African Trade Finance: why a practical approach is needed

Access to finance remains a significant constraint to the survival and growth of micro, small, and medium enterprises (MSMEs) in Africa. As the drivers of broad-based economic growth in developing economies, addressing the trade finance gap is crucial.

Unfortunately, the current Western-driven sustainable trade finance approaches are ill-suited for the needs of African MSMEs. A practical solution is needed that leverages existing anti-money laundering (AML) and correspondent banking controls while also considering the specific challenges faced by MSMEs.

Prevailing Western-led methodologies for sustainable trade finance focus on corporate trade within Organisation for Economic Cooperation and Development (OECD) investment banks. In this way, they fail to recognise the realities of African transactional banking. Furthermore, policymakers often conflate developmental sustainability with Western ESG (Environmental, Social, and Governance) investment banking sensibilities, and neglect the unique circumstances in developing economies. The result is a regulatory framework that imposes solutions on African MSMEs that are impractical because they do not align with their operational realities.

In this way, sustainable trade finance proposals in Africa often end up repurposing established Western ESG methodologies, an approach that is not only reductive but also subjective. All participants in a trade transaction are required to subjectively rate each leg of the supply chain and enforce compliance through third-party verification. This is unworkable and impractical as it overlooks the fundamental differences between investment banking and transactional banking.

Trade finance is not an investment activity but rather is all about risk management, credit, and payments in the buying and selling of goods and services. In developing economies, trade finance underpins the real economy and is vital for sustainable growth. Every day, African banks service millions of MSMEs with thousands of small invoices, requiring a vastly different approach to financing.

The Western interpretation of sustainability, often framed through ESG lenses, fails to adequately address the pressing developmental needs of African societies. In this context, the UN’s Sustainable Development Goals (SDGs) should focus on alleviating poverty and hunger, rather than merely imposing existing systems that do not address the fundamental challenges faced by millions of Africans. The emphasis on ESG, which prioritises environmental and governance factors, often neglects the critical aspect of development, which is paramount for the continent.

As noted above, the subjective nature of ESG ratings further complicates matters. The inconsistent ratings given to companies like Tesla by various ESG agencies (Tesla has been simultaneously rated best, middle and worst by three top ESG rating agencies) illustrate the point. ESG consultants, often lacking local market insights, are ill-equipped to assess the sustainability of trade transactions in African economies. Instead, it is the transactional bankers, who possess the necessary knowledge and understanding of local contexts, who are best placed to make these assessments.

These Western ESG frameworks end up not only disqualifying sustainable trade from receiving concessional incentives but also impose excessive compliance costs on African MSMEs. This leads to administrative burdens that are often unmanageable for local businesses, further exacerbating the trade finance gap.

Despite the focus of multilaterals and development finance institutions (DFIs) on supporting MSMEs, the trade finance gap in developing markets continues to widen and is estimated to be around US$120bn currently. The causes of this failure are many, including a lack of understanding of the unique challenges faced by African MSMEs, as well as inadequate coordination among various stakeholders, including local banks, fintechs, and governments.

One significant challenge to highlight is the high cost of developing financing products appropriate for African MSMEs. Financiers often avoid offering structured trade financing because of the prohibitive capital expenditure required for product development and implementation. This situation relegates many MSMEs to having to rely on overdrafts and mortgage loans, which do not adequately meet their working capital needs.

Many MSMEs on the continent furthermore lack the necessary financial records and accounting systems to secure loans. Without meaningful financial information, access to credit becomes negligible or prohibitively expensive. The future of trade finance lies in open account and digital solutions, yet the costs associated with implementing these systems remain another significant hurdle for lower-tier MSME financiers.

To effectively address the trade finance gap, a collaborative approach is needed. DFIs, multilaterals, and local banks should work together to develop practical solutions tailored to the specific challenges faced by African MSMEs, including simplifying legal documentation and creating standardised loan agreements that are accessible to smaller traders.

Moreover, a ‘trade not aid’ approach on the part of DFIs, which seeks to provide technical assistance funds to offset the legal, accounting, and IT costs incurred by MSMEs, can be effective. This practical support is crucial for developing trade products and working capital facilities that empower African businesses.

To effectively tackle the trade finance gap, a collaborative effort is required among all stakeholders, including governments, financial institutions, and international partners. By addressing the root causes of the gap and coming up with scalable, practical solutions, African MSMEs can trade sustainably and ultimately lift millions out of poverty. The existing multilateral resources and relationships should be harnessed to create a conducive environment for sustainable trade finance, fulfilling the promise of the SDGs and fostering economic growth across the continent.