Hands holding soil

14 Sep 2022

African ESG trade finance realities – the wood and the trees

Derryn Faure | Institutional Trade Finance, Investec

When it comes to realising the UN’s Sustainable Development Goals (SDGs) on the African continent, the small and medium-sized enterprise (SME) sector is a good place to start.

 

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SMEs employ as much as 85% of the population and form the ultimate supply mechanism for food security, health, industrialisation and infrastructure into their economies. Accordingly, they speak directly to five of the 17 SDGs, in particular SDG 1 (no poverty), SDG 8 (decent work and economic growth), SDG 9 (industry, innovation and infrastructure), SDG 10 (reduced inequality) and SDG 11 (sustainable cities and communities), as well as playing a pivotal role in addressing other goals, such as SDG 2 (zero hunger), SDG 5 (gender equality), SDG 12 (responsible consumption and production) and SDG 16 (peace, justice and strong institutions).

Given the power that lies in unlocking the potential of SMEs in Africa, it’s a source of great frustration that although the multilateral agencies and development finance institutions (DFIs) profess to pledge support to the SMEs, when it comes to the practicalities of actually providing financing for the SMEs, their stringent requirements make it practically impossible to do so. It’s particularly problematic in the light of the need to address the African trade gap first flagged by the African Development Bank (AfDB) in 2014 – now believed to be more than US$120bn following the disruptions caused by the COVID-19 pandemic.

With Trade being estimated as contributing up to a third of GDP growth in developing African economies and with SMEs taking the brunt of the blows inflicted by lockdowns and supply chain disruptions, it makes sense that this sector should be targeted in any programme to address the trade gap and make proper inroads into the SDGs highlighted above.

Understanding where the real climate change problem lies

One of the problems with the approach of agencies and DFIs is that they apply a developed world template when dealing with issues regarding sustainability.

There’s too much of an emphasis on the ‘E’ in ESG (environment, social and governance), especially in the light of the recent COP 26 resolutions that highlighted climate change as the major threat to our joint futures.

Without downplaying the importance of climate change as a target for action, in the African context, it is a chimera. For Africa to achieve its growth and development goals, it needs to be accepted that fossil fuels still have to play a role, at least in the near to medium term and the multilaterals and DFIs who wish to deploy their funding need to acknowledge that they simply cannot cut off African bank trade finance (which is the most effective channel for this funding to deliver the intended goals) because it does not comply with their developed world strategies.

Too often, solutions are ruled out simply because they fail to comply with environmental standards that are more apposite to developed markets.

Moreover, this approach fails to recognise where the real work needs to be done in reducing carbon emissions … and it’s not in Africa. Given that the vast majority of greenhouse gas emissions come from the developed world, that’s where the ‘just transition’ focus on the E part of ESG should be and not on Africa.

Extraneous regulatory and evidence obstacles

Not only is the focus on the “E” in ESG, to the detriment of those markets that desperately need dollar funding (the Global trade currency), another problem is the failure to understand the reality of the SME world in Africa and how it is banked. Again, applying a template designed for financial institutions in sophisticated developed markets is likely to fail. Typically, top tier banks in Africa will not finance the SME sector, for the intuitive reasons, and it is left to the lower tier African banks to fund their trade requirements. These banks, however, are not in a position to obtain cheap US dollar borrowing in order to do so, not to mention the fact that the (internationally imposed) regulatory requirements make the banking of this sector completely uneconomic for them. 

Rather than investing their finite liquidity and capital in lending to SMEs with returns on equity below their cost of equity, they simply invest in risk-free government bonds at a yield of 15%.  It’s no surprise then that they avoid trade finance – hence the trade gap.

The requirements of multilaterals and DFIs and what they expect from beneficiaries of their funding are not practical when it comes to financing SMEs and thus exacerbates the lack of cheap dollar funding for this sector.  Digital is the obvious developed market answer to the emerging market (EM) trade information problem – it just cannot work in African trade, now.  SMEs and lower tier African financiers do not have the digital technology, nor sophistication when it comes to digitalisation to be able to capture all the underlying trade details and SME information that the multilaterals and DFIs require before they will offer up funding. Their world is still characterised by paper-based administration.  

How then can we tackle this trade gap and harness the power of the SME sector to grow and develop African countries? We believe that African bank trade finance is the most effective channel for this funding to deliver the intended goals. However, the problem lies in the capital treatment of trade and the supporting evidence necessary in order to prove that it is trade.

Under the Basel 2 AIRB (advanced) methodology, sophisticated international lending banks can use lower loss given defaults (LGDs) for assets designated as ‘trade’. This results in considerably lower capital costs, the benefits of which can be shared with the emerging market borrowing banks and their merchant clients through lower pricing.

This sounds promising, but unfortunately, trade refinance can only usually be used for large, lumpy, long-tenor assets as in order to qualify as ‘trade’ and receive the LGD relief, the borrowing bank must provide the full details of the transaction: importer, exporter, goods, origin, tenor, shipping, ports, etc and other documentation.

This is unworkable for the vast majority of real SME trade. They typically work in large numbers of small, short tenor, randomly drawn, maturing and revolving assets, all of which have to be funded at uneconomic rates out of their African banks’ Treasuries. The information marshalling and administration required renders these impossible to refinance.

Worryingly, the situation will become worse for SMEs and the banks that finance them under, Basel 4 (more international DM regulation), from 1 January 2023:  that LGD relief which makes trade refinance viable will be obliterated in a misguided effort to ‘level the playing field’ of international banks’ internal capital models.

Developed markets’ arrangers and lenders who don’t understand the African market or trade finance products are tempted to repurpose all the existing ESG debt certification standardisation for trade finance to prove to their backers and governments that they’re not facilitating ‘greenwashing’.  But we now KNOW from trade refinancing that trying to curate and prove all the details, let alone the qualifying sustainability certification of each and every underlying trade transaction, doesn’t work for African SME trade.      

The solution?

The intuitively obvious solution, in our opinion, is to acknowledge that the trade finance portfolios of African banks should automatically qualify as fulfilling the economic and social SDG requirements, acknowledging the role the SME sector plays as a kind of flywheel for fulfilling the SDGs that we highlight above.    

Firstly, there has to be a realisation by the international community of agencies, banks, investors and DFIs that the environmental component cannot completely preclude and override the social development goals. They should trust the private commercial banks in Africa.  With so much compliance and auditing oversight within regulated banks, and with the checks and controls conducted by skilled career professionals with an intimate understanding of individual transactions and their trader clients:  they effectively deliver the independent governance between ultimate lender and borrower for sustainable African trade finance, in place of First World domiciled ‘independent’ ESG specialists KPI certification for debt.  EM trade finance is nothing like debt and African banks are capable of governance, too. 

All the existing infrastructure of the different African tiers of banks could easily be used as aggregators of constantly revolving trade portfolios, structured into notes and securities activist investors can safely and accurately identify as ESG. 

We would then have a practical mechanism to properly deploy the billions of ESG dollars burning a hole in funds’ pockets into truly sustainable development goals, close the African trade gap and move the Continent towards sustainable prosperity just in time to maximise the potential of the AfCFTA.

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