Compact with Africa: Fostering Private Long-Term Investment

The German G20 Presidency puts the spotlight on Africa’s economic development. In its ´Compact with Africa´, the German G20 Presidency, jointly with the African partners, wants to encourage institutional investment by pension funds and life insurers in infrastructure to encourage corporate direct investment. The objective of the “Compact with Africa” is to boost growth and jobs, promote inclusion and give people economic opportunities at home so that they do not have to leave their home country to seek subsistence elsewhere. 

Foreign direct investment (FDI), building on institutional infrastructure investment, can foster structural transformation with employment creation. The G20 should help make private investment in Africa more attractive by making it more secure, and reducing the barriers to investment. How can the G20 move forward? The G20 should engage in a coordinated dialogue with the regulatory authorities and the Financial Stability Board to remove supply-side barriers to higher institutional investment in infrastructure. Host-country conditions in the poorest African countries, however, do not lend themselves easily to institutional investment, even with strong blending support by development finance institutions.

Both institutional investments by pension funds, life insurers, as well as corporate FDI can benefit Africa. Institutional investors enjoy long-term liabilities in their balance sheets, essential to fund Africa´s infrastructure, a central growth prerequisite for the continent. FDI, in turn, requires modern infrastructure, especially energy and connectivity, to fully deploy its external benefits. FDI can entail spillovers for the modernization of production capacity; knowledge transfer; integration into global and regional value chains; as well as employment for the jobless.

Fill Africa’s infrastructure funding gap

To fill Africa´s annual infrastructure funding gap of $50 billion, one percent of new institutional investment by pension funds, life insurance companies and sovereign wealth funds would need to be invested in Africa´s infrastructure every year. Yet, despite the longstanding policy focus of G8 and G20 leaders, private institutional investment still plays a minority role in funding Africa´s infrastructure.

Regulatory supply-side barriers and stable profit margins explain why life insurers and pension funds mostly have stayed in the comfort zone of liquid bond and equity markets. Ultimately, encouraging long-term investment of pension funds and life insurers in infrastructure – including in Africa – will need the G20 to engage in a coordinated dialogue with the regulatory authorities and the Financial Stability Board (FSB)—the international body of finance ministers, central bankers, and other agencies established in 2009 after the global financial crisis.

G20 should envisage a prominent role for private institutional investors once barriers are removed

Most African countries remain poor, have immature domestic financial markets, and have recently featured deteriorating scores of safety and rule of law. This holds particularly in those low-income countries, such as in the Sahel Zone, where present demographic and future migration pressures remain extremely high. Common infrastructure project risks (completion, performance, revenue, financing, maintenance and operation risks) weigh also particularly in low-income Africa. In low-income Africa, a prominent role of private institutional investors should be envisaged only once the discussed host-country barriers have been largely removed.

Despite policy efforts to mobilize private finance through official development finance interventions, they so far have represented a small fraction of the flows directed to low-income Africa. The central dilemma: low domestic savings, weak government finances and a low debt tolerance militate against forcing foreign private debt and contingent fiscal liabilities upon low-income African countries where infrastructure deficits are most blatant. Grants, remittances and FDI equity finance should be preferred over debt-creating finance as the International Monetary Fund’s (IMF) debt sustainability assessments have deteriorated in a number of Africa´s countries, not least due to public infrastructure commitments.

Integration in value chains foster absorption of technology and promote inclusive growth

FDI inflows produce important effects which go beyond spillovers to domestic firms. They are contributing to structural change, but the effects of different FDI inflows vary (FDI in resource-driven countries vs. consumer-market oriented industries). The shift of FDI to consumer-sectors has created jobs, mainly low-skilled. Some middle-income African countries have managed to enter global value chains. Generally, a stronger integration of African countries into global value chains may foster the absorption of technology and build skills, and promote inclusive growth. But so far the transfer of technology and spillover effects are still limited.

FDI in manufacturing, construction, trade services, in transport, ICT etc. have experienced growing employment and positive labor productivity growth. This is mainly the case in urban hubs and in sectors which are integrated in global and regional value chains. Generally, stronger integration of African countries into GVCs may foster the absorption of technology and skills from FDI and thereby enhance structural change and promote inclusive growth.

Policy measures which drive structural transformation in Africa

Based on the analysis of trends and the channels that are expected to drive structural transformation in Africa, the following policy measures are key:

1. Macroeconomic and political stability and attractive general investment conditions are prerequisites for long-term growth. Regulatory quality and a positive overall institutional environment are important in attracting FDI and stimulating domestic enterprises.
2. Policies that deepen the complementarities between FDI and domestic investment should be promoted to ensure sustainable growth. The development of backward linkages and local supply chains depends on creating a favourable investment climate for both local firms and foreign investors. Strong FDI linkages with the domestic economy result in greater diffusion of knowledge, technology, and know-how from foreign investors. An important channel for potential spillovers is the collaboration of foreign investors with local institutions.
3. Reaping the benefits of global value chain integration depends upon industrial policy reform. Shifting the focus from national industry development to deeper integration into global value chains is essential. African economies can benefit most by specializing in particular segments of a value chain. Governments can foster foreign firms to create linkages with domestic suppliers through tax incentives and local content requirements.
4. Agglomeration economies can be utilized in cities and industrial clusters. These are important for increasing firm production. Innovative and competitive clusters can be drivers for more FDI. Clusters and networks between enterprises have particular significance for the industrial take-off. Improving job creation in small and medium sized enterprises requires barriers being removed, enabling them to grow, and supporting young people to become entrepreneurs. Start-up programmes, funds for young entrepreneurs, and business services can drive innovation and job creation.
5. Regional economic integration is essential for Africa to utilize its full growth potential. Many countries profit from stronger intraregional cooperation, connectivity, regional market expansion, all of which makes African markets attractive to local and foreign investors. Intraregional investment in infrastructure will reduce trade and transportation costs, foster competitiveness, and facilitate regional value chains and integration into global value chains as well as technology transfers to local entrepreneurs.
6. The limited penetration of long-term finance in African markets is of particular concern given the huge long-term investment needs of African economies.

High growth rates and FDI inflows are not necessarily accompanied by a structural transformation towards a modern economy and, in turn, the creation of jobs in industry. Many African economies are still resource dominant, and FDI inflows are mainly resource driven. Some countries have very low FDI inflows and some others started attracting consumer-driven FDI inflows. The recent trend of FDI inflows in the manufacturing sector show that these are more employment intensive and change the African transformation process. They indicate an initial shift in production and employment pattern in some African countries and especially in urban hubs. But some African countries can be trapped in low value-added manufacturing with little positive spillovers and limited employment effects.