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External Credit, Growth and Stability

To the extent that countries such as Ghana and Kenya are graduating towards middle-income status, they will increasingly use private foreign finance for funding. Too much dependence on foreign capital is risky, especially if it is of a short-term nature, and/or that currency mismatches become significant. In all, foreign debt, especially short-term debt, creates the risk of excessive external debt and vulnerabilities in their financial systems, whilst having an unclear effect on growth.

As capital flows are an important conduit of risks and source of financial vulnerability, the country studies examined carefully the issue of capital account management. In the Ethiopian case this sort of risk is very limited, because the country has a fairly restricted capital account, which essentially allows only for foreign direct investment and some borrowing by the government on the international bond market. Portfolio flows are not permitted, and banks are not allowed to borrow from abroad.

In Ghana, Nigeria, and Kenya, capital accounts are fairly liberalized, letting in all forms of capital, including short-term bank lending and portfolio flows. The country studies show that this policy stance has created important vulnerabilities in all three countries. The Nigeria case is interesting, as the drying up of capital flows to the country in late 2008 and early 2009 was a major contributory factor to the banking crisis the country suffered in 2009. The country studies also show that both Kenya and Ghana have large current account deficits and are therefore vulnerable to sudden reversal of capital flows.

In Kenya, more than half of its current account deficit is financed with short-term capital flows. Given the close links between such flows and domestic financial systems, the latter are also vulnerable. So, although the volatility of capital flows is a balance of payments issue in the first instance, what is particularly worrying is that it constitutes a critical source of instability for their financial systems. This can be true, for example, not just in terms of direct impacts resulting from the currency mismatches of the banks themselves, but also in terms of the currency mismatches of companies. Where companies borrow from banks in foreign currency, but sell mainly in local currency, they are exposed to foreign exchange risk, which can indirectly also cause problems for the banks’ stability.

If standard indicators, such as the capital adequacy ratios given above, show that financial systems are in good shape, then there may well be a problem with the indicators being used for financial stability assessment. These indicators should be broadened and measures should be undertaken to gradually reduce vulnerabilities.

As a contrasting example, Ethiopia may also have balance of payments’ financing problems, but it is not resorting to easy foreign capital, due to the risks it creates. This at least keeps its financial system, still underdeveloped, insulated from external shocks.

Returning to the issue of a more diversified banking structure, there are important questions about the best composition of such a structure, as well as how this is to be achieved. African regulators envisage a diversified financial system, as mentioned above, but does this imply less (rather than more) consolidation? And if foreign banks are admitted, thus contributing to a more diversified system, does it matter whether these banks are Pan-African or from developed countries? More broadly, do foreign banks contribute to financial stability or do they make countries more vulnerable to financial instability? Beck et al. (2014) summarizes the recent empirical evidence well, stating that cross-border banking can help mitigate the impact of local financial shocks, but exacerbate global financial shocks.

In addition to the role that external capital had on Nigeria’s banking crisis of 2009, the Nigeria experience further suggests that in a LIC context a more consolidated banking system, which the country had attained prior to the crisis, does not necessarily make the system any safer. Despite consolidation, Nigeria did not close down its development and specialized banking institutions. However, the past track record of these banks has been perceived as not good. Nevertheless, Nigeria has recently created new development financial institutions and mechanisms, which hopefully will be more efficient. As with the point made about development banks above, it may not be the precise form that a financial institution takes that is most important, but whether it operates effectively and efficiently with appropriate safeguards against excessive bureaucracy and/or capture by corrupt practices. The ideal may be a diversified system, but only if the components of this system operate effectively.

A lesson from Nigeria’s recent experience is that what a natural resource-rich country like Nigeria needs to achieve may not just be more or less consolidation, or more or less development banking. No approach is likely to succeed without institutional mechanisms that are more accountable and better governed so that natural resources wealth can be effectively channeled to support pro-poor and pro-growth projects.

Though development banks and sovereign wealth funds may play an important positive role, especially in channeling resources into long-term and strategic private and public investment for structural transformation, it is important they are well designed and well run. It is also important they complement, as well as work with, private banks and capital markets, where these function well, and that they do not attempt to substitute them. On this point, the Ethiopian experience reflects some concerns about public banks excessively drawing on resources from private banks, even though it seems the public development bank does seem to channel its resources efficiently towards long-term structural transformation.

There are divergent views on whether foreign banks from developed countries or Pan-African banks are preferable. Although foreign banks are currently not permitted to operate, Ethiopian regulators would give preference to those from developed countries if this were to change. These are seen as stronger, better managed, and subject to better regulation and supervision. They are often large and have more capital. If they came to Ethiopia, they would need to comply with the high national capital requirements shown above.

Regulators from other case study countries express a different opinion. For them, banks from developed countries would just be more of the same: acting conservatively and following a banking model already practiced by the established foreign banks in their countries. In contrast, they believe that Pan-African banks would lend more, and cheaper, as has been reportedly already the case in Kenya, Tanzania, Uganda, Rwanda and other African countries where these banks have a presence. The lower spreads charged in the East African Community countries by PanAfrican banks (both in their home and their host countries) than either foreign banks from outside the region or domestic private banks is confirmed empirically by evidence provided by the World Bank (2013) in the Financial Sector Assessment Program led by World Bank (see also Beck et al. op. cit.). It should be noted, however, that even the relatively lower spreads reported charged by the EAC cross-border banks are still high, at an average of almost 12 percent for 2012.

The Ghana experience, in contrast, suggests that the presence of PanAfrican banks may generate important cross-border risks at the regional level, which their regulatory framework is not equipped to deal with. It also makes the point that regional colleges of supervisors, discussed further below, are good for information sharing, but not very useful for addressing crisis resolution problems, which would arise in case of failure of a Pan-African bank. The Nigerian experience, moreover, alerts us to the fact that the supervision of the operations of Nigerian banks with branches and subsidiaries abroad has been largely deficient so far, which poses risks both for Nigeria as a home country of several Pan-African banks and also for countries hosting such banks.

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