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Hidden Gems: When risks are mitigated, Africa offers EU investors intriguing opportunities

This article originally appeared in the 2005/2006 Euromoney Yearbook.

Despite a recent surge in foreign direct investment in Africa, which reached US$18bn in 2004, the FDI gap between Africa and other developing regions on a per capita basis continues to remain large. Recent progress on many key fronts across the region - from better governance and accountability to improved economic and social performance to better policies and institutions- is obscured by misperceptions of inhospitable investment climates and other obstacles to business. Africa, it seems, is the victim of a self-fulfilling prophecy, where the all-pervasive perception of risk obscures legitimate investment potential.

In fact, Africa—with its rich agricultural and natural resources, preferential trade agreements, lower cost of doing business, and new national efforts to stabilize government, curb corruption, encourage foreign investment, and improve business climates—deserves more than a second look as a potential investment destination.

The Africa of today is about more than just commodities and oil, just as the continent is about more than the AIDs epidemic, famine, civil war and poverty. In fact, recent World Bank studies suggest that potential return on investment in Africa for foreign investors across the range of industrial sectors is among the highest compared to other regions in the world.

South Africa, for example, already a location of choice for automotive manufacturers, is getting more than just a cursory review from companies looking for offshoring in software development and back office services functions. And in Lesotho, investors have built a viable textile industry from the ground up. The country reported textile exports worth US$450m in 2004, from virtual non-existence in 2000.

‘Year of Africa’ brings new investment potential for careful investors

In a year many are calling “the Year of Africa,” progress is being seen in many areas. Africa’s political leadership is taking ownership of conflict resolution, good governance, and poverty reduction at a regional level, with the New Partnership for Africa’s Development (NEPAD) providing the overall framework. Since the mid-1990s, 15 countries have seen GDP grow consistently over 6% a year. Many countries have increased exports by more than 8% a year, despite falling prices in some of their primary commodities.

“Now is a wonderful time to get in,” notes David Bridgman, Africa Manager for MIGA. “Many countries in sub-Saharan Africa are really focusing on critical reforms, and going in now means you are getting in on the ground floor, before everyone else.”

He advises potential investors to consider countries on an individual basis, rather than ruling out an entire continent based on potential difficulties in some places. So, investors should do their homework and look at a country on its own merits.

“Africa is no more homogeneous from Casablanca to Capetown than Europe is from Scotland to Serbia,” he points out.

Trade agreements set the stage

While all eyes were on European Union expansion and the introduction of the common currency, in the past few years EU officials were busy negotiating other agreements as well, with African countries. These new treaties give rise to investment opportunities allowing foreign investors preferential access to the markets of industrialized countries for a range of products and goods exported from sub-Saharan Africa.

The African Caribbean and Pacific (ACP)-EU Partnership Agreement, called the “Cotonou Agreement,” for example, is an aid and trade agreement concluded between 76 of the 78 ACP countries and the EU in June 2000 in Cotonou, Benin. Cotonou is an agreement that offers tariff and quota-free entry to the EU for ACP countries. The preferences will be maintained until the December 31, 2007, when alternative trade arrangements will replace them. The Cotonou agreement covers 100% of industrial products and 80% of agricultural products. Manufactured and processed products are exempted from customs duties.

A similar agreement, the African Growth and Opportunity Act, gives 35 sub-Saharan nations duty free and quota-free US-market access for all products through the Generalized System of Preferences (GSP) program.

And in February 2001, the EU General Affairs Council adopted the Everything But Arms (EBA) amendment to the EU’s own GSP program. The amendment gives duty and quota free access to all products originating in what the World Bank terms “Least Developed Countries,” except arms and ammunitions. For now, the agreement excludes controversial imports such as bananas, rice and sugar, which are slated for phase-in by 2009.

“These agreements have laid the groundwork and contributed to rising interest in Africa from an FDI perspective,” says economist Stephen Thomsen, an associate fellow with the Royal Institute of International Affairs and author of a new Chatham House white paper on FDI in Africa. Mr. Thomsen explains that while the US$50bn invested in Africa between 2000 and 2003 represents a mere drop in the bucket of global flows, when compared to the size of the African economy, the figure is far more impressive.

Efforts to reduce corruption and improve business environment enhance appeal

Until recently, corruption has been a fact of life in many African nations. But for some, such as Mozambique, Uganda, Tanzania and Ghana, heightened attention to anti-corruption measures, along with other efforts to improve the business environment, has paid off in a big way.

“The revival of foreign investment in Africa suggests that the risks to private investment have been lowered as a result both of specific policy changes and of improvements in governance more generally,” Mr. Thomsen says. “Things appear to be changing, and there are efforts across the region to improve the business climate.”

For example, private interest in constructing an aluminum smelter inaugurated in Mozambique five years ago led to lasting changes in commercial development approval processes. Since then, the project has generated additional investment, and has been a large part of the reason for Mozambique’s 7% sustained growth rate since 2002. Mozambiquan officials regularly seek advice from the business community on the kinds of reforms that would improve the business climate even more.

In other countries, like resource-rich Nigeria, authorities have pledged increased transparency as the nation commits to a new international extractive industries code of conduct. Efforts are also underway to revise the nation’s incentives policies to attract more foreign investors. Ghana and the Republic of Congo have also signed on to the initiative.

The examples of countries such as Uganda—with a 5% growth rate—and Mozambique, only recently emerged from decades of disastrous policies and civil war, have not gone unnoticed. Other African nations are beginning to think about what investors are looking for in a new location. Almost all have established investment promotion agencies to provide facilitation and support to foreign investors and their agents when making site selection decisions.

And while real risks do exist for foreign investors, an additional problem is, to put it simply, the image thing.

“The perception of risk in Africa has not gone away,” Thomsen notes. “This has been cultivated by relentless, negative headlines around the world.”

Risks—real and perceived—obstacles to investment

Most African countries are not even on the radar screen of European companies in expansion mode because of this perception of risk. According to a recent study by AT Kearney, a global consultancy, corporate concern about country financial risk and government interference or regulation may prevent them from investing in certain countries. The survey also finds that executives are concerned about terrorist activity, as well as war and political upheaval.

And investors willing to look beyond the headlines still have to contend with the “glass half empty” crowd. “Such risks—whether they are real or perceived—can increase project costs, since there may be a risk premium imposed on bank loans,” explains Nick Halkas, MIGA’s Extractive Industries sector head.

Additional non-commercial, or so-called political risks, include the inability to transfer currency outside the country if the nation imposes a moratorium. And certain projects, such as those in the infrastructure sector that require massive upfront costs, typically take longer to complete and are reliant on future cash flows to meet financial obligations and provide reasonable returns. Political resistance to private provision of service can be an issue as well. Plus, the emergence of public-private partnerships in infrastructure projects adds another layer of complexity, involving multiple layers of public authority, and numerous opportunities for contract disputes. As governments decentralize control of services, states and municipalities with little experience dealing with the private sector become the lead public partner in such deals.

Can non-commercial risks be mitigated?

No deal is risk-free. And certainly, a decision to invest in a nation that might be emerging from war or civil conflict—like Mozambique or Uganda—could add more uncertainty than investment in a more stable nation.

Investors might not be able to make their risks go away completely as they consider sub-Saharan investments. But they can take steps to balance the potential risks, thus making deals viable, explains MIGA’s Bridgman. Sound deal structure and good project fundamentals are the place to start. And companies should also investigate the added protection that political risk insurance—or PRI—provides.

“Political risk insurance makes it possible to get debt funding for projects in countries where banks otherwise might not be willing to lend. It can also make these funds cheaper, and protect the investment for a longer tenure,” he says. “PRI allows investors to act on a hunch.” And this ability to act on a hunch, being in the right place at the right time, is the hallmark of successful investments around the world.

For example, Afriproduce, a UK-based company took advantage of a strong business opportunity with the support of PRI in Uganda. Guarantees are the security that underpins the company’s investment in Ugacof, a coffee processing facility. The decision to invest came in 1999, at a time when Uganda’s political situation was highly unstable, following years of trouble. Political risk coverage protects the investment against the risks of transfer restriction, expropriation, and war and civil disturbance, and offered critical security during this uncertain time. Today, despite some ongoing political unrest, the company is thriving, employing 200 and sourcing beans from local farmers.

And when South African oil, gas and chemical firm Sasol identified business potential in a natural gas deposit in resource-rich Mozambique, lenders remained wary of investing given their perceptions of country risk. The company took out political risk insurance as a way to mitigate the risk and reduce the cost of the investment.

The resulting debt financing structure is “an innovative combination of corporate and traditional project finance lending, interwoven with a supporting web of political risk insurance,” according to industry experts at Cadwalader Wickersham and Taft.

Sasol, which is developing the Temane and Pande gas fields, assumed the commercial risks for the project on its own balance sheet. The company constructed a central processing facility to clean up and compress the gas, and built an 865 km cross-border gas pipeline that is now sending gas from Temane in Mozambique to Secunda in South Africa. Building on the success of the natural gas project, and its positive relations with the Government, Sasol has just announced an expansion of its Mozambique operations, to include offshore drilling and exploration. Investment guarantees cover the project against the non-commercial risks of transfer restriction, expropriation, war and civil disturbance, and breach of contract.

One area of growing interest—endorsed by Africa’s leaders through NEPAD and gathering momentum across the continent—is support for regional integration through the creation of common institutional and legal frameworks in areas such as customs, competition policy, and the regulation of common property sources. For investors, this means streamlined ways of doing business and potential expansion of consumer bases, making an investment more bankable.

The West African Gas Pipeline project, launched in December 2004, is a good illustration of an investment in markets reliant on regional economies. The project involves the construction of a 678 km pipeline to transport natural gas from Nigeria to Ghana, Togo, and Benin, which will allow abundant and cheap natural gas from Nigeria to replace the expensive alternate fuels used by the power, industrial, mining, and commercial sectors in the recipient countries. The project is part of an overall strategy of these countries to improve the efficiency of their energy sectors, by decreasing input costs and diversifying fuel supply. A critical element of the project was the decision of the project sponsor to proceed only with the appropriate mitigation of risks, particularly those related to the gas purchase obligations of the power utilities in Ghana, Togo, and Benin.

Capitalizing on African opportunities

It would be foolish to suggest that investors ignore the problems that continue to haunt parts of Africa today. Infrastructure in many nations is incomplete, making it difficult to get goods to market or to count on a reliable source of electricity to power industrial processes. And macroeconomic, legal and regulatory concerns remain.

But so do the opportunities. Economic viability tends to grow on itself. And as more companies make African investment decisions in countries that have committed to encouraging foreign investment through legal and regulatory reforms and anti-corruption measures, the market itself will expand. In turn this creates additional opportunity, and more investors will decide to move forward with their plans. With the stage set through new trade agreements, European investors are well positioned to capitalize on the vast prospects in many African nations by incorporating careful deal structure with appropriate measures to mitigate risks.


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