low and middle .. .. .. .. .. 85.1 46.3 67.9 87.6 122.3 58

World .. .. .. .. .. 77.1 .. 86.8 87.6 74.7 123.6Source: Emerging Stock Markets Fact Book – 1997; World Development Indicator 2001, 2002, 2003 2004

Liquidity (Turnover)

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1997 1998 1999 2000 2001 2002 2003

Sub Saharan Africa Developing World

40

c. Afro-Pessimism/Contagion: In international news headlines, Sub-Sahara Africa still

conjectures up images of war, famine, massive corruption, failed projects, grossly undisciplined governance, and gross violations of human rights in international news. This is despite the extensive political, economic and financial sector reforms that have taken place in the region. This information gap has serious consequences for pre-emerging African stock markets and the financial systems in large. This may be conjecturing up a phenomenon called “Afro-pessimism”, which lead to high, and even untenable, political and investment risks as perceived by potential investors in Africa. This is, in part, captured by low ratings for creditworthiness of Sub-Sahara African countries as shown, relative to other regions (see Table 11), although they have displayed considerable improvement in the 1990s (an average rating of 18.1 in 1997 versus 28.7 in 2003). However, these ratings are still very low suggesting high country risk. As shown in the preliminary results of Appendix 3, country risk is bad for the African stock markets.

Table 11 [African Country Risk Ratings; Also, see Appendix 3 – Country Risk Effect]

Again, the perceptional risk is beyond the fundamental. Unfortunately, perception is reality in an environment characterized by grossly imperfect information, whereby it would be difficult to separate out good prospects from bad prospects. The average quality of the Africa “pool” may mask the high quality of genuinely reforming component countries due to the monolithic view of Africa as a single, troubled "country" (i.e., pooling equilibrium). In reality, Africa is a continent of much diversity in terms of how genuine the financial sector reforms are. This information gap can be minimized through the provision of timely and reliable data required for making estimates of investment risks in Africa. Consequently, there is a need for more extensive, detailed and reliable data capturing the diversity of Africa, along with data capturing the financial circumstance of private institutions within the formal financial system

d. Globalization and Capital Flow Volatility: In the earlier section we catalogued

mutual benefits of financial globalization to both Africa and global investors. The other side of financial globalization is that it engenders considerable risks, and the associated crisis, as recently witnessed in East Asia. The global risks stemming from volatility of the global financial markets, the large unfavorable international exchange rate fluctuations, and large unfavorable international interest rate movements manifest themselves in large unfavorable swings in international capital flows. For instance, it was witnessed that countries, that experienced large capital flows, suffered commensurately large and sudden outflows. The sudden and large collapse of capital inflows can be enormously costly. There could be sudden withdrawals of deposits, leading to credit crunch in the economy. Moreover, here will be unwillingness on the part of creditors to supply short-term credit even for liquidity crisis, and default and contagion of the type experienced in

41

Table 10

African Currencies: Currency Appreciation/Depreciation (relative to the USD) 1992 - 2002

Country Value of currency in 1992

Value of currency in 2002

% Change in the value of the currency

Annualized change in the value of the currency

Algeria 21.86 71.66 -227.81 -11.40 Botswana 2.23 5.4 -142.15 -8.37 Egypt 3.33 4.65 -39.64 -3.08 Ghana 520 8634.9 -1560.56 -29.10 Kenya 36.22 77.83 -114.88 -7.20 Malawi 3.6 87.27 -2324.17 -33.62 Mauritius 15.4 29.42 -91.04 -6.06 Morocco 8.89 10.42 -17.21 -1.45 Namibia 4.84 8.73 -80.37 -5.51 Nigeria 21.5 130.62 -507.53 -17.82 South Africa 4.8 8.66 -80.42 -5.51 Swaziland 4.2 8.65 -105.95 -6.79 Tanzania 297.71 992.22 -233.28 -11.57 Tunisia 0.96 1.37 -42.71 -3.29 Uganda 1133.8 1738 -53.29 -3.96 West Africa 271.49 625.85 -130.52 -7.89 Zambia 156.25 4600 -2844.00 -36.00 Zimbabwe 5.48 57.15 -942.88 -23.76

Source: Emerging Market Handbook, Liquid Africa and authors’ calculations

All the currencies have depreciated relative to the US dollar

42

Table 11 African Country Risk Ratings

Investment Climate

Institutional Investor Credit Rating 1996-2003 Country 1996 1997 1998 1999 2000 2001

Sept. 2002 2003

% Change Since 1996 Annualized % change

Algeria 22.8 24.5 25.8 26.5 33.1 30.6 31.5 41.6 82.46 7.81

Botswana 49.8 51.2 51.9 36.5 56.1 56.7 59 62.2 24.90 2.82

Cote d'Ivoire 18.5 20.1 22.2 25.5 24.1 18.5 18.5 15.7 -15.14 -2.03

Egypt 35.1 39.7 43.2 45.4 51 47.1 45.5 41.1 17.09 1.99

Ghana 29.6 31.5 30.3 30.7 29.5 25.4 25.7 25.8 -12.84 -1.70

Kenya 27.9 28.6 25.9 24.8 25 21.7 22.9 24.6 -11.83 -1.56

Malawi 19.7 21 19.8 19.5 19.6 17.9 19.6 18.8 -4.57 -0.58

Mauritius 50.8 51.9 53 53.9 54.6 53.9 53.5 53.9 6.10 0.74

Morocco 39.3 40.9 42.4 44.3 47.3 45.4 48.2 49.4 25.70 2.90

Namibia .. 38 37.4 39.1 40.8 39.8 4.74 0.93

Nigeria 15.2 15.3 16.4 17.9 18.1 18.3 17.6 20.2 32.89 3.62

South Africa 46.3 46.4 46.6 45.6 55.1 49.5 52.7 54.6 17.93 2.08

Swaziland 27 28.2 30.7 13.70 4.37

Tanzania .. 18.7 19.9 19.5 20.3 20.6 21.3 21.8 16.58 2.22

Tunisia 45.5 47.9 49 50.3 54.5 50.8 53.7 52.6 15.60 1.83

Uganda 16.1 20.1 19.9 21.7 22.7 21.4 20 20.1 24.84 2.81

Zambia 16.5 16 17.2 14.9 15.5 16 15.8 15.3 -7.27 -0.94

Zimbabwe 32.5 33.8 29.8 25.1 17.1 13 11.9 11 -66.15 -12.66

Sub-Saharan Africa 18.1 18.5 19.3 17.9 17.5 19 28.7 58.56 6.81%

Low and middle income 28.6 28.6 28.5 28 27 26.8 25.3 -11.54 -1.74%

World 38.6 35.3 36 37 33.9 33.5 30.4 -21.24 -3.35% Source: World Development Indicator, 2002, 2003, and 2004 Emerging Stock Markets Fact Book - 1997 Country risk rating of African countries by Moodys and Standard and Poors is a recent phenomenon. Institutional Investor Credit Rating ranks, from 0 to 100 (highest risk to lowest risk), the chances of a country's default. Investment climate in most of the countries has improved. Over the seven year period (during which data was compiled), the there has been improved from a low rating (high risk indicator) of 18.1% suggesting a high risk to about 29, an improvement of over 50%, with an annualized improvement of 6.8%. Only Cote d’Ivoire, Kenya, Ghana Malawi, Zambia and Zimbabwe have experienced deterioration in the investment/country risk rating. Algeria, Nigeria and Swaziland have recorded significant improvement in the investment climate. At the same time, the risk investor risk rating of low and middle-income countries and the world as a whole has worsened.

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East Asia (and earlier in Mexico). The damage associated with the financial crisis is evident in the dramatic declines in the asset and currency values.6 The currency values for Thailand, Korea, Indonesia, and Malaysia declined by, at least, 50%. So did the stock market and property values. The dramatic financial instability is accompanied by poor or declining economic performance. There has been shrinkage in GDP for the first quarter of 1998 for Indonesia, Thailand, Korea, Malaysia, Hong Kong, and even Japan. The unfavorable economic performance of the East Asian region is, in part, attributable to the negative wealth effect arising from dramatic declines in currency and asset values. In addition, the IMF austerity measures typically called for budget discipline (i.e., reduction in government spending and budget deficit) and increase in interest rates to avert further outflow of capital. The spillover effect of the Asian crisis was worldwide, including the US where the Asia-dependent companies experienced declining profits. The East Asian countries have been back in recovery and those who genuinely reformed their financial systems in responding to financial crisis are particularly performing well (The Economist, July 2002).

e. Lack of Risk Control Mechanisms and Talented Financial Manpower: The financial

systems require a sophisticated financial manpower, as they become increasingly sophisticated with the advancing technology and multiplying financial products. Inadequately trained manpower, along with inefficient management of these financial systems, contributes to their dysfunctionalities. This serious problem is evident in African banking systems, despite serious attempts to improve conditions through training programs. However, these programs have been limited and inadequate (Aryeetey and Senbet, 1999).

POLICY GUIDES: Building Capacity of African Financial Systems We have taken a functional perspective in providing diagnostics of the current African financial systems. The inadequacies of the banking systems in providing quality intermediation and promoting resource allocation have been noted. So have the inadequacies in regulatory and supervisory schemes. The rapid growth in the number of the stock markets is a welcome development particularly in its potential to foster competition in the financial system and promote more efficient allocation of capital. However, its features in terms of liquidity provision and exit strategies are grossly malfunctional. The dysfunctionalities in the African financial systems and its inadequacies in resource allocation have contributed to continuing marginalization of Africa in the global financial economy. The shortage of domestic resource mobilization, marginalization in the global markets for financial capital, coupled with shrinking official aid flows is at the heart of tremendous financing gap facing the region. In this section, we wish to catalogue policy prescriptions to help develop and enhance capacity of African financial systems toward the goal of filling the severe financing gap. Again, we will be using a functional perspective as guiding principle. As discussed in the earlier sections, the channel for financial sector development to impact economic development is through the multiple functions that the systems perform (e.g. liquidity provision). Promoting economic development has a long-run implication for poverty alleviation in Africa. A. Domestic Financial Sector Development versus Financial Globalization It would be tempting to think that, rather than grappling with the immense challenges facing the domestic African financial systems, African countries can bypass those and access global financial markets to meet the severe financing gap. This temptation is fueled by the prospect of domestic companies cross listing in

6 See Gande, John, and Senbet (2004) for the role of distorted incentives in making emerging economies more vulnerable to financial crisis and the proposed mechanisms to prevent financial crisis. See the AERC plenary synthesis by Senbet (1998) for more detailed analsis of global financial crisis and its implications for Africa.

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foreign stock exchanges and /or issuing depositary right securities traded on these exchanges. This view is misguided. While financial globalization can be an important complement, it cannot be an absolute substitute for domestic financial sector development. In fact, a vital source of integrating Africa into the global financial economy is the existence of deep and well-functioning domestic financial systems, including local banking systems and local stock markets. Well-functioning domestic financial systems are vital for domestic resource mobilization, since they provide incentives and profitable options for domestic capital to be retained. Retention of domestic capital is crucial in view of massive financial capital flight from Africa. Thus, financial sector development goes beyond coming up with measures for financial globalization as a means of attracting foreign capital inflows. It also seeks measures to mobilize domestic investor interest through the cultivation of attractive investment opportunities to channel savings within a domestic economy. Africa has potential channels for investment opportunities with the potential for wider local participation in the stock markets, credit markets, mortgage markets. As in other countries, investor participation is possible directly or indirectly through such vehicles as pension plans, insurance policies, mutual funds, etc. Domestic investors are also more likely be better informed about economic opportunities in the country than those in the other countries and domestic financial sector development is a one mechanism of empowering domestic investors. Thus, it is crucial to create incentives for the development of domestic channels for attractive investment opportunities as part of a broad agenda for financial sector development.

Building world-class financial institutions and intermediaries in Africa, such as merchant banks, mutual funds and trade credit providers, will help provide the necessary financial infrastructure for strong capital markets. While financial institutions have been the beneficiaries of recent private equity investments, a significant share of the international investments in Africa to date have targeted infrastructure development, energy and natural resource development, and communications firms. However, interest is growing in financial sector investment opportunities. Just recently, a fund was established to invest in privatized African banks. Building on this momentum, the U.S. government should consider establishing a private equity fund that focuses on African financial institutions and intermediaries, particularly those that invest longer term.

B. Designing Efficient Regulatory Schemes and Safety Nets The current regulatory and supervisory systems have not been effective in most African countries. This is in part reflected in the prevalence of banking failure and distress even in those countries, which have reformed extensively. On the extreme, some regulatory regimes have been too strict and detract from optimal bank risk-taking that is vital for efficient resource allocation in the economy. At the outset, it should be recognized that the purpose of banking regulation is not elimination of banking failure altogether but to curtail general, systemic, banking crisis. This is done with an appropriate regulatory and supervisory scheme that relies on capital adequacy requirements, surveillance on asset risk choices, and fast resolution of crisis. Below we discuss the efficacy of the common features of a bank regulatory scheme.7

1. Restricting Bank Asset Choices One way to regulate bank behavior is to impose mandatory restrictions on bank asset choices so as to limit bank risk-taking. However, the regulatory restriction of bank asset risk choices can be 7 Financial globalization can have a spillover effect on bank behavior and the associated regulation. As suggested by Kane and Rice (1998), the discipline coming from globalization brings banking crisis more in the open. They argue that the severity of such crises is diminished, since globalization will make it less likely that regulators keep banking insolvency underground while increasing the social cost on taxpayers. The policy implication is then straightforward. Encourage entry by foreign banks into Africa as a mechanism for pressure and market discipline

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counterproductive. Often, such restrictions boil down to regulating banks to a common pool of risk. The regulatory corrective actions should not be designed to homogenize all banks to some common pool of risk. Such restrictions on asset choices may lead to socially counterproductive outcomes. Banks are characterized by differential investment opportunity sets (e.g., rural banks versus urban banks), with different risk choices and hence differential value creation strategies. Consequently, pushing banks to a common pool of low risk investments leads to inefficient allocation of resources in the economy. In this sense, capital regulation is superior to asset regulation. Under capital regulation, on the other hand, the bank's own incentives would limit the risk shifting.

2. Regulating through Capital Adequacy Requirements Capital regulation is a useful scheme in terms of reducing risk-shifting incentives of banks. Since the degree or risk distortion is larger with greater leverage (lower bank capital), regulatory measures designed to move a bank, which is critically undercapitalized, to a higher level of capitalization will reduce incentives for excessive risk-taking. However, capital regulation has only limited effectiveness in controlling risk incentives. Since banks may have different opportunities to exploit risk within any capital zone, categorizing all within the same zone into identical risk classification is inappropriate. In this sense, capital ratios are poor proxies for measuring bank safety (see John, Saunders, Senbet, 2000). This point brings forth the danger of standardizing capital adequacy requirements across countries (e.g., the Basle accord), since capital regulatory rules cannot be used to fit all banks even in a single country. At least such schemes should be country-specific (see Kane and Rice, 1998 for alternative views).

3. Designing Appropriate Deposit Insurance Scheme A debate still continues on the relative efficacy of explicit and implicit insurance of bank deposits. The debate is not resolved by abolishing deposit insurance altogether. Even in countries that lack formal or explicit deposit insurance schemes (i.e., most African countries), deposits are implicitly insured. Often banks which are presumed to be too big to fail are bailed out by governments to minimize the adverse impact of banking crisis on society. Deposit insurance can play a potentially useful function in enhancing the stability of financial institutions and helping to reinforce their delegated monitoring functions. However, given the already shaky state of African financial institutions, it is even more important that any such schemes introduced are incentive compatible and do not work to actually increase risk-taking incentives of financial institutions and hence enhance financial sector instability (see Cull, Senbet, Sorge, 2004). This suggests that rather than importing deposit insurance systems, with all their imperfections, existing in developed countries, such as the US, African schemes should be modeled so as to avoid such mistakes. One clear advantage of explicit insurance is that the regulatory agency can charge an insurance premium, and this reduces pressure on government budget. Such is not possible with implicit insurance. An additional and indirect advantage of explicit deposit insurance is the pricing of the insurance itself can be used in the regulatory process, since it has implications for bank incentives (see below). 4. Regulating Through Incentives Features of Management Compensation The regulatory schemes involving bank capital and assets can be improved upon by explicit consideration of the incentives of bank decision-makers (or top management). The extent to which bank management is aligned with shareholder interests depends on the structure of compensation in place. Hence, bank regulation can be more efficient if it takes account of these incentive features of compensation in pricing deposit insurance and disciplining bank risk behavior. It can be shown (see John, Saunders, and Senbet, 2000) that managerial compensation interacts with capital regulation to induce bank risk choices that are optimal from the standpoint of the society. The principal reason is that the risk shifting incentives embodied in bank equity can be mitigated through appropriate design of managerial compensation contracts. Consider, for instance, the incentive features of management compensation involving fixed salary, bonus, and equity participation. Designing an optimal structure can produce the right risk

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incentives for bank management so that they would be neither overly risk aggressive nor overly conservative. This calls for fair pricing of deposit insurance premium, reflecting the incentive features of bank management compensation. If so, it pays bank owners to pre-commit to socially optimal risk levels by designing (declaring to the government regulator) an optimal compensation structure with the appropriate incentive features. Thus, African bank regulators should seriously consider adopting an incentivized regulatory system. 5. Fostering Bank Competition and Accelerating Bank Privatization Programs Sub-Saharan African financial activity is largely characterized by the oligopolistic behavior of a few commercial banks (in several cases, government-owned). The absence of adequate competition is reflected in the large gap between deposit rates for savers that tend to be very low, and interest rates for borrowers that tend to be very high. Moreover, there is evidence that banks’ returns on equity (ROE) are higher in Africa than in other developing regions. 8 By cultivating channels for firms to issue various debt instruments and to raise equity, while simultaneously providing more long-term options for saving and asset management for investors, financial activity can becomes more market-efficient and helpful for economic growth. Privatization is one way to curtail state dominance of the banking system and foster banking competition. However, the performance outcomes of African bank privatizations have not been encouraging both from the standpoint of operating performance and efficiency (see Table 7 and 7a). As argued earlier, the continuing partial state ownership of these banks interferes with the full achievement of gains from bank privatizations, and as a policy matter, privatization programs should be genuine and devoid of government intervention. Partial privatizations detract from achieving performance and efficiency gains from privatizations. Finally, the emergence of non-bank financial institutions and activities would be an important avenue for fostering competition in the African financial systems. The development and building capacity of African stock markets can be viewed in this same framework, because they allow for mobilization of capital beyond traditional bank savings accounts apart from injecting competition into the system. Moreover, the non-banking systems can allow for large scale privatizations of the state-owned enterprises (see below – privatization through the stock markets). Like-wise, African financial systems should create an environment that enables the development of mutual funds or unit trusts as well as pension funds and insurance companies. 6. Designing Efficient Stock/Capital Market Regulation

Capital markets cannot be expected to develop without credible legal and regulatory schemes that promote, rather than inhibit, private initiative, whereby investors and savers build confidence in the functioning of markets. This is also a foundation for fostering regional stock markets and attracting international investments, with the ultimate integration of Africa into the global economy. On the other hand, it is dangerous to over regulate capital markets and take a paternalistic view to investors. It is not the job of the regulator to determine what is best of the investor, but to create an environment in which an investor makes an informed decision. Thus, the regulatory emphasis should be on fairness, full disclosure, and transparency. Government regulation of securities markets, particularly stock markets, should be more of an oversight over self-regulatory agencies, such as the stock exchanges and brokerage industry. Self-regulatory organizations design rules for business operations and professional conduct of members who are properly licensed. The oversight function itself is typically done by securities and exchange commissions (SECs), which are organs of the government. Self-regulation builds on the capacity and wisdom of men and women inside the member firms that participate in the capital market process directly 8 To be completed

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rather than government bureaucrats who lack intimate knowledge of the day-to-day functions of markets, which are increasingly sophisticated. C. Measures for Increasing Depth and Liquidity of African Stock Markets

1. Fostering Public Confidence and Informational Efficiency At the core of the functioning of the financial markets is maintenance of public confidence and informational efficiency through transparent and credible financial disclosure rules. Transparent and trusted financial statements are a fundamental element of information about public and private firms The confidence factor is particularly crucial in the context of Africa. Confidence cannot be achieved by mere legislation. Public confidence is fostered by an even playing field, with strict enforcement of existing rules. The mere existence of legislation, which declares and grants inalienable property rights, is inconsequential. There ought to be an independent judiciary strongly enforcing and protecting these rights. The government’s role is vital in this regard in ensuring enforceability of private contracts and accounting procedures and legal standards. Thus, capital market development and functioning requires regulatory schemes that promote, rather than inhibit, private initiative, whereby investors and savers build confidence in the functioning of markets.

2. Developing Incentives for Listing

Some African governments already give tax incentives for listed companies. This incentive is designed to encourage companies to list their shares on the stock exchange and thereby help develop the capital markets. For example, Ghana’s regular corporate tax rate is 32.5%, but it is 30% for listed companies. Zambia’s regular corporate tax rate is 35%, but it is 30% for listed companies (ACM Forum Quarterly Newsletter, Jan 2003). It would also be useful for large multinational companies already operating in Africa to consider mobilizing financing locally either through issuance of debt or equity in the domestic markets. Their participation can help deepen the domestic capital markets. This requires partnership with the respective countries from which these MNCs originate, since companies do benefit from donor subsidized financing or risk insurance mechanisms, such as OPIC. 9 Also, strengthening local insurance, pension, and social security institutions can increase domestic savings and improve the quality of investment decision-making. Another impediment to listing is limited knowledge or lack of awareness about accounting and disclosure requirements for listing. It is important stock exchange authorities design a systematic program to assist firms in meeting these requirements. This could be in-house or with technical assistance from the advanced countries with well-established stock markets. The level of awareness should be such that companies are able to list not only locally but also cross-list globally. Thus, it is important to bring African firms, stock exchanges, market participants and securities regulators to avail themselves of best international practices in listing requirements.

9 According to Applegarth’s report to the US State Department (March 2004), Chevron/Texaco recently raised financing in Angola. Also, the U.S. Export-Import Bank recently provided a guarantee for a bond issuance on South Africa’s bond exchange in connection with financing for the purchase of U.S. manufactured aircraft. According to the report, the bond is supported by the full faith and credit of the U.S. government. This provides an opportunity for local investors to access an investment grade security while simultaneously increasing US exports to Africa. This is another example of mutual gains from globalization.

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3. Consolidating African Stock Markets Stock market consolidation and regional cooperation of African stock markets is an important vehicle toward pooling resources and building capacity of the illiquid and thin markets. These efforts are already under way. Regional stock exchanges are being created along linguistic lines. The francophone countries of West Africa have formed the first regional stock exchange, the Abidjan-based Bourse régionale des valeurs mobiliéres (BVRM) in 1998. The BVRM comprises the equity markets in Benin, Burkina Faso, Cote d’Ivoire, Guinea-Bissau, Mali, Niger, Senegal and Togo. Currently on the drawing board, the Anglophone countries of West Africa are contemplating forming a regional stock exchange under the umbrella of the ECOWAS. Similarly Kenya, Tanzania and Uganda have mooted the idea of forming a regional stock exchange, so have Southern African Development Community (SADEC) stock exchanges proposed the idea of a regional stock exchange. Regionalization of African stock markets should enhance mobilization of both domestic and global financial resources to fund regional companies, while injecting more liquidity into the markets (Senbet, 1998). The establishment of regional securities and exchange commissions, regional self-regulatory organizations, regional committees to promote harmonization of legal and regulatory schemes, and coordinated monetary arrangements (e.g., via currency zones) are among the mechanisms for regional integration. In particular, the tax treatment of investments must be harmonized, since tax policy is an important incentive or disincentive both for issuers and investors. Ultimately, the regulations, accounting reporting systems, along with clearance, settlement and depository systems, should conform to international standards. The following are some crucial elements of stock market consolidation or regionalization.

a. Harmonizing Rules and Regulations: Regionalization requires a strong commitment on the

part of African economies to harmonize legal and regulatory schemes, accounting and disclosure rules, tax regulations and incentives, and fiscal and monetary policies. Indeed, cross-border monitoring and enforcement of laws may enhance competition among the member countries in the region and enhance public confidence in the markets. Thus, as a prerequisite to large-scale cross-border trading, the infrastructure for the domestic capital markets and the regulatory regimes need to be strengthened.

b. Synergizing Development Efforts in Human Resources: Regional co-operation in capital

market development calls for a regional approach for skills development, training programs, and research and information collaboration. Thus, it should be clear that Regionalization or sub-Regionalization is an essential element facing the continent in its effort to develop and build capacity of capital markets, as well as integrating into the global economy.

c. Pooling Resources for the Production of Capital Market Data and Research: As discussed

earlier, there is considerable information gap surrounding African financial systems in the eyes of global investors as well as local investors. A comprehensive effort in developing and building capacity of African stock markets and consolidation of these markets requires a research and information arm. This is another area of synergy and team effort calling for regional co-operation. In the short-run it would be desirable to leverage the activities of some important institutions that are already in place, since they can anchor the collaborative effort in setting up the research and information arms of stock market development in Africa. Such existing institutions include the African Economic Research Consortium (AERC), United Nations Economic Commission for Africa (UNECA), African Development Bank (ADB), International Development Research Centre (IDRC), and New Partnership for African Development (NEPAD), etc. Of particular need is the existence of deep capital market and banking databases allowing for first-rate research to be conducted by African financial economists as well as others outside Africa. This should eventually lead to the establishment of a frontier Africa index or regional indices monitored both by practioners and researchers. By the same token, mechanisms should also be in place to get coverage of African markets in the global press and Wall Street research

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departments. Governments may even play a role to facilitate research coverage of companies on other African exchanges and the development of a frontier Africa index or regional indices.

4. Privatizing Through African Stock Markets

Stock markets can be an important avenue for privatization, and there is now a growing number of African state-owned enterprises which are using this vehicle for privatization (e.g., Kenya Airways). See Table 13. These stock market-based privatization programs contribute directly to the depth of the stock markets through increased supply of listed companies. This should be a welcome development in view of the observed thinness and illiquidity of African stock markets. In addition, there are less obvious benefits of privatization of state-owned enterprises through the stock market. First, state-owned enterprises are brought to the discipline of stock markets (recall the governance and control function of stock markets discussed earlier). Consequently, privatization is one way to take advantage of the multiple functions that the stock markets provide. Given the fact the heavily subsidized state-owned enterprises in Africa generally lack effective monitoring mechanisms that curtail inefficiencies resulting from mismanagement, and face little competition, bringing them to the discipline of the stock markets should be greatly encouraged.

Appendix 2 [African Privatizations through the Stock Markets]

Second, the stock market vehicle is an important means of depoliticizing privatization programs, since it makes it possible for large-scale programs to take place at fair pricing of assets to be sold. Third, local stock markets provide an opportunity for local investor participation through purchases of privatization shares. This helps alleviate some concerns about foreign grab of privatization assets. Moreover, such privatization programs foster diversity of ownership of the economy’s resources and help alleviate the concern that the stock market is just for the elite. To the contrary, privatization through the stock market, as opposed to an outright sale to an individual or a favored group, promotes distribution of ownership. Further, privatization through the stock market increases public awareness about the market through a creation of first time buyers of market instruments. Institutional funds or unit trusts are effective means of local/small investor participation in large-scale privatization, suggesting another rationale for creating an environment that fosters the development of such funds and alleviate concerns concerns that stock markets are for the elite. 10

5. Building Capacity in Human Resources and Training Programs Global financial markets have become highly sophisticated in recent years with the advancing information technology. They are increasingly characterized by advanced and exotic securities, including a variety of derivative securities, demanding that market participants stay abreast of recent advances. Indeed, derivatives have gotten their way into Africa. They are useful mechanisms in terms of risk control and hedging, but if mismanaged, they lead to financial disasters. This is just to dramatize the point that training of financial manpower should be at the forefront of financial market development in Africa. It can be done through improved business school curricula in universities and training programs at capital market institutions, including securities and exchange commissions, central banks, stock exchanges, etc. It is a basic characteristic of well-functioning markets that they have well-informed participants: investors, investment advisors, brokers, accountants, government regulators, and self-regulators. Such

10 Privatization should also include financial institutions so that they can perform their proper function of delegated monitoring and help achieve efficient allocation of resources.

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market participants and regulators are in short supply particularly in Sub-Saharan Africa. Apart from University programs, there should be specialized training programs to produce financial manpower and regulatory force that is appropriate for well-functioning capital markets. This is an area calling for regional co-operation and approach. Indeed, a regional approach for skills development, training programs, and research and information collaboration, facilitates the development of regional markets (see above). Human capital development should be thought of more comprehensively to include the banking sector. Capacity building in risk assessment and control is vital for banks to carry out their functions in building information capital. Banks, that fail to develop the capacity of risk assessment and monitoring of optimal management of their loan portfolio, become disinterested in investing in information capital which is crucial for the development and functioning of financial systems and integration of other-wise locally fragmented markets. 6. Fostering an Environment for Good Corporate Governance

There are natural conflicts of interests among parties to an organized firm, particularly between management and shareholders (owners of the firm), and even between shareholders and bondholders (see Figure 1). There ought to be appropriate mechanisms available to stakeholders of a corporation to exercise control over corporate insiders and management so that stakeholder interests are protected. Corporate governance provides such mechanisms. One familiar element of corporate governance is the board of directors, but more recently its effectiveness has been called into question. The growing consensus is that the board has to be independent of the chief executive officer, through appointments of directors who are outsiders with no serious business interests with the firm. In fact, the audit committee of the board should be composed entirely of outside directors. Moreover, it is often suggested the audit committee should take the responsibility of appointing an external auditor (see John and Senbet (1998) for the specific elements of board effectiveness). The recent corporate scandals in the United States involving companies, such as Enron and WorldCom, are attributable to the failure of corporate governance. In particular, the board members and external auditor were hostaged by corporate insiders and did not carry out their functions properly. Given the crucial role of transparent financial statements in fostering confidence in financial markets, African governments can play a vital role in improving corporate governance by creating an environment for the establishment of globally accepted accounting and disclosure rules and regulations. 11 Thus, corporate governance, as well as an appropriately designed bankruptcy code, which provides sufficient creditor and debtor right, should be a key ingredient of any agenda for stock market development. An additional role of well-functioning corporate governance is to facilitate financial globalization of African markets.

7. Promoting the Development of Regional Credit Rating Agencies

There should be a viable and credible credit rating agency at a regional level. Such an agency is non-existent in Africa. Its establishment can be facilitated through regional cooperation in the same manner as regionalization of stock markets by pooling resources of the region. Thus, regional co-operation can go beyond stock markets into the development of debt or bond markets. A regional credit rating agency is vital for the development of secondary markets in private bonds. While the individual markets themselves may be too small to support a rating agency locally, a sufficient number of debt instruments available in the region may support the establishment of a regional credit rating agency. The added advantage is that such an agency will be a catalyst for cross-border trading in debt securities by providing an assessment of sovereign and credit risk for investors with limited knowledge of the debt in other countries within the region. The rating agency could be used to rate both corporate and government debt.

11 The recent welcome development is NEPAD’s identification of economic and corporate governance as one of its priority areas which are tasked to a committee of finance ministers for developing action plans.

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Its existence should be an important step in facilitating issuance of long-term government which can then serve as a benchmark for issuance of long-term private corporate debt.

8. Promoting Financial Globalization of Africa

Africa has been left out of the massive international capital that flowed to developing economies with the

opening up of the world economy in 1980s. As a result, Africa has also been insulated from the adverse shocks of the crises in Mexico and East Asia due to its relative absence in the global financial markets. As we have witnessed from the Asian crisis, the negative wealth shocks and the global contagion can be enormously costly to the countries affected and potentially destabilizing to the entire global economy. The wrong lesson to draw, though, is to continue being insulated from financial globalization and its attendant “risks” which were discussed earlier. The region can avoid the risk of globalization altogether [e.g., Africa being left out of massive private flows]. However, that just exposes the region to “extreme risk”(marginalization). In its global marginalization, Africa stands to lose out on the potential benefits of financial globalization as discussed in the second section of this piece, although it escapes the risks of globalization. It is interesting that the East Asian financial crisis erupted in the wake of Africa’s gradual embrace of financial globalization and its slow march toward the emerging markets club. The lessons from the crisis, if drawn correctly, can help Africa to adopt sustainable financial globalization.12

Among these lessons is the need to build information capacity which allows for more extensive, detailed and reliable data capturing the diversity of Africa, along with data capturing the financial circumstance of private institutions, listed companies, and banks. The timeliness and reliability of financial data are crucial for making reliable estimates of investment risks in Africa. Moreover, the very measures discussed above to develop and build capacity of the African financial systems are the ones which would help achieve sustainable financial globalization of Africa. It should, of course, be recognized that financial crises do occur (ex post) even when these reform measures are in place (ex ante). African financial systems should also cultivate the capacity to resolve or control financial crisis in an efficient fashion if and when it arises. The control of financial crisis calls for speedy measures, including speedy closure of failed banks or restructuring of their balance sheets and speedy restructuring of insolvent firms. The tenure of failed banks should not be prolonged, since it simply transfers private losses to the taxpayers. Moreover, in a crisis environment, failed banks have incentives to take even wilder risks.

To sum up, financial globalization is here to stay. African countries should not avoid globalization in pursuit of total prevention of financial risk potentially arising from integration into the global financial economy. Rise avoidance leads to lack of access to potential benefits of financial globalization as detailed in the second section. The crucial lesson to be drawn from recent crises in Asia and Latin America is that, as Africa ventures into global integration, it should develop appropriate measures to build capacity to manage risk (i.e., when the sun is still shining) and resolve crisis efficiently if it arises. Without such capacity, the region would have difficulty in withering the discipline coming from the global financial markets which at times can be sudden and ruthless as witnessed by sudden outflows of capital from East Asia in the 1990s.

D. Financial Sector Reforms: Research Going Forward There is dearth of reliable data on African financial systems, making it difficult to integrate these systems into the best research practices. However, we have seen improvements in the availability of data, with particular reference to the fledgling African capital markets. Getting depth and reliability of these databases should be part of the development agenda facing policy makers. This can be facilitated through pooling of resources within and across subregions and leveraging existing institutions (e.g.,

12 See Senbet (1998) for further details on globalization.

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AERC, ADB, NEPAD, UN ECA, MEFMI, etc.) and establishing regional research institutes in the long-term. As deeper and more reliable data are available, we can enhance our understanding of the functioning and performance of the African financial systems.

1. Direct functional indicators and African financial systems: The paper has taken a functional perspective in diagnosing the African financial systems, but the analysis has been through the use of indirect indictors, such as liquidity provision. As we gain more data on direct indicators (e.g., corporate governance), we can perform a more direct diagnosis and bring forth modern analtycs to bear upon the capacity of African financial systems.

2. Financial Sector development and African economic performance: This paper has used evidence from other emerging markets to motivate the linkage between financial sector development and economic performance. However, as we obtain more cross-sectional and time series data on the channels for this linkage (e.g., liquidity), we can address the issue directly based on African data.

3. Understanding African Risk-return tradeoffs: Again, as we access deeper and more reliable data, we can perform direct analysis of the contribution of the African stock markets to the global markets and its positioning in the global risk-reward ratio. Moreover, we can expand on the performance analsysis, such as in Appendix 3 to fully capture the risk dimensions influencing African financial systems.

4. Capital Flight and African financial systems: One can justifiably take a premise that the

very measures that retain capital domestically are those that help attract international capital and reverse the exorbitant capital flight from Africa. One key factor here is the extent to which Africa is integrated into the global financial economy. The gap in financial globalization can fuel capital flight and it would be interesting to study the issue of capital flight in the context of reforming African financial systems. Again, we need a capital market database commensurate with the data already available on African capital flight.

5. Micro and informal finance: This paper has focused on the financial sector reforms

involving formal finance through banks and non-banks (e.g., the stock markets). The performance outcomes of the financial sector reforms have been severely inadequate, and there continues to be a prevalence of informal and microfinance responding to financing gaps faced by small borrowers both in the rural and urban sectors. However, as pointed out by Nissanke and Aryeetey (1998), the credit flow through informal finance has not increased significantly. There are several challenges facing the microfinance sector, and among those are lack of transparency in the lending and deposit relationships, and the price at which credit is available. Moreover, there is very limited integration between the informal and formal sectors. The issue of financial integration and the introduction of appropriate legal and regulatory regimes should be of ample research interest. A linkage with the formal sector would be one way to get the savings mobilization into the open at an integrated market price. The research agenda should also examine the extent to which measures for the development and capacity of the formal financials sectors feeds into the “formalization” of microfinance.

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McKinnon, R.I. 1973. Money and Capital Market in Economic Development. Washington D.C.: The Brookings Institution. Megginson, W, R. C. Nash, M. van Randenborgh. 1994. “Financial and Operating Performance of Newly Privatized Firms: An International Empirical Analysis.” Journal of Finance, 49(2). Megginson, W. and J. M. Netter, 2002. “From State to Market: A Survey of Empirical Studies on Privatization.” Journal of Economic Literature, 39 (2). Merton, R.C. and Z. Bodie 1998. Finance, Prentice-Hall, Inc., New Jersey. Nissanke, M and E. Aryeetey 1998. Financial Integration and Development in Sub-Saharan Africa, ODI and Routledge, London and New York. Ncube, M. and L.W. Senbet 1997. “Perspectives on Financial Regulation and Liberalization in Africa Under Incentive Problems and Asymmetric Information,” Journal of African Economies, 6, pp.29-89.

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Niepold, J. 1998, “Africa’s Emerging Markets”, Africa Business Focus (The Yearbook of the British African Business Association), pp. 29-32. Otchere, I., 2005. ” Do privatised banks in middle and low-income countries perform better than rival banks? An intra-industry analysis of bank privatisation”, forthcoming,, Journal of Banking and Finance. Otchere, I , 2002. “ Does the Response of Competitors to Privatization Announcements Reflect Competitive or Industry-wide Information Effects? International Evidence”, Working Paper, University of Melbourne. Popiel, P.A. 1994. Financial Systems in Sub-Saharan Africa; A Comparative Study, World Bank Discussion Papers 260, Africa Technical Department Series, Washington. Radelet, Steven and Jeffrey Sachs 1998. “The East Asian Financial Crisis: Diagnosis, Remedies, and Prospects”, Mimeo, Harvard Institute for International Development. Senbet, L.W., 1998, “African Capital Markets: Development Potential and Capacity Building”, Prepared for the United Nations Workshop “Advancing Financial Intermediation in Africa”, Mauritius. Senbet, L.W. 2001 “Globalization of African Financial Markets”, in Asia and Africa in the Global Economy (eds., E. Aryeetey, J. Court, M. Nissanke, B. Weder, UNU Press), based on a presentation at the UNU and AERC conference “Africa and Asia in the Global Economy”, Tokyo, August. Senbet, L.W. 2001. “Global Financial Crisis: Implications for Africa”, Journal of African Economies, Vol.10, February, pp. 104-140. Shaw, E. 1973. Financial Deepening in Economic Development. New York: Oxford University Press. Stiglitz, J. E. 1994. “The Role of the State in Financial Markets", Proceedings of the World Bank Annual Conference on Development Economics 1993, Washington DC. Tadesse, S. 2004. “The Allocation and Monitoring Role of Capital Markets, “ Journal of Financial and Quantitative Analysis, Vol. 39, No. 4, pp. 701-730.

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Appendix 1 P/E Ratio, Price-to-book ratio and Dividend Yield of Top Listed African Companies

December 2003

Appendix 1 P/E Ratio

Dividend Yield

Price-to-book Ratio

Algeria Saidal Pharmaceuticals 15.9 4.7 5.5 Aurassi Hotel 8.3 8.3 0.8 Botswana Barclays bank Banks 14.9 6 6.6 First National Bank Banks 15.3 4.4 6.4 Standard Chartered Bank Banks 16.3 5.4 7.5 Sechaba Brewery holding Beverages 9.8 10 3.3 Sefalana Holding Retail & Dist 8.9 9.8 1.2 Cote d'Ivioire Nestle Food 11.3 10.9 3.9 Unilever Household 26.3 12.5 1.7 Bicici Banks 16.7 5.2 1.5 Sgbci Banks 8.3 9.4 1.2 Filtisac Textile 10.3 6.4 1.8 Cie Utilities 9.5 9.6 1.8 Egypt Egyptian Co mobile Telecom 9 2 Suez cement Cement 21.3 1.7 Egyptian Media Prod Media 47.6 0.8 Orascom Telecom Telecom 35.9 0.5 Ghana Produce Buying Agricultural Prod 27.9 5.3 Kenya Bamburi Cement Cement 21.1 2.6 1.5 BAT Kenya Tobacco 8.9 14.6 1.3 National Media Group Media 10.7 3.2 2 Brooke Bond Agric Products 11.8 3.7 0.6 Mauritius New Mauritius Co Hotels and Tourism 8.8 6.8 1.1 Ireland Blyth Ltd Retail & Dist 8.5 9.7 0.6 Morocco BCM Banks 12.1 3.9 1.5 SNI Other Financial Services 11.6 3.5 1.4 Samir Industrial Conglomerate 24.2 2.9 2.8 BMCE Banks 19.5 4.4 2.3 Ciment Du Maroc Industrial Conglomerate 11.7 3.3 1.1 Wafabank Banks 20.2 3 1.9 Brasseries Du Maroc Industrial Conglomerate 9.5 5.5 1.9 Namibia Nam Harvest Investment Other Financial Services 13.8 - 0.5 Namibia Sea Products Agric Products 30 - 0.4 PEP Namibia Retail & Dist 13.3 - 0.1

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Nigeria Nigerian Breweries Beverages 22.1 7.3 4.7 First Bank of Nigeria Banks 9.6 6 2.9 Union Bank of Nigeria Banks 8.2 5.8 1.7 Nestle Nigeria Food 12.7 6.3 24.6 Cadbury Nigeria Food 16.2 3.5 8.3 WA Portland Co Cement 24.3 3.6 2.2 Total Nigeria Oil & Gas 10.8 8.7 8.4 African Express Bank Banks 8.6 2.1 3.2 South Africa BHP Billiton Other Metals 18.1 3.1 1 Comp Finan AG Household Appliance 11.6 1.7 1.1 Sasol Oil & Gas 9.4 4.3 3.2 Anglo America Platin Co Platinum 8.6 7.9 5.4 SABMiller Beverages 15.6 4.4 3 Goldfields Gold Mining 16.6 2.6 8 Old Mutual Life Assurance 9.6 6.7 1.4 Standard Bank Banks 8.7 3.6 1.5 Firstrand Banks 11.1 3.9 2.4 Swaziland Royal Swaziland Sugar Sugar 57.9 1.7 6 Swaziland Property Real Estate 8.2 12.1 1.22 Nedbank Banks 9.7 2.7 - Newera Partners Other Financials 21 - 1.4 Tanzania Tanzania Breweries Beverages 14.5 7.2 4.7 Tanga Cement Co Cement 14.6 3 1.8 Tanzania Tea Packers Food 15.2 7 1.6 Tunisia Societe Brasserie-Tunis Beverages 17.5 3.1 4.1 Banque Du sud Banks 10.7 5.8 1.1 Uganda British American Tobacco Tobacco 15 15 2.2 Uganda Clays Capital Goods 20 11.9 0.8 Zambia National Breweries Hotels & Tourism 9.9 1.7 1.2 Zimbabwe Delta Industrial Conglomerate 19.4 2.2 1.6 Meikles Hotels & Tourism 78.3 0.3 Innscor Hotels & Tourism 143.4 - Barclays Banks 13.5 7.5 6.5 British American Tobacco Tobacco 40 2.3 10.4 Tanganda Tea Co Agric Products 29.1 0.7 16 Cottco Agric Products 15.6 2.7 5.6 THZ Zimbabwe Capital Goods 10.9 5.4 4.4 Astra Capital Goods 31.3 0.6 6.9

Source: Liquid Africa, UNDP 2003

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Appendix 2

African Firms Privatized Through Public Share Offerings (1988 to June 1999)

1999 Cote d'Ivoire SGBCI Financial intermediation (Banking)

1993 Cote d'Ivoire Capral Food 1994 Cote d'Ivoire SICOR Agriculture 1994 Cote d'Ivoire Filtisac Industry 1994 Cote d'Ivoire SICABLE Manufacturing 1995 Cote d'Ivoire SOGB Rubber 1997 Cote d'Ivoire Plantations et Huileries de Cote d'Ivoire Edible oil 1994 Ghana Ashanti Goldfields Company(AGC) Mining 1988 Kenya Kenya Commercial Bank Banking 1992 Kenya Housing Finance Company Financial Services 1992 Kenya Uchimi Supermarkets Retail 1993 Kenya CMC Holdings Engineering 1993 Kenya E.A. Oxygen Ltd Manufacturing 1994 Kenya National Bank of Kenya Banking 1996 Kenya Kenya Airways Airlines 1996 Kenya Kenya National Capital Corporation Banking 1997 Kenya Safari Lodges & Properties Ltd Tourism 1997 Kenya Tourism Promotions Services Ltd Tourism 1998 Kenya Kenya Commercial Bank Financial 1998 Kenya Mumais Sugar Corporation Agroindustry 1998 Kenya Kenya Commercial Finance Corp Banking 1999 Kenya Kenya Housing Finance Manufacturing 1996 Malawi National Insurance Co. Insurance 1998 Malawi Packaging Industries Ltd. Manufacturing 1998 Malawi Commercial Bank Banking 1996 Mozambique Agro Alfa - Alfaias Agriculture 1996 Mozambique Agro Alfa - Fundicao Agriculture 1996 Mozambique Agro Alfa - Offices Agriculture 1996 Mozambique Agro Alfa - Forja Agriculture 1989 Nigeria Imprest Bakalori Plc .. 1989 Nigeria Nigerian Yeast & Alcohol Pic Agribusiness 1989 Nigeria Cement Co. of Northern Nigeria Pic Cement 1989 Nigeria The United Nigeria Insurance Co. Insurance 1989 Nigeria American International Insurance Co. Insurance 1989 Nigeria Prestige Assurance Co. Insurance 1989 Nigeria Royal Exchange Assurance Co. Insurance 1989 Nigeria Sun Insurance Nigeria Plc. Insurance 1989 Nigeria British American Insurance Co. (Nig) Insurance 1989 Nigeria Crusader Insurance Co. (Nig) Insurance 1989 Nigeria Guinea Insurance Co. Insurance 1989 Nigeria Law Union and Rock Insurance Co. Insurance 1989 Nigeria United Life Insurance Co. Insurance 1989 Nigeria NEM Insurance Co. Insurance 1989 Nigeria The Niger Insurance Co. Insurance 1989 Nigeria West African Provincial Insurance Insurance 1989 Nigeria African Petroleum Plc Petroleum 1989 Nigeria National Oil & Chemical Marketing Petroleum 1990 Nigeria Okomu Oil Palm Agribusiness

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1990 Nigeria Flour mills of Nigeria Pic Agribusiness 1990 Nigeria Aba Textile mills Agribusiness 1990 Nigeria Ashaka Cement Cement 1990 Nigeria Benue Cement Cement 1991 Nigeria Ayip Eku Oil Palm Manufacturing 1991 Nigeria Unipetrol Petroleum/Petrochemicals 1991 Nigeria National Salt Company Salt 1992 Nigeria FSB International Bank Ltd. Banking 1992 Nigeria NAL Merchant Bank Banking 1992 Nigeria Tourist Co. of Nigeria Hotel 1993 Nigeria First Bank of Nigeria Banking 1993 Nigeria Savannah Bank of Nigeria Banking 1993 Nigeria Union Bank of Nigeria Banking 1993 Nigeria International Merchant Bank (Nig) Banking 1993 Nigeria Afribank Nigeria Banking 1993 Nigeria United Bank for Africa Banking 1993 Nigeria Allied Bank Banking 1994 Nigeria Federal Palace Hotel Hotel

1997 Senegal Societe Nationale des Telecommunications (Sonatel) Telecom

1998 Senegal Société nationale des télécommunications (SONATEL) Telecommunications

1991 South Africa National Sorghum Breweries Brewery 1995 Tanzania Mbaya Ceramics Co. manufacturing/ceramics 1998 Tanzania Tanzania Oxygen Limited Industry 1998 Tanzania Tanzanian Breweries Brewery 1999 Tanzania Tanzania Breweries Manufacturing 1998 Uganda Barclays Bank Banking 1999 Uganda Uganda Clays, Ltd. Manufacturing 1995 Zimbabwe Delta Corporation Tourism 1997 Zimbabwe Commercial Bank of Zimbabwe Banking 1997 Zimbabwe Cotton Company of Zimbabwe Agriculture 1997 Zimbabwe Dairibord Zimbabwe Limited (DZL) Dairy product 1999 Zimbabwe Zimbabwe Reinsurance Company Financial intermediation

Source: World Bank Privatization Database

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Appendix 3

Factors Affecting African Stock Market Performance*

Preliminary Results from Cross-Sectional Regressions

Sample Period

Factors (Partial list)

Effects Explanations

Liquidity Positive The higher the liquidity the lower the stock returns

Exchange Rate Change Negative The higher the depreciation of the African currency

relative to the US dollar, the lower the returns

Country Risk Negative The higher the institutional credit rating (the lower the country risk), the higher the stock market performance

* These results are preliminary and are now being subject to more detailed analysis. The stock market performance measure (dependent variable) is the average three year African country stock market return. The factors listed above constitute just a partial list of the relevant set and are mentioned in the paper. A more complete analysis with a more complete set that expands into such factors as investor protection/legal origin, capitalization, is now under way. However, the preliminary results are indicative of the predicted signs. Liquidity is measured by the value of the shares traded as a ratio of market capitalization. The exchange rate is proxied by a three year exchange rate relative to the US dollar.