CHALLENGES FOR FINANCIAL SECTOR REFORM IN AFRICA: DISCUSSION NOTES

1. CHALLENGES FOR FINANCIAL SECTOR REFORM IN AFRICA: DISCUSSION NOTES Victor Murinde University of Birmingham

2. Background: Making Finance Work for Africa • Very thorough and comprehensive study, which covers the main financial institutions, markets and instruments • Highlights the challenges for financial sector reform in Africa, including low financial depth, limited access to finance and high cost of capital • Timely, in view of current emphasis on the role of finance in economic growth • Policy relevant, especially by emphasizing the policy choices for governments (indirectly, for the private sector as well)

3. Low financial depth • The problem of rudimentary capital markets; also incomplete and missing markets (see Figure 1) • Market imperfections and asymmetric information problems • Policy issues and gaps: capital market integration; cross-listing; regional capital markets, etc…

5. Bank efficiency and the role of banks in Africa • Bank efficiency, branch network (access) and the role of banks in Africa • Kirkpatrick, Murinde and Tefula (2007) find that the mean value for cost x-inefficiency based on the DFA is 20.256 while a similar measure based on the SFA method has a mean value of 19.286, suggesting that on average banks are 80 percent cost efficient.

6. Bank efficiency (continued) • It is also found that the mean value of profit x-inefficiency based on the DFA method is 33.465 while the corresponding mean value based on the SFA method is 33.646, suggesting that banks are on average 67 percent profit efficient. • The pan-African scenario may be different because these results are based on a sample of 89 banks altogether for 1992-1999, from Botswana, Ghana, Kenya, Lesotho, Malawi, Namibia, Nigeria, Swaziland, and Zambia.

7. Bank efficiency (continued) • KMT (2007) also find that an increase in the degree of foreign bank penetration, representing an increase in foreign bank ownership, is associated with a reduction in profit and cost x-inefficiency. • This finding is consistent with Murinde and Ryan (1998) who argue that foreign bank entry is good for Africa

8. Table 1: Empirical Measures of Cost and Profit X-inefficiency for a Panel of Commercial Banks in Africa DFACOST CINEFFS DFAPROFIT PINEFFS Mean 20.25582 19.28643 33.46510 33.64627 Median 20.47019 19.22322 34.29631 34.43725 Standard Deviation 6.611879 6.508377 7.803044 7.701402 Skewness 0.213978 0.214675 -0.876920 -0.903132 Kurtosis 3.491629 3.633730 6.558330 6.695169 Jarque-Bera 5.133561 7.080299 190.1635 204.4120 Probability 0.076782 0.029009 0.000000 0.000000 • Notes:DFACOST=Cost x-inefficiency based on the Distribution Free Approach; CINEFFS=Cost x-inefficiency based on the Stochastic Frontier Approach; DFAPROFIT=Profit x-inefficiency based on the Distribution Free Approach; PINEFFS=Profit x-inefficiency based on the Stochastic Frontier Approach. • Source: Kirkpatrick, Murinde and Tefula (2007, Table 2)

9. Limited Access to Finance • Aspects of financial exclusion, especially in the rural communities • Links between informal financial sector and the formal financial sector • Arguably, financial exclusion and growth in informal financial sector exacerbated by political risk and civil conflict in Africa • Finance for small enterprise growth and poverty reduction (Green, Kirkpatrick and Murinde, 2006)

10. Microfinance: Outreach and sustainability issues in Africa • Makame and Murinde (2007) empirically study microfinance commercialization factors to probe the cognitive dissonance surrounding microfinance outreach and sustainability in African economies. • We analyze a balanced panel of 198 observations consisting of 33 MFIs over a period of six years from 2000 to 2005 in Burundi, Kenya, Rwanda, Tanzania and Uganda.

11. Microfinance: what determines outreach? • Specifically, we focus on the determinants of depth and breadth of microfinance outreach. • We find that commercialization factors (or mission drift indicators) do not significantly explain the depth or breadth of outreach. • We also find that efficient MFIs have greater potential of reaching the poorest.

12. Portfolio behaviour of households in Africa • Making finance work for Africa: what do we learn from the portfolio behaviour of households in Africa? • Al-Zoubi and Murinde (2007) study the portfolio behaviour of households in African economies. • Households hold five assets, namely currency (notes and coin), demand deposit, time deposit, government debt and company securities. • In a flow-of-funds framework, we estimate asset demand equations for the household sector in Cote d’Ivoire, Kenya, Malawi, Nigeria, Rwanda, South Africa and Uganda over 1981 – 2004.

13. Portfolio behaviour of households in Africa: the evidence • We find weak substitution and complementary effects amongst the financial assets, perhaps due to the initial setbacks of the adjustment and reform programmes in most African countries in the 1980s. • We also find that asset allocations explain a major part of the variability in portfolio returns. Implications for interest rate policy and financial sector reforms? • In addition, macroeconomic factors have a strong impact on fund allocation decisions; residents seem to reflect a ‘wait-and-see’ stance in the face of uncertainties surrounding the economic prospects of the region.

14. High Cost of Capital • The dimension I would like to explore here is the cost of capital for firms or investment projects • Capital market determined prices and yields provide a benchmark against which the cost of capital for and returns on investment projects can be judged, even if such projects are not in fact financed through the stock markets.

15. High COC: Information problems? • High COC for firms is related to low financial depth: functioning capital markets are forward looking and provide a unique record of the shifts in investors’ views about the future prospects of companies and the economy. • In many respects, therefore, a capital market is a vast information exchange, which efficiently reduces transaction costs (Green, Maggioni and Murinde, 2000).

16. High COC: Information problems in African Markets • To play the above roles, a capital market must be effectively organised and operated, with a continuous flow of orders around equilibrium prices. • Few of the frontier markets in Africa live up to this ideal. • Many are characterised by intermittent trading of relatively few stocks, often held by a relatively small group of investors. • Thin markets are characterised by imperfections and asymmetric information; they cannot adequately perform their information processing and signalling functions. • They may be excessively volatile; and vulnerable to price manipulation by a small group of insiders. • Indeed, there is abundant evidence that African capital markets are inefficient in certain key respects and may be subject to “excess volatility” & speculative “bubbles”.

17. Evidence on Cost of Capital in Africa • Table 2 reports different measures of the cost of capital for firms in a sample of 11 African countries (see also Murinde, 1997). • Cost of capital: high cost of equity capital, irrespective of measure /model used • Likely consistent with scenario for a weighted cost of capital (WACC) metric as the cost of debt is also high.

18. Table 3: Cost of Equity Comparisons in African Capital Markets

19. Concluding Remarks • Low financial depth: policy reforms and incentives for an increasing role of the private sector in financial institutions, markets and instruments in Africa • Limited access to finance: (a) finance for small enterprise growth and poverty reduction in Africa; (b) microfinance outreach versus sustainability • High cost of capital: (a) research issues; (b) identify policy gaps and address key issues such as ‘missing markets’ and market failure in Africa. • Political risk: the role of finance in post-war recovery and conflict resolution in Africa

20. References Al-Zoubi, B. and Murinde, V. (2007), “Portfolio Behaviour in A Flow of Funds Model for The Household Sector in Sub-Sahara African Countries”, Finance Working Papers, Birmingham Business School. Green, C.J., Kirkpatrick, C. H. and Murinde, V. (2005), “How does finance contribute to the development process and poverty reduction?”, in C. J. Green, C. H. Kirkpatrick and V. Murinde (eds.), Finance and Development: Surveys of Theory, Evidence and Policy, Cheltenham: Edward Elgar, Chapter 1, pp. 1-26. Green, C.J., Kirkpatrick, C. H. and Murinde, V. (2006), “Finance for small enterprise growth and poverty reduction in developing countries”, Journal of International Development, Vol. 18, pp. 1017-1030.

21. References (concluded) Kirkpatrick, C.H., Murinde, V. and Tefula, M. (2007), “The Measurement and Determinants of X-inefficiency in Commercial Banks in Africa”, European Journal of Finance (forthcoming). Makame, A.H. and Murinde, V. (2007), “Empirical Findings on Cognitive Dissonance Around Microfinance Outreach and Sustainability in Africa”, Finance Working Papers, Birmingham Business School. Murinde, V. (2007), “Capital Markets in Africa: Roles and Challenges”, paper presented at the Africa Economic Conference, African Development Bank, Tunis, November 2006. Murinde, V. and Ryan, C. (2003), “The implications of WTO and GATS for the banking sector in Africa”, The World Economy, Vol. 26, No. 2 (February), pp. 181-207.