Q&A

According to the Journal of African Trade, studies have shown that interest rates on emerging market sovereign bonds are 2.9 per cent higher than comparable bonds issued by sovereigns with similar credit ratings and economic fundamentals. 

Engagement by counterparties such as  the LSF can compress yields by strengthening the demand and consequently, the price of eligible sovereign bonds. Demand would be enhanced by improving the liquidity of such instruments through a more robust and liquid repo market and by requiring sovereign bonds as collateral for development financing at competitive rates. 

Central banks, the International Capital Market Association, and large international asset management groups all confirmed the importance of a functioning repo market in compressing liquidity premiums and improving sovereign access to international bond markets. 

Repo markets play a key role in facilitating the flow of cash and securities around the financial system, with benefits to both financial and non-financial firms. A well-functioning repo market also supports liquidity in other markets, thus contributing to the efficient allocation of capital in the real economy.” Bank for International Settlements

Repo markets have been created specifically and successfully to improve the liquidity of financing instruments such as government bonds. Developed countries have long enjoyed the existence of large repo markets for their government bonds, facilitating the creation of stable and additional funding sources. The Term As- set-Backed Securities Loan Facility program initiated by the Federal Reserve of the United States in November 2008 provides a useful precedent. 

Central banks, the International Capital Market Association, and large international asset management groups all confirm the importance of a functioning repo market in compressing liquidity premiums and improving sovereign access to international bond markets.

 In the case of Africa, a well-functioning repo market could improve the liquidity of sovereign bonds by providing a mechanism for bondholders to refinance their positions. This reduces the liquidity premia. While repo markets alone will not solve Africa’s credit risk challenges, they can contribute to reducing interest rates by compressing the liquidity premium, reducing the debt vulnerabilities of African sovereigns and expanding the fiscal space for investments in critical trade-enabling infrastructure. In effect, compressing Africa’s liquidity risk premium is good for trade and the related opportunities offered by the African Continental Free Trade Area. And, collectively, these impacts can reduce credit risks and improve perceptions.

The “kickstart” effect of similar publicly funded initiatives is well established. The LSF aims to contribute to strengthening the  African bond market by attracting to it a wider range of international investors. The focus will be on international investors because the domestic investor base in African countries is limited. This explains the focus on euro-bond markets rather than domestic markets. 

The majority (around 56 %) of existing climate finance flows are being generated by the private sector. Africa receives 23% of official global public climate finance flows (OECD, 2021), but receives as little as 5% of total financial flows for climate investment (GCF, 2020). However, the lack of appropriate vehicles to channel that financing and the lack of domestic capacity have limited the ability of African countries to access those flows effectively. By leveraging the increased liquidity of Sustainable Development Goal (SDG)- or climate-linked bonds that are issued by low and middle income countries, the volume of green and blue bond financing can be dramatically increased, and at more affordable rates. 

The basis on which the LSF is prepared to engage in the market is governed by the overarching principles of debt sustainability, sustainable development and equitable benefits for the investor and the sovereign debtor. Sustainability requirements would be consistent with existing global agreements and standards, which could be factored into the lending terms of the LSF. Specifically, this is achieved by advancing financing on more favourable terms (i.e., at better rates and for longer maturities) for SDG-aligned investments and investments that contribute to the objectives of the Paris Agreement in African economies. Both the SDG and the Paris Agreement processes benefit from existing monitoring mechanisms. Currently, Africa and the Middle-East account for 1 per cent of all sustainability-linked bond issuances.

African leaders have consistently demonstrated leadership in calling for meaningful concerted global action on climate change and green recovery. 

All but two African countries have ratified the Paris Agreement with very ambitious NDCs that require about USD 3 trillion of conditional and unconditional financing for implementation, with at least 38 of those countries having already submitted their revised NDCs as required by the Paris Agreement.

As African Ministers of Finance of Democratic Republic of Congo, Ghana, Ivory Coast and Nigeria said calling for action at the Venice G20 meeting, “a successful COP26 hinges on the availability to upfront finance to change the development trajectory towards a ‘clean and green’ development model”, this is what the LSF intends to contribute to.

African Development Bank Head Akinwumi Adesina identified “energy, agriculture and infrastructure as key areas of investment potential for a post-Covid-19 recovery in Africa. With abundant solar, wind, hydro and geothermal energy resources, Africa’s energy transition alone presents a $100 billion per year investment opportunity. Agriculture potentially offers massive investments in climate-smart crops to build more resilient food systems. And climate-resilient infrastructure offers investment potential of between $130 billion and $170 billion”

He also said that “the private sector, especially small and medium-sized enterprises, is critical in mitigating climate change and implementing adaptation methods. This calls for innovative approaches to attract and steer financial flows toward low carbon and climate resilient development”. 

The LSF initially targets African economies with access to capital markets and with sound economic fundamentals. Currently, there are at least 22 African countries with access to capital markets. 

The LSF engages with counterparties established in recognized jurisdictions and of the highest quality and reputation such as insurance companies, banks, pension funds, asset management firms, and public and private investment funds.

Repo lending is structured in such a way that eligible investors are required to post collateral in excess of the loan value (i.e., maintain a margin), and should there be a decrease in value of the posted collateral, the LSF would issue a margin call and require the investor to advance more bonds or cash to compensate for the loss in value.

 Target investors likely to participate in the LSF being insurance companies, pension funds, asset managers, public and private investment funds and commercial banks, any scenario where the private investor fails to repay the LSF would constitute a default event for the counterparty in question, which has been a very rare occurrence historically.

An  objective of the LSF is to support the access of African Sovereigns to capital markets. This may indeed result in volume expansion for countries that investors are willing to fund. Governance and sound financial management are therefore crucial to ensure prudence in investment choices and transparency and accountability in the use of funds. 

On the contrary, in the event of tightening markets, the LSF would provide investors with the option of holding to their positions while generating any cash necessary to sustain their investment policies in the short term. From that perspective, the LSF doesn’t contribute to the downward pressure that can be felt in such situation.

It must also be noted that the LSF is not a mechanism to backstop central banks or local markets. Its focus is to engage in the repo market relating to Eurobonds issued in hard currencies by middle-income and low-middle-income countries. As such, it has no impact on local monetary policies. 

For the G7 to reach its target pledge of $100Bn a year by rich countries to help poorer countries cut carbon emissions and cope with global warming it needs practical and actionable solutions such as the LSF, which is endorsed by the largest economies in Africa. Further, the challenges the LSF aims to contribute to alleviate such as the pandemic and climate change are both global in nature. In such environment, cooperation is the best way forward to tackle these challenges as no country on its own can address these problems in a sustainable way. We believe the LSF presents a unique opportunity not only to alleviate Africa’s pressing issues and transform the continent’s development path, but also to contribute to the establishment of long-lasting solutions to some of the world’s most pressing issues which would benefit all parties.

The LSF would charge a spread above prevailing interest rates on every repo transaction. The spread level will be a function of the current market conditions and the specificities of each transaction (credit, maturity, quality of the collateral, etc.). The spread plus the full interest rate received from the repo counterparties are expected to cover and pay for all costs incurred by all parties involved.

The LSF aims to provide improved terms for Green and SDG Linked Bonds to foster green finance in Africa, still the overall spread received would remain higher than SDR on-lending costs.