LFI

Local Finance
Initiative

Infrastructure Financing Market in

Ethiopia

1
Copyright © United Nations Capital Development Fund, 2016
P.O. Box 60130
Addis Ababa, Ethiopia
Tel: +251 91250 6767
Website: www.uncdf.org

All rights reserved

First printing: May 2016

Material in this publication may be freely quoted or reprinted. Acknowledgement is requested,

together with a copy of the publication.

The views expressed in this publication are those of the author(s) and do not necessarily
represent the views of UNCDF, the United Nations or any of its affiliated organizations or its
Member States.

The designations employed and the presentation of material on the maps and graphs
contained in this publication do not imply the expression of any opinion whatsoever on the
part of the Secretariat of the United Nations or UNCDF concerning the legal status of any
country, territory, city or area or its authorities, or concerning the delimitation of its frontiers
or boundaries.

Author: Dmitry Pozhidaev

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Contents
ACRONYMS ............................................................................................................................................................... vi
FOREWORD ............................................................................................................................................................. viii
Executive Summary ................................................................................................................................................. ix
1. INTRODUCTION ................................................................................................................................................... 1
1.1 Infrastructure Needs and Infrastructure Finance in Developing Countries .......................................... 2
........................................................... 3
1.3 Focus of the Research ................................................................................................................................... 5
2. INFRASTRUCTURE FINANCING MARKET ......................................................................................................7
2.1 Characteristics of the Infrastructure Financing Market ............................................................................7
2.2 Infrastructure Financing Market Defined ................................................................................................... 8
2.3 State of the Infrastructure Financing Market in Developing Countries ...............................................13
2.3.1 Equity Financing .....................................................................................................................................13
2.3.2 Debt Financing ...................................................................................................................................... 14
2.3.3 Public Sector Financing ........................................................................................................................ 17
2.4 Infrastructure Financing Constraints in Developing Countries ........................................................... 19
2.4.1 Capital market imperfections ............................................................................................................. 20
2.4.2 Characteristics of borrowers .............................................................................................................. 23
2.4.3 Macroeconomic Factors ..................................................................................................................... 23
3. RESEARCH METHODOLOGY ......................................................................................................................... 25
3.1 Research Aim and Objectives ..................................................................................................................... 25
3.2 Research Methods........................................................................................................................................ 25
3.3 Issues of Reliability and Validity ................................................................................................................. 27
4. EMPIRICAL RESULTS: STATE OF THE ETHIOPIAN INFRASTRUCTURE FINANCING MARKET .. 28
4.1 Macroeconomic environment ................................................................................................................... 28
4.2 Equity Financing ............................................................................................................................................31
4.2.1 Private Nonfinancial Sector ..................................................................................................................31
4.2.2 Banking Sector ...................................................................................................................................... 32
4.2.3 Insurance Sector ................................................................................................................................... 32
4.2.4 Venture and Private Equity Firms ....................................................................................................... 33
4.2.5 Commodity Exchange Market............................................................................................................ 35
4.2.6 Equity Market Characteristics ............................................................................................................. 36
4.2.7 Equity Market Assessment ................................................................................................................... 38
4.3 Debt Financing.............................................................................................................................................. 38
4.3.1 Overview of the Banking Sector ......................................................................................................... 38

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 4.3.2 Bond Financing ..................................................................................................................................... 39
4.3.3 Loan Financing ...................................................................................................................................... 40
4.3.4 Debt Market Assessment ..................................................................................................................... 48
4.4 Public Sector Financing and Nonfinancial Support ............................................................................... 49
4.4.1 Subnational Government Financing .................................................................................................. 49
4.4.2 Institutional and Mixed Financing ...................................................................................................... 52
4.4.3 Domestic Financing and Nonfinancial Support .............................................................................. 55
4.4.4 Bilateral and Multilateral Financing and Nonfinancial Support .................................................... 57
4.4.5 Public Sector Market Assessment ...................................................................................................... 60
4.5 Demand Side of the Infrastructure Financing market ........................................................................... 61
5. CONCLUSIONS AND RECOMMENDATIONS ............................................................................................. 63
5.1 Demand for infrastructure Finance ........................................................................................................... 63
5.2 Supply for infrastructure Finance .............................................................................................................. 66
5.2.1 Equity Financing .................................................................................................................................... 66
5.2.2 Debt Financing ...................................................................................................................................... 68
5.2.3 Public Sector Financing and Nonfinancial Support ........................................................................ 70
5.2.4 Concluding General Remarks ............................................................................................................ 72
BIBLIOGRAPHY ....................................................................................................................................................... 80
ANNEXES .................................................................................................................................................................. 87
Annex 1. Analysis of the Surveyed Institutions ............................................................................................... 87
A1.1 General Composition of the Survey Participants ............................................................................. 87
A1.2 Policy Makers and Regulators .............................................................................................................. 87
A1.3 Characteristics of Financial Market Participants ............................................................................... 88
Annex 2: Research Analytical Framework ...................................................................................................... 91
Annex 3: Analysis of Bank-Level Determinants Affecting Long-Term Lending in Ethiopia .................. 93
Annex 4: Analytical Assessment Matrix ........................................................................................................... 98

List of Tables
......7
9
Table 3: Infrastructure financing market: Type of financing, capital providers and instruments
Table 4: Ethiopia: GTP II Targets and IMF Projections (2015/16 2019/20)
Table 5: Ethiopia: Risk assessment 29
Table 6: Real Interest Rates, 2013/14 ..30
Table 7: Ratings of macroeconomic indicators

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Table 8: Risk free rate, market risk premium and required return on equity according to domestic
financial institutions
Table 9: Ratings of equity financing indicators
Table 10: Corporate Bond Issuance, ETB million
Table 11: Domestic lending (origination and outstanding loans), ETB million ......41
Table 12: Average loan portfolio by maturity for Ethiopian banks
Table 13: Ratings of debt finance indicators
Table 14: PSSSA asset allocation strategy
Table 15: Public sector assessment ....60
.73
Table 17: Recommendations to the Government and development community 75
Table 18: Recommendations for programmatic support to infrastructure finance Ethiopia
Table A1: Type and number of surveyed agencies by category 87
Table A2: Surveyed policy makers and regulators
Table A3: Surveyed banks by capitalization and share of loans and advances
Table A4: Surveyed insurance companies by capitalization
Table A5: Definition of regression variables
Table A6: Descriptive statistics of bank financial characteristics
Table A7: OLS regression results
Table A8: Bivariate correlations for model variables

List of Figures
.10
Figure 2: Domestic credit to private sector (% of GDP) in select developed and developing
economies
16
....17
Figure 4: Mechanisms of public sector support for infrastructure financing ..19
Figure 5: Collateral requirements, % of loan (2014-2015) ..22
Figure 6: Ease of Doing Business Ranking (2015)
Figure 7: Inflation and USD exchange rate, 2004-2013
Figure 8: International comparisons of required returns on equity, 2015
Figure 9: Perceptions of availability of investment information and quality of financial data
Figure 10: Trends of loan portfolio, Wegagen Bank

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Figure 11: Term structure of lending interest rates
Figure 12: Riskiness of medium- and long-term infrastructure loans
Figure 13: Satisfaction of the demand for medium and long-term loans
Figure 14. Federal structure of the Ethiopian Government
Figure 15: Major reasons for rejecting loan applications for infrastructure financing
Figure 16: Project development support
Figure 17: Indicative structure of a Local Infrastructure Finance Fund 72

List of Boxes
Box 1: Busia Multi-Purpose Parking Project
Box 2: Schulze Global Ethiopia Growth and Transformation Fund I

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ACRONYMS

AFD Agence Française de KfW Kreditanstalt für

Développement Wiederaufbau
AGP Agricultural Growth Program LDC Least Developed Country
AIB Awash International Bank LFI Local Finance Initiative
ATA Agriculture Transformation MDB Multilateral Development
Agency Bank
BI Business Interruption MFI Microfinance Institution
CBE Commercial Bank of Ethiopia MIGA Multilateral Investment
Guarantee Agency
CEAR Construction and Erection All
Risks MoARD Ministry of Agriculture and
Rural Development
CRB Credit Reference Bureau
MoCIT Ministry of Communication
DBE Development Bank of
and Information Technology
Ethiopia
MoFED Ministry of Finance and
DFID Department for International
Economic Development
Development (UK)
MoI Ministry of Industry
DSU Delay in Start-up
MoWE Ministry of Water and Energy
EEPCO Ethiopian Electric Power
Corporation MUDHC Ministry of Urban
Development, Housing and
ECX Ethiopian Commodity
Construction
Exchange
NBE National Bank of Ethiopia
EIA Environment Impact
Assessment PFI Public Financial Institutions
EIC Ethiopian Investment PSSSA Public Servants Social
Commission Security Agency
ETB Ethiopian Birr REF Rural Electrification Agency
FCA Federal Cooperative Agency ROE Return on Equity
FEMSEDA Federal Micro and Small SACCO Savings and Credit
Enterprises Development Cooperative
Agency
SEIA Socio-Economic Impact
GDP Gross Domestic Product Assessment
GNI Gross National Income SHIA Social Health Insurance
Agency
IMF International Monetary Fund

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SME Small and Medium UNCTAD United Nations Conference
Enterprises for Trade and Development
SNNP Southern Nations,
Nationalities and Peoples
UNDP United Nations Development
(Region in Ethiopia)
Program
SOE State Owned Enterprise
USAID United States Agency for
TSP Technical Service Provider International Development
OECD Organization for Cooperation
and Development
UNCDF United Nations Capital
Development Fund

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 FOREWORD

We are pleased to present this study on the infrastructure financing market in Ethiopia
commissioned by UNCDF and carried out with the support of other UN agencies, the
government, private sector and non-government institutions. The study is an example of a
practical and tangible response of the UN system in Ethiopia to the development challenges
faced by the country, particularly in the context of the newly adopted 2030 Agenda for
Sustainable Development and the Addis Ababa Action Agenda (AAAA).

Ethiopia has embarked on the implementation of its second Growth and Transformation Plan
(GTP II), an ambitious development blueprint that sets the objective of making Ethiopia a
middle income country by 2025 by accelerating the growth and transformation of the
economy. GTP II makes strong emphasis on fast transformation and capacitating of local
investors and on increasing the accessibility and quality of infrastructure and social services.
GTP II stresses a number of conditions for achieving its ambitious goals, including overcoming
the growing gap between savings and productive investments. Both the 2030 Agenda for
Sustainable Development and the AAAA recognize the vital role of public finance in catalyzing
other sources of finance as well as the critical importance of the diverse private sector in the
implementation of the new Agenda.

The UN in Ethiopia has recently finalized the new UN Assistance Development Framework
(UNDAF), which is fully aligned with the GTP II priorities and endeavors to assist the people and
the Government of Ethiopia in achieving their national goals as well as the 2030 Agenda for
Sustainable Development. As part of the UN system in Ethiopia, UNCDF exercises its unique
financial mandate within the UN system to assist developing countries in the development of
their economies by supplementing existing sources of capital assistance by means of grants
and loans. Hence, UNCDF commissioned this study of the infrastructure financing market to
investigate the opportunities for financing small- and medium-sized economic infrastructure
in Ethiopia through mobilization of domestic public and private resources. The findings and
recommendations of this study are designed to suggest key actions that can be undertaken by
the Government of Ethiopia and international development partners to unlock the domestic
capital market for local infrastructure in productive sectors. It is hoped that it will stimulate
debate and engage Ethiopians throughout the country, as well as international partners, in
creat
development gains.

David Jackson Ahunna Eziakonwa-Onochie

Director, UNCDF Local Development United Nations
Finance Practice Resident Coordinator

viii
Executive Summary

This
opportunities for financing small- and medium-sized economic infrastructure in Ethiopia
through application of advanced financing techniques, such as project finance, in the context
of the efforts currently undertaken by the United Nations Capital Development Fund (UNCDF).
The structure and approach of the research were defined by the requirements of the Local
the effectiveness of financial
resources for local economic development through mobilization of primarily domestic private
capital and financial markets in developing countries to enable and promote inclusive and
sustainable local development. However, the findings and recommendations of this scan refer
to the situation of the infrastructure financing market as a whole and are designed to suggest
key actions that can be undertaken by the Government of Ethiopia and development partners
to unlock the domestic capital market in Ethiopia for local infrastructure as well as to inform

Consequently, the aim of the research was to investigate the opportunities for unlocking
financing markets for small- and medium-sized economic
infrastructure investments through introduction of advanced project financing techniques. In
the context of the overall aim, the research endeavors to answer two questions:
 To what extent do the state
permit increased supply of domestic capital for small- and medium-sized local
infrastructure?
 Given the state of the capital market and conditions for infrastructure finance, what
project financing techniques would be particularly useful for achieving this goal? Are
advanced project financing techniques, such as project finance, a feasible and
appropriate approach?
The research used a mixed methods design, including primary research through a survey of

research were collected through a survey involving 38 financial and nonfinancial institutions
with substantive roles in the infrastructure financing market.
The research provides a definition of the infrastructure financing market and analyzes its three
dimensions: equity financing, debt financing, and public sector financing and nonfinancial
support. The research notes significant challenges on both the supply and demand sides of
the infrastructure financing market and notes its limited capacity to increase supply of capital
for infrastructure investments and to apply advanced financing techniques. However, the
research argues that the same challenges make the objective of unlocking domestic capital
markets very relevant in the Ethiopian context and justify introduction of advanced project
financing techniques. At the same time, the research notes the need for broader policy and
regulatory actions to ensure that the advances achieved through such programs are both
sustainable and replicable. Some of these policy and regulatory actions are long-term and may

ix
require a substantive review of the existing policies and approaches while others can be easily
incorporated into the currently used policies and regulations through a process of natural
development and upgrading. The study also recommends that the outcomes and objectives
of programs that aim at addressing imperfections of the domestic capital market be adjusted
to the realities of the Ethiopian infrastructure financing market and realigned with the
government policy and developmental priorities.
The recommendations target seven key areas:
 Improving demand for capital finance: including establishment of a Project
Development Fund to provide technical and financial advisory services to public and
private project sponsors and integrating technical and financial advisory services to the
existing and future grant and guarantee schemes.
 Adequate regulatory framework for financing local economic infrastructure:
including defining investments in local economic infrastructure as an investment class
in its own right; introduction of a diagnostic and planning process at the subnational
level to incorporate and mainstream public-private partnership as a substantive
element; and revision of the borrowing limits of subnational governments based on
application of project financing.
 Improved awareness and incentive framework for equity providers: including
creation of an incentive framework for private equity firms to finance local economic
infrastructure (e.g., tax relief, partial guarantees, intercepts, etc.) and establishment of
mechanisms for regular interaction with the private sector to ensure timely
dissemination of investment information.
 Development of the private financial sector including review of the regulatory
barriers to lending for small- and medium-sized infrastructure by private banks and
improvement of the awareness of private financial institutions on opportunities and
methods of infrastructure investments.
 Full use of the DBE and CBE potential for productive long-term lending including
designing financial vehicles that tap into CBE and DBE resources as the primary source
of debt finance for local economic infrastructure in the short run.
 Gradual introduction of project finance and other advanced methods of
infrastructure finance including creation and application of financial products required
for supporting project financing deals and delivery of capacity building mechanisms for
a broad range of relevant stakeholders in advanced infrastructure finance..

Improved use of public support mechanisms for infrastructure financing including a

dedicated financing mechanism for small- and medium-sized infrastructure,
mono-thematic or with multiple thematic windows (Local Infrastructure
Finance Fund) and introduction of performance measures for public sector
entities, particularly subnational governments, related to the leverage of private
capital for infrastructure development.

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1. INTRODUCTION

This research of the infrastructure financing market focuses on the opportunities for financing
small- and medium-sized economic infrastructure in Ethiopia through application of advanced
financing techniques, such as project finance, in the context of the efforts currently undertaken
by the United Nations Capital Development Fund (UNCDF).1 As explained in the following
paragraphs, the research chooses a specific entry point of economic small- and medium-sized
infrastructure to analyze the situation of the infrastructure financing market in Ethiopia. The
findings and recommendations of this scan are designed to inform, through the prism of this
particular class of infrastructure, policy actions and programming activities that aim at
addressing imperfections of the domestic capital market as well as to analyze UNCDF
programming opportunities for launching the Local Finance Initiative, a global program that
seeks to increase the effectiveness of financial resources for local economic development
through mobilization of primarily domestic private capital and financial markets in developing
countries to enable and promote inclusive and sustainable local development.

The research endeavors to investigate the opportunities for unlocking domestic finance for
potentially profitable infrastructure investments, whether private, public, or mixed with a
noticeable impact on local development. The small- and medium-sized infrastructure is
defined in the context of LFI as economic projects in the range of $100,000 - $20,000,000.

Economic infrastructure projects refer to infrastructure projects that are economically viable,
i.e. generate a stream of revenues sufficient for financing and operating the project. From the
economic point view, such projects produce private goods characterized as rivalrous and
excludable. At the same time, the produced goods must demonstrate enough positive
externalities to justify the public sector involvement in their development and finance. In the

infrastructure should firstly, leverage the local development potential (i.e. the local
endowments, natural and human resources) and secondly, generate local economic and social
returns. In other words, such projects demonstrate what is known in financial terms as a triple
bottom line , which includes economic benefit, social responsibility, and environmental
safety. Following Bond et al. (2012), examples of economic infrastructure include warehouses,
transport depots and terminals, markets, energy generation facilities, processing plants and

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UNCDF has a unique financial mandate within the UN system. It provides investment capital and
technical support to both the public and the private sector. The ability to provide capital financing -- in
the forms of grants, soft loans and credit enhancement and the technical expertise in preparing
portfolios of sustainable and resilient capacity building and infrastructure projects, makes its mandate a
very useful complement to the mandates of other UN agencies. It also positions UNCDF as an early
stage investor to de-risk opportunities that can later be scaled up by institutional financial partners and
increasingly by philanthropic foundations and private sector investors (UNCDF, 2014).

1
similar, capable of producing revenues (see Box 1), including the cases when revenue
production is supported through public funds (e.g., output-based aid).

Box 1: Busia Multi-Purpose Parking Project

One of the economic projects supported by UNCDF in Uganda included a multi-purpose parking
project in the District of Busia on the border with Kenya. The project uses the strategic border
location of the district and is designed to facilitate the cross-border movement and trade between
Uganda and Kenya. UNCDF helped develop and design the project as a tripartite public-private
partnership between the local government, Church of Uganda and a private investor (Agility Uganda
Limited). De-risking the project through local economy analysis, feasibility studies, structuring and
financial modelling resulted in leveraging 70% of the total cost of this US$ 2.5 million worth project
in private equity and debt. The project (currently under implementation) will greatly improve traffic
flow and make the town clean; boost business for the region; create over 100 jobs directly or
indirectly including, lorry, petrol station, and shop attendants; and in addition to the license fees
collected from traders, allow the local government to receive 10% of the project revenue quarterly.

1.1 Infrastructure Needs and Infrastructure Finance in Developing Countries

growth performance and has the potential to contribute even more in the future (World Bank,
2010), an inadequate economic infrastructure has been widely recognized as one of the
growth constraints in developing and particularly least developed countries (LDC). The World
Bank estimates that $1.1 trillion in annual infrastructure expenditure is needed in developing
countries through 2015, of which the greatest needs, as a share of GDP, are in low income
countries, estimated at 12.5 percent of GDP (World Bank, 2011).

developing countries, most finance has been directed towards large-

projects that receive substantial funding from national governments, development finance

2
institutions and donors include large transportation infrastructure, energy production and
distribution, communications, water and waste management projects.

However, smaller economic infrastructure, particularly in rural and peri-urban areas receives
far less attention despite its importance for generating local growth, which eventually
translates into accelerated national development. Even when an excess capacity exists,
domestic financial institutions, including large institutional investors, shy away from such
investors. A UN report stresses the challenge of longer-term domestic financing, noting that
develo
securities accounting for 61 per cent of global foreign exchange reserves. The continued
accumulation of safe low-yielding investments comes at significant opportunity costs, since
reserves could have been invested in domestic resources at much higher returns and with a

Given the international consensus about the significance of domestic capital, particularly
private capital, as a source of development finance (as reflected, for example, in the Addis
Ababa Action Agenda on Financing for Development, 2015), mobilization of domestic capital
for small- and medium-sized economic infrastructure investments is a topical task. UNCDF
approaches this task through application of more advanced financing techniques, such as
project finance, for structuring and financing of transformative infrastructure projects at the
local level.

1.2 requirements

Ethiopia has demonstrated robust and sustained growth during the past decade. The most
recent data, for 2013/14, reveal that GDP registered a growth rate of 10.3 per cent (NBE, 2014);
and this growth was accompanied by an increase in the domestic savings rate and a low
budget deficit of 2 percent of GDP helped by a prudent fiscal policy UNDP (2015b). As UNDP
(2015b The
sources of growth in Ethiopia have gradually shifted over the decade from agriculture to
services and from private consumption to public investment. On the demand side, public
investment has become the dominant growth engine in recent years. On the supply side,
e the result of expansion in the services sector than
the agriculture sector.
accounts for about 45 percent of GDP and roughly 60 percent of export earnings and employs
about 75 percent of the population (UNDP, 2015b).

II (GTP II), is to
increase per capita income of its citizens to middle-income levels by 2025 and to transform
the economy by developing the agricultural sector and by raising the share of industry through
expanded investment. The GTP II is designed to enable the economy to grow at an average of
11% a year to enable structural transformation of the economy. It will involve stabilization of
the macro-economy, keep inflation in single digits, and stabilize foreign exchange rates. The
current fiscal policy, focusing on effective administration of tax policies, raising tax revenue,

3
allocating public expenditure on capital investment and on key poverty-reduction sector will
continue. Efforts will be made to cover major investments by mobilizing internal savings,
narrowing the gap between investment and savings. The aim is to provide appropriate fiscal
policies to allow internal revenue to reach 29.6% of GDP and for investment to account for
41.3% of GDP by the end of the GTP period. Agricultural production is to double, to ensure
food security in Ethiopia for the first time and the contribution from the industrial sector
(particularly focused on increased production of sugar, textiles, leather products, and cement)
should increase. The strategy for achieving this is structural transformation to change the
structure of current production (which is mostly subsistence) to commercially oriented small-
scale production, including for exports.

The Plan makes special emphasis on the development of manufacturing industries and related
infrastructure, particularly small industries, which should provide for up to 6 million new jobs
in the GTP II period with support and encouragement to produce competitive price and quality
products. The private sector will be expanded to include increased public-private partnership.
Attention will be given to make government services transparent, accountable, fair, efficient,
effective, and predictable, and remove bottlenecks in infrastructure, logistics, credit and
finance, foreign currency provision, customs systems, and tax administration.

At the same time, there is insufficient emphasis in the Plan on development and financing of
local infrastructure to support small and medium-sized manufacturing industries. The GTP II
continues the big-push investment program launched under the previous GTP, focusing on
large government-sponsored investments, primarily in the energy sector and transport.

For years,
emphasizing massive public investments in infrastructure. However, this model has proved to
be insufficient for structural transformation, which is a critical conditions for GTP
implementation. The agriculture sector has been showing rather moderate growth rates in the
past year (5.4 percent in 2013/14, according to NBE). At the same time, industry contributed
only 14.2 percent in total domestic output and 26.4 percent to the overall economic growth
(NBE, 2015). The labor force composition has changed insignificantly: For the past ten years,
the share of the population employed primarily in the agricultural sector has fallen only by 8
percent, from 81 percent to 73 percent in 2013 (CSA, 2014). The transformation agenda is not
achievable only through the large-scale infrastructure investment emphasized in the GTP II.
An adequate localized infrastructure that leverages the local development potential will be
critical for increasing the share of manufacturing industries and agricultural processing in the

The government thus realizes the need for enhancing investment in manufacturing sector
competitive advantages 4: 4). IMF (2015) expresses

substantial investment in key industries. UNDP (2015b

the momentum [from supporting public infrastructure] towards directly productive sectors
the GTP goals.

4
The World Bank (2012:14) notes the limited availability of domestic resources and argues that

growth in Ethiopia, will not be sufficient to maintain hi

The World Bank therefore stresses the criticality of enhanced opportunities for domestic and
-led job creation
agenda, significantly leverage public sector financing and foster technology and knowledge

Creation of economic infrastructure with active participation of the private sector is not only a
key growth requirement for the achievement of the GTP goals but also a powerful tool to
address development inequalities between various regions of Ethiopia that are characteristic
of its growth (UNDP, 2015b) if such infrastructure investments tap into the potential of specific
localities and are based on their comparative advantages.

1.3 Focus of the Research

the limited capacities of the state to continue to finance economic growth through
transformation, the research is se
domestic infrastructure financing markets for small- and medium-sized economic
infrastructure investments through introduction of LFI support.

LFI is a global program with three initial pilots in Tanzania, Uganda and Bangladesh that intends
to improve the effectiveness of financial resources for local economic development. The
program focuses on addressing the widely acknowledged problem of blocked domestic and
private financial sectors, resulting in a suboptimal allocation of funds to productive uses critical
to development. As a result, social resources are used at a suboptimal level, resulting in
diminished total social benefits. In essence, the program strategy consists of bringing the
supply and demand to an optimal level by reducing perceived risks and transaction costs of
financial services for all local development stakeholders and participants of the finance market.

The program targets five major institutional groups engaged in support to local infrastructure:

 Project developers: Private businesses, local governments, domestic non-

government sector. This includes SMEs and farmers suffering from a lack of basic
industrial infrastructure such as warehouses and logistic services, processing plants,
cold storage facilities, and traditional infrastructure services as irrigation, water,
energy, transport, communications, etc.
 The financial sector and related services: Commercial banks, institutional
investors such as pension funds and insurance companies, as well as service
providers such as public and private credit bureaus, consulting and accounting
firms, lawyers and others providers that are needed to building internal capacity for
developing and financing infrastructure projects.
 Local governments: Local institutions with a mandate to promote the economic
and social development of their territorial jurisdictions. These institutions produce

5
 social and economic development plans, engage with local chambers of
commerce and also have responsibilities to promote an enabling environment for
local economic development.
 Government agencies: ministries and agencies defining policy development and
finance, and regulatory and operational frameworks, such as ministries of local
government, finance, investment promotion, investment, trade and commerce,
government regulators, and others.
 International development community: UN family and Bretton Woods
institutions, bilateral development partners, multilateral development agencies and
international non-government organizations which provide invaluable technical
assistance at the local level.

LFI approach is executed through four main programmatic features:

1. Project development activities that enable the identification and development

of up to 4 demonstration proje

for investments in strategic, smaller scale infrastructure projects.

2. Finance and credit enhancement facilities to enable jumpstarting the process of
project identification, development and deal/financing structuring. Where
appropriate, and depending on availability of funds, UNCDF will provide and / or
facilitate financing to project sponsors to enable access to domestic finance;
3. Capacity-building activities that provide for the training of public and private
stakeholders and increased government capacity to facilitate finance, project
development, and business-enabling environments
4. Monitoring and evaluation and impact verification. One important outcome of
the LFI project will be its contribution to the measurement of investment impact.
The Impact Reporting and Investment Standards (IRIS) network will be involved
in designing a framework for measuring the impact on LED.

In line with this design and requirements, the research has the following primary objectives:

 To design an assessment matrix enabling an analysis of the key features of the

national infrastructure financing market that can be used in various country
contexts.

identify its capacity for increased supply of capital for local infrastructure.
 To analyze the applicability of advanced project financing techniques against the
established conditions.
 To make recommendations concerning and suitability of the infrastructure market
conditions for advanced project financing methods.

6
2. INFRASTRUCTURE FINANCING MARKET
Whereas the overall design of the scan is driven by the LFI practical information requirements
that would determine whether adequate conditions exist for its launch in a particular country,
the approach detailed in the subsequent sections is based on a solid theoretical foundation.

Central to this research is the concept of infrastructure financing market, particularly its
segment that deals with the infrastructure within the cost range of LFI. Prior to defining the
infrastructure financing market, it is necessary to analyze the characteristics of finance for
economic infrastructure.

2.1 Characteristics of the Infrastructure Financing Market

Literature on this subject stresses several characteristics of infrastructure investments as
compared to more traditional asset classes. Thus, Grigg (2010) and Estache (2010) emphasize
a number of economic characteristics, such as long-term nature and a link to provision of key
public services (e.g., transportation, telecommunications energy, water and waste sectors,
etc.). Other authors focus on financial characteristics of infrastructure investments, such as
frequent natural hedge against inflation and stable, predictable operating cash flows, and a
relatively high ratio of debt to equity (Yescombe, 2002). Croce and Gatti (2012) note regulatory
characteristics of infrastructure investments, such as natural monopoly or quasi monopoly
market context, high entry barriers and regulated assets. Others note the continued significant
role of public sector finance, either through direct public investments or through provision of
de-risking and non-financial support to the private sector (World Bank, 2004; Seidman, 2005;
Delmon, 2011). Of special importance in the context of developing states is the financing role
played by development banks and agencies, and guarantee agencies whose share in the total
infrastructure investments reaches as high as 15-20% (Estache, 2010: 79).

Table 1. Typical characteristics of infrastructure investments

Economic  Long-term assets with long economic life

 Strongly non-elastic demand due to the unique nature of
infrastructure
 Provision of key public services
Financial  Long-term equity or debt finance
 Stable, predictable operating cash flows
 Frequent natural hedge against inflation
 Relatively high ratio of debt to equity (leverage)
 Significant public sector finance, de-risking and non-financial
support
 Finance and de-risking instruments by international development
agencies
Regulatory  Natural monopoly or quasi monopoly market contexts
 High entry barriers because of a high capital requirement
 Regulated assets

7
2.2 Infrastructure Financing Market Defined

Infrastructure finance implies primarily fixed asset finance. It is known from standard theory of
corporate finance (e.g., Brealey at al., 2011) that firms finance fixed assets either through capital
with no maturity or long-term maturity, coming from either internal sources (retained
earnings) or external (a mix of equity and long-term debt). This is also true for the public sector
when it finances infrastructure investments either directly through a partnership with the
private sector.

Hence, the three major sources for infrastructure financing include:

 Equity financing. Researchers explain the relatively important role of equity in financing
infrastructure investments in developing countries by three factors (World Bank, 2004;
Spratt, 2009; Estache, 2010). Firstly, the state remains the single most important
investor in infrastructure at all levels, particularly in infrastructure that supports public
services. Secondly, domestic equity markets are underdeveloped and do not allow
private companies to raise significant capital for infrastructure finance (UN, 2005).
Thirdly, this venue is available for large and established firms whereas for smaller firms
raising equity publicly is prohibitively expensive while their access to debt financing (as
discussed below) is also significantly curtailed until they have reached a critical stage of
development.
 Debt financing. In developing countries debt financing may vary significantly and be
as, or even more, expensive than equity. Whereas developing countries benefit from
long-term preferential loans by international development agencies and banks, the cost
of domestic debt often remains high. Indeed, the extant research (e.g., Booth et al.,
2001) confirms that the capital structure of private firms in developing countries is
much less leveraged than in developed countries and that developing countries have
substantially lower amount of long-term debt. The domestic bond market in
developing economies is often underdeveloped, undercapitalized or simply non-
existent, which is particularly true for sub-Saharan Africa (Mu et al., 2013: 9). At the same
time, domestic credit to the private sector is insufficient and often subject to rationing.
This is particularly true for small and medium-sized enterprises: In most African LDCs,
between 70% and 90% of SMEs lack access to formal financial institutions (UNCTAD,
2014).
 Public sector financing. Bagchi (2001: 385) connects the dominant role of the public

non- The authors of the 2008 flagship

Growth Report emphasize the direct interdependence between the level of
infrastructure investment and growth rates, and call for increased public sector finance
for infrastructure, particularly in Africa (World Bank 2008: 36). Hence, the public sector,
in particular public financing institutions (PFIs) are critical actors in the flow of finance
for infrastructure development into/within developing countries. A number of research
indicate four major avenues for the public sector support to infrastructure investments

8
 (Seidman, 2005; World Bank, 2010; Delmon, 2011). These include both financial and
non-financial support: (1) direct financing of public infrastructure projects; (2) financing
of private sector infrastructure projects; (3) public-private partnerships and (4) advisory
services and facilitation.

Infrastructure projects can obviously be financed using a variety of financing methods and
techniques, the most common of which is corporate financing via equity or debt. There are
however two methods that are particularly suited to financing of long-term assets with long
economic life, project finance and leasing.

Project Finance. Of particular interest in the context of this research is project finance, which
structured financing of a specific economic entity the SPV, or special-
purpose vehicle, also known as the project company created by sponsors using equity or
mezzanine debt and for which the lender considers cash flows as being the primary source of
loan reimbursement, whereas assets represent only collateral .

A number of authors argue that in practice project finance presents an effective way of
financing tangible assets (Yescombe, 2002; Easty, 2004; Gatti, 2012). Croce and Gatti (2014:

financial markets have developed for the participation of private capital in unlisted
In particular, project finance allows equitable allocation of project risks
between the parties involved in the transaction such that each risk is managed by a party that
is best positioned to manage it. Consequently, the deal can attain a debt-to-equity ratio that
is not otherwise achievable.

The key characteristics of project finance as compared to more traditional corporate finance
are summarized in Table 2.

Table 2: Key characteristics of project finance and corporate finance

Factor Project Finance Corporate Finance

Guarantees for financing Project assets Assets of the borrower

(already-in-place firms)
Effect on financial elasticity No or heavily reduced effect Reduction of financial
for sponsors elasticity for the borrower
Accounting treatment Off-balance sheet (the only On-balance sheet
effect will be either
disbursement to subscribe
equity in the SPV or for
subordinated loans)
Main variables underlying the Future cash flows generated Customer relations
granting of financing by the project Solidity of balance sheet
Profitability

9
 Degree of leverage utilizable Depends on effects
on Depends on cash flows
generated by the project
(leverage is usually much
higher)
Average weighted cost of Relatively low due to high Relatively high due to low
capital leverage leverage

Adapted from: Gatti, 2012: 19.

The ability of project finance to support a high leverage based on the nature of the
infrastructure project rather than on and the balance sheet makes it
a potentially promising method of raising capital for infrastructure in the context of developing
countries. Since project risks can be isolated within an SPV structure, relatively small private
investors may gain access to dormant public and private capital, thus putting it to a better
productive use.2

Project financing is used not only for financing private infrastructure also as an approach to
implementing PPPs with a significant infrastructure component (Delmon, 2011), the following
diagram illustrates the application of project financing in a PPP context.

Figure 1: PPP Project financing: Structure and financial flows

Shareholders
Equity and/or
Equity quasi-equity

Public entity/
Net income
As s e t s

Private entity
Ass

Government
Ass

Credit
enhancement
NO RECOURSE
Capital
Loans or investments &
mezzanine Project operating
products costs
Lenders Company Project
Principal and (SPV) Revenues
interest
repayments

2
t LDCs have underdeveloped
financial sectors, and therefore low levels of bank lending, which is often oriented towards consumption,

development of a fina
(UNCTAD, 2014: 118).

10
Leasing. Another method often mentioned in the context of infrastructure financing is leasing.
Fabozzi et al. (2006: 207) define
equipment permits another entity to use it in exchange for a promise by the latter to make a
Leasing is often described as an alternative financing method different to
conditions of a debt or equity contract (Curtiss, 2012).

Leasing has become a popular method of financing the equipment component of

infrastructure projects, more than bank loans or private placements (Fabozzi et al., 2006).
mpirical studies suggest that leasing is a more expensive
method of acquiring assets relative to standard debt purchase instruments, which is likely due
to the fact that lessors (providers and owners of assets) are not restricted by interest rate
ceilings and also due to insurance payments that are included in the lease price . At the same
time, a number of authors describe leasing as an attractive alternative to purchasing. Thus,
Seidman (2005) and Fabozzi et al. (2006) argue that payments under a lease may be lower than
through asset acquisition with debt financing depending on the size of the transaction and
whether the lease is tax-oriented or non-tax oriented.

To arrive at a more accurate definition of the infrastructure financing market, it is necessary to

summarize the above review of various financial sectors that provide capital for infrastructure
investment (Table 3).

Table 3: Infrastructure financing market: Type of financing, capital providers and

instruments

Type of financing Capital providers Instruments

Equity financing  Wealthy individuals  Non-listed ordinary shares
 Private equity and venture  Listed ordinary shares
capital firms  Listed preference shares
 Public sector entities  Quasi-equity (convertible loan
(dedicated funds, agencies instruments, unsecured loans,
and institutions) preference shares, mezzanine
and subordinated loans)
Debt financing  Commercial banks  Term loans
 Thrifts  Corporate bonds
 Investment banks and  State and local government
finance companies bonds
 Institutional investors  Government agencies long-
(pension funds, insurance term bonds
funds, etc.)  Mortgage loans

11
 Lease financing  Leasing companies
Public sector  Global and regional multi-
financing3 lateral development banks
 Government aid agencies
 Bilateral development banks,
export credit agencies,
specialized funds
 National development banks,
government ministries and
specialized agencies
 Sovereign wealth funds
 Non-tax oriented lease
 Tax-oriented lease (single-
investor and leveraged)
 Interest-free and concessional
loans
 Grants and other subsidies, such
as output-based aid and tax
relief
 Guarantees (market, price,
performance, cost, etc.)
 Insurance
 Currency swaps, interest rate
swaps4
 Direct and indirect equity
investments
 Equity-like contributions (land
physical structures, equipment)

Source: Seidman, 2005; Delmon, 2011; Wyk et al., 2012.

The resulting definition of the infrastructure financing market should therefore involve the
following elements: specific characteristics and requirements of infrastructure finance;
diversity of the type of finance and financial markets that supply such finance; and a
combination of private and public financing and financial mechanisms. Hence, the following
definition is suggested: The infrastructure financing market comprises public and private
mechanisms and conventions that offer a variety of financial instruments as well as non-
financial support suitable for financing long-term assets with long economic life.

3
As discussed before, the public sector can operate as a debt and equity provider for publicly financed
projects, privately financed projects or projects with mixed public-private financing (PPP).
4
Currency and interest rates swaps designed to hedge against foreign exchange risks and interest rate
risks respectively, can also be offered by the private derivatives market. In addition, the derivatives market
may offer other hedging instruments potentially relevant in the context of infrastructure financing, such
as forward and futures, options and equity swaps (Wyl et al., 2012). However, Mihaljek and Packer (2010:
44) point out that despite the increased turnover in derivatives markets in EMEs , they make up only

traded derivatives in EMEs (50% of total turnover), while interest rate derivatives remain
underdev
derivatives on development due to the high volatility, poor regulation and vulnerability to crisis of these
instruments. Due to these reasons, the derivatives market, although relevant for infrastructure financing,
is not considered separately in this research but as an element of financial market development (see
Section 3.3).

12
2.3 State of the Infrastructure Financing Market in Developing Countries

Infrastructure finance implies primarily fixed asset finance. It is known from standard theory of
corporate finance (e.g., Brealey at al., 2011) that firms finance fixed assets either through capital
with no maturity or long-term maturity, coming from either internal sources (retained
earnings) or external (a mix of equity and long-term debt). This is also true for the public sector
when it finances infrastructure investments either directly through a partnership with the
private sector.

2.3.1 Equity Financing

The existing research identifies equity (particularly public equity) as an important source of
infrastructure finance in developing countries although the contribution of private equity in
these countries is also on the rise. Researchers explain the relatively important role of equity
in financing infrastructure investments in developing countries by three factors (World Bank,
2004; Spratt, 2009; Estache, 2010). Firstly, the state remains the single most important investor
in infrastructure at all levels, particularly in infrastructure that supports public services. This role
of the state is explained by a relatively under developed private sector and equity markets that
do not allow private companies to raise significant capital for infrastructure finance (UN, 2005).
However, as national equity markets become more functional and public listing is introduced
at national stock exchanges, larger firms gain access to additional public equity. In addition,
the private and public sectors in developing countries benefit from access to equity-like
capitals and quasi-equity from international development agencies and bilateral partners,
which improves the access of public and private entities to inexpensive equity.

Still, this venue is available for large and established firms whereas for smaller firms raising
equity publicly is prohibitively expensive while their access to debt financing (as discussed
below) is also significantly curtailed until they have reached a critical stage of development. In
a more developed context, smaller firms rely on the private equity5 and venture capital market
consisting of wealthy individuals, private equity and venture capital firms and some dedicated
government agencies, such as specific funds, agencies and institutions established for this
purpose but public financial institutes and pension funds are also in some cases assigned
important roles in this respect (Ogden et al., 2003; Andersson and Napier, 2007). However, the
private segments of this market in developing countries remain woefully underdeveloped, with
few and mostly foreign-funded venture capital firms and private equity funds present in that
market, not least because most financial systems in developing countries are bank-based
rather than market-based (Spratt, 2009; Divakaran et al 2014).

Lastly, debt markets in developing countries are also underdeveloped, and in many cases
access to credit is restricted and expensive, which makes potential investors to look for other
sources of finance such as equity (including retained earnings). The interest rate curve in

5
equity (or equity-like)

(Divakaran et al., 2014: 3).

13
developing countries does not flatten out as early as in more developed financial markets,
meaning that for longer-term investments equity may be, in fact, cheaper than debt. The
national public sector plays a double role, both as a provider of equity, either as grants and
interested free loans to private firms directly or public-private partnerships or through equity-
like contributions to PPPs (e.g., land, physical structures and such like) as well as a user of
equity coming from international development agencies and bilateral partners.

Whereas equity plays the key role in financing infrastructure investments in developing

l., 2012: 366) display a number of

institutional and structural weaknesses (Litan et al., 2003; Spratt, 2007). The institutional
infrastructure and regulation are usually weak or non-existent (as is the case in Ethiopia). The
exchange tends to be concentrated in a narrow range of sectors, have a limited number of
listed companies (the Tanzanian stock exchange has only six, for example); a low turnover
(below 10% of market cap); and are largely illiquid (eight of the twelve most illiquid stock
markets in the world are in sub-Saharan Africa) (Spratt, 2007: 106). In the situation when market
mechanisms are ineffective, the exchange of equity between capital providers and investors
takes place largely without financial intermediaries and through direct contacts between
capital providers (such as the family, business partners, private and public sector) and
infrastructure investors.

2.3.2 Debt Financing

Debt financing becomes an attractive option for capital finance when corporate tax is included
in the equation because financial expenses are tax deductible but dividends are not
(Vernimmen et al., 2011). In reality, in developing countries debt financing may vary significantly
and be as, or even more, expensive than equity. Whereas developing countries benefit from
long-term preferential loans by international development agencies and banks (the World Bank
group and regional development banks, such as the European Investment Bank, African
Development Bank, Asian Development Bank, etc.), the cost of domestic debt often remains
high. Indeed, the extant research (e.g., Booth et al., 2001) confirms that the capital structure of
private firms in developing countries is much less leveraged than in developed countries and
that developing countries have substantially lower amount of long-term debt. In particular, the
long-term book-debt ratio (defined as total liabilities minus current liabilities divided by total
liabilities minus current liabilities plus net worth) is significantly lower in developing economies.

The debt market is a market in which debt instruments are issues and exchanged for funds.
The debt market, in turn, consists of two financial markets: (1) the bond market that deals with
bond instruments issues by public, private and parastatal borrows and (2) the credit market.
The domestic bond market in developing economies is often underdeveloped or simply non-
existent, which is particularly true for sub-
market capitalization of both government securities and corporate bonds in sub-Saharan
African countries is typically much lower than those of other developing, emerging, and

is even larger for corporate bonds, with the average capitalization of corporate bonds 1.8

14
percent of GDP in 2010 for these countries. In addition to low capitalization, the bond markets
in developing economies are characterized by a limited repertoire of financial instruments
used, with the basic (plain vanilla) bonds prevailing in the market. These markets are dominated
by government securities; municipal bonds may not be present at all or legally restricted only
to the capital municipality; and corporate bonds make up only a small share of the market
(including government-owned enterprises and parastatals) (Spratt, 2009: 107-108).

Secondly, domestic credit to the private sector is insufficient and often subject to rationing
(due to structural characteristics of developing economies). This is particularly true for small
and medium-sized enterprises: In most African LDCs, between 70% and 90% of SMEs lack
access to formal financial institutions (UNCTAD, 2014). This is particularly obvious when a
comparison of domestic credit to private sector (% of GDP) is made between developed and
developing economies6 (see Figure 2).

Thirdly, financial systems in developing countries demonstrate heavy reliance on the banking
sector at the expense of other financial intermediation vehicles, including equity and fixed-
income markets. Hence, the debt market is dominated by bank loans. However, both the
lending interest rates and the interest rate spreads in developing countries are higher than in
developed countries, which restricts access to credit, particularly to smaller and startup
businesses, and encourages adverse selection an issue to be discuss further (Figure 2). As
IMF (2015) notes, interest rate spreads in low-income countries are almost twice as high as
those in emerging market countries (e.g., Malaysia, Brazil, Russia).

In addition, the term structure of interest rates in developing countries has a particular curve
that distinguishes it from the term structure in developed economies. A number of researchers
(Sheppard, 2003; Spratt, 2009) argue that the upward slope of the yield curve in developing
economies is much steeper and flattens out later than in more developed economies. Loans
with longer maturities are comparatively more expensive in less developed economies, which
presents a distinct disadvantage to debt finance for infrastructure investments. This also
explains why equity is often preferred to debt when raising finance for infrastructure.

6
Domestic credit to private sector refers to financial resources provided to the private sector by financial
corporations, such as through loans, purchases of nonequity securities, and trade credits and other
accounts receivable, that establish a claim for repayment. For some countries these claims include credit
to public enterprises (World Bank, World Development Indicators).

15
Figure 2: Domestic credit to private sector (% of GDP) in select developed and developing
economies (2013)

Denmark 199.6

United States 192.3

Germany 93.1

Angola 23.5

Burundi 18.0

Zambia 16.5

Ethiopia 15.3

Source:

In a number of cases, governments in developing countries attempt to correct market

imperfections by resorting to the so-called financial repression through government controls
of financial variables and credit allocation (Spratt, 2009: 43-44). Williamson and Mahar (1998)
identify six key elements of financial repression:

- interest rates controlled by government;

- credit controls in place;
- barriers to entry to the financial sector in place;
- government control of banking operations;
- government ownership of banks;
- international capital flows restricted.

As the following discussion of the infrastructure financing market in Ethiopia will demonstrate
(particularly Section 4.3), most of these elements are in place in Ethiopia and produce mix
results on the availability of long-term finance for infrastructure.

A notable structural feature of developing (emerging) markets, which creates additional risks
and constraints debt financing, is lack of institutions, such as credit agencies and credit bureaus
that provide reliable information about the creditworthiness of borrowers. Spratt (2009: 313)

time to process loan applications, (b) increases the cost of loans, and (c) raises the level of
nsidered in more detail when discussing imperfection of the
infrastructure financing market.

16
Figure 3: Lending interest rate and interest rate spread, % (2014)

Angola 16.4
12.5
Tanzania 16.2
6.3
Burundi 15.7
n.a.
Zambia 11.6
3.7
Ethiopia 11.2
3.8
Australia 6.0
3.0
United States 3.3
n.a.

Lending interest rate, % Interest rate spread, %

Source:

2.3.3 Public Sector Financing

Public finance is an important part of national infrastructure development strategies in
developing countries. The authors of the 2008 flagship Growth Report emphasize the direct
interdependence between the level of infrastructure investment and growth rates, and call for

spending on infrastructure roads, ports, airports, and power crowds private investment in;

way for new industries to emerge, it is also a crucial aid to structural transformation and export
ank 2008: 36). OECD (2006: 12) points to the positive impact of
infrastructure on pro-poor growth and poverty reduction. In addition to enhancing economic

hurt poor people by impeding asset accumulation, lowering asset values, imposing high

people in the growth process through the employment and income opportunities and
generates distributional effects on growth and poverty reduction.

Hence, the public sector, in particular public financing institutions (PFIs) are critical actors in
the flow of finance for infrastructure development into/within developing countries. PFIs are
well-placed not only to provide investments for traditional public infrastructure development
projects but also to redirect private sector investment toward infrastructure projects. As
indicated in the previous text and discussed in more detail below, there are several categories
of PFIs that provide and intermediate finance into, or within, developing countries for
infrastructure projects.

 Multilateral Sources and Intermediaries: Global and regional MDBs, such as the World
Bank Group, the African Development Bank, the Asian Development Bank, the
European Investment Bank, the European Bank for Reconstruction and Development,

17
 and the Inter-American Development Bank. These MDBs provide finance using their
own capital (raised through capital initially provided by multiple government donors) or
on behalf of government donors.
 Bilateral Sources and Intermediaries: These include national institutions, such as
government aid agencies, bilateral development banks, export credit agencies, specially
designed funds that provide finance bilaterally, typically from a developed country to
multiple developing countries.
 Domestic Sources: National development banks, government ministries and
specialized agencies, including government-owned pensions and social security funds,
and sovereign wealth funds. These institutions have always played an important role in
financing infrastructure (although sovereign funds are a more recent phenomenon). In
the developing context, these institutions still are the major providers of domestic
infrastructure finance although the private sector is playing an increasingly important
role (Harris, 2003; Estache, 2010).

A number of research indicate four major avenues for the public sector support to
infrastructure investments (Seidman, 2005; World Bank, 2010; Delmon, 2011). These include
both financial and non-financial support: (1) direct financing of public infrastructure projects;
(2) financing of private sector infrastructure projects; (3) public-private partnerships and (4)
advisory services and facilitation. We will consider in more details the first three types of public
sector support below.

 Direct financing of public sector infrastructure projects comes in the form of budget
appropriations from the public sector budget, sovereign or sub-sovereign. The source
of capital is either government revenues or borrowing through sovereign (sub-
sovereign bonds) and term loans. One emerging source of capital for infrastructure
finance in developing countries is land leasing (Peterson, 2006). As already discussed,
developing countries often benefit from the so-called soft or development loans
originated by multilateral or bilateral sources at below the market rates.
 Financing of private sector infrastructure is exercised through application of financial
de-risking instruments issued by the government. Three basic types of financial
instruments that can be used by the public sector to mobilize private sector
infrastructure investment include (1) grants and other subsidies (e.g., output-based aid
to complement or reduce user fees and tax relief) as well as interest-free loans; (2)
various types of guarantees; and (3) concessional loans. Public sector offers a wide
range of specialized de-risking instruments designed to address the challenges of
infrastructure financing in developing countries, such as political and currency risks,
and include political insurance, synthetic local currency loans, currency swaps and
interest rate swaps, etc.
 Public private partnerships imply joint ownership of an infrastructure project (with
significant positive externalities but economically viable) co-funded with a private

18
 sector entity.7 In such cases, the public sector acts as a co-investor by providing project
equity or equity-like contribution (e.g., land, buildings, equipment, etc.). Also, the public
sector may issue quasi-equity products, such as convertible loan instruments,
unsecured loans, preference shares, mezzanine and subordinated loans, often as part
of a financing package by institutional investors (Yescombe, 2002). In addition, the
public sector may apply other financial de-risking instruments mentioned in the
previous bullet point.

There is strong evidence that public support to infrastructure financing, particularly risk de-
risking measures and risk guarantees from multilateral development banks or export credit
agencies, dampen the perceived risk of longer-
spreads by almost one third on average (i.e. by about 50 bp from an average spread of about
and Gadanecz, 2004: 2).

Figure 4: Mechanisms of public sector support for infrastructure financing

Budget/ Budget/ Debt/ Capital Guarantee Output-

Land fund Project Equity grant Contingent based
prep. fund debt subsidies

Land Funding for Project

project Revenues
acquisition financing
preparation

Preparation Financing Implementation

Adapted from: Delmon, 2011.

2.4 Infrastructure Financing Constraints in Developing Countries

The 2005 World Economic and Social Survey (UN, 2005) argues that there are three main
reasons for the insufficient provision of long-term finance: market imperfections in the
financial sector; the characteristics of borrowers in the country; and macroeconomic factors
that may inhibit the provision of long-term credit.

entities aimed at improving and/or expanding infrastructure services, but excluding public works

19
2.4.1 Capital market imperfections
The infrastructure financing market in general, but in developing countries in particular, heavily
relies on the capital market even when it uses non-market arrangements. However, the
primary justification for resorting to non-market mechanisms is the existence of market
imperfections that prevent the optimal allocation of financial resources. Financial economics
theory maintains that in a perfect capital market, there is no interdependence between
demand for physical capital and conditions of financial capital supply. As Curtis (2012: 2) points

imperfections affect the effective demand for physical capital resulting in sub-optimal
capitalization and limit and postpone physical capital acquisition (Curtis, 2012).

A perfect capital market is defined by a set of five assumptions (Ogden et al., 2013: 30-31).
Capital markets are supposed to be frictionless (i.e., market participants face no transaction
costs, fees or taxes); all market participants share homogeneous expectations about the
prospects of investments; all markets participants are atomistic (i.e., all producers and
consumers

investors are perfectly

rational and use it to maximize their utility; and all agents who act in the interest of principles

Any departure from these assumptions results in market imperfections, which is a normal state
of the capital market. While developed countries are not spared market imperfections, such
imperfections are particularly characteristic of developing markets and economy, which partly
explains the greater volatility observed in those markets (UN, 2005). The key market
imperfections in developing markets and their sources are briefly considered below.

Information asymmetries and incentive conflicts. Asymmetric information refers to a

h one agent has better information on the characteristics of a good or an
investment project than another agent (Lensnik et al.: 2001: 14). The problem of information
asymmetry is particularly important to credit relationships, and the longer is the term credit (as
is the case in infrastructure financing), the more pronounced is the impact.

Asymmetric information results in two well-known problems. The first one formulated by
has prior
information on the quality of a good whereas a second agent at most knows the probability

problem manifests itself in the lack of certainty about the riskiness of the agent as believed or
presented during the closing of the loan contract. Consequently, the lender is unable to
distinguish between good and bad investment proposals. In credit markets, adverse selection
may (and in developing countries does) lead to a situation when a rise in the interest rate results
in a deteriorated quality of group of loan applicants.

20
parties agree on a contract, but one party afterwards takes an action that is not observed by

such as loan covenants. In general, Stiglitz and Weiss (1981) demonstrated that asymmetric

iss, 2015: 5).

This problem is also important in the context of equity market where the principal-agent
relationship extends to the relationship between an investor (stockholder) and a firm.

One of the manifestations of the information asymmetries in the capital markets in developing
economies is a high collateral requirement. In a situation when the lender does not have
adequate information about the borrower, the lender assumes at least the average default risk
for a loan rather than the risk of a particular loan. As a result, the risk of good projects is
overestimated whereas the risk of bad projects is underestimated leading to the adverse
selection situation discussed above. The lender has only two readily available instruments to
minimize the repercussions of information disparities between the lender and the borrower,
interest rates and collateral. Since raising the interest rates above a certain level encourages,
rather than discourages, adverse selection by inviting riskier borrowers with a higher default
risk, lenders often resort to collateral as the main mitigation tool (Berger and Udell, 1995). As a
result, the collateral requirement in developing economies is significantly higher and is 3-4
times that of developed economies, restricting access to credit, particularly for smaller
companies with less or no quality collateral to offer (Figure 5).8

In practice, market imperfections in financial markets contribute to the insufficiency of long-

term finance. The 2005 World Economic and Social Survey (UN, 2005: 22) describes this as
typically commercial banks in developing countries typically have
short-term liabilities and thus prefer the use of short-term lending as a way of reducing the
risks associated to a mismatch in their portfolio. They also use short-term credit as a means to
monitor and control borrowers and they are more likely to use this approach if the financial
infrastructure, including accounting, auditing and contract enforcement systems, is
inadequately deve

8
Despite relatively lower collateral requirements in Mozambique, access to the financial system, as
measured by the share of firms with credit, is lower in Mozambique than in Uganda and Kenya (Dabla-
Noris et al., 2015)

21
Figure 5: Collateral requirements, % of loan (2014-2015)

Ethiopia 249%

Uganda 173%

Regional averge (SSA) 160%

Kenya 120%

Mozambique 92%

Malaysia 65%

100% SSA average

requirement

Source:

Weak property rights and enforcement of contracts. Secure property rights, particularly land
titling, is a fundamental requirement for infrastructure financing, which by definition has a
spatial dimension. Spratt (2009: 316)
prevents the banking sector form being able to compensate for incomplete informati
property rights render ineffective the mechanisms such as covenants, collateral and personal
commitments that are supposed to mitigate the problems of moral hazard and adverse
selection. In addition, weak property rights and unclear land ownership negatively impact

Transaction costs. institutions in many

developing countries to properly enforce business contracts and property rights and to provide
adequate information on markets, raises the costs of governing market exchanges, sometimes
nguishes between explicit transaction costs due
to fees and charges (e.g., as part of the loan application process) and implicit transaction costs,
such as the costs of processing and using all available information in designing a contract,
agency costs (of free cash flow dispersion, resistance to profit liquidation, replacement
resistance, etc.), the costs of monitoring and enforcing contracts, etc. (Curtiss, 2015: 8). North
such as legal fees,
realtor fees, title insurance, and credit rating searches and partly the costs of time each party

From the theoretical perspective, transaction costs affect both demand and supply side of the
capital market. The effect on the supply side is limited supply of capital to potentially profitable
businesses with a high rate of return when collecting relevant information about them involves
significant explicit or implicit transaction costs on the part of the capital providers. On the other
hand, in many cases the burden of transaction costs is borne by agents on the demand side

22
who have to invest significant resources in, for example, structuring the project, preparing
accounts, and financi
financial status Curtiss (2015). World Bank research suggests that transaction costs for
infrastructure projects may reach 10 to 12 percent in a poorly regulated environment with weak
enforcement mechanisms typical for developing economies as opposed to about 3 to 5
percent in well-developed policy environments (Klein et al., 1996). Due to higher transaction
costs in developing economies, in many cases smaller businesses do not have financial or
human resources to cope with such transaction costs and, as a result, cannot raise capital
required for infrastructure investment.

2.4.2 Characteristics of borrowers

According to the UN (2005: 22), the term structure of finance in an economy also depends on

liabilities; firms with mostly fixed assets, such as land, buildings and heavy equipment, are likely

in capital investments require long-term finance due to a long gestation period of the
infrastructure projects before producing any profit. This is not the case for small retailers and
similar businesses. Whereas small and medium enterprises make the bulk of businesses in any
countries, in developing economies, the number of large companies that can raise long-term
capital in proportion to the total number of registered companies is considerably smaller than
in developed economies (Spratt, 2009). This situation limits the market demand for
infrastructure financing, thus holding in check the incentives of finance providers to increase
its supply.

finance is firm size. As discussed shortly before, obtaining information about smaller firms is
more expensive than about larger firms because they are less likely to be publicly traded, less
likely to have a recorded credit history, and also because obtaining a credit rating for smaller
companies is much more difficult. In addition, the disclosure requirements for smaller firms
are less rigorous than for larger ones. In developing countries, a combination of information
asymmetry and insecure property rights lead the profit-maximizing firms to having short time
horizons and little fixed capital, resulting in smaller firms (except those operated or protected
by the government) (North, 1990: 64-67). The prevalence of smaller firms in developing
economies suppresses the aggregate demand for long-term debt in developing economies
and reduces its supply.

2.4.3 Macroeconomic Factors

Macroeconomic factors that affect the provision of long-term finance for capital investment
include high inflation or unpredictable inflation (UN, 2005: 22). As a result, savings in financial
instruments, particularly those with a long maturity, are discouraged. At the same time both
theory and practice point to high real interest rates as a tool to curb high inflation (Spratt,
2009). In addition, the term structure of interest rates has a relatively steep upward slope of
the yield curve. This reduces the demand for credit: Firms need more credit for long-term
investment but cannot afford it at the prevailing market interest rate (UN, 2005: 22). As

23
discussed before, one answer to the underprovision of long-term financing by private capital
markets, particularly in the context of developing economies, is public sector financing of
infrastructure investment through development banks, specialized government agencies,
funds, etc.

Apparently, developing and emerging markets demonstrate special vulnerability to market

imperfections due to governance issues, underdeveloped financial infrastructure,
macroeconomic instability and other negative phenomena that characterize those markets
(UN, 2005; Spratt, 2009; Shapiro, 2014), and the risks present in those markets are real risks.
Yet, the story would be incomplete without mentioning risk perceptions as a factor that
constraints both domestic and foreign investments in developing economies. A number of
authors (Sheppard, 2003; Sorge and Gadanecz, 2004; IFC, 2009; Haas et al., 2010) argue that
not all investment decisions are rational and misperceptions may and do affect domestic and

participants. IFC (2009: 5) points out that this is particularly true for crisis periods when market

importantly, lose sight of fundamentals, act on the basis of short-term events and fall prey to
the madne -sectors may experience difficulties
raising enough capital for investments that are otherwise both profitable and reasonably safe
(Sheppard, 2003).

One of the generally accepted indices that reflects the domestic market inefficiencies is the
Doing Business index regularly updated by the World Bank. Most of the dimensions measured
by this index are related to the quality of the national institutional frameworks that support the
functioning of the private sector, including its access to finance. The latest survey shows that
developing countries are significantly lagging behind developed economies in this respect
(Figure 6), with a gap as large as 30-40 points on the distance to frontier (DTF) scores.

Figure 6: Ease of Doing Business Ranking (2015)

South Africa (Rank 43) 71.08

Rwanda (Rank 46) 70.47

Ethiopia (Rank 132) 56.31

Kenya (Rank 136) 54.98

Regional Average (Sub-Saharan Africa Rank 142) 51.87

Uganda (Rank 150) 51.11

0 20 40 60 80 100

Source: World Bank (2014)

24
3. RESEARCH METHODOLOGY
3.1 Research Aim and Objectives

infrastructure financing markets for small- and medium-sized economic infrastructure

investments through introduction of LFI support based on advanced project financing
techniques. The aim and objectives of the research have been shaped by the theoretical
framework described in Chapter 1 as well as by the UNCDF requirements for developing a
strong evidence base for the possible rollout of its Local Finance Initiative to Ethiopia.

In the context of the overall aim, the research endeavors to answer two questions:


market permit increased supply of domestic capital for small- and medium-sized
local infrastructure?
 Given the state of the capital market and conditions for infrastructure finance, what
project financing techniques would be particularly useful for achieving this goal?
Are advanced project financing techniques, such as project finance, a feasible and
appropriate approach?

The research has the following primary objectives:

 To design an assessment matrix enabling an analysis of the key features of the

national infrastructure financing market that can be used in various country
contexts to establish the baseline and allow cross-country comparisons.

identify its capacity for increased supply of capital for local infrastructure.
 To analyze the applicability of advanced project financing techniques against the
established conditions.
 To make recommendations concerning and suitability of the infrastructure market
conditions for LFI; the most appropriate financing techniques for increased supply
of capital for local infrastructure; and the approach/steps that would allow an early
introduction of such techniques.

3.2 Research Methods

Hence, the research uses mixed methods, both qualitative and quantitative, to address
comprehensively all aspects of the study. Mixed-model research combines quantitative and
qualitative data collection techniques and analysis procedures as well as combining
quantitative and qualitative approaches at other phases of the research such as research
question generation (Saunders et al., 2009: 151). This approach makes it possible to qualitize
quantitative data, that is, convert it into narrative that can be analyzed qualitatively or to
quantitize qualitative data, making it suitable for statistical analysis.

In particular, the research will use two primary methods:

25
 1. Literature review, primary and secondary data research involving qualitative and
quantitative data. This method helps establish the regulatory characteristics of
ure financing market (legal and normative provisions) as well as key
quantitative characteristics of the market itself (e.g., composition, size, concentration,
etc.) and its participants (e.g., share of the debt/loan market; composition of debt/loan
portfolios; investment and credit practices, including investment sectors and prevailing
debt terms, etc.). The required secondary data were obtained either directly from the
corporate records of the participants concerned or from published research and
surveys.

2. Primary research through

financing market. This method targets primarily senior and mid-level managers of the
key participant agencies and applies semi-structured interviews (an analysis of the
surveyed institutions is presented in Annex 1). Primary data were designed to
complement the qualitative and quantitative data from secondary sources in two
respects: to fill data gaps when relevant information is not available from secondary
sources and to strengthen the qualitative aspect by collecting information about
institutional policies, practices and interest in financing small- and medium-sized
economic infrastructure. Semi-structured interviews were based on the assessment
matrix (Annex 4) and included questions that followed the structure and content of this
matrix (the methodologies and sources of the matrix are described in Annex 2).
Depending on the sector and type of the institution, the interviews were customized to
focus on those parts of the matrix that were relevant for a sector or institution. Where
appropriate, additional questions were added to explore the research question and
objectives in depth, given the nature and relations to the market of each particular
agency. For the purpose of this research, all participating agencies were categorized
into four broad groups:

 Policy-makers and regulators: National Bank of Ethiopia, other relevant

government agencies and ministries.

 Financial market participants: Financial institutions, funds, venture capital firms,

insurance companies, etc.

 Public participants in the infrastructure market: Development banks, relevant

government agencies, international organizations, UN agencies, bilateral and
multilateral development agencies, etc.

 Business services providers: Public and private agencies delivering technical

support and other services in the development and structuring of infrastructure
projects.

26
3.3 Issues of Reliability and Validity
The use of a mixed-method design as well as a combination of several independent sources
of data as described above allowed triangulation and improved research reliability (Saunders
et al., 2009: 154). The semi-structured interview guide was designed to minimize subject bias
and other threats to reliability. The use of multiple indicators for the assessment of certain
aspects of the infrastructure financing markets (multi-item scales) contributes to better
reliability. The respondents were not requested to directly assess certain dimensions of the
infrastructure financing market; rather, they were asked, through a series of probing questions,
to provide stylized facts on the relevant issue and then make a conclusion based on these
facts. Assessments of various aspects of the infrastructure financing markets were cross-
referenced and compared both against the secondary data and extant research as well as
against assessments and opinions of different not overlapping participating groups (e.g., banks
versus regulators).

The risks to internal validity (Saunders et al., 2009: 156-157; Remler and Ryzin, 2015: 215-218)
were addressed by applying a credible theoretical approach reflected in the assessment matrix
(described in the previous sections), which creates enough confidence that the individual
dimensions measured in the assessment matrix do collectively reflect the state of the
infrastructure financing market.

The issue of external validity and generalizability of results was dealt with as following.
Considering the descriptive nature of the research and use of mixed methods, a purposive
sampling was applied for each group of the participating institutions mentioned above (Remler
and Ryzin, 2105: 258). Specifically, the research targeted on the largest and/or most important
institutions in each group defined by their market capitalization, market share, budget or their
role in the infrastructure financing market so that the sample covers the area of interest either
completely or to a large extent (above 50% of the market). In some cases, the sample was
obvious and minimal: e.g., NBE is the primary policy-maker and regulator of financial markets.
In other cases, the sample was somewhat larger: For example, the six surveyed commercial
banks account for 65.8% of the total market capitalization and 81.6% of total loan share (Table
5). In addition, it was assumed that the data obtained from the representative(s) of a
participating agency (particularly qualitative data) are representative for that agency as a whole.
Hence, in terms of the coverage, the research approximated a census of the target population
in each participating category thus allowing generalization of the results beyond the sample
group and enabling conclusions about the state of the infrastructure financing market as a
whole.

27
4. EMPIRICAL RESULTS: STATE OF THE ETHIOPIAN
INFRASTRUCTURE FINANCING MARKET

4.1 Macroeconomic environment

The 2005 World Economic and Social Survey (UN, 2005) argues that macroeconomic factors
are among the three main reasons for the insufficient provision of long-term finance.

Ethiopia is categorized as a low income country with GNI per capita at $550 (2014, Atlas
method, current US$) although it has been demonstrating robust growth in the past 10 years.
According to IMF (2015), real GDP growth remains robust and was estimated at about 8 percent
in 2013/14 and 8.7 percent in 2014/15 and is projected to slightly slow down to 7.5-8 percent
in the mid-term perspective. The National Bank of Ethiopia (NBE, 2014) estimates real GDP
growth somewhat higher, at 10.3 percent in 2013/14. But even the conservative estimates of
the economic growth fare well compared with the 5.4 percent growth estimated for Sub-
Saharan Africa in 2014 and is primarily attributed to service sector (51.7 percent), agricultural
sector (21.9 percent) and industrial sector (26.4 percent) (NBE, 2014: 1).

Recent macroeconomic developments are encouraging, with a significant deceleration in

inflation, which declined from the peak of 40 percent in July 2011 to around 7 percent in June
2013 (IMF, 2013). However, since then inflation has been on the rise, with domestic food prices
pushing it above 10 percent in 2014/15 (IMF, 2015). NBE aims at single-digit inflation and argues
in price of tradable commodities
in the international market and improvement in domestic supply have contributed to
slowdown in headline, food and non-

Figure 7: Inflation and USD exchange rate, 2004-2013

Source: World Bank Indicators

28
Noteworthy is the difference, in some respects quite substantive, between the government
and IMF projections relating to GTP II targets (Table 4). IMF projections, although positive, are
less optimistic than those by the government. The difference, as in the case of goods exports
and saving rates, is as big as 1.5-2 times.
some downside risks, of which constraints on financing for development, slow implementation
of structural reforms, and deterioration of SOE loan quality are the principal risks.

Table 4: Ethiopia: GTP II Targets and IMF Projections (2015/16 2019/20)

GTP II IMF
Average annual growth rate (2015/16 2019/20)
Real GDP (percent) 11.0 7.7
Goods exports (U.S. dollars, incl. 29.0 15.2
electricity, percent)
Target (GTP II) or projection (IMF) for 2019/20
Taxes / GDP (percent) 17.0 14.4
Savings / GDP (percent) 29.0 18.9
Investment / GDP (percent) 41.3 32.9

Source: IMF (2015)

According to the Economist Intelligence Unit (2015), Ethiopia remains in the CCC band risk-
wise. In December 2014 it issued a debut dollar-denominated bond worth US$1bn to help
finance infrastructure development, and is expected to issue another bond by the end of 2015.
is will add to the country's public debt burden but continued rapid

Yet,
IMF (2015) stresses that large public borrowing from abroad, combined with weak exports,
The following
table summarizes country risks as of June 2015.

Table 5: Ethiopia: Risk assessment

Sovereign Currency Banking Political Economic Country

risk risk sector risk risk structure risk risk

June 2015 CCC B CCC CCC CCC CCC

Source: EIU, 2015.

In the past few years, NBE has been pursuing a tight monetary policy using reserve money as
the nominal anchor for its monetary policy (the reserve requirement increased by 23.7% in
2013/14) (NBE, 2014). NBE has been keeping both minimum and maximum deposit interest
rates at the same 5.0 percent and 5.75 percent for the past three years. According to NBE

29
over the past year as a result of a year-on-year drop in inf
lending interest rate at 3.41 percent although the real interest rates on deposits and the yield
on T-Bills remained negative (Table 6).

Table 6: Real Interest Rates, 2013/14

Instrument 2012/13 2013/14

Saving Deposit -3.33 -3.09
Time Deposit -3.04 -2.81
Lending 3.17 3.41
T-bills -6.84 -6.92

Source: NBE, 2014: 49.

It also suggests that more flexibility is required to make T-bills an effective instrument for

2014: 29).

According to Transparency International (2015), Ethiopia ranks 110 out of 175 with a score of
33 out of 100. The 2013 Global Corruption Barometer shows that Ethiopians have little
confidence in the police and judiciary, with 42 percent and 35 percent respectively believing
these institutions to be corrupt or extremely corrupt. 35 percent of respondents felt that public
officials and civil servants were corrupt or extremely corrupt whereas 29 percent shared the
same opinion about business (TI, 2015). 36 percent of respondents reported paying a bribe to
the police during the last 12 months, 38 percent to Registry and Permit services, and 41 percent
to the Tax revenue and 31 percent to the Land Services (TI, 2015).The latest Doing Business
survey (World Bank, 2015), puts Ethiopia with its score of 56.31 slightly above the regional
average for Sub-Saharan Africa (51.87) (Figure 6). However, on a number of dimensions the
country is behind the regional average, including the ease of starting a business (63.15/71.24),
getting credit (15/32.34); and protecting minority investors (41.67/46.08)

Despite the socio-political challenges in most of its neighboring countries, Ethiopia remains a
reasonably stable and secure country with a relatively functioning judicial system. The World
Justice Project (WJP) ranked Ethiopia 91st out of 102 states in its 2015 Rule of Law Index.
Accountability ranks low on both government openness (15th out of 18 regional states and 94th
globally) and on fundamental rights (last but one regionally and 97th globally). Of greatest

88). Regulatory enforcement and civil justice (particularly relevant in the context of contract
enforcement and business dispute resolution) remain low: Regionally, Ethiopia is ranked last
but one on regulatory enforcement and last on civil justice (98th globally on both dimensions).

30
Nevertheless, Ethiopia ranked quite high in order and security, both regionally (4th out of 18)
and globally (56th out of 102), which is no small achievement, given the unstable regional
surroundings.

Based on the foregoing, the key macroeconomic indicators can be assessed as following
(Table 7).

Table 7: Ratings of macroeconomic indicators

Indicator Rating
0.1 GNI per capita (Atlas method) 1
0.2 GDP growth 4
0.3 Annual inflation rate 1
0.4 Country credit risk 2
0.5 Central bank monetary policy 2
0.6 Corruption (country corruption ranking) 2
0.7 Security and rule of law 2
Average 2

4.2 Equity Financing

Ethiopia is the largest country in the world without a stock market, and although private share
companies have proliferated in the past 15 years, no formal stock market has emerged as yet
despite the existence of an informal stock market languishing during this period. Chewaka

Commercial Code and the subsequent proclamations fail to provide legal and institutional
frameworks for the prudent regulation of subsequent transactions of shares in an open

for listing and delisting of stock and, as a result, share issuing companies have to operate under
unregulated market. Hence, there have been no public or private placements of stock
(Ruecker, 2008: 32).

Notwithstanding the absence of a stock market, equity financing of startups and existing
businesses is taking place through three channels (in the order of importance): existing public
and private non-financial companies; financial institutions, and venture and private equity
firms. The primary source of equity finance is the private sector itself, through retained
earnings, mergers and acquisitions, and to a lesser extent financial institutions (banks and
insurance companies) allowed by applicable regulation to keep a certain share of their assets
in stocks followed by venture and equity firms.

4.2.1 Private Nonfinancial Sector

The most typical form of equity investment by the private nonfinancial sector is when an
existing company, usually a producer and/or wholesaler with an established reputation, takes
a minority position in a startup or a small business seeking expansion that produces inputs for

31
the investing company. This typically happens along the value chain when, for example, a large
producer of dairy products may invest in milk production, initial processing, storage and
transportation to improve its supply base. According to the survey, the initial equity investment
usually amounts to about 30% of the total cost of the new business (business expansion)
followed by either exit, usually in 4-5 years or a larger position and, possibly, acquisition
depending on the succ
of a proper equity market, finding new investment opportunities for the private sector entails
significant transaction costs and is based on a network of personal relationships. There have
been some attempts, supported by development partners (e.g., USAID and UNDP), to establish
matchmaking services between emerging and small enterprises at the local level and potential
investors, in particular through Regional Investment Forums. A number of technical services
providers, such as First Consulting and the Entrepreneurship Development Center (EDC) have
been involved in such activities. However, the success rate appears rather low and is limited to
a dozen of successful completed deals.

4.2.2 Banking Sector

The liquidity crunch that the Ethiopian banking sector has been experiencing in the past few
years, the NBE requirement for short-term lending at 40 percent of their capital (considered in
more detail in Section 6), as well as non-existence of a regulated stock market substantially
restrict bank equity investments. According to NBE Directive No. SBB/12/1996, a bank may
hold shares in a non-banking business only up to 20 percent
and total holdings in such business shall not exceed 10 percent
However, the practice of investing in share companies is very limited. The largest commercial
bank, Commercial Bank of Ethiopia owned by the government and holding 34 percent of the
sector in terms of capitalization, does not have any stock investments. Private banks (e.g.,
Awash and Dashen) pursue a more aggressive policy in this respect and are known to have
invest equity in a number of businesses, including manufacturing (such as breweries, flour mills,
pharmaceuticals, etc.) but because of the challenges mentioned above as well as the difficulty
of identifying good investment opportunities, these investments are limited to larger
established companies and account for a small share of the overall equity investments.

4.2.3 Insurance Sector

The existing insurance sector regulation is not supportive of investment in long-term assets.
With the liquidity requirement of minimum 60 percent and the allowed ceiling of 15 percent
for long-term investments, the ability of the insurance sector to invest in capital assets is very
limited. This is further compounded by the low depth of the insurance sector, which generates
in premium only about ETB 5 billion annually (approximately US$250 million). According to
NBE Directive SIB/25/2004, insurance companies are allowed to keep up to 15 percent of their
total admitted assets in shares (public or private) but the insurance companies surveyed report
that this asset class remains underutilized due to the difficulties of identified reliable investment
opportunities and even when utilized, shares are kept in the banking sector (under the
Ethiopian law, banks are formed as share companies) rather than used for productive
investments. Since most private insurance companies are related to relevant commercial

32
banks, the entire allowed share of capital held in private stock is normally placed in the parent
bank.

In principle, neither banks nor insurance companies that participated in the survey are averse
to equity investments in small and medium-sized infrastructure but the limitations described
above are keeping this potential in check.

Neither banks nor insurance companies in Ethiopia have experience in project financing (with
the exception of the Development Bank of Ethiopia). This has a negative impact on not only
their willingness and ability to finance infrastructure projects that rely on this approach but also
on the availability of insurance products required to de-risk operational and financial contracts
around non-recourse or limited recourse projects as described in Section 2.1.4. Whereas some
products are relatively well known and applied (e.g., CEAR or standard marine/cargo
insurance), the insurers are unfamiliar with the specifics of their application in project financing
and other more complex products (e.g., DSU or BI) are completely unknown.

4.2.4 Venture and Private Equity Firms

Venture and private equity firms represent an emerging sector dominated by foreign-owned
companies and holds a small share of the equity market. There has been some increase in the
inflow of foreign equity to Ethiopian enterprises lately and US private equity
groups KKR and Blackstone have both recently supported deals in the country, in floriculture
and infrastructure respectively whereas London-based Vasari Global injected equity in a
brewery and biscuit production. However, the number of such deals is minimal and they target
large investments and infrastructure projects
deal backed by Blackstone concerns a pipeline for refined fuel between Ethiopia and Djibouti,
flower company Afriflora was about US$200 million and the
Dashen Brewery which Vasari Global supported is responsible for 20 percent of the market).

Only a few venture equity firms have their branches in Ethiopia and are directly accessible to
prospective investors. These include Schulze Global Investments, Ascent Capital, Empact
Capital, as well as a small number of domestic firms, such as Zoscales Partners and One Cent
Management. The equity fund for these firms varies from about US$30 million to about US$100
million and aims at a somewhat lower investment range comparing to the large international
equity firms. These firms engage in a variety of investment areas such as agro-industry and
agro-processing, floriculture, fast moving consumer goods (FMCG), leather, garments and
textiles, construction materials, support services and social services, including health and
education. Most of the firm
impression from Empact Capital while others have a more focused approach (for example,
Zoscales Partners target consumer goods, healthcare, materials and energy as sectors with a
high projected compound annual growth rate of over 15 percent).

33
 Box 2: Schulze Global Ethiopia Growth and Transformation Fund I

Nature and Status Schulze Global Ethiopia Growth and Transformation Fund (SGE) is a
commercially oriented fund managed by Schulze Global Investments (SGI), an
emerging markets private equity firm. SGEGT was established in 2012
(operational as of November 2012).
Geographical SGE targets investments in Ethiopia only. Since 2008, SGI is registered in
Coverage and Ethiopia and operates out of Addis Ababa as a consulting company (not as a
Location fund manager), although the general fund is incorporated and located
overseas.
Funding At final closing, SGE will have reached $100 million in capital. With a $15
million contribution, CDC is the leading fund provider, along with other
development finance institutions and private investors.
Investment Criteria SGE provides long-term growth capital to SME in expansion phase (not start-
and Guiding ups) and whose financing needs are le
Principles traditionally conservative lending practices. In particular, it will target SME that
have the potential to become major players in their respective industries.
Additionally, at the same level as financial returns, SGE also holds social,
governance, and environmental impacts at the core of its investment strategy.
Sector Focus SGE is a generalist fund, with no sector-specific orientation. In practice, its
investments are expected to focus primarily in the agro-processing and
manufacturing sectors. The deals closed so far included, among others,
minority investments in a leading national cement factory (National Cement),
in a wheat-based food production company (Kaliti), and a premium coffee
roasting and export company (Jalannera Coffee).
Size of Deals SGE will typically seek to deploy investments in the $1 $10 million range.

Source: Schulze Global Investment website,

http://www.schulzeglobal.com/markets/africa/ethiopia/
Characteristically, some of them (such as Schulze Global and One Cent Management) claim
double or benefit, social responsibility, and
environmental safety), thus approaching impact investors. The UNDP study on impact
investment (2015c) notes a certain role of private equity funds in impact investment in the
African context. The primary reason for this is high risks and transaction costs of doing business
in Africa, which makes it all but impossible for private equity firms to operate without some
support in the form of direct funding or guarantees provided by DFIs and bi- or multilateral
development agencies with certain conditionalities including double and triple bottom lines.
For example, a number of deals closed by Schulze Global had MIGA support and a US$10
million investment by the German Investment and Development Corporation (DGE) whereas
the Corbetti Geothermal Power project announced during President Obama visit to Addis
Ababa in July 2015 is supported by the Power Africa initiative.

The Ethiopian-located equity firms are engaged in primarily three areas (Schultze Global,
2015):

34
  Minority investments into established companies seeking capital for expansion (organic
or inorganic) and/or to increase operational efficiency.
 Minority and majority investments into new business ventures with established
entrepreneurs in industries related to their business expertise.
 Co-investments, for minority positions, alongside strategic/trade investors entering a
country through acquisition of a local business.

-40 percent that allows

them to exercise close control of the business and influence its management and
development. Depending on the type of the business, exit is exercised in 4-7 years mainly
through secondary buyouts and sales to strategic investors. The deals financed by private
equity firms may vary immensely, from hundreds of millions of dollars (in case of mammoth
foreign equity investors operating with government guarantees) to a few million and below in
case of Ethiopia-based private equity firms. For example, Empact Capital backs deals for SMEs
through investments of US$500,000 to US$5 million in companies that require risk capital in
order to accelerate their growth and profitability. In general, among non-DFI impact investors
in Ethiopia, close to 50% invest between US$1 million and US$5 million per deal, although most
impact deals are less than US$1 million. To date, the majority of capital has been disbursed in
the US$1 million to US$
manufacturing sector (GIIN and Open Capital, 2015: 14)

Similarly to banks and insurance companies, private equity firms that participated in the survey,
name the lack of a proper regulatory framework (including pr
unfriendly and lengthy government bureaucratic procedures, inadequate information on
investment opportunities, and a low quality of investment proposals as the major issues
constraining the growth of private equity investments in Ethiopia. Similarly, high transaction
costs related to the significant time required to source deals, conduct due diligence on
businesses, and supply appropriate business development services feature prominently among
the constraining factors.

Yet, the stagnating private credit (an issue to be discussed in the following section) may mean
additional opportunities for private equity firms which end up becoming the only realistic
alternative to infrastructure financing in some cases. UNDP (2015d) notes he great potential of
private equity and venture capital as a source of finance for development in Ethiopia
particularly in such sectors as agriculture and agro- processing, manufacturing, consumer
goods and the service industry.

4.2.5 Commodity Exchange Market

The major reason for the absence of the stock market is the position of the Ethiopian
government, which has long maintained that there is no need for a stock market. Although not
focus has been on

-445). Hence, the Ethiopian Commodity

Exchange (ECX) was established in 2008 to provide fair and transparent pricing for major

35
agricultural commodities, such as coffee, sesame, haricot beans, wheat and maize. The vision

reliable and sustainable marketplace that serves all market participants, including farmers,

system for handling, grading, and storing commodities, matching offers and bids for
commodity transactions, and a risk-free payment and goods delivery system to settle

ECX is a well regulated mechanism, with the Ethiopian Commodity Exchange Authority (ECEA)
serving as the
blueprint for all rules governing membership, management, trading, warehousing, clearing and
ker,
2011: 29). ECX also plans to introduce stocks and bonds under a five-year expansion plan but
the specific timeline and action plan are yet to be defined (Davison, 2015). In the meantime in
the absence of a security market, ECX can serve as a tool to de-risk input supply contracts for
agro processing facilities financed via a project financing modality.

4.2.6 Equity Market Characteristics

The required return for equity for domestic financial institutions (including the local branches
of international equity companies) varies, depending on the sector, between 20.0 percent and
35.0 percent in nominal terms and averages 27.5 percent (inflation unadjusted) or 19.5 percent
(adjusted for 8% inflation).

Table 8: Risk free rate, market risk premium and required return on equity according to
domestic financial institutions

Minimum Maximum Average

Risk-free rate 3.0%* 5.0%** 4.0%
Market risk premium 17.0% 32.0% 24.5%
Required return on equity (nominal) 20.0% 35.0% 27.5%
Required return on equity (real) 12.0% 27.0% 19.5%

* Interest rate on 5-year development bonds of DBE with sovereign guarantees

** Minimum saving rate established by NBE

Source: financing market.

Internationally, Ethiopia has a higher equity return requirement than most developed and
developing countries, almost on par with Greece (29.3 percent) and lower than Argentina (35.5
percent). Even when adjusted for inflation, the required return on equity is still more than 10
percent higher than in developed economies experiencing zero or slightly negative inflation
(e.g., Germany and UK). There is no clearly identifiable ROE for small- and medium-sized
infrastructure but it appears from the interviews that it lies between the average and the
maximum, closer to the average value.

36
Figure 8: International comparisons of required returns on equity, 2015

Germany 6.6%

United Kingdom 7.2%

South Africa 15.9%

Thailand 16.0%

Venezuela 23.1%

Ethiopia 27.5%

Argentina 35.5%

0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0% 35.0% 40.0%

Source: Fernandez et al., 2015.

In the absence of a proper stock market any discussion of its properties and compliance with
international standards becomes meaningless, of course.

Figure 9: Perceptions of availability of investment information and quality of financial data

50.0%
Very low
58.3%

36.1%
Low
33.3%

13.9%
Average
8.3%

0.0%
High
0.0%

0.0%
Very high
0.0%

0% 10% 20% 30% 40% 50% 60% 70%

Availability of investment information Quality of financial data

Source: financing market.

However, it makes sense to discuss some properties of the equity financing market in general,
both because they determine the prospects of unlocking it for the type of infrastructure

37
investments supported by UNCDF and because they emphasize the difficulties of establishing
a stock market. These include specifically the availability of information on investment
opportunities and the quality of accounting and financial data. The surveyed entities
characterized these two dimensions as predominantly very low or low (86.1% for availability of
investment opportunities and 91.6% for quality of financial data), very few as average and none
as high or very high.

4.2.7 Equity Market Assessment

The situation of the equity financing market for infrastructure is summarized in Table 9, which
also provides the respective ratings.

Table 9: Ratings of equity financing indicators

Indicator Rating
1.1 Size of the stock market 1
1.2 Accessibility of the stock market 1
1.3 Stock market liquidity (total value traded/GDP) n.a.
1.4 Stock market regulation 1
1.5 Compliance of the regulation with the international 2
standards
1.6 Listing requirements n.a.
1.7 Private equity providers (apart from public sector entities) 3
1.8 Average equity market risk premium (MRP) for small- and 1
medium-sized infrastructure
Average 1.5

4.3 Debt Financing

4.3.1 Overview of the Banking Sector

the main source of debt financing; hence, a few stylized facts about
its capacity and key features are discussed below. The banking sector in Ethiopia is small
(consisting of 19 banks) and relatively undeveloped. Bank capitalization has improved in the
past few years as banks are striving to comply with the NBE requirement of a minimum paid-
up capital of ETB500 million by 2016. Still, it remains very low at 2.5 percent of GDP (NBE,
2014). In 2013/14, banks assets to GDP stood at about 25 percent (NBE, 2014), which is far
behind developed countries where this indicator may run as high as 400% (for example, in the
UK) but on par with or even slightly better than other least developed countries, such as Laos
(22.4 percent), Liberia (20.2 percent), Tanzania (23.5 percent), and Uganda (19.1 percent)
(HelgiLibrary, 2015).

The banking sector is closed and characterized by a large share of state ownership (Bezabeh
and Desta, 2014). Ethiopian laws explicitly forbid foreign nationals or organizations fully or
partially owned by foreign nationals to open banks or branch offices or subsidiaries of foreign

38
banks in Ethiopia or acquire the shares of Ethiopian banks (Banking Business Proclamation No.
592/2008). The sector is heavily dominated by the state, both in terms of ownership and
regulation. In 2013/14, public banks accounted for 72 percent of total deposits and 67 percent
of loans and advances (including outstanding credit) (NBE, 2014).

Government dominates lending, controls interest rates, and owns the largest bank, the
Commercial Bank of Ethiopia (CBE) whose assets represented about 70 percent of the sector
total in fiscal year 2013/14. The other large state-owned commercial bank is Construction and
Business Bank (CBB). There is also one specialized state-owned bank, Development Bank of
Ethiopia (DBE), which extends short, medium and long-term loans for viable development
projects, including industrial and agricultural projects. The Central Bank, the National Bank of
Ethiopia is the financial sector regulator and has a monopoly on all foreign exchange
transactions and supervises all foreign exchange payments and remittances.

The Economist Intelligence Unit (2015) notes the robust performance of the national banking

overall liquidity ratio is only just above the 15% minimum requirement, and structural
constraints on lending and the lack of credit-assessment agencies will remain a significant

4.3.2 Bond Financing

The only regular financial market in Ethiopia is treasury bill market for short-term government
treasury bills (91 days and 364 days). Due to its short-term nature this type of security is not
suitable for fixed asset financing (leaving alone the challenge of the presently negative interest
rate on government securities). A bond market as such does not exist. Although the
Government bonds are occasionally issued to finance government expenditures and/or to
absorb excess liquidity in the banking system, these bonds are illiquid and have to be hold to
maturity. One of the recent cases in question is the NBE development bill introduced in April
2011 and levied on new loan disbursements by commercial banks.

There is no primary or secondary market for the securities such as corporate or municipal
bonds due to the lack of a legal and regulatory framework for this type of securities. In recent
years, following the growth in economic activities and real income, there has been strong
demand for corporate bonds. As a result, CBE has been purchasing corporate bonds from
major public institutions whose outstanding holdings increased to ETB 109.1 billion in 2013/14
from ETB 80.5 billion a year before (NBE, 2014). However, CBE is the only purchaser of these
bonds and their origination is limited to four public agencies, such as the Ethiopian Electric
Power Corporation (EEPCO), City Government of Addis Ababa, Railway Corporation and
Ethiopian Housing Development Agency. These bonds have tenors up to 10 years and a 6
percent coupon (the minimum saving rate plus 1 percent) paid annually. The City of Addis
Ababa sells bonds to CBE for financing its Integrated Housing Development Program. These
bonds are secured under a Bond Agreement and are payed back over five years.

In principle, the right of issuing bonds is granted to all state-owned enterprises (SOE), city
corporations (there are two, Addis Ababa and Dire Dawa) as well as Regional Governments.

39
However, in practice any bond issue requires a pre-approval of the Central Government. The
issuance of corporate bonds for the past two years are detailed in the Table below.

Table 10: Corporate Bond Issuance, ETB million

Issuer 2012/13 2013/14 Percentage

change
EEPCO 16,200.0 22,000.0 35.8
Regional governments 0.0 0.0 0.0
Development Bank of Ethiopia 0.0 0.0 0.0
City Government of Addis Ababa 5,675.0 7,000.0 23.3
Railway Corporation 1,100.0 4,200.0 281.8
Private Sector 0.0 0.0 0.0
Total 22,975.0 33,200.0 44.5

Source: NBE, 2014.

No private sector enterprise has ever issued bonds in Ethiopia, even through direct private
placement. NBE announced in April 2015 its intention to introduce a secondary bond market
will allow any
corporate entity, which has a legal personality and fulfills the eligibility conditions to be
established by NBE, to issue bonds. However, the details remain sketchy (e.g., a regular bond
market vs. OTC trade) and the timeline has not been defined. Given the daunting challenge of
developing a proper infrastructure for the bond market, bond financing is unlikely to become
an option for economic infrastructure financing in the foreseeable future. In general, the bond
market in Ethiopia meets the general description of debt markets in developing economies
(Spratt, 2009: 107-108): a limited repertoire of financial instruments used, domination of
government securities; limited use of absence of municipal bonds, etc.

4.3.3 Loan Financing

Financing infrastructure through bank loans is the primary method of infrastructure financing
(in addition to equity financing considered in Section 5.2). New lending to the economy has
been on the increase in the past five years. According to NBE (2014), commercial banks and
Development Bank of Ethiopia (DBE) disbursed ETB 59.9 billion in 2013/14, an increase of 10.5
percent over the previous year. NBE (2014: 57) reported that in 2013/14 f the total new loans
disbursed by the banking system, 35.1 percent was by private banks, while the share of public
banks was 64.9 percent
agriculture (18.1 percent) and domestic trade (15.2 percent), while other sectors consumed the
remaining balance

40
Table 11: Domestic lending (origination and outstanding loans), ETB million

2012/13 2013/14
D* O* Total D* O* Total
Public banks 33,249.7 91,173.4 124,423.1 38,937.9 114,664.0 153,601.9
Private banks 21,001.8 44,656.5 65,658.3 21,027.5 53,691.1 74,718.6
Total 54,251.5 135,829.9 190,081.4 59,965.4 168,355.1 228,320.5
* D = Disbursement, O = Outstanding credit (excluding central government borrowing)

Source: NBE, 2014.

Despite an increase in lending, domestic credit to the private sector increased at a lower rate
as out of the total new and outstanding credit of ETB 240,780 million in 2013/14, ETB 80,159
million was issued to the central government and public enterprises (NBE, 2014). In fact, the
increase in domestic credit to the private sector is attributable almost entirely to the public
Hence, domestic credit to the private sector
in 2013/14 was 15.3 percent, lower than in developed economies and in other more developed
economies in the region, such as Kenya (34.4 percent) but close to other least developed
countries, e.g. Tanzania (13.8 percent), Uganda (14.3 percent), and Zambia (13.4 percent).

Bank credit, particularly medium and long term, remains constrained due to certain regulatory
provisions. With their relatively low capitalization, private banks find it difficult to comply with
the NBE ETB 500 million minimum requirement for the paid-up capital by 2016 while at the
same time being subjected to the April 2011 NBE directive requiring them to hold 27 percent
of new loan disbursements in low-yield NBE bills. The 5-year bills pay a nominal annual interest
of 3 percent and their proceeds are transferred to the state-owned DBE which, according to
the stated policy is supposed to on-lend them to government targeted private sector activities
(IMF, 2013). n analysis of DBE balance sheet reveals that
more than half of the proceeds are used to buy T-bills. This, combined with the policy of
directed lending mainly to public enterprises in an environment of negative real interest rates,
results in a significant transfer of resources from creditors (savers) to borrowers, especially the

that it forced banks to unnecessary portfolio adjustments.9 In fact, to avoid the effects of this
27 percent bond requirement, private banks moved up market and towards longer-term
financing. In an attempt to counteract this tendency and to push for T-bill purchases, NBE
issued a new directive in February 2013 setting the minimum requirement for short-term loans

The total NBE bills purchased by the banking sector have reached Birr 26.0 billion by end
2013/14 (NBE, 2014). The surveyed banks noted that the provision depletes the loanable fund
forcing the banks to maintain the 40 percent share in short-term loans each time a loan is

9
In addition, the return on the NBE bills is below the cost of capital for private banks, which is about
6-7 percent, according to the surveyed private banks.

41
renewed.
for agriculture and SMEs) will require efforts in many areas, including the elimination of the 27

The chart below (Figure 10)

demonstrates the impact of the
Private banks have no reason to complain [about the
their loan portfolio. The share of NBE 27 percent bond requirement on new loans]. This
money eventually returns to them through
rising whereas private sector credit government on-lending to support private sector
has been stagnating. Whereas both activities.
types of credit show a decreasing Director, Banking Supervision Directorate (NBE)
trend, the change of rate for private
sector credit is much steeper and
goes into the negative sector. Should this trend continue, private sector credit will register a
quick decline. NBE argues that the requirement to hold 27 percent of new loan disbursements
does not produce any negative effect in private banks which remain profitable (IMF (2013).
However, the argument of profitability does not address the concerns about the possible
negative impact on the ability of the financial sector to allocate savings towards the most
productive use and thus contribute to improved economic growth rates. It is of course possible
for financial institutions to remain profitable and create financial wealth without creating any
economic value or even decreasing societal well-being and economic efficiency and
diminishing investments in real capital the plant and equipment that make the economy
function and grow (Stiglitz, 2015: 82-83, 124).

The composition of loan portfolios by maturity is thus significantly influenced by the Regulator.
The 40 percent requirement for short-term loans combined with 10 percent of total loans
usually used for revolving loans disbursed to pre-shipments, merchandise, and over draft
facilities, leaves the remaining maximum capacity for medium- and long-term loans at 50
percent.

Figure 10: Trends of loan portfolio, Wegagen Bank

100% 4.7 4.6 5

80% 3.6 4
3.3
ETB, million

60%
2.4 3
40%
1.6 2
20%

0% 1
2011/12 2012/13 2013/14
-20% 0

Private sector loan (ETB, billion) NBE bills (ETB, billion)

Private sector loan, change (%) NBE bills, change (%)

42
Although not all surveyed banks have complied with the January 2015 deadline established by
NBE (for example, CBB has slightly above 50% of its lending portfolio in medium- and long-
term loans), the share of short-term loans in their portfolios is approaching the target and in
some cases exceeds it, sometimes significantly, reducing the share of medium- and long-term
loans to 20 percent. The tenors for private banks are limited to 10-12 years, CBB (specializing
in mortgage finance) has maximum tenors of 7 years whereas CBE lends up to 15 and DBE up
to 20 years for projects in agriculture, manufacturing and export. Furthermore, loans with
tenors over 5 years (typically used to finance infrastructure) have on average a small share of
the total loan portfolio (10-20%) of private banks. The government-owned banks, such as CBE
and DBE, not constrained by the 27 percent requirement, tend to maintain a higher share of
medium- and long-term loans than private banks. DBE originates only medium-term loans
(repayable within 3-5 years including any grace period) and long-term loans.

Table 12: Average loan portfolio by maturity for Ethiopian banks

Tenor Average Percentage

Short 45
Medium 40
Long 15

Source: .

The banking sector demonstrates a peculiar double yield curve, one for public banks and the
other for private banks. The upward slope of the yield curve for public and private banks is
steeper than for developed economies and flattens out much later as, for example, Sheppard
(2003) and UN (2005) point out. However, the yield curve for public banks is less steep than
for private banks and flattens out earlier, at about 5-7 years of maturity.

When comparing to the Euro area interest rates, it should be taken into account that the data
for the loan yield curve in Ethiopia is based on averaging the interest rates collected during the
survey, which reflect average risk premium. In reality, as indicated by the surveyed banks, the
rates for premium customers will be below the average, making the yield curve flatter than
shown in the graph. Furthermore, a number of Ethiopian banks (both public and private) offer
reduced interest rates. For example, DBE offers 8.5 percent for the priority areas as compared
to the regular 9.5 percent interest rate; one of the surveyed private banks offers an interest rate
discount of 0.5-2.5 percent against the regular rates for export-oriented investments.

If the expectations theory is to be believed (Fabozzi, 2013: 123), the difference in the yield
curves between Ethiopia and the Euro area may reflect the expectations of rising short-term
rates in Ethiopia (which is quite likely given the currently negative real yield on treasury bills)
and the expectations of the same short-term rates in the Euro area. This is particularly true
when the term structure of interest rates for the Ethiopian private banks is considered because
it presents market expectations better than the obviously subsidized rates of the public banks.

43
Figure 11: Term structure of lending interest rates

18%
15.50%
16%
14% 12.50%
12%
9.75%
10%
10.57% 10.57%
8%
8.73%
6%
4%
2%
2.11% 1.96% 2.10%
0%
SHORT-TERM MEDIUM-TERM LONG-TERM

Euro area Government banks Private banks

Source financing market; ECB (2015).

A high rate of loan performance (with nonperforming loans at slightly above 2 percent) is worth
mentioning. UNDP (2015a: 20-21)
(among other factors) the extremely high value of collateral needed for a loan, corresponding
Of course,
this varies between banks and between regions and in some cases may go over 5 percent. In
particular, performance rates appear to be lower in Addis Ababa and higher in rural areas
(although it may be related to the total lending amount). It also appears to be related to the
loan maturity, with short-term and long-term loans performing better than medium-term in
some banks. However, on the whole the surveyed banks believe medium-term and long-term
loans to be less risky than short-term loans, possibly because of the higher standards applied
to these loans and hence a reduced probability of default.

Figure 12: Riskiness of medium- and long-term infrastructure loans

More risk 13.9%

Same risk 30.6%

Less risk 55.6%

0% 10% 20% 30% 40% 50% 60%

Source

44
 -term lending behavior

capitalization, loan performance or risk perception play any significant role in determining the
- and long-term loans demonstrate only one
strong and statistically significant positive relationship with the type of ownership. As
discussed in this study, state-owned banks originate significantly more longer-term loans as a
percentage of their assets or as a percentage of their total loan portfolio than private banks.
The average share of medium- and long-term loans to assets for public banks is 38% whereas
for private banks it is only 16%.
Ethiopian banks base their lending policy and loan classification on government regulations,
which promote export-related businesses, manufacture and agriculture. Hence, most banks
do not have a specialized SME unit or department or a specialized lending program to better
serve this business segment (Awash Bank is one notable exception that has an SME credit
division dealing with loans below ETB 10 million). According to the World Bank (2015: 36), the
share of SME lending in overall lending portfolio in Ethiopia is only 7 percent, among the
smallest shares in Sub-Saharan African countries as well as far below that of developing
CBE is by far the largest lender to the SME sector with a total
loan portfolio in that sector worth ETB 1.6 billion as of end 2012 although it represented only
(World Bank, 2015). Overall, credit rationing is a
typical feature of the Ethiopian credit market as predicted by UNCTAD (2014), and this is
particularly true for SMEs.
The average loan size issued by CBE for SME was about ETB 18 million, which is close to the
average size of infrastructure loans issued by the surveyed banks ETB 20-30 million.
According to the World Bank (2015), the average maturity for SME loans is 6 years, which is
somewhat shorter that the average maturity of infrastructure loans reported by the surveyed
banks at 7-9 years. The surveyed banks confirmed that the demand for medium- and long-
term loans for infrastructure investment remains high and largely unsatisfied.

Figure 13: Satisfaction of the demand for medium and long-term loans

Unsatisfied 61.1%

Somewhat unsatisfied 27.8%

Somewhat satisfied 11.1%

Satisfied 0.0%

Fully satisfied 0.0%

0% 10% 20% 30% 40% 50% 60% 70%

Source

45
And yet, the surveyed banks feel that the transaction costs of lending for small- and medium-
sized infrastructure are relatively high. There is a perceived correlation between the size of the
loan and transaction costs per unit of a loan in terms of required time and effort defined by the
quality of the loan application and availability of information about the borrower. According to
the surveyed banks, smaller borrowers tend to submit loan applications of inferior quality and
their ability to repay the loan cannot be adequately established without significant additional
efforts. All banks note the generally
low quality of the financial
We have no confidence whatsoever in the financial statements submitted by the
data provided by most applicants. Apart from applicants as well as the lack of
independent audit, which is the
intentional misrepresentation of financial data,
major reason for a relatively high
mistakes, inconsistencies and omissions of critical
collateral requirement when
information are frequent and obvious. This is borrowing against the balance sheet
particularly true for smaller applicants but even the even when it appears quite healthy.
bigger ones often do not meet the standard where we The survey demonstrates that,
would feel comfortable [to lend against the balance generally speaking, private banks
sheet alone]. require a higher collateral than
publicly-owned banks and in certain
Manager of Credit Department, Private Commercial Bank cases and may go as high as 250 per
cent for smaller enterprises and start-
ups. In any case, the collateral
requirement does not go below 100 per cent of the loan, and even DBE which
ess to cheap capital
subsidized by the state requires first-degree collateral as a condition for loan issuance.

Report on the
Observance of Standards and Codes (2007), which notes the general lack of understanding of
accounting standards and weak regulatory enforcement of such standards with no set
penalties for noncompliance with the requirements on accounting and financial reporting (WB,
2007: 12-17). The new Proclamation on Financial Reporting No. 847/2014 issued on 5
December 2014 addressed the issue of financial standards determining that the financial
standards to be used when preparing financial statements are the International Financial
Reporting Standards (IFRS) for private entities or the International Public Sector Accounting
Standards (IPSAS) for charities and societies. The same proclamation determines that the
International Standards for Auditing (ISA) issued by the International Federation of Accountants
should be applied for auditing. However, actual application of the new standards will take time,
and no noticeable improvements should be expected in the near-term perspective, particularly
given the dearth of accounting professionals in Ethiopia which compares it negatively to the
other counties in the region.10 The banks participating in the research did not register any

10
The number of professional accountants in Ethiopia is rather low in relation to the size of the
economy. There are an estimated 200 professional accountants in the country. In comparison, Uganda

46
improvement in the financial data as of August 2015. Notably, this proclamation does not cover
the public sector as such, i.e. municipalities and other local governments as well as regional
governments whose financial reporting practices continue to be regulated by the Financial
Administration Proclamation (2009) and associated internal directives.

One of the notable weaknesses of the Ethiopian infrastructure financing market is lack of
reliable credit rating data. NBE took some steps to improve the availability of information for
assessing the creditworthiness of borrowers and introduced in 2012 the Credit Reference
Bureau (CRB) as an NBE unit (Directives CRB 2012/1). Participation in CRB is mandatory for all
registered banks and allows exchange of and access to the credit history of individual
reduces credit risks. However, unlike
credit rating agencies, it cannot provide comprehensive assessment of the credit quality of the
loan or bond issuer based not only on the credit history but also on the ability of the issuer to
pay interest and repay capital. As a result, banks have to use relationship lending and rely to a

as on personal guarantees of key shareholders when the borrower is a share company. Some
banks combine this approach with transactional technologies such as credit scoring and risk
rating tools.

Project financing, particularly with respect to small- and medium-sized infrastructure, is not
known and is not practiced by the Ethiopian financial market. The surveyed financial and non-
financial institutions (such as TSPs) admitted lack of knowledge about project financing and
could not express their interest in the use of this financing approach. However, the elements
of project financing are present in a number of transactions. The availability of some insurance
products usually required for a project financing deal has already been mentioned. The
essential elements for a project financing deal in terms of required documentation are in place
and enforced by the banks (although some are more lenient that the others). These include
feasibility studies, including market and technical studies and environmental impact
assessments; project financial studies, including social and economic impact assessments;
various contract agreements, etc.

Similarly, banks are not averse to highly leveraged deals or to longer loan tenors. DBE, for
example, will finance the remaining balance up to a maximum of 70 percent of the total project
cost in addition to 30 percent equity contribution from the borrower. Some private banks also
indicated their willingness to finance up to 35-40 percent of project costs, with the rest
provided by the borrower in the form of equity. However, the non-recourse (or limited

and Ghana, with economies less than Ethiopia, each have more than 1,000 professional accountants.
Kenya, whose economy is roughly 1.5 times that of Ethiopia, had 3,000 professional accountants in
2001. Having a shortage of professional accountants means that there are positions in the private and

interactions with Ethiopian CPAs during 2015 seem to indicate that the situation has changed
insignificantly and the shortage of professional accountants remains a serious challenge.

47
recourse) nature of project financing is an obvious challenge to the banking sector, which in
inexperienced in off-balance sheet finance and perceives such lending as too risky.

In 2014, the Ethiopian parliament endorsed the provision for capital goods leasing, following
which the NBE issued in July 2014 a directive that opens this segment of the financial market
to both domestic and foreign firm, thus making it the only financial business permitted for
foreigners. The new directive specified three distinct categories for equipment leasing
business: operating leasing, finance lease and a hire-purchase system. According to NBE's
directive, ETB 200 million is needed as a minimal requirement to engage in this particular
sector, and by the end of 2014, five companies had indicated their interest in this new line of
business (Atnafu, 2014). So far, there have been no cases of financing infrastructure investment
through leasing in Ethiopia.

4.3.4 Debt Market Assessment

The situation of the debt financing market is summarized in Table 13.

Table 13: Ratings of debt finance indicators

Indicator Rating
2.1 Domestic credit to private sector 2
2.2 Providers and insurers of long to medium term debt 2
2.3 Banking sector concentration 2
2.4 Banking sector risk 2
2.5 Banking sector regulation with respect to medium- and 2
long-term C&I credit11
2.6 Banking sector liquidity ratio (liquid assets to total assets) 2
2.7 Medium to long-term loans to total gross loans 3
2.8 SME lending to total gross loans 2
2.9 Nonperforming loans to total medium to long-term loans 4
2.10 Term structure of interest rates (curve shape and actual 2
rates)
2.11 Demand for medium to long term infrastructure credit 4
2.12 Credit rating availability 1
2.13 Use of lending technologies for infrastructure 2
2.14 Application of project financing for infrastructure lending 1
crediting (frequency)
2.15 Application of project financing for infrastructure lending 1
(size of the project)
2.16 Regulation of capital goods leasing business 2
2.17 Development of capital goods leasing business 1
2.18 Perception of risk of lending for infrastructure investment 4

11 Medium- to long-term loans are defined as loans with a maturity of above 5 years.

48
 2.19 Interest in application of project financing for 1
infrastructure investment
2.20 Perception of the transaction costs of lending for small- 2
and medium-sized infrastructure
Average 2.1

4.4 Public Sector Financing and Nonfinancial Support

As mentioned previously, there are four major avenues for the public sector support to
infrastructure investments (Seidman, 2005; World Bank, 2010; Delmon, 2011): (1) direct
financing of public infrastructure projects; (2) financing of private sector infrastructure
projects; (3) public-private partnerships and (4) advisory services and facilitation. Of these, the
first method by far prevails; the second and third methods play a marginal role in infrastructure
financing and the forth method targets primarily micro and small enterprises a sector too
small for meaningful infrastructure investments.

4.4.1 Subnational Government Financing

single most important investo

supports public services. This role of the state is explained by a relatively under developed
private sector and equity markets that do not allow private companies to raise significant
capital for infrastructure finance Ethiopia is a federal state with a two-tier structure of
subnational government: regional states, also known as regions (nine in total)12 and two
chartered cities (Addis Ababa and Dire Dawa) as the first tier and city administrations/woredas
(in rural areas) on the second tier. City administrations and woredas constitute the lowest level
of local government in Ethiopia with constitutionally mandated responsibilities for service
delivery.

The Constitutions of Ethiopia grants significant powers to the regional states, including a fiscal
authority to collect its own revenues, partake in revenues collected by the central government
(Articles 96 and 97 of the Constitution) and engage in internal borrowing. However, the
revenue generation capacity of the Regions is limited and own source revenues account for
less than 2o percent of the regional annual budgets, the rest being covered from the federal
grants and revenue sharing arrangements. The Federal Government currently uses one block
grant, and at least four Specific Purpose Grants (SPGs) to transfer resources to regions. The
degree of expenditure discretion to regions vary across instruments ranging from full control
in allocation in the case of FBG to partial control or delegated spending of Federally budgeted
programmes (such as the Support to the SDG grant introduced in FY 2015/16).

12
The regional states include Afar, Amhara, Benishangul-Gumuz, Gambella, Hareri, Oromia, Southern
Nations, Nationalities and Peoples (SNNP), Somali, and Tigray (Articles 46-49 of the Constitution of the
Federal Democratic Republic of Ethiopia).

49
Figure 14. Federal structure of the Ethiopian Government

Federal Government
First Tier

Regional Governments City Administrations

Government (9) (2)
Second Tier

Special Cities Special Zones

(99)

Sub-Cities Woredas Woredas Sub-Cities

(671) (6) (10+1) Third Tier

Urban Rural Kebeles Kebeles

Kebeles Kebeles
Fourth Tier

Source: MOFA (2015)

The borrowing power of the Regions is limited by the existing regulation and is under full
control of the central government represented by the Ministry of Finance and Economic
Development (MoFED).
Proclamation of the Federal Government of
borrowed by individual regions shall be determined by MoFED based on all relevant
information provided by the regions and taking into account national fiscal policy and
borrowing limitations imposed by law or agreements. Furthermore, disbursements on
borrowings of Regional Governments shall be managed by NBE (unless these borrowings are
from entities other than NBE). And if Regional Governments borrow from entities other than
NBE, the administrative arrangements related to such borrowings are jointly agreed between
the respective Regional Government and MoFED.

In practice, the principal originator of regional debt is CBE, which lends to the regions at a
subsidized annual rate of 7.25 percent. According to MoFED and CBE, about 30% of regional
borrowing is used for providing fertilizer credit to their farmers through agricultural
cooperatives. The rest is used for various projects, including infrastructure projects although
the borrowing capacity of the Regions varies, with most Regions (e.g., Afar, Benishangul-

50
Gumuz, Gambella, Somali, SNNP) borrowing very small amounts (Mentta et al., 2015).
Interestingly, CBE is legally mandated to apply intercept with respect to defaulting Regional

transfers to the regional level. In addition, given the low revenue generating capacity of the
Regions (in most of them own revenues account for 20-25 percent of the annual budget as
Mentta et al. (2015) point out), they cannot obtain credit from commercial banks and other
financial institutions whereas the legislation fails to specify the instrument of borrowing
available for regions (Assefa and Gebre-Egziabher, 2007). The creditworthiness of subnational
governments at all levels is further hampered by inadequate public financial management
systems and procedures, resulting in unreliable data about the financial positions of local
governments and inadequate annual financial statements (MoFED, 2010).

To make things more complicated, the Agricultural Transformation Agency (ATA) is now
working on its own guarantee scheme for fertilizer provision (and other inputs) through MFIs,
which will make regional involvement in this area redundant. Potentially, this development may
release additional borrowed funds for other investments, including infrastructure but it may
also mean less lending to the regions from the central government.

The lowest level of local government, city administrations and woredas, are not adequately
institutionalized to exist as an autonomous level of government. Mesfin and Bogale (2013)
explicit and implicit provisions in the regional constitutions and statutes
render local government a subsidiary structure whose function is limited to implementing
The status of woredas and city administrations is defined by
regional constitutions and statutes, which establish direct responsibility of city administrations
and woredas to regional governments. The various regional constitutions make woreda
councils responsible for levying and setting tax rates and collecting taxes. However, in practice
most tax rates have been established at the federal level. The taxing powers of woredas
specified in the regional constitutions are limited and include rural land use and agricultural
income tax, the rate of which is determined by the regional states .
Woredas can also collect service user fees, which are variously established at the regional,
woreda and even kebele level (e.g., water user fees) (Yilmaz and Venugopal, 2008). The
proceeds of these taxes are expected to be transferred to the regional government (even
though in practice woredas retain the proceeds).

As the revenue collected from a woreda covers not more than about 20 percent to 25 percent
of the recurrent expenditure, a woreda has not been able to cover the required expenditure
from own sources of revenue (even this collection is not entitled to be used). Therefore, since
2002, general purpose grant has been allocated to woredas from Regional Government on
the basis of a simple and transparent formula approved by each Regional council (World Bank,
2010b). However, the general purpose grant is designed primarily to cover the salaries of
government employees in a woreda, and the woreda council has little discretion, if any, over
the use of this grant.

51
City administration are in a somewhat better situation and are legally allowed to retain own
revenues from direct and indirect tax sources although this right is based on a rather outdated
Proclamation No. 74 of 1945. The four main types of municipal revenues as per the
Proclamation include

 Property taxes collected in the form of land rents, lease income and building taxes
 Business income taxes
 Market fees (for stalls and use of markets)
 Fees for municipal services, including: sanitary services, slaughter houses, fire brigade
services, mortuary and burial services, registration of births and marriages, building plan
approval, property registration and surveying, and use of municipal equipment,
transport or employees

Some municipalities are known to have been allowed to collect other types of local fees, such
as goods entry taxes and vehicle loading and unloading fees (Yilmaz and Venugopal, 2008).
City administrations generally receive transfers in the form of block grants/allocations from
regional governments in order to fund state functions. However, municipal functions have
historically only been funded from municipal own source revenues, which are meager at best.
This fiscal gap is compounded by the rapid urbanization in the country. The recent Urban Land
Lease Proclamation No. 721 2011 may improve the own source revenue generation capacity
of municipalities. This proclamation allows regional governments and city administrations to
regulate long-term land lease for urban development using a market-based approach,
including for housing, science and technology, research and studies.

The applicable regulation does not contain any provisions for borrowing by city
administrations and woredas. In any case, the revenue generating capacity of local
governments is low and the share of block grants in their budgets is high, making them very
unlikely borrowers even if the relevant regulation were in place. Neither woredas nor
municipalities have the power to introduce new source revenues or change the existing tax
rates without the necessary federal or regional government legislation or regulations to allow
implementation.

4.4.2 Institutional and Mixed Financing

The challenges faced by insurance companies in financing economic infrastructure have
already been discussed. Contrary to the situation in other countries where public financial
institutions and pensions funds are assigned important roles in infrastructure financing (Ogden
et al., 2003; Andersson and Napier, 2007), such institutions in Ethiopia do not play a substantive
role in supporting infrastructure development. The social security and pension sector in
Ethiopia is underdeveloped and represented by three government institutions. The Public
Servants Social Security Agency (PSSSA) is a federal agency responsible for administering the
pension scheme of all federal and regional public servants, and the Private Organizations
Employees Social Security Agency (POESSA), another federal agency in charge of the overall
administration The former covers a
small segment of the market and is limited to the government sector whereas the latter is only

52
emerging as a social security mechanism having been decreed relatively recently, in June 2011.
The third agency, Ethiopian Social Health Insurance Agency (SHIA) was established in 2010 to
manage a universal health insurance (UHI) scheme mandatory for government and private
employees required to contribute monthly 3 percent of their salaries. SHIA had a very slow
start, with the regulatory framework and operational manuals still incomplete and the UHI not
fully operational.

PSSSA is at the moment the only fully functional

investment policy but follows government directives prescribing it to
and other secured investments specified by directives issued by the Ministry of Finance and
Economic Development (Government Regulation 203/2011 on PSSSA). The PSSSA asset
allocation strategy is representative of the investment policies of the other social security funds
and is presented in the Table below.

Table 14: PSSSA asset allocation strategy

Type of Investment Portfolio, %

Short term

Demand Deposit 2
Saving Deposit 8
Fixed time Deposit 35
Treasury Bill 15
Sub total 60
Long term
Government Bond 5
Corporate bond & shares 25
Real Estate 10
Sub-total 40
Total 100
Source: PSSSA (2015)

The regulation on investment of social security and pension funds is very similar to that for
insurance companies, with the same liquidity requirement of 60% but with a higher allowed
share for corporate bond and shares. In reality, PSSSA buys SOE bonds and shares, which have
government guarantees. The other funds, when fully operational, are expected to follow the
same investment policy. Theoretically, particularly if a proper bond market is established in
Ethiopia, social security and pension funds may be significant infrastructure investors but the
way things are at the moment, this is unlikely in the foreseeable future.

efforts at public divestiture and privatization were not adequate in addressing the unmet

Specifically, PPPs have not been initiated in key sectors such as

transport and telecommunications, energy, tourism.

53
PPP application is Ethiopia is regulated by Procurement and Property Administration
Proclamation No. 649/2009, which clearly defines the term
sector participation by a contractual arrangement between a public body and a private sector
and empowers the Minister of MoFED to issue the rules and
directives on establishing and implementing PPPs (UNDP, 2015a). Subsequent Investment
Proclamation No. 769/2012 makes the Privatization and Public Enterprises Supervising Agency
(PPESA) responsible for receiving investment proposals submitted by any private investor
intending to invest jointly with the government, submitting such proposals to the Ministry of
Industry (MoI) for decision and, upon approval, designate a public enterprise to invest as
partner in the joint investment. Ministry of Communication and Information Technology
(MoCIT) has issued recently rather detailed guidelines to devise a framework for the Ethiopian

infrastructure creation, maintenance and/or operation of structures and facilities that are in

Yet, according to some authors (Asubonteng, 2011; Beyene, 2015), the existing regulation is
not adequate: It lacks clarity, does not specify special legal instruments for PPPs, does not
elaborate the PPP procurement process and procedures and contains conflicting provisions
(e.g., in some cases vesting the authority for PPP approvals with MoFED and in others, with
country
empowered public agency to run PPP issues in Ethiopia, which further exacerbated mistrust

(Beyene, 2015: 153). The other reasons for a limited use of the PPP model in Ethiopia include
high investment requirements and high perceived risks (Asubonteng, 2011). None of the
financial institutions
participation in PPPs for these reasons. Furthermore, as Ausbonteng (2011: 18) points out, even
though some form of PPP arrangement exists as a
bridging arrangement between the transfer of state assets from public ownership and
management to full scale privatization (Asubonteng, 2011).

54
 The implemented PPP projects can
be easily numbered, and only a few
Over the years, the private-public discussion forums
of them belong to economically
in Ethiopia have evolved into some sort of a standard productive infrastructure, and in a
exchange between the two parties which involve the few such cases the private sector is
government criticizing the private business usually manages the assets rather
community about its defiance in getting on board on than finances them. The most
the country development agenda by investing in significant PPPs by size are in the area
of housing delivery with the Ministry
growth propelling manufacturing and industrial
of Urban Development, Housing and
sectors. Meanwhile, these discussions usually see the
Construction (MUDHC), other
business community urging the government to look examples include unified billing of
into itself and its service delivery and the overall water, electricity, telephone services
incentive structure before pointing fingers at the via a service contract managed by
private sector. MoCIT; Community- Public-Private
irrigation project via a management
Dawit Taye, business affairs journalist for The Reporter contract supervised by the Ministry of
Water and Energy (MoWE); small-
scale textile, garment and food (fruit)
processing via service contracts managed by FEMSEDA and a few others. There have been no
examples of PPPs with the participation of regional governments, let alone city administrations
or woredas. The current situation of PPPs in Ethiopia does not allow to consider this approach
as a realistic venue for infrastructure financing in the near-term perspective.

Some international partners are providing assistance to transform PPPs into an effective
financing mechanism. AfDB is implementing the Institutional Support Project for Public-Private
Partnerships (ISP-PPP) with the aim to create an enabling environment and build the requisite
capacity for private sector participation in infrastructure as a means of boosting private
investments in the delivery of infrastructure and other public services. The project is focusing
on the development of a policy, legal, regulatory and institutional framework for PPPs as well
as on PPP capacity development and outreach.

4.4.3 Domestic Financing and Nonfinancial Support

The Government of Ethiopia has set several mechanisms that provide financial and
nonfinancial support to private investments in small- and medium-sized infrastructure. The
role of DBE as the primary financial institution for development has been discussed in the
previous sections. Indeed, the subsidized interest rates on loans, long loan tenors and its focus
on the so- -processing,
manufacturing and extractive industries (preferably export focused) make DBE an effective and
relevant mechanism for financing various types of infrastructure, including small- and
medium-sized economic infrastructure.

In addition, DBE is the Trust Agent for the Rural Electrification Fund designed to facilitate and
accelerate off-grid rural electrification, particularly through solar PV and mini/micro

55
hydropower development. REF provides concessional loans to diesel (85% loan with an interest
rate of 7.5%) and renewable energy projects (95% loan with zero interest rate). In order to
favorably promote the renewable energy projects, REF provides 20-30% capital subsidy of the
investment costs to project developers on a reimbursement basis. DVE is the financial
intermediary between the REF and Project Promoters. DBE disburses funds during project
implementation and later recovers loans according to the loan agreement agreed upon
between the Fund and the Project Promoters.

DBE also acts as the financier for the Federal Cooperative Agency (FCA) in charge of, among
other things, facilitating access to finance for cooperatives. FCA, through its regional branches,
reviews infrastructure project proposals prepared by cooperatives
support) and forwards them to DBE for its credit decision.

There is one specialized funding facility for the private sector, the Ethiopian Competitiveness
Facility (ECF). This is a grant program aimed at improving the competitiveness of the Ethiopian
private sector and its export and domestic sales through increased competitiveness,
strengthened market support institutions and market information systems. The facility is
operated by MoI and financed by DFID through its Private Enterprise Programme Ethiopia
(PEPE). The facility has an export-oriented window, which provides firm-level support to
priority sectors (agro-processing, leather and leather products, textiles and garments) through
a matching grant scheme. The initial cumulative grant per firm is up to US$100,000 (in local
currency), and the proportion of eligible costs supported by the grant is 75%. Businesses can
apply for an additional or second and last grant up to a cumulative total of US$200,000 per
firm, in which case the matching proportion should be 50%. Eligible firms include those
engaged in production for export, or planning to move into production for export, and
operating in one of the priority sectors. ECF is planning to launch another window for non-
exporting firms but those support the supply chain of exporting firms or substituting imports.
The additional sectors for this window include metal and engineering, pharmaceuticals and
chemicals but the matching grant amount (at least during the pilot stage) will be limited to an
equivalent of US$50,000.

A public credit guarantee scheme is run by the Federal Micro and Small Enterprise
Development Agency (FEMSEDA), in collaboration with regional governments. The scheme
provides a 50 percent guarantee for loans worth up to $25,000 extended to microenterprises
active in manufacturing and in the construction industry. The scheme was launched at the
beginning of 2012, and by end of the year had benefited some 250 300 firms.

A number of federal agencies provide various technical and business services to small and
medium-sized project promoters although the bulk of the support appears to be directed
towards the lower end (micro and small enterprises). As already mentioned, FCA provides
support in preparation of business plans and project proposals to cooperatives, including
assignment of experts for certain periods of time. It also delivers business incubation services,
including provision of office space, and facilitates access to market information for
cooperatives. Similarly, FEMSEDA collects, analyzes and supplies market information to

56
MSMEs, helps develop project proposals and business plans, including production building
designs, machinery installation layouts, product designs, and delivers business and technical
skills training. It also facilitates MSMEs access to finance by matchmaking with selected MFIs.

There are also some private TSPs (often supported by the public sector, particularly bilateral
and multilateral donors) who deliver a variety of business and technical services, such as
business plan preparation, accounting, financial analysis and specialized studies (feasibility,
market, EIA, SEIA, etc.). UNDP-supported Entrepreneurship Development Center (EDC) that
works in close cooperation with FEMSEDA provides generic and specialized entrepreneurship
training to various target groups (such as youth, women, farmers) aimed at MSMEs. Thanks to
the ongoing construction boom, Ethiopia has a large number of architect and construction
consultancy firms. A detailed list of TSPs in Ethiopia by category can be found on
2Mercato.com business portal (http://www.2merkato.com/directory/5/). However, the
prevailing opinion of the finance providers who participated in the survey is that the quality of
the specialized studies produced by Ethiopian TSPs, particularly in financial modelling and
analysis, is not sufficiently high and that only a few domestic providers meet the standard.
Nevertheless, there are a number of TSPs affiliated with consultancy firms in the region (e.g.,
Kenya) or farther abroad who produce quality studies and analysis.

4.4.4 Bilateral and Multilateral Financing and Nonfinancial Support

The support provided by bilateral and multilateral agencies to infrastructure financing has three
distinct characteristics.

Firstly, it heavily relies on grants at the expense of other de-risking instruments. Secondly, it is
skewed towards the public sector who is by far the largest beneficiary of international
assistance, financial and nonfinancial. Thirdly, this assistance appears to be targeting the two
opposing ends of the infrastructure, micro and small on the one end and large on the other
end, emphasizing the well-

Grants

In terms of aid volume, the lead agency is the World Bank with its Urban Local Government
Development Program worth US$380 million and implemented through MUDHC. The major
component of this program is performance-based fiscal transfers (grants) to 44 city
administrations. Most of the grant is designed for urban public infrastructure and services, such
as roads, water and sanitation, solid waste management, urban parks and greenery, etc.
However, the investment menu includes areas that can be privately financed and co-financed
together with the public sector and/or implemented through a PPP modality, including
construction and operation of landfills, biogas and composting plants, urban markets with
associated services (water supply, drainage, access roads, and the like), development of
production and market centers for small businesses, slaughter houses (abattoirs), with by-
products and processing facilities and such like. This offers some opportunities for UNCDF
programming but city authorities appear to be focused almost exclusively on purely public
infrastructure. KfW also provides funds to city administrations for the construction of similar

57
infrastructure including landfills, sewage treatment plants, drainage systems, markets and
roads.

USAID widely uses in

agriculture, food security and livestock through three flagship programs: Feed the Future,
Agricultural Growth Program (AGP) and the New Alliance for Food Security and Nutrition. Of
these, only AGP provides grant of the size that can be useful for infrastructure financing (about
US$100,000). Eight Ethiopian businesses have received AGP grants for projects that include
infrastructure components, such as an abattoir, a milk testing laboratory and a facility for
preparing livestock feed from agricultural waste products.

DFID (the third largest provider of international aid to Ethiopia after the World Bank and USAID)
is implementing a grant-based Private Enterprise Program Ethiopia (PEPE) with a total budget
of up to £70 million. The program uses technical assistance and grant funding to micro-finance
institutions and banks to increase the availability of financial products, both for saving and
lending, for MSMEs. As already mentioned, this program supports ECF operated by MoI. Within
this program, DFID also plans to establish a £10m-£15m SME finance facility for equity-type
finance (including the possibility for quasi-equity) to cater for the needs of firms unsuited to
debt.

Loans

EIB provides loans directly to the private sector for commercially viable projects. Such loans to
Ethiopia have supported large infrastructure projects beyond the scope of UNCDF
programming, in the fields of telecommunications, aviation and energy. In addition, EIB
provided a global loan to DBE for onlend
and its disbursement is based on the general DBE requirements described in the previous
sections.

AFD is currently negotiating the first sovereign loan with the Ethiopian government for projects
in electricity and the urban sector. In addition, AFD is considering smaller non-sovereign loans,
which can be used for small- and medium-sized infrastructure and extended to solvent public
sector market-oriented enterprises, private firms, or subnational government directly at
concessional rates provided the concessionality is justified.

Guarantees

As the World Bank (2015) notes, partial credit guarantee schemes help address the challenge
of collateral-based lending in Ethiopia and incentivize financial intuitions to serve SMEs.
However, the collateral requirement is less important for infrastructure lending because banks
and other investors rely, at least partially, on the project fixed assets as collateral. In addition,
certain categories, such as cooperatives, are exempt from the collateral requirement subject
to their previous satisfactory performance. Several multilateral and bilateral agencies have
introduced guarantee schemes but only a few are relevant for infrastructure financing.

58
guarantee facility designed to unlock more lending from MFIs and SACCOs and shared by
seven private commercial banks. AFD offers ARIZ13 guarantees aimed at easing access to credit
for MFIs and SMEs, having so far issued such guarantees to five commercial banks for a total
. Another guarantee scheme similar in nature is maintained by KfW Development
Bank. These schemes support the participating banks in extending credit to agricultural
cooperatives, livestock marketing groups, and agro-processors.

USAID is relying on the Development

Credit Authority to extend credit We had two issues with the credit guarantee [from
guarantees to local banks. For USAID]: Firstly, we simply could not get enough
example, the guarantee scheme for
good proposals in the sectors for which this
Abyssinia Bank, AIB and Dashen Bank
(worth US$ 4.2 million) allowed these
guarantee was designed; secondly, we didn’t have
three banks to provide more short- enough liquidity to utilize this guarantee because of
and medium-term loans to the regulator’s requirements. As a result, we could
entrepreneurs engaged in agriculture never fully utilize it.
related activities, manufacturing,
services, and trade while at the same Director of Credit Management Directorate, Private
time reducing collateral requirements commercial bank
to beneficiaries by 50%. However,
several banks participating in the
survey stated that this scheme was underutilized due to the challenge of identifying credible
investment proposals. Furthermore, some banks indicated a higher rate of default among the
borrowers benefitting from externally-funded credit guarantee schemes. According to those
banks, they apply the same stringent criteria to the credit applications but the borrowers are
inclined to view this as a kind of international assistance, which does not have to be repaid and
The concerning
-term lending behavior (Annex 3) is that the availability
of guarantees apparently has no statistically significant correlation with the amount of
medium-term credit issued by the participating banks. In other words, while medium-term
credit may have increased, the positive relationship with the guarantees could not be
established.

MIGA guarantees are used for supporting larger infrastructure investments. These include two
in agribusiness and one in cement with total net exposure of US$16.8 million. The two
agribusiness projects involve an investment by Africa Juice BV of the Netherlands in production
and export of tropical fruit juices including rehabilitation, and expansion of an existing
plantation of tropical fruits as well as the construction of a new fruit-processing facility. The
manufacturing project is related to a minority equity investment by Schulze Global Investments
(SGI) into the National Cement Share Company of Ethiopia (NCSC). MIGA has also made use

13
Assurance pour le risque de financement de l'investissement privé en zone d'intervention de l'AFD.

59
of its more streamlined Small Investment Product (SIP) to allow smaller projects to be
supported through more streamlined procedures have allowed.

4.4.5 Public Sector Market Assessment

The situation of the public financing market and nonfinancial support is summarized in Table
15.

Table 15: Public sector assessment

Indicator Rating
3.1 Regulation of subnational borrowing 2
3.2 Development of the government bond market for 1
subnational government securities (municipalities and
parastatals)
3.3 Regulation of public and mixed public-private 2
institutional investors (social security and pension funds,
life and health insurance funds, property and causality
insurance companies)
3.4 Level of institutional investment in infrastructure 1
(except for residential property)
3.5 Regulation of public-private partnerships for 2
infrastructure, particularly for subnational governments
3.6 Average number of PPP deals for productive 2
infrastructure, annually
3.7 National public sector support to private 2
infrastructure investment through de-risking
mechanisms
3.8 Bilateral support to private infrastructure investment 2
3.9 Multilateral support to private infrastructure 3
investment
3.10 Availability of dedicated technical and financial 3
support to SMEs
3.11 Availability of a pipeline of infrastructure projects 3
sponsored by SMEs with institutions providing technical
and/or financial support
3.12 Availability of dedicated technical and financial 3
support to cooperatives
Average 2.2

60
4.5 Demand Side of the Infrastructure Financing market
This research focused predominantly on the supply side of the infrastructure financing market
and it may be appropriate to say now a few words about the demand side of the equation. As
for any other good, the availability of long-term capital is determined by a complex interplay
of supply and demand. As discussed in the previous sections, the supply of long-term capital
in Ethiopia is heavily influenced by the state through a regime of financial repression when
market mechanisms are replaced by direct government intervention in the determining of the

2008: 381). The financial sector directly controlled by the government displays little elasticity
in response to the changing external conditions. At the same time, the private financial sector
appears more elastic, and the recent increase in long-term credit in response to the
(see Section
4.3.3). Judging by this spike in long-term lending by private banks in 2011-2012, elasticity of
the private capital finance is in the range of 10-20 percent.

Demand for infrastructure finance (as defined in the beginning of this study, i.e. finance for
economically viable small and medium-sized infrastructure in the productive sector or
supporting the productive sector) is seemingly high. One study (WB, 2015) argues that if a
lending to GDP ratio of Kenya is taken as representative to the true unmet demand for credit
in Ethiopia, a total credit shortage would be about US$3 billion. Most of the existing demand
for credit is related to fixed assets financing although, as has been discussed previously, a large
part of it relates to services rather than industry or manufacturing.

The question is whether the demand for long-term finance is as high as it seems to be. Seidman
(2005: 370) notes that whereas potential customers may think that they need capital, in reality
they may lack the capacity to qualify for financing or productively use it. At the same time,
other firms may qualify but prefer to rely on in internal funds, even if it means slower growth
and lower profits.

The 2005 World Economic and Social Survey (UN, 2005) points out that the major constraining
factor on the demand side is the low capacity of the potential investors (project promoters),
both public and private. Capacity here refers to both the financial and technical capacity of the
promoters to develop and bring an investment to financial closure. The private sector in
Ethiopia

firms are responsible for production of only 11% of manufacturing value-added whereas firms
with 50 or more employees produce more than 85% of manufacturing value-added
(Söderbom, 2012: 135). Furthermore, the Ethiopian private sector has a large informal sector
accounting to about 60% of GDP (Kolli, 2010). This impacts not only on the capacity of the
firms to develop infrastructure proposals but also, more importantly, on the need for capital
investments. In other words, the segment of the private sector requires fixed assets finance of
the size handled by LFI and other similar programs supporting small- and medium-sized
investments is quite limited. Half of the banks that participated in the WB study on SME

61
involvement with SMEs.

The skewed character of the private sector also means that when a requirement for capital
investment exists in principle, a limited number of firms can transform this requirement into a
proper bankable project proposal. Figure 13 demonstrates that although insufficient
creditworthiness was the most significant single reason for rejecting credit applications,
collectively the banks rejected applications most often because of the low quality of the
application itself (technical studies, financial analysis, balance sheet, etc.).

In other situations the public sector can somewhat compensate for the weak demand of the
private sector by stepping in. However, subnational public sector investors (the likeliest target
group for infrastructure in question) also appear to be constrained financially, technically
and by the applicable regulation. As discussed, the revenue generating capacity (and therefore,
the investment and/or loan repayment capacity) of subnational governments is low.
Furthermore, their capacity to borrow and/or enter into PPP arrangements with the private
sector is limited by the existing regulation, is subject to review and approval by the central
government and involves lengthy bureaucratic procedures. In addition, subnational
governments lack the capacity to develop bankable project proposals and prefer budget
finance, even when project may be structured as economically viable.

Figure 15: Major reasons for rejecting loan applications for infrastructure financing

Inadequate creditworthiness/lack of
31.6%
collateral

Low quality of project's financial analysis 21.1%

Low quality of the balance sheet 18.4%

Low quality of project's technical studies 15.8%

Non-compliance with banks' investment

13.2%
policy

0% 5% 10% 15% 20% 25% 30% 35%

Source

62
5. CONCLUSIONS AND RECOMMENDATIONS

One general conclusion is that Ethiopia presents a challenging infrastructure financing market.

real GDP growth (around 8.7 percent and 8 percent for fiscal years 2014/15 and 2015/16),
higher than in the rest of SSA countries and moderate inflation (IMF, 2015). Security is good in
most parts of the country and the rule of law, although still inadequate, is gradually improving.
All these factors contribute to the stability of financial markets and the infrastructure financing
market in particular.

However, the infrastructure financing market is facing a two-fold challenge. Firstly, the market
lacks depth and breadth on the supply side. Alternative sources of finance such as leasing,
factoring and capital market are not readily available in Ethiopia as an additional source of
liquidity for infrastructure financing. Hence, most investors rely on equity investment and
limited access to credit from banks as an external source of finance for their businesses. The
infrastructure financing market (as the financial market in general) is dominated by public
(primarily government) finance, with a limited space for development of the private financial
sector. The government continues to exert strong influence on financial fundamentals and has
been the engine of economic development in general and of infrastructure development in
particular. There are doubts however that the government will be able to play this role for
much longer without engaging the private sector and private sector investments. Secondly,
while the supply appears to be lagging behind the potential demand, the demand is restricted
by the current state of potential infrastructure investors/project promoters.

5.1 Demand for infrastructure Finance

In some respect, there is a good match between an approach to developing high-quality
infrastructure projects that minimizes commercial and financial risks through thorough
structuring of such projects and the unmet demand for small- to medium-sized local
infrastructure finance by investors and financiers. On the other hand, programs that apply this
approach (such as LFI) are likely to encounter difficulties in identifying an adequate number of
credible investors and investment proposals, private or public. In addition, the conditions of
credit rationing in Ethiopia require an additional effort to establish the link between qualifying
potential investors and the formal financial sector. Regional governments (the only layer of
subnational government legally allowed to borrow) may be difficult to convince to transition
from budget financing of economic infrastructure to credit-based or mixed financing.
Furthermore, the capacity of subnational governments to engage in infrastructure financing
using sources other than the budget are significantly limited as has been already discussed and
requires the consent of the federal government.

Support to project development and structuring

If the private sector is to become a serious financier of local economic infrastructure, its
demand capacity needs to be significantly strengthened. One mechanism to be considered in
this respect is a Project Development Fund similar to those established in South Africa and

63
India. Such funds are single-function trading entities, public or private, that provides technical
and financial advisory services and supports project promoters with the transaction costs
project development. The Fund recovers its disbursed funds either in part or in full as a success
fee payable by the successful bidder at the financial close of the project. The PDF may be
involved in the standardization of methodology or documentation, its dissemination, and
monitoring of the implementation of good practices. It should provide support for the early
phases of project selection, feasibility studies, and design of the financial and commercial
structure for the project, through to financial close and possibly thereafter, to ensure a properly
implemented project (Delmon, 2011: 218). The PDF may provide grant funding, require
reimbursement (for example, through a fee charged to the successful bidder at financial close)
with or without interest, or obtain some other form of compensation (for example, an equity
interest in the project), or some combination thereof, to create a revolving fund. The
compensation mechanisms can be used to incentivize the PDF to support certain types of
projects.

In South Africa, the PDF operates within the National Treasury in accordance with the Public
Finance Management Act. Its primary function is to support governmental entities in the
development of PPP projects. The PDF collaborates with the Department of Provincial and

preparation of feasibility studies and procurement of service providers.

A PDF that targets subnational public entities would be particularly relevant in the Ethiopian
context. On the one hand, subnational government are in most cases the best source of
project ideas due to their intimate knowledge of local needs and conditions. On the other
hand, the challenge of capacity to design and structure infrastructure projects at the local level
is daunting and cannot be addressed in the short-term perspective. In this situation, the PDF
may be the only realistic way of upgrading the demand for local infrastructure on the part of
subnational governments in Ethiopia (initially at the regional level but as the capacity develops,
also at the municipal and woreda levels).

The focus on the development of quality infrastructure projects that are commercially viable
will help to resolve the biggest obstacle to subnational
that is their low creditworthiness. While improving the creditworthiness of subnational
governments may take years to achieve, the PDF may be the only venue for subnational
governments to access capital finance in the near perspective. The establishment of such a
PDF in Ethiopia would not only improve the technical capacity of the government entities
involved in a PPP but would also attract qualifying private businesses by partly covering the
project development costs. By implication, the improved quality of infrastructure projects
would have a positive impact on the creditworthiness of the entities promoting them and
would improve their access to capital and ensure full utilization of the existing (under
employed) credit enhancement mechanisms (see Section 4.4.4).

The possible range of support activities as shown in Figure 16 reflects in general the LFI
approach to financing small- and medium-sized infrastructure. Integration of the PDF in the

64
existing public sector planning and budgeting cycles, with a specially designed diagnostic
instrument added, will guarantee its institutional sustainability in the long run. In the initial
phases of its operation, the PDF can be co-funded by the Government and development
partners so that it eventually becomes self-financed through cost recovery.

Figure 16: Project development support

Source: UNCDF

In the early stages, the PDF may engage directly with MoI, MoARD (through ATA) and other
sectoral ministries and agencies (e.g., EIC) who have pipelines of infrastructure projects in
priority areas and some public funding earmarked for supporting these projects (as grants or
guarantees). The other source of projects is public banks, such as CBE and DBE, which have
accumulated a number of loan applications requiring relatively minor additional work and
improvement to become bankable. This said, the potential of such pipelines also appears to
be limited, given the general dearth of adequately developed project proposals.

The issue of unlocking the demand side is linked to the issue of the institutional home for the
future program in support of local economic infrastructure. The program may be better
located with an institution that has an access to a pipeline of project or has substantive powers
to access such a pipeline. If the program intends to engage seriously with regional
governments (a long shot but nevertheless an opportunity as well), it would be better located
at MoFED. Furthermore, location at the MoFED will allow the program to engage in building
the demand for infrastructure investment by influencing the regulatory framework for regional

the program. If the progr

infrastructure) and MoARD (for agriculture processing infrastructure) may be appropriate
options.

65
Adequate regulatory framework for financing local economic infrastructure

Economic development is one of the key functions of the government at all levels, and
Ethiopian governments will continue to play an important role in financing infrastructure at all
levels in the foreseeable future. However, not enough emphasis is put on the development of
local economic infrastructure, which needs to be better defined as an investment class in its
right. The institutional framework for engaging with private sector entities for implementing
small- and medium-sized infrastructure is inadequate in two respects. Firstly, subnational
governments do not have a clear idea of what may present viable opportunities for engaging
the private sector; secondly, in the absence of such information, the demand for capital
finance on the part of the private sector remains suppressed.

There is clearly a need for a diagnostic and planning process at the subnational level that would
incorporate and mainstream public-private partnership as a substantive element. In this
respect, a proper PPP framework for subnational governments would be a critical
development. Such a framework should emphasize the role of subnational governments and
be adapted to their particular circumstances. It should define the conditions and types of
partnerships between the public and private entities at the subnational level as well as various
financing modalities. This framework should further specify legal and commercial instruments
for PPPs, elaborate the PPP procurement process and procedures and de-conflict the current
legal provisions

As discussed earlier, the borrowing capacity of regional governments is limited by both

statutory requirements and their weak financial position. Whereas limiting the borrowed
amounts by a percentage of annual revenues or annual transfers is a common good prudential
practice, application on a larger scale of project financing techniques may require revision of
the existing limitations. The borrowing limits should be defined by the nature of the project
itself rather than by other exogenous factors. In this, the PDF discussed earlier should play an
important role as a guarantor of the quality and commercial viability of the project deals
submitted for debt financing.

5.2 Supply for infrastructure Finance

5.2.1 Equity Financing

itself through equity injections in supply business, mergers and acquisitions) make a small part
of the total infrastructure finance. Whereas the government admits that the lack of regulated
equity and bond markets constrains domestic financing capacities and appears to be
increasingly more supportive of introducing stock trading, setting up and making this market
operational will certainly extend beyond the possible period of LFI operation and cannot be
considered as a source for infrastructure financing.

66
In addition, domestic financial institutions require high return on their investment, which,
depending on the sector, varies between 20.0 percent and 35.0 percent in nominal terms and
averages 27.5 percent (inflation unadjusted) or 19.5 percent (adjusted for 8 percent inflation).
Nevertheless, there is a growing private equity investment market, which may be explored to
complement other sources of finance (i.e., debt) for infrastructure financing. Private investors,
particularly when supported through guarantees (such as MIGA) are more flexible and willing
to invest at lower ROE rates. Indeed, during the survey, private equity firms expressed interest
in investing in infrastructure projects normally supported by UNCDF at below 30 percent ROE
(inflation unadjusted).

Improved awareness and incentive framework for equity providers

It is suggested that LFI or other similar programs give consideration to leveraging private equity

de-risking instruments financed by the public sector (or its own guarantee mechanism if
established in the future). A body of research notes the great potential of private equity and
venture capital for financing development in Ethiopia but stresses that a number of critical

the capital, foreign exchange regulations, financial market regulations and legal framework for
In the near perspective, it will be important for the
government to create an incentive framework for private equity and venture firms to finance
local economic infrastructure. The incentives may include various forms of tax relief as well as
credit enhancement mechanisms, such as partial guarantees and intercepts in case of
subnational governments.

Private banks and insurance companies would be a remote perspective, given their liquidity
constraints and regulatory limitations but some insurance companies participating in the
survey indicated their willingness to learn more about this types of investment and associated
risks. Government therefore should consider designing a framework for more substantive
engagement of private banks, pension and insurance companies in financing local economic
infrastructure.

An important step in this direction would be improving the awareness of these entities about
the opportunities for equity participation in local economic infrastructure. Information about
such opportunities should be created through local diagnostic and planning processes led and
supported by the government. The government should also design and put in place
mechanisms for regular interaction with the private sector to ensure timely dissemination of
investment information. These mechanisms may include regional or local economic
development forums, investment conferences and such like. However, in the long run the
participation of the private financial sector as equity or debt providers in local economic
infrastructure will depend on the revised relationship between the public and private financial
institutions.

67
5.2.2 Debt Financing
Ethiopia does not have a regulated capital market and therefore loan financing is the major
source of financing for infrastructure investments. However, bank credit, particularly medium
and long term, remains constrained. Several challenges and constrains to loan financing have
been identified during the study.

The baking system is dominated by public banks, particularly CBE which accounts for 53.7% of
all disbursed loans and advances and dwarfs the rest of the sector. Although the private
banking sector has been growing, private credit originated by these banks has been stagnating.
The major reason seems to be a liquidity crunch caused by the regulatory requirement to buy
low-paying NBE bills amounting to 27 percent of the disbursed loans combined with a
mandatory 40 percent share of short-term loans in the lending portfolio, regulato
requirements and lack of liquid financial instruments. its
subsidized interest rates create an uneven playing field in the industry and distort the demand
for finance in favor of the public sector. On the other hand, the private credit by the public
banking sector is growing (partly financed by the NBE bills) and the flat rates and long tenors
make this type of finance suitable for infrastructure financing.

Private and (to a somewhat less degree) public commercial banks use predominantly
transactional lending technologies and a collateral regime which make it difficult for SMEs
(who are usually the promoters of small- and medium-sized infrastructure projects) to obtain
credit. Although practically all banks have integrated priority areas in their investment policies,
specialized expertise and/or internal structures for dealing with economic infrastructure or
SME lending are usually absent.

Development of the private financial sector

The reasoning behind the government regulation of, and engagement in, the financial market
is well understood: It is supposed to facilitate the supply of long-term, developmentally
focused financing, which a commercially driven financial sector is thought unlikely to provide.
And yet, this survey demonstrates that private banks are not averse to issuing longer-term debt
for infrastructure financing, particularly when the investment proposal is of high quality.
However, the present regulatory requirements for the private financial sector (described in
Section 4.3.3) hinder both private equity and debt finance.

-term lending behavior (Annex 3) is a testimony that tying up

w paying development bonds distorts the market mechanisms
of supply and demand for various classes of investments but especially for small- and medium-
sized infrastructure by depleting the availability of long-term capital. None of the usual
determinants o -
perception and availability of risk guarantees, works in Ethiopia. Private banks have to compete
with public banks on unequal terms where public banks have access to cheaper money and
less regulation with regard to the composition of the credit portfolio that their private
counterparts.

68
Seemingly, a high degree of financial regulation allows state-owned banks to fulfil an
important social welfare agenda by extending large amounts of relatively cheap long-term
financing. However, the unanswered question is whether this agenda is implemented to
some extent at the expense of the private financial sector and whether private banks could
contribute to this agenda more meaningfully if the financial sector is liberalized.

IMF (2015) suggests certain key elements for financial reform, such as liberalization of interest
rates; liberalization of credit allocation (while maintaining support for priority sectors);
increased exchange rate flexibility; restructuring and privatization of state-owned banks;
gradual opening up to foreign banks; enhanced regulatory and supervisory framework.
Introduction of new financial instruments, such as CDs, insurance and remittance products,
mutual funds, corporate bonds, commercial paper will facilitate the availability of, and access
to, long-term finance.

Thus, development of the private financial sector and its liberalization and deregulation (within
reasonable prudential norms) is a key solution to the availability of private capital for
infrastructure investments. While private banks are unlikely to serve as a source of financing
in the short run, improving their awareness on opportunities and methods of infrastructure
investments should be an important objective of the future program.

Full use of the DBE and CBE potential for productive long-term lending

However, in the short-term perspective, any program dealing with finance for local economic
infrastructure should focus on developing a strong relationship with CBE and DBE, considering
them as the primary source of debt finance. The other advantage of engaging with CBE is that
is finances the debt of regional governments and therefore can facilitate financing of
infrastructure investments with the participation of regional governments or city
administrations/woredas (if submitted through the regions). At the same time, DBE through its
regional branches has access to a large number of investment proposals for local
infrastructure.

Gradual introduction of project financing and other advanced methods of infrastructure

finance

Although some elements important for non-recourse project financing are practiced by
Ethiopian financial institutions, project financing as a methodology is not applicable. The non-
recourse (or limited recourse) nature of project financing is a challenge to the banking sector,
which in inexperienced in off-balance sheet finance and perceives such lending as too risky.
Putting in place proper project finance deals may be too challenging in the current situation
(which is unlikely to change any time soon). In the short-term perspective, programs
supporting local economic infrastructure in Ethiopia are advised to use on-balance SME
finance.

At the same time, UNCDF experience in other LDCs, such as Uganda and Tanzania,
demonstrates that project finance deals are possible even when the regulatory framework and

69
domestic expertise are insufficient. A limited number of demonstration deals with a high
financial leverage may be launched to introduce the qualifying banks and project sponsors to
project financing. At the same time, LFI may engage with the insurance sector to encourage
the creation and application of the products required for supporting project financing deals.

A better use should be made of the extant training opportunities and venues, such as the
course in project finance offered by the Ethiopian Institute of Financial Studies (EIFS) at NBC.
New customized capacity development platforms, public and private, should be established
for various groups of relevant stakeholders to promote more advanced infrastructure financing
techniques and their application. There is a reasonable amount of technical and business
support available domestically and adequately qualified services for project development and
structuring may be obtained on the local market.

5.2.3 Public Sector Financing and Nonfinancial Support

The principal domestic venues for supporting economic infrastructure financing by the private
and public sector are CE and DBE which offer long tenors and subsidized interest rates (CBE
at 9.5 percent up to 15 years and DBE at 8.5 percent for priority areas and 9.5 percent for non-
priority areas up to 20 years).

Other forms of domestic public support are limited. The social security and pension sector is
underdeveloped, heavily regulated and only partly functional and cannot be viewed as a
realistic source for institutional investments in economic infrastructure any time soon. Public-
private partnerships remain largely an unchartered and inadequately regulated territory, limited
to a few larger projects supported by the central government where the private sector usually
administrates the assets rather than finances them.

Grants, credit lines and guarantee schemes to support private infrastructure investments are
few and far between. RER has a very specific focus on renewable energy projects but the lack
of regulation and inadequate tariff rates put in question the usability of this fund.14 PEPE has a
broader focus but is limited in terms of the eligible sectors and its funding per project is limited
to USD$200,000 maximum whereas the fund itself is not sufficiently capitalized. Existing
guarantee schemes funded by bilateral and multilateral institutions (World Bank USAID, AFD,

14
Ethiopia opened up the electricity generation and distribution sector to private players
very recently, in 2013. The current tariff rates for Independent Power Producers (IPP) vary from a
minimum tariff rate for hydropower at US$0.08 for generation of 100 kilowatts of electricity to a US$0.10
maximum tariff rate allotted for the generation of 500 kilowatts of electricity generated from biomass
and wind power. So far, the only IPPs that entered into agreement with EEA have been large foreign
companies. The latest example is Corbetti geothermal power project funded by Icelandic Drilling
Co. and the African Renewable Energy Fund. A total of $2 billion will be invested for generation of the
full 500 megawatts, which is expected to be completed by about 2023. A company representative

(Davison, 2015). However, what can be economically acceptable for a large producer is unlikely to be
viable for small IPPs.

70
KfW) target predominantly micro and small enterprises and have a limited value and usability
in the context of LFI.

Improved use of public support mechanisms for infrastructure financing

Nevertheless, the recurrent issue of the usability of grant schemes and guarantees (reported
by the participating banks) leaves a space for LFI and other programs to engage on developing
and structuring a pipeline of projects feeding into the guarantee schemes. PEPE can be
leveraged for adding equity in the financing structure of the projects that may be supported by
LFI and other similar programs (together with other sources of finance). Further discussions
with the relevant donors, government agencies (such as MoWE and MoI) as well as the
participating banks may be helpful in identifying and agreeing on investment opportunities.

The existing large-scale grant schemes for urban infrastructure development, such as the

excellent opportunities for leveraging private capital for infrastructure development and
significantly increasing the impact of such grant schemes. Both the coverage (44 city
administrations) and the type of projects financed with these guarantees (construction and
operation of landfills, biogas and composting plants, urban markets with associated services,
development of production and market centers for small businesses, abattoirs, etc.) are well
suited for co-financing or private financing, provided the issues of public financial
management, including capital planning and budgeting, revenue administration, accounting,
etc. are addressed. The performance-based nature of these grants makes it possible to
incorporate performance measures related to leveraging private capital for infrastructure
development and thus encourage relevant behavior of the public sector. To make this reality,
the PPP framework needs to be substantively upgraded, with detailed guidelines on setting
such partnerships at the subnational level.

Further engagement and advocacy with the government and development partners will be
required on two issues. Firstly, creation of a dedicated financing mechanism for small- and
medium-sized infrastructure, a national and/or regional platforms that address this investment
class, either mono-thematic or with multiple thematic windows. Secondly, existing and new
grants or guarantees should be made, to the extent possible, part of a continuous project
development and financing process (Figure 14).

The financing vehicle for local economic infrastructure can be, for example, in the form of a
state-owned corporation similar to the Bangladesh Infrastructure Finance Fund Limited (BIFFL),
a public limited company. BIFFL is licensed by the Bangladesh Bank and operates as a Non-
bank Financial Institution under the Financial Institutions Act, 1993. The main objective of BIFFL
is to provide predominantly long-term financing for PPP projects through issuance of bonds
and debt instruments and equity offerings. BIFFL envisages attracting private investments from
local and foreign investors to invest in private companies that are implementing infrastructure
projects in Bangladesh.

71
Such a local infrastructure finance fund in Ethiopia may have a regional representation to
ensure the participation and input of regional governments and local governments they
represent. Figure 17 shows an indicative structure of such a fund.

The Local Infrastructure Finance Fund can be organized and structured as a subnational
pooled financing facility with the direct participation of regional and local urban and rural
governments. A pooled financing facility similar to those functioning in Kenya, India and
Philippines, would offer credit enhancements to subnational governments to secure both
banks loans and bond finance. The credit enhancements may include reserve accounts, cash
flow over-collateralization, transfer intercepts from state/regional governments and partial
credit guarantees (FMDV, 2015).

Figure 17: Indicative structure of a Local Infrastructure Finance Fund

Regional
Government Development
Government
Regional partners
Government
Equity/transfers Guarantees
Domestic lenders
(banks and institutional International lenders
investors)

Medium- and Medium- and

LOCAL INFRASTRUCTURE FINANCE long-term loans
long-term loans
FUND

Loan Thematic Thematic Thematic Loan

repayments Window Window Window repayments
long-term loans long-term loans
P r o j e c t s

Cost recovery &

administration fees Project development and structuring

Project Development Fund

Potentially, such a pooled facility may have a transformational effect on the development of
local infrastructure, both economic and social. However, putting in place a subnational pooled
facility is a lengthy process that requires both a strong political will and a number of technical
conditions including improved creditworthiness of participating subnational governments.

5.2.4 Concluding General Remarks

As shown in Table 15, Ethiopia ranks low on all four dimensions of the infrastructure financing
market, particularly on equity financing. Given the low level of private credit and the sluggish

72
growth of the private credit originated by private banks, the potential for increased loan
financing does not look very promising, either.

Table 16: Summary of Eth

Dimension Rating
Microeconomic environment 2
Equity financing 1.5
Debt financing 2.1
Public sector financing and non-financial 2.2
support

Source

a limited capacity to increase supply of domestic capital for small- and medium-sized local
infrastructure, and most of this capacity is concentrated in the public sector and the public
banking sector. This said, the private financial sector also has a capacity to increase the supply
of capital finance but this requires a drastic change in the present regulatory environment and
the relationship between the public and private financial sectors. Furthermore, given the state
of the capital market and conditions for infrastructure finance, the prospects for application of
advanced financing techniques, such as project financing do not appear very promising.
Neither the demand nor the supply sides of the infrastructure financing market demonstrate
the complexity and sophistication identified by a number of researchers (Yescombe, 2002:
Delmon, 2011; Gatti, 2013) as necessary for application of this technique.

But what does it mean for the future program in support of domestic financing of local
economic infrastructure? In the context of the preceding analysis, the two immediate
objectives of such programs are very relevant for the current state of the infrastructure
financing market: Improve capacities of public and private project developers to identify and
develop small-to-medium sized infrastructure projects essential for inclusive local
development in a number of target developing countries; and increase the ability and
willingness of domestic financial sector to provide financing for small to medium-sized local
development infrastructure projects. As already discussed, Ethiopia does experience a strong
need for more economically productive infrastructure and the public sector is unlikely to stand
up to this challenge alone. There is a growing realization of this fact in the government, which
is moving towards adopting more flexible approaches to capital market development. From
the point of view of its relevance, LFI does respond to the national requirements.

infrastructure financing market, given that the, as any other program, it has a limited duration
and can achieve only so much?
effectiveness of financial resources for local economic development through mobilization of

73
primarily domestic private capital and financial markets in developing countries to enable and
promote inclusive a

There are at least two major impediments to this. One is the overall state of the infrastructure
financing market, which requires systemic changes to ensure increased effectiveness of
financial resources. The other is related to the lack of a policy focus on local development as
a subject in its own right. The closest developmental priority of the government is rural
development but it is closely related with agriculture and targets primarily the community level.
Incorporating local development as part of a political and developmental agenda will take time,
which LFI will not have. The government is concerned about the lack of development in some
regions (notably, Afar, Benishagul-Gumuz, Gambella and Somali) and has been supportive of
developmental interventions in those regions but any attempts to leverage private financing
for infrastructure in those regions will face immense difficulties because of the low economic
capacity and perceived high risk of investing in those areas.

Hence, the outcome objective for any program that targets the infrastructure financing market
needs to be moderated and adjusted to one of the existing developmental priorities of the
government. A focus on the developing regional states may be one option despite all the
related challenges. Rural development and support to agro-processing may be another. The
advantage of focusing on these areas, in addition to alignment with government priorities and
guaranteed political support, is that both areas have some earmarked public funding, domestic
and international, which can be further leveraged. This will also ensure the continuity of the
programmatic approach by UNCDF and other UN organizations in Ethiopia, which have
focused during the past decade on supporting developing regional states. In a situation when
the bulk of infrastructure financing comes from the public sector, the future program may be
better off working with subnational governments although their level of expertise and statutory
limitations is yet another challenge. The attempts to introduce more advanced financing
techniques and develop financial markets should be gradual will involve much advocacy and
capacity development for adjusting existing regulatory framework and designing new ones to
tackle this challenge.

The recommendations for unlocking domestic finance for small- and medium-sized local
economic infrastructure in Ethiopia are summarized in Tables 17 and 18.

74
Table 17: Recommendations to the Government and development community

Key areas of Recommendations

infrastructure
Government Development community
financing support
Improving demand  Enhance support to project  Consider adding technical
for capital finance development and and financial advisory
structuring. services to the existing grant
 Consider establishment of a and guarantee schemes.
Project Development Fund to  In the future ensure that
provide technical and financial support is related to
financial advisory services to technical and financial
public and private project advisory services to improve
sponsors. utilization of financial
mechanisms.
 Provide technical and
financial support to the
establishment of a Project
development Fund and its
initial capitalization.
 As part of PSD, support
development of relevant
skills and capacities with local
business services providers
Adequate regulatory  Define investments in local  Provide technical and
framework for economic infrastructure as financial assistance for
financing local an investment class in its own introducing diagnostic,
economic right. planning and budgeting at
infrastructure  Introduce a diagnostic and the local level to leverage
planning process at the public and private finance for
subnational level to local infrastructure.
incorporate and mainstream
public-private partnership as
a substantive element.
 Design a proper PPP
framework for subnational
governments with detailed
guidelines for subnational
PPPs.
 Review the borrowing limits
of subnational governments

75
 based on application of
project financing.
Improved awareness  Create an incentive  Provide technical and
and incentive frame- framework for private equity financial assistance for
work for equity firms to finance local introducing and maintaining
providers economic infrastructure mechanisms for regular
(e.g., tax relief, partial interaction between the
guarantees, intercepts, etc.) governments and the private
 Design a framework for more sector at the subnational
substantive engagement of level.
private banks, pension and
insurance companies in
financing local economic
infrastructure.
 Improve the awareness of
these entities about the
opportunities for equity
participation in local
economic infrastructure.
 Design and put in place
mechanisms for regular
interaction with the private
sector to ensure timely
dissemination of investment
information (e.g., regional or
local economic development
forums, investment
conferences, etc.).
Development of the  Review and remove  Continue dialogue with the
private financial regulatory barriers to lending government to stress the
sector for small- and medium-sized positive consequences of
infrastructure by private liberalization and
banks. deregulation of the financial
 Improve the awareness of sector.
private financial institutions
on opportunities and
methods of infrastructure
investments.
Full use of the DBE  Design financial vehicles that
and CBE potential tap into CBE and DBE
resources as the primary

76
for productive log- source of debt finance for
term lending local economic
infrastructure in the short
run..
Gradual introduction  Encourage the creation and  Provide technical and
of project finance application of financial financial support to a limited
and other advanced products required for number of demonstration
methods of supporting project financing deals with a high financial
infrastructure deals. leverage.
finance  Develop and deliver capacity  Provide technical assistance
building mechanisms for a in the development of
broad range of relevant training materials and
stakeholders and make a relevant courses.
better use should be made of
the extant training
opportunities and venues in
advanced infrastructure
finance.
Improved use of  Create a dedicated financing  Support the development
public support mechanism for small- and and structuring of a pipeline
mechanisms for medium-sized infrastructure, of projects feeding into the
infrastructure mono-thematic or with existing grant and guarantee
financing multiple thematic windows schemes.
(Local Infrastructure Finance  Ensure that the existing and
Fund). new grants or guarantees are
 Introduce performance made, to the extent possible,
measures for public sector part of a continuous project
entities, particularly development and financing
subnational governments, process.
related to the leverage of  Provide technical assistance
private capital for in the design of the Local
infrastructure development. Infrastructure Finance Fund.
 Provide technical assistance
for improved public financial
management at the
subnational level to increase
the number of subnational
governments qualifying for
the Local Infrastructure
Finance Fund.

77
Table 18: Recommendations for programmatic support to infrastructure finance Ethiopia

Programmatic aspect Recommendation

Overall outcome
limiting the scope of the outcome to specific thematic
and/or geographic areas.
Institutional partner/Program MoFED is likely to be the most appropriate institutional
implementing agency partner. Other partners may include MoI and MoARD.
Thematic focus Establish a clear thematic focus (other than LED) in line with
government priorities (e.g., agricultural processing, export
orientation, manufacturing)
Geographic coverage Consider a geographic coverage that is of particular interest
to the government (i.e., developing regions) and allows for

Engagement with public If subnational governments are to be involved, this is

sector developers possible only at the level of regional governments. The
advantages and disadvantages of engaging with regional
governments (access to cheap finance vs. low level
capacities) need to be carefully considered before deciding.
Engagement with private This engagement has to be on a case-to-case basis and will
sector developers require efforts and time to identify suitable private sector
partners due to the general weakness of the private sector.
Existing pipelines of projects may be used to some extent
(EIC, ATA, PEPE).
Engagement with financiers Primarily with public banks (CBE and DBE), to a lesser extent
with private equity firms and agencies in charge of grant
and/or guarantee schemes. Limited engagement with
private banks, mostly on awareness raising, information
sharing and capacity building.
Engagement with supporting Limited engagement with pension and insurance companies
agencies to improve their awareness on opportunities in
infrastructure investment and encourage possible
investments in infrastructure as well as development of
insurance products required for project financing.
Major source of financing Debt (primarily from public banks, such as CBE and DBE);
grants (limited) from the existing grant schemes; equity
(limited) from private equity firms (possibly in combination
with international guarantees, such as MIGA).

78
Financing approach SME balance sheet financing (noting that the Ethiopian
definition of a small enterprise is below the level required for
meaningful infrastructure investments). A limited number of
demonstration project finance deals.

79
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ANNEXES

Annex 1. Analysis of the Surveyed Institutions

A1.1 General Composition of the Survey Participants

As previously indicated, the survey targeted four principal categories of agencies participating
in the Ethiopian infrastructure financing market. Table 4 provides more detailed information
about the type and number of participants in each category.

Table A1: Type and number of surveyed agencies by category

Category Sub-category Number

Policy makers and regulators Central regulator 1
Ministries 2
Government agencies 4
Sub-total 7
Financial market participants Equity providers 4
Commercial banks 6
Insurance and pension 6
companies
Sub-total 16
Public sector participants Development Bank 1
Multilateral development banks 3
Multilateral development 1
agencies
Bilateral development agencies 4
Sub-total 9

Business services providers Public 2

Private 4
Sub-total 6
TOTAL 38

A1.2 Policy Makers and Regulators

The survey included regulators and policy makers with important roles in the infrastructure
financing market as detailed in the Table below.

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Table A2: Surveyed policy makers and regulators

Institution Key functions in the infrastructure financing market

National Bank of Ethiopia
Ministry of Finance and
Economic Development
Ministry of Federal Affairs
Ethiopian Energy Agency
Federal Cooperative
Agency
 Regulation of the national financial system in general
 Regulation of the banking sector
 Regulation of the insurance sector
 Regulation of the microfinance sector
 Regulation of the social security and pension sector
 Regulation of capital goods leasing
 Maintenance and management of credit reference data
 Regulation of public procurement
 Regulation of subnational borrowing
 Regulation of public-private partnerships
 Oversight of planning and budgeting at the subnational
level
 Provision of development assistance to regional states
particularly to those requiring special support and
coordination of the Federal Special Support Board
(Prime Minister Office, MoA, MoE, MoWE, MCS, MoH)
 Implementation of the federal decisions concerning
regional states and subnational governments
 Issuance of operation licenses for energy producers
 Determining electricity tariff
 Setting performance standards for energy production
 Legal and regulatory frameworks for establishment and
operation of cooperatives
 Credit facilitation for cooperatives with regional
governments, CBE and DBE
 Technical service support to cooperatives for
development of business plans and proposals
 Support to cooperative governance structures (Board of
Directors and Executive Committees)

A1.3 Characteristics of Financial Market Participants

In total, seven commercial banks participated in the survey, including all three government-
owned and seven private banks. Out of the seven private banks, six are the largest by
capitalization making up 36.2% of the entire private sector banking. One smaller bank (Addis
International) has been added to reflect the perspective of the smaller actors in the banking
sector.

88
Table A3: Surveyed banks by capitalization and share of loans and advances
Name Capitalization Capitalization Percentage
(as % of total (as % of total share of loans
banks) private or and advances
public banks) (disbursement)
Public banks
Commercial Bank of Ethiopia 34.2 76.5 53.7
Construction and Business Bank 2.4 5.4 2.1
Development Bank of Ethiopia 8.1 18.1 9.1
Total 44.7 100
Private banks
Awash International Bank 7.5 13.5 3.2
Dashen Bank 7.5 13.6 9.6
United Bank 5.0 9.1 3.5
Addis International 1.1 1.9 0.4
Total 21.1 38.1
GRAND TOTAL 65.8 81.6
Average capitalization (ETB, million) 2,486
Modal capitalization (ETB, million) 1,980

Source: NBE, 2014.

The composition of the surveyed banks reflects a high concentration of the Ethiopian
banking sector a topic discussed in more details in the next section.

In addition, the survey included four private equity investment companies, Schulze Global
Investments, Empact Capital, Zoscales Partners, and One Cent Management, managing equity
funds between USD 30 million and USD 100 million.

The insurance companies that participated in the survey are listed in the following Table.

Table A4: Surveyed insurance companies by capitalization

Name Capital (ETB Capitalization Capitalization

million) (as % of total (as % of total
insurance private or
sector) public
insurance
sector)
Public insurance companies
Ethiopian Insurance Corporation 434.4 21.4 100.0
Total 434.4 21.4 100.0
Private insurance companies
Awash Insurance Company 182.9 9.0 11.4

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 Africa Insurance Company 106.5 5.2 6.7
Nile Insurance Company 182.0 8.9 11.4
Nib Insurance Company 207.3 10.2 12.3
Total 678.7 33.3 41.8
GRAND TOTAL 1,113.0 54.7
Average capitalization (ETB, million) 222.6
Modal capitalization (ETB, million) 182.0

Source: NBE (2014)

As compared to the banking sector, the insurance sector is less concentrated but the
government still retains over one fifth of the insurance market in terms of capitalization. It is
also less capitalized with the average capitalization of insurance companies 10 times less than
for the banking sector (the same is true for the entire populations of the banks and insurance
companies).

90
Annex 2: Research Analytical Framework

Similarly to the aim and objectives, the analytical framework has been informed by UNCDF
requirements. The analytical framework of the research (presented in Annex 1) is grounded in
the general approach formulated in the previous chapters that describes the infrastructure
market as a combination of public and private mechanisms and conventions that offer a variety
of financial instruments as well as non-financial support suitable for financing long-term assets
with long economic life. Consequently, the analytical framework is based on the analysis of
the institutional infrastructure and related constraints in the three areas of infrastructure
financing described in the previous chapter (see Table 3) equity financing, debt financing and
public sector financing. Due to the importance of non-financial support that affects the ability
of infrastructure investors to access capital for their projects, non-financial support is also
included in the analytical framework.

The analysis of the areas of financing is preceded by a brief description of the macroeconomic
environment, which focuses on factors such as gross national income, GDP growth, annual
inflation rate, sovereign credit rating, central bank monetary policy and issues of security and
rule of law.

Each area of financing is analyzed along four dimensions:

 Level of development of the relevant market segment. The key indicators include
the width and breadth of the segment, its capitalization and concentration (if
appropriate), coverage and other relevant features.

 Regulatory environment. It analyzes the level of development of legal and regulatory

frameworks and the policies and capacities of the regulators, particularly from the
point of view of infrastructure financing. The analysis may look into specific areas of
regulation with respect to particularly significant aspects of the market and market
participants.

 Composition. This dimension is related to the type and characteristics of market

participants and their capacities, including, where appropriate, providers of non-
financial services. It also describes internal policies and regulations, mechanisms and
instruments applied by various market participants for infrastructure financing.

and attitudes toward infrastructure financing.

 Characteristics of financing. This dimension concerns specific characteristics of each

type of financing, such as required return and risk premiums on equity or debt,
composition of investment portfolios, performance of loans and their average size, etc.
Where appropriate, it also measures the ease of access to a particular type of finance
and/or instrument.

91
The analytical framework has been further developed into an assessment matrix. The objective
of designing an assessment matrix is two-fold. Firstly, this is an attempt to categorize and
quantify the wealth of data collected in the course of the research; even when the data are
originally quantitative, their categorization with respect to infrastructure financing remains
unclear without a dedicated tool. Secondly, considering that this research one of the first
attempts to assess the state of a national infrastructure financing market, the assessment
matrix will allow cross-country comparisons for the future similar exercises in other countries.

In the assessment matrix, each indicator is measured on a 5-point Likert-type scale (Corbetta,
2003). The scales have been constructed and assigned values from 1 to 5 to reflect the degree
of presence of indicators supporting infrastructure investment through medium to long term
financing and non-financial assistance. 1 signifies non-existence or low level of development
and 5 means a very significant presence of the indicator and therefore a very favorable situation
for infrastructure financing. The minimum values of the scale (where it is not zero) and the
maximum values have been determined based on the review of secondary sources describing
the relevant features and characteristics. During construction of the scales, particularly when
quantitative data was involved, an extensive use was made of such data sources as the World
Bank Open Data (www.data.worldbank.org). OECD data (https://data.oecd.org), Open Data for
Africa by the African Development Bank (http://www.afdb.org/en/knowledge/statistics/open-
data-for-africa/), African Financial and Economic Data (http://www.africadata.com/) as well as
Statistical Database System by the Asian Development Bank (https://sdbs.adb.org). Similarly, a
number of surveys produced by various organizations, such as the World Bank, OECD,
UNCTAD, UN Regional Economic Commissions, and other public and private organizations
proved to be useful for graduating the scales.

92
Annex 3: Analysis of Bank-Level Determinants Affecting Long-Term Lending in
Ethiopia

Theoretical and empirical literature confirms the importance of long-term loans to finance
infrastructure development and economic growth in emerging economies as well as the
shortage of these loans. It also predicts that the share of medium- and long-term credits
required for financing infrastructure should be less in countries with higher legal risk and more
risky or opaque corporate borrowers (Spratt, 2009).

However, as Chernyh and Theodossiou (2011) note, very little is known about bank-level
determinants that affect long-term lending to firms. The below analysis focuses on bank-level
determinants of long-term lending to firms (primarily for infrastructure finance) in Ethiopia and

such credit.

The general form of a multiple linear regression was used of the type y = Xβ + ε where y is a
T-vector containing T observations of the dependent variable, β is a k + 1 vector of regression
coefficients (betas), X is a T x (k + 1) matrix of 1 s in the first column followed by the explanatory
variables and is a T-vector of disturbances. T represents the number of observations (8) and k
is the number of independent variables (6). Table A5 provides the definitions of the analysis
variables.

The major dependent variable is the ratio of bank medium- and long-term business loans to
total assets. The supplementary dependent variable is the bank approach to medium- and
long-term lending as part of its credit portfolio policy, measured as the ratio of medium- and
long-term bank business loans to total loan portfolio size. Business loans in this study are
defined as loans to private non-financial firms. Long-term business loans are defined as loans
with over three years to maturity.

General existing literature on bank lending behavior was used to explain the bank-level cross-
sectional variability in long-term business loans ratio (for relevant literature review, see
Sections 2.3 and 2.4 as well as Chernyh and Theodossiou, 2011). Specifically, explanatory
variables identified for this research include bank size, capitalization, risk-taking and ownership
type. Bank size is measured as the logarithm of bank assets. Larger banks are more diversified,
have larger pools of funds available, have access to larger and more creditworthy corporate
borrowers, and have more resources for the development of advanced credit risk management
and evaluation systems. Therefore, a positive relation is expected between bank size and the
ratio of long-term loans.

Bank capitalization is measured by the book equity to assets ratio. Bank capitalization can affect
bank willingness and ability to extend long-term loans in several different ways. Banks with
larger capital cushion against credit risks should have higher capacity to extend risky, long-
term loans. In addition, better capitalized banks can attract more creditworthy borrowers that
will qualify for longer term loans.

93
Three variables control for the risk-taking behavior with respect to medium- and long-
term lending. One is the share of non-performing loans, which may indicate a higher risk
appetite and less stringent credit assessment procedures. Whereas initially this may lead to an
expansion of longer credit, eventually banks with a higher share of non-performing loans are
bound to limit credit to minimize their losses whereas banks with a lower percentage of non-
performing loans are likely to expand their credit. The other variable concerns interest rates
for medium- and long-term loans. On the one hand, a higher interest rate makes longer-term
crediting more profitable while at the same time minimizing associated risks. On the other
hand, higher interest rates may result in adverse selection resulting in a deteriorated quality of
group of loan applicants (Lensnik et al., 2001).
external guarantees provided by development agencies, such as USAID. Given the stated
objective of guarantees to reduce lending risks and increase the supply of credit, banks
benefitting from such guarantees should originate a larger amount of medium- and long-term
loans.

Bank ownership type is captured by one dummy variable that indicates state-owned banks.
State-owned banks can allocate long-term credit to promote economic growth and to
address the shortage of long-term financing found in the Ethiopian banking sector. If this is
the case and state banks indeed fulfill the social welfare agenda, there should be a positive and
significant relation between the state-controlled dummy and the ratio of long-term loans, after
controlling for all other potential explanatory variables in the regression analysis.

Table A5: Definition of regression variables

Variable
Medium- and long-term business
loans (assets)
Medium- and long-term business
loans (loan portfolio)
Size
Definition
s outstanding loans to nonfinancial
private firms with over three years maturity divided by
assets, expressed as a percentage.
s outstanding loans to nonfinancial
private firms with over three years maturity divided by
the loan portfolio, expressed as a percentage
Log (Bank assets in ETB million)

Capital The ratio of book equity to assets expressed as a

percentage
Non-performing loans (NPL) The value of nonperforming loans divided by the total
value of the outstanding loans expressed as a
percentage
Medium- and long-term loan Annual interest rate for medium- and long-term loans
interest rates expressed as a percentage
State = 1 if a bank is state-owned and zero otherwise.

94
 Guarantee = 1 if a bank has access to external credit guarantees
and zero otherwise

The descriptive statistics of the nine banks (three state-owned and six private)15 for all
regression non-dummy variables are presented in Table A6. Annex 1 provides more detailed
description of the banking sector where lending in general and medium- and long-term
lending is dominated by the state-owned banks.

Table A6: Descriptive statistics of bank financial characteristics

Mean SD Minimum Maximum

Size 9.60 1.42 7.14 12.18
Capital 11.45 0.05 4.63 22.00
NPL 2.59 0.89 1.20 4.00
MLT interest rate 12.65 2.35 9.00 15.00
MLT loans to assets 24.29 12.35 12.89 44.36
MLT loans to portfolio 53.35 22.54 29.60 84.80

The results of the regression analysis are presented in Table A7.

Table A7: OLS regression results

Dependent variable: MLT Dependent variable: MLT

loans to assets loans to portfolio
Coefficient estimate Coefficient estimate
(t- Statistic) (t- Statistic)
Ownership 0.927 0.915
(6.048)*** (5.564)***
Size 0.015 -0.80
(0.084) (-0.409)
Capital -.010 0.038
(-0.053) (0.182)
NPL -0.226 -0.126
(-1.229) (-0.579)
MLT interest rate -0.366 -0.005
(-1.777)* (-0.017)
Guarantees -0.182 -0.260
(-1.072) (-1.581)
Constant 16.014 38.400

15
The private banks included Awash International Bank, Wegagen Bank, Dashen Bank, United Bank,
Addis International Bank, Bank of Abyssinia

95
 (17.118)*** (8.752)***
N 9 9
Adjusted R Square 0.836 0.811
F-Statistic 36.572 30.958

The results are rather unexpected in the light of the foregoing theoretical discussion of the
factors affecting allocation of the longer-term credit but predictable in the Ethiopian context
characterized by a high degree of financial repression (see Sections 4.3 and 4.4). Medium- and
long-term loans demonstrate only one strong and statistically significant positive relationship
with the type of ownership. As discussed in this study, state-owned banks originate
significantly more longer-term loans as a percentage of their assets or as a percentage of their
total loan portfolio than private banks. The average share of medium- and long-term loans to
assets for public banks is 38% whereas for private banks it is only 16%.

No other determinant is sufficiently strong or significant with the exception of the interest
rates. This is however a spurious relationship because the effect of interest rate is due to the
type of ownership such that public banks issue loans at lower interest rates (hence the negative
relationship between medium- and long-term loans and interest rates, which appears
counter-intuitive prima facie). The analysis demonstrates no influence of size, capitalization or
guarantees on the amount of longer-term credit.

A multiple linear regression with the same variables applied to the subset of six private banks
does not return any statistically significant predictors for the model, either. A bivariate
descriptive analysis (Table A8) returns only one relatively significant correlation between MTL
loans and external guarantees. Curiously, this correlation is negative implying that loan
guarantees result in comparatively less medium- and long-term credit issued.

Table A8: Bivariate correlations for model variables

MTL
interest Loan
Size Capital NPL rate guarantee

Pearson MLT loans to assets -.131 .187 -.271 -.368 -.659

Correlation

Sig. (1-tailed) MLT loans to assets .403 .361 .301 .237 .077

Of course, this relationship may be a result of the bank selection for application of guarantee
schemes: The guarantees may have been extended to banks that originally allocated less
medium- and long-term credits than their peers. In addition, most guarantees related to It is
also possible that other factors not covered in the model, such as assets growth, produced a

96
greater impact on the amount of longer credit that the guarantees, and the banks in question
grew at a slower pace.

The results of the regression analysis demonstrate the heavy impact of financial repression on
key financial variables. Consequently, the usual factors identified in other countries do not
work in Ethiopia. Empirical research in other countries demonstrates that bank size and capital
are the
businesses long term, indicating that larger banks and better capitalized banks tend to extend
more long-term credit to firms than smaller and less capitalized banks (Gambacorta and
Mistrulli, 2004; Chernyh and Theodossiou, 2011). However, in Ethiopia the high level of
regulation, including the prescribed composition of loan portfolios for private banks (see
Section 4.3), makes these factors meaningless in the face of the prevailing dichotomy between
the public and private financial sectors.

Seemingly, state-owned banks do fulfil an important social welfare agenda by extending large
amounts of relatively cheap long-term financing. However, the question persists if this agenda
is implemented to some extent at the expense of the private financial sector and whether
private banks could contribute to this agenda more meaningfully if the financial sector is
liberalized.

97
Annex 4: Analytical Assessment Matrix

Dimension Rating
1 2 3 4 5
0. Macroeconomic environment
0.1 GNI per capita (Atlas Low-income, Lower-middle income Upper-middle income ($4,125-$12,746) High-income
method) $1,045 ($1,045-$4,125) ($12,746 or more)
0.2 GDP growth (Change Very low Low Average High Very high
of GDP on previous year,
measured in percent)
0.3 Annual inflation rate i > 7%
0.4 Country credit risk C-D CCC-CC BB-B A-BBB AAA-AA
0.5 Central bank Very tight Tight Somewhat relaxed Relaxed Very relaxed
monetary policy
0.6 Corruption (country Last quintile Fourth quintile Third quintile Second quintile First quintile
corruption ranking)
0.7 Security and rule of Insecure, weak rule Somewhat insecure, Relatively secure, Secure, Very secure, very
law of law (last quintile weak rule of law somewhat strong reasonably strong strong rule of law
in the Rule of Law (fourth quintile in the rule of law (third rule of law (fourth (first quintile in the
Index) Rule of Law Index) quintile in the Rule quintile in the Rule of Law Index)
of Law Index) Rule of Law
Index)
1. Equity financing
1.1 Size of the stock Stock market does Only primary stock Only primary stock Both primary and Primary and
market not exist; existing market exists, low market exists with secondary secondary markets
firms are unlisted capitalization (less low to medium markets exist with with medium to high
than 10% of GDP) capitalization (10- low to medium capitalization (more
30% of GDP) with capitalization (10- than 30% of GDP)
large firms that use 30% of GDP) and with a full range of
direct placement various stock stock listing methods
and some other listing methods

98
 methods of stock
listing
1.2 Accessibility of the Very high High concentration, Medium Medium Low concentration,
stock market concentration, open open only to large concentration, concentration, open to all size of
only to large firms firms open to large and open to all size of firms; there is a
medium firms firms special arrangement
for SMEs
1.3 Stock market liquidity Very low Low Average High Very high
(total value traded/GDP)
1.4 Stock market No regulation No dedicated Dedicated Dedicated Dedicated regulatory
regulation regulatory authority regulatory regulatory authority as well as
and no dedicated authority may exist authority exists; other bodies
regulation; some as well as many aspects of supporting the stock
aspects of the stock dedicated the stock market market exist; most or
market are regulated regulation that are regulated all aspects of the
by other laws regulates certain stock market are
aspects of the regulated
stock market
1.5 Compliance of the Very low Low Average High Very high
regulation with the
international standards
(availability of
information, accounting
standards, investor
protection)
1.6 Listing requirements No stock market and Compliance with Compliance with Compliance with Compliance with
no listing listing requirements listing listing listing requirements
requirements exist takes significant requirements takes requirements is is relatively easy and
efforts and does not moderate effort relatively easy and allows most
allow medium-sized and allows some allows most medium- and small-
non-financial medium-sized medium- and sized non-financial
companies to get non-financial some small-sized companies to get
listed non-financial listed

99
 companies to get companies to get
listed listed
1.7 Private equity Individuals and Individuals, A small number of A number of A variety of private
providers (apart from communities communities, private venture capital venture capital equity providers,
public sector entities) non-financial firms and/or private and private equity both foreign and
equity firms with firms with a domestic, including
high sector broader sector impact investors and
concentration coverage philanthropists, with
a comprehensive
sector coverage
1.8 Average equity market MRP > 14%
risk premium (MRP) for
small- and medium-sized
infrastructure16

2. Debt financing
2.1 Domestic credit to Less than 10% of 11-30% of GDP 31-60% of GDP 61-90% of GDP More than 90% of
private sector GDP GDP
2.2 Providers and insurers Commercial banks Commercial banks Commercial banks, Commercial Commercial banks,
of long to medium term and institutional institutional banks, institutional
debt investors investors and institutional investors, financial
financial firms investors, financial firms, lease
firms, lease companies,
companies monoline insurers
2.3 Banking sector Very high, with a few High Average Average to low Low, with a variety of
concentration large national banks banks by size, region
and specialization
2.4 Banking sector risk C-D CCC-CC BB-B A-BBB AAA-AA
2.5 Banking sector Existing regulation is Existing regulation is Existing regulation Existing regulation Existing regulation is
regulation with respect to unfavorable, makes somewhat is relatively is largely favorable favorable and
credit procedurally unfavorable, makes favorable contains specific

16 To be considered in combination with the average required rate of return on equity.

100
 medium- and long-term difficult and credit difficult but provisions to
C&I credit17 economically profitable encourage private
unprofitable sector credit
2.6 Banking sector Very low, Low Low to average Average to high High
liquidity ratio (liquid constraining credit
assets to total assets) or making it
impossible
2.7 Medium to long-term 20% or less 21-30% 31-40% 41-50% More than 51%
loans to total gross loans
2.8 SME lending to total 5% or less 6-10% 11-15% 16-20% More than 21%
gross loans
2.9 Nonperforming loans More than 11% 9-11% 6-8% 3-5% 2% or less
to total medium to long-
term loans
2.10 Term structure of Steep upward slope Moderate upward Slight upward Flat Downward slope
interest rates (curve slope slope
shape and actual rates)
2.11 Demand for medium Low Low to average Average Average to high High
to long term
infrastructure credit
2.12 Credit rating Not available Available only for large Available for most Available for all Available for all large,
availability enterprises (with large and some large and most medium, and
foreign participation medium medium qualifying small
or engaged in foreign enterprises enterprises enterprises
trade)
2.13 Use of lending Relationship lending Mostly balance sheet Mostly balance Asset-based All lending
technologies for and balance sheet lending and pledge of sheet lending, lending and credit technologies used
infrastructure lending collateral pledge of collateral scoring depending on the
and elements of borrower and type of
asset-based investment
lending

17 Medium to long term loans are defined as loans with a maturity of above 5 years.

101
 2.14 Application of Never Rarely Occasionally Quite often Often
project financing for
infrastructure lending
crediting (frequency)
2.15 Application of None Large (above $100M) Large to medium Medium ($20M - Medium to small
project financing for ($100M - $20M) $5M) (below $5M)
infrastructure lending
(size of the project)
2.16 Regulation of capital None Existing regulation is Existing regulation Existing regulation Existing regulation is
goods leasing business not conducive is somewhat is generally very conducive
(significant conducive conducive
constraints, high
transaction costs, etc.)
2.17 Development of None Weak development Moderate Strong Very strong
capital goods leasing (only a few leasing development development development (a large
business companies offering number of leasing
services to large companies of various
investors) types offering
services to a broad
range of investors of
all sizes)
2.18 Perception of risk of Very high High Average Average to low Low or no risk
lending for infrastructure
investment
2.19 Interest in Low or no interest Low to average Average High Very high
application of project
financing for
infrastructure investment
2.20 Perception of the Very high High Average Average to low Low or no costs
transaction costs of
lending for small- and
medium-sized
infrastructure

102
3. Public sector financing and non-financial support
3.1 Regulation of Subnational Subnational Subnational Subnational Subnational
subnational borrowing borrowing is not borrowing is allowed borrowing is borrowing is borrowing is allowed
allowed only for a few chosen allowed for certain allowed for all for all subnational
subnational subnational subnational jurisdictions at all
jurisdictions at one jurisdictions at jurisdictions at levels
level and on a case- more than one more than one
by-case basis level of level of
subnational subnational
government government
3.2 Development of the None Highly concentrated Highly Moderately Low concentration
government bond market with low concentrated with concentrated and high
for subnational capitalization moderate with moderate capitalization
government securities capitalization capitalization
(municipalities and
parastatals)
3.3 Regulation of public Institutional Institutional investors Institutional Institutional Institutional investors
and mixed public-private investors are not are allowed to invest investors are investors are are encouraged to
institutional investors allowed to invest in in certain publicly allowed to invest in allowed to invest invest in publicly and
(social security and individual funded infrastructure all publicly funded in publicly and privately funded
pension funds, life and infrastructure projects infrastructure privately funded infrastructure
health insurance funds, projects projects infrastructure projects
property and causality projects
insurance companies)
3.4 Level of institutional None A small proportion of 5-10% of assets 11-15% of assets 16-20% or above
investment in assets (below 5%)
infrastructure (except for
residential property)
3.5 Regulation of public- None Existing regulation is Existing regulation Existing Existing regulation is
private partnerships for not conducive is somewhat regulation is very conducive
infrastructure, particularly (significant conducive generally (broad scope of
for subnational constraints, conducive application, easy to
governments complexity and/or implement, available

103
 ambiguity, limited for governments at
scope of application, all levels)
high transaction
costs, etc.)
3.6 Average number of None Less than 10, only 11-20 21-30 31-40, broad
PPP deals for productive large national projects geographic and
infrastructure, annually substantive coverage
3.7 National public sector Public sector Public sector support Public sector Public sector Public sector
support to private support is non- is somewhat weak support is support is well support is very well
infrastructure investment existent or very moderately developed developed,
through de-risking limited and highly developed characterized by a
mechanisms concentrated, larger number of
eligibility criteria are support mechanisms
stringent, the and various
number of available instruments, is
mechanisms and widely available to a
instruments is small broad range of
private investors and
support various
stages of project
development
3.8 Bilateral support to Bilateral support is Bilateral support is Bilateral sector Bilateral sector Public sector
private infrastructure non-existent or very somewhat weak support is support is well support is very well
investment limited and highly moderately developed developed,
concentrated, developed characterized by a
eligibility criteria are larger number of
stringent, the support mechanisms
number of available and various
mechanisms and instruments, is
instruments is small widely available to a
broad range of
private investors and
support various

104

3.9 Multilateral support to
private infrastructure
investment
3.10 Availability of
dedicated technical and
financial support to SMEs
3.11 Availability of a
pipeline of infrastructure
projects sponsored by
SMEs with institutions
providing technical
and/or financial support
stages of project
development
Multilateral support Multilateral support is Multilateral Multilateral Public sector
is non-existent or somewhat weak support is support is well support is very well
very limited and moderately developed developed,
highly concentrated, developed characterized by a
eligibility criteria are larger number of
stringent, the support mechanisms
number of available and various
mechanisms and instruments, is
instruments is small widely available to a
broad range of
private investors and
support various
stages of project
development
None Very limited, with a Somewhat limited, Developed Very developed
few mechanisms with a larger support, with a support covering
focusing primarily in number of more large number of above 30% of
one or two narrow varied mechanisms various support registered SMEs
areas of support and and covering a mechanisms and
covering a small large number of covering a
number of SMEs SMEs substantive
number of SMEs
(e.g., 30% of
registered SMEs)
None Limited number pro- Larger number of Substantive Large number of
ject proposals project proposals number of project project proposals in
concen-trated in one with a greater proposals in various sectors
or two sectors, sector and SME various sectors relating to various
covering a certain type coverage relating to various types of SMEs
segment/type of types of SMEs delivered by various
providers
105
 SMEs delivered by a
few providers
3.12 Availability of None Very limited, with a Somewhat limited, Developed, with a Very developed
dedicated technical and few mechanisms with a larger large number of support covering
financial support to focusing primarily in number of more various support above 50% of
cooperatives one or two narrow varied mechanisms mechanisms and registered
areas of support and and covering a covering a cooperatives
covering a small larger number of substa-ntive
number of cooperatives number of
cooperatives registered coope-
ratives (up to 50%)
t

106
With its capital
public and private resources, especially at the domestic level, to reduce poverty and support local
economic development. This last mile is where available resources for development are scarcest;
where market failures are most pronounced; and where benefits from national growth tend to
leave people excluded.

-led financial inclusion that

expands the opportunities for individuals, households, and small businesses to participate in the
local economy, providing them with the tools they need to climb out of poverty and manage
their financial lives; and by showing how localized investments -- through fiscal decentralization,
innovative municipal finance, and structured project finance -- can drive public and private funding
that underpins local economic expansion and sustainable development. UNCDF financing models
are applied in thematic areas where addressing barriers to finance at the local level can have a
transformational effect for poor and excluded people and communities.

By strengthening how finance works for poor people at the household, small enterprise, and local
infrastructure levels, UNCDF contributes to SDG 1 on eradicating poverty with a focus on reaching
the last mile and addressing exclusion and inequalities of access. At the same time, UNCDF
deploys its capital finance mandate in line with SDG 17 on the means of implementation, to unlock
public and private finance for the poor at the local level. By identifying those market segments
where innovative financing models can have transformational impact in helping to reach the last
mile, UNCDF contributes to a number of different SDGs and currently to 28 of 169 targets.

United Nations Capital Development Fund

P.O. Box 60130
Addis Ababa, Ethiopia
Tel: +251 912 506767
Web: www.uncdf.org