Infrastructure Financing Market in Ethiopia

This research focuses on the state of Ethiopia’s infrastructure financing market and 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). 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 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.

LFI Local Finance Initiative Infrast ruct ure Financing Market in Et hio pia 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 i Cont ent s ACRONYMS ............................................................................................................................................................... vi FOREWORD ............................................................................................................................................................. viii Executive Sum m ary ................................................................................................................................................. 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 ii 4.3.2 Bond Financing ..................................................................................................................................... 39 4.3.3 Loan Financing ...................................................................................................................................... 40 4.3.4 Debt Market Assessm ent ..................................................................................................................... 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 Table 5: Ethiopia: Risk assessment Table 6: Real Interest Rates, 2013/ 14 2019/ 20) 29 ..30 Table 7: Ratings of macroeconomic indicators iii 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 iv 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 v ACRONYMS AFD Agence Française de Développement KfW Kreditanstalt für Wiederaufbau AGP Agricultural Growth Program LDC Least Developed Country AIB Awash International Bank LFI Local Finance Initiative ATA Agriculture Transformation Agency MDB Multilateral Development Bank BI Business Interruption MFI Microfinance Institution CBE Commercial Bank of Ethiopia MIGA CEAR Construction and Erection All Risks Multilateral Investment Guarantee Agency MoARD Ministry of Agriculture and Rural Development MoCIT Ministry of Communication and Information Technology MoFED Ministry of Finance and Economic Development MoI Ministry of Industry MoWE Ministry of Water and Energy MUDHC Ministry of Urban Development, Housing and Construction NBE National Bank of Ethiopia PFI Public Financial Institutions CRB Credit Reference Bureau DBE Development Bank of Ethiopia DFID Department for International Development (UK) DSU Delay in Start- up EEPCO Ethiopian Electric Power Corporation ECX Ethiopian Commodity Exchange EIA Environment Impact Assessment EIC Ethiopian Investment Commission PSSSA Public Servants Social Security Agency ETB Ethiopian Birr REF Rural Electrification Agency FCA Federal Cooperative Agency ROE Return on Equity FEMSEDA Federal Micro and Small Enterprises Development Agency SACCO Savings and Credit Cooperative SEIA Socio- Economic Impact Assessment SHIA Social Health Insurance Agency GDP Gross Domestic Product GNI Gross National Income IMF International Monetary Fund vi SME Small and Medium Enterprises SNNP Southern Nations, Nationalities and Peoples (Region in Ethiopia) SOE State Owned Enterprise TSP Technical Service Provider OECD Organization for Cooperation and Development UNCDF United Nations Capital Development Fund UNCTAD United Nations Conference for Trade and Development UNDP United Nations Development Program USAID United States Agency for International Development vii 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 im portance 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 Director, UNCDF Local Development Finance Practice viii Ahunna Eziakonwa- Onochie United Nations Resident Coordinator Execut ive Summ ary 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:       Im proving dem and 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 fram ew ork for financing local econom ic 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. Im proved aw areness and incentive fram ework 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. Developm ent 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 m ethods 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.. Im proved use of public support m echanism s 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. x 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 1 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 and the technical expertise in preparing the forms of grants, soft loans and credit enhancement 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 largeprojects 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 smallscale 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 nongovernment 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 com panies, 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 governm ents: 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. Governm ent 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 developm ent com m unity : 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. 2. 3. 4. Project development activities that enable the identification and development of up to 4 demonstration proje for investments in strategic, smaller scale infrastructure projects. 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; 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 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:     6 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. 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 investm ents Econom ic Financial          Regulatory    Long- term assets with long economic life Strongly non- elastic demand due to the unique nature of infrastructure Provision of key public services 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 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 nonexistent, 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 nonThe 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 specialpurpose 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 for sponsors Reduction of financial 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 granting of financing by the project Customer relations Solidity of balance sheet Profitability 9 Degree of leverage utilizable Depends on effects on Average weighted cost of capital Relatively low due to high leverage Depends on cash flows generated by the project (leverage is usually much higher) Relatively high due to low 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 flow s Shareholders Equity and/or quasi-equity NO RECOURSE Loans or mezzanine products Lenders 2 Principal and interest repayments As s e t s Ass Private entity Net income Equity Project Company (SPV) Public entity/ Government Capital investments & operating costs Credit enhancement Project Revenues 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 m arket: Type of financing, capital providers and instrum ents Type of financing Equity financing Capital providers    Debt financing     Wealthy individuals Private equity and venture capital firms Public sector entities (dedicated funds, agencies and institutions) Commercial banks Thrifts Investment banks and finance companies Institutional investors (pension funds, insurance funds, etc.) Instrum ents          Non- listed ordinary shares Listed ordinary shares Listed preference shares Quasi- equity (convertible loan instruments, unsecured loans, preference shares, mezzanine and subordinated loans) Term loans Corporate bonds State and local government bonds Government agencies longterm bonds Mortgage loans 11 Lease financing Public financing3 sector       Leasing companies Global and regional multilateral 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 (singleinvestor 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 m arket com prises public and private m echanism s and conventions that offer a variety of financial instrum ents as w ell as nonfinancial support suitable for financing long- term assets w ith long econom ic 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 equitylike 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 nonexistent, which is particularly true for submarket 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, w ith 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 fixedincome 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: Dom estic credit to private sector (% of GDP) in select developed and developin g econom ies (2013) Denmark 199.6 United States 192.3 Germany Angola 93.1 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 12.5 Tanzania Burundi 15.7 n.a. Zambia 3.7 Ethiopia 3.8 United States 16.2 6.3 Australia n.a. 16.4 3.0 3.3 11.6 11.2 6.0 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 Interm ediaries: 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 Interm ediaries: 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. Dom estic 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 dom estic 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.    18 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 (subsovereign 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 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 derisking measures and risk guarantees from multilateral development banks or export credit agencies, dampen the perceived risk of longerspreads by almost one third on average (i.e. by about 50 bp from an average spread of about and Gadanecz, 2004: 2). Figure 4: Mechanism s of public sector support for infrastructure financing Budget/ Land fund Budget/ Project prep. fund Land acquisition Funding for project preparation Preparation Debt/ Equity Capital grant Guarantee Contingent debt Project financing Financing Outputbased subsidies Revenues 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 macroecono mic factors that may inhibit the provision of long- term credit. 7 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. Inform ation asym m etries 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 longterm 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 (DablaNoris et al., 2015) 21 Figure 5: Collateral requirem ents, % of loan (2014- 2015) Ethiopia 249% Uganda 173% Regional averge (SSA) 160% Kenya 120% Mozambique Malaysia 92% 65% 100% SSA average requirement Source: Weak property rights and enforcem ent 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 Source: World Bank (2014) 24 20 40 60 80 100 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:     26 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. 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 crossreferenced 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 w as 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 INFRASTRUCTURE FINANCING MARKET THE ETHIOPIAN 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 SubSaharan 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 nonFigure 7: Inflation and USD exchange rate, 20 04- 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 Average annual growth rate (2015/ 16 2019/ 20) Real GDP (percent) 11.0 Goods exports (U.S. dollars, incl. 29.0 electricity, percent) Target (GTP II) or projection (IMF) for 2019/ 20 Taxes / GDP (percent) 17.0 Savings / GDP (percent) 29.0 Investment / GDP (percent) 41.3 IMF 7.7 15.2 14.4 18.9 32.9 Source: IMF (2015) According to the Economist Intelligence Unit (2015), Ethiopia remains in the CCC band riskwise. 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 assessm ent June 2015 Sovereign risk Currency risk Banking sector risk Political risk Econom ic structure risk Country risk 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 Instrum ent Saving Deposit Time Deposit Lending T- bills 2012/ 13 2013/ 14 - 3.33 - 3.09 - 3.04 - 2.81 3.17 3.41 - 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 94 th 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 (98 th globally on both dimensions). 30 Nevertheless, Ethiopia ranked quite high in order and security, both regionally (4 th out of 18) and globally (56 th 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 m acroeconom ic 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 Grow th and Transform ation Fund I Nature and Status Geographical Coverage and Locatio n Funding Investm ent Criteria and Guiding Principles Sector Focus Size of Deals 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). SGE targets investments in Ethiopia only. Since 2008, SGI is registered in Ethiopia and operates out of Addis Ababa as a consulting company (not as a fund manager), although the general fund is incorporated and located overseas. 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. SGE provides long- term growth capital to SME in expansion phase (not startups) and whose financing needs are le 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. SGE is a generalist fund, with no sector- specific orientation. In practice, its investm ents 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). SGE will typically seek to deploy investments in the $1 $10 million range. Source: Schulze Global Investment website, 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, m arket risk prem ium and required return on equity according to dom estic financial institutions Minim um Risk- free rate Market risk premium Required return on equity (nominal) Required return on equity (real) Maxim um Average 3.0%* 5.0%** 4.0% 17.0% 32.0% 24.5% 20.0% 35.0% 27.5% 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 com parisons 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 0.0% 35.5% 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 investm ent inform ation and quality of financial data 50.0% Very low 58.3% 36.1% 33.3% Low 13.9% Average 8.3% High 0.0% 0.0% Very high 0.0% 0.0% 0% 10% 20% 30% Availability of investment information Source: 40% 50% 60% 70% Quality of financial data 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 1.1 Size of the stock market 1.2 Accessibility of the stock market 1.3 Stock market liquidity (total value traded/ GDP) 1.4 Stock market regulation 1.5 Compliance of the regulation with the international standards 1.6 Listing requirements 1.7 Private equity providers (apart from public sector entities) 1.8 Average equity market risk premium (MRP) for small- and medium- sized infrastructure Average Rating 1 1 n.a. 1 2 n.a. 3 1 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 paidup 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 m illion Issuer EEPCO Regional governments Development Bank of Ethiopia City Government of Addis Ababa Railway Corporation Private Sector Total 2012/ 13 16,200.0 0.0 0.0 5,675.0 1,100.0 0.0 22,975.0 2013/ 14 22,000.0 0.0 0.0 7,000.0 4,200.0 0.0 33,200.0 Percentage change 35.8 0.0 0.0 23.3 281.8 0.0 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: Dom estic lending (origination and outstanding loans), ETB m illion Public banks Private banks Total 2012/ 13 2013/ 14 D* O* Total D* O* Total 33,249.7 91,173.4 124,423.1 38,937.9 114,664.0 153,601.9 21,001.8 44,656.5 65,658.3 21,027.5 53,691.1 74,718.6 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 their loan portfolio. The share of NBE Private banks have no reason to complain [about the 27 percent bond requirement on new loans]. This money eventually returns to them through government on-lending to support private sector activities. rising whereas private sector credit has been stagnating. Whereas both 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 m aximum capacity for medium- and long- term loans at 50 percent. Figure 10: Trends of loan portfolio, Wegagen Bank 80% 4.6 3.6 5 3.3 60% 20% 3 2.4 40% 1.6 2 1 0% -20% 42 4 2011/12 2012/13 2013/14 Private sector loan (ETB, billion) NBE bills (ETB, billion) Private sector loan, change (%) NBE bills, change (%) 0 ETB, million 4.7 100% 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 longterm 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 m aturity for Ethiopian banks Tenor Short Medium Long Source: Average Percentage 45 40 15 . 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% 8% 10.57% 8.73% 6% 4% 2% 2.11% 1.96% 2.10% SHORT-TERM MEDIUM-TERM LONG-TERM 0% Euro area Government banks Source Private banks 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 m edium - and long- term infrastructure loans More risk 13.9% Same risk 30.6% Less risk 55.6% 0% Source 44 10% 20% 30% 40% 50% 60% - term lending behavior capitalization, loan performance or risk perception play any significant role in determining the - and long- term loans demonstrate only one with the type of ownership. As strong and statistically significant positive relationship 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 longterm loans for infrastructure investment remains high and largely unsatisfied. Figure 13: Satisfaction of the dem and for m edium 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 mediumsized 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 statements submitted by the We have no confidence whatsoever in the financial 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 require a higher collateral than sheet alone]. publicly- owned banks and in certain cases and may go as high as 250 per Manager of Credit Department, Private Commercial Bank cent for smaller enterprises and startups. 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 nonfinancial 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 econom y 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 Providers and insurers of long to medium term debt 2.3 Banking sector concentration 2.4 Banking sector risk 2.5 Banking sector regulation with respect to medium - and long- term C&I credit 11 2.6 Banking sector liquidity ratio (liquid assets to total assets) 2.7 Medium to long- term loans to total gross loans 2.8 SME lending to total gross loans 2.9 Nonperforming loans to total medium to long- term loans 2.10 Term structure of interest rates (curve shape and actual rates) 2.11 Demand for medium to long term infrastructure credit 2.12 Credit rating availability 2.13 Use of lending technologies for infrastructure 2.14 Application of project financing for infrastructure lending crediting (frequency) 2.15 Application of project financing for infrastructure lending (size of the project) 2.16 Regulation of capital goods leasing business 2.17 Development of capital goods leasing business 2.18 Perception of risk of lending for infrastructure investment 11 Medium- to long-term loans are defined as loans with a maturity of above 5 years. 48 2 2 2 2 2 2 3 2 4 2 4 1 2 1 1 2 1 4 2.19 Interest in application of project financing for infrastructure investment 2.20 Perception of the transaction costs of lending for smalland medium- sized infrastructure Average 1 2 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 adm inistrations/ 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 Governm ent Federal Government First Tier Regional Governments Government (9) Special Cities (99) Sub-Cities Urban Kebeles City Administrations (2) Second Tier Special Zones Woredas (671) Woredas (6) Sub-Cities (10+1) Rural Kebeles Kebeles Kebeles Third Tier 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 Investm ent Short term Demand Deposit Saving Deposit Fixed time Deposit Treasury Bill Sub total Long term Government Bond Corporate bond & shares Real Estate Sub- total Total Portfolio, % 2 8 35 15 60 5 25 10 40 100 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 MoCIT; Community- Public- Private private sector. irrigation project via a management Dawit Taye, business affairs journalist for The Reporter contract supervised by the Ministry of Water and Energy (MoWE); smallscale 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 nonexporting 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 byproducts 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 guarantee was designed; secondly, we didn’t have (worth US$ 4.2 million) allowed these enough liquidity to utilize this guarantee because of three banks to provide more shortthe regulator’s requirements. As a result, we could and medium- term loans to entrepreneurs engaged in agriculture never fully utilize it. related activities, manufacturing, Director of Credit Management Directorate, Private services, and trade while at the same 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 am ong 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 assessm ent Indicator 3.1 Regulation of subnational borrowing 3.2 Development of the government bond market for subnational government securities (municipalities and parastatals) 3.3 Regulation of public and mixed public- private 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 (except for residential property) 3.5 Regulation of public- private partnerships for infrastructure, particularly for subnational governments 3.6 Average number of PPP deals for productive infrastructure, annually 3.7 National public sector support to private infrastructure investment through de- risking mechanisms 3.8 Bilateral support to private infrastructure investment 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 3.12 Availability of dedicated technical and financial support to cooperatives Average 60 Rating 2 1 2 1 2 2 2 2 3 3 3 3 2.2 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 unm et 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 collateral 31.6% 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 policy 13.2% 0% Source 62 5% 10% 15% 20% 25% 30% 35% 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 developm ent 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 developm ent 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 fram ew ork for financing local econom ic 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). Im proved aw areness and incentive fram ew ork 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. Developm ent 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 mediumsized 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 to financing. However, the unanswered question is whether this agenda is implemented 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 m ethods 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 nonrecourse (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 nonpriority 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. Publicprivate 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 biom ass 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 econom ically acceptable for a large pro ducer 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. Im proved use of public support m echanism s 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 Nonbank 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 Government Development partners Equity/transfers Guarantees Regional Government Domestic lenders (banks and institutional investors) International lenders Medium- and long-term loans Loan repayments long-term loans Medium- and long-term loans LOCAL INFRASTRUCTURE FINANCE FUND Thematic Window Thematic Window P Cost recovery & administration fees r o j e Thematic Window c t Loan repayments long-term loans s 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: Sum m ary of Eth Dim ension Microeconomic environment Equity financing Debt financing Public sector financing and non- financial support Rating 2 1.5 2.1 2.2 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: Recom m endations to the Governm ent and developm ent com m unity Key areas of infrastructure financing support Improving demand for capital finance Recom m endations Governm ent   Developm ent com m unity Enhance support to project  development and structuring. Consider establishment of a Project Development Fund to  provide technical and financial advisory services to public and private project sponsors.   Adequate regulatory framework for financing local economic infrastructure     Define investments in local  economic infrastructure as an investment class in its own right. Introduce a diagnostic and planning process at the subnational level to 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 Consider adding technical and financial advisory services to the existing grant and guarantee schemes. In the future ensure that financial support is related to technical and financial advisory services to improve 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 Provide technical and financial assistance for introducing diagnostic, planning and budgeting at the local level to leverage public and private finance for local infrastructure. 75 Improved awareness and incentive framework for equity providers     Development of the private financial sector   Full use of the DBE and CBE potential 76 based on application project financing. of Create an incentive  framework for private equity firms to finance local economic infrastructure (e.g., tax relief, partial guarantees, intercepts, etc.) Design a framework for more substantive engagement of 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.). Review and remove  regulatory barriers to lending for small- and medium- sized infrastructure by private banks. Improve the awareness of private financial institutions on opportunities and methods of infrastructure investments.  Provide technical and financial assistance for introducing and maintaining mechanisms for regular interaction between the governments and the private sector at the subnational level. Continue dialogue with the government to stress the positive consequences of liberalization and deregulation of the financial sector. Design financial vehicles that tap into CBE and DBE resources as the primary for productive logterm lending Gradual introduction of project finance and other advanced methods of infrastructure finance Improved use of public support mechanisms for infrastructure financing     Encourage the creation and  application of financial products required for supporting project financing deals. Develop and deliver capacity  building mechanisms for a broad range of relevant stakeholders and make a better use should be made of the extant training opportunities and venues in advanced infrastructure finance. Create a dedicated financing  mechanism for small- and medium- sized infrastructure, mono- thematic or with multiple thematic windows (Local Infrastructure Finance  Fund). Introduce performance measures for public sector entities, particularly subnational governments, related to the leverage of  private capital for infrastructure development.  source of debt finance for local economic infrastructure in the short run.. Provide technical and financial support to a limited number of demonstration deals with a high financial leverage. Provide technical assistance in the development of training materials and relevant courses. Support the development and structuring of a pipeline of projects feeding into the existing grant and guarantee schemes. Ensure that the existing and new grants or guarantees are made, to the extent possible, part of a continuous project development and financing process. Provide technical assistance in the design of the Local 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: Recom m endations for program m atic support to infrastructure finance Ethiopia Program m atic aspect Recom m endation Overall outcome limiting the scope of the outcome to specific thematic and/ or geographic areas. Institutional partner/ Program implementing agency MoFED is likely to be the most appropriate institutional 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 sector developers If subnational governments are to be involved, this is 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 sector developers This engagement has to be on a case- to- case basis and will 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). 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 financiers Engagement with supporting agencies Limited engagement with pension and insurance companies 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. 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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 num ber of surveyed agencies by category Category Sub- category Policy m akers and regulators Central regulator Ministries Government agencies 1 2 4 7 Equity providers Commercial banks Insurance and pension companies 4 6 6 Sub- total Financial m arket participants Sub- total Public sector participants 16 Development Bank Multilateral development banks Multilateral development agencies Bilateral development agencies Sub- total Business services providers Sub- total TOTAL Num ber Public Private 1 3 1 4 9 2 4 6 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. 87 Table A2: Surveyed policy m akers and regulators Institution National Bank of Ethiopia Ministry of Finance and Economic Development Ministry of Federal Affairs Key functions in the infrastructure financing m arket              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 governmentowned 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 Nam e Capitalization (as % of total banks) Public banks Commercial Bank of Ethiopia Construction and Business Bank Development Bank of Ethiopia Total Private banks Awash International Bank Dashen Bank United Bank Addis International Total GRAND TOTAL Average capitalization (ETB, million) Modal capitalization (ETB, million) loans and advances Capitalization Percentage (as % of total share of loans private or and advances public banks) (disbursement) 34.2 2.4 8.1 44.7 76.5 5.4 18.1 100 53.7 2.1 9.1 7.5 7.5 5.0 1.1 21.1 65.8 2,486 1,980 13.5 13.6 9.1 1.9 38.1 3.2 9.6 3.5 0.4 81.6 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 com panies by capitalization Nam e Capital (ETB million) Capitalization (as % of total insurance sector) Capitalization (as % of total private or public insurance sector) Public insurance com panies Ethiopian Insurance Corporation Total 434.4 434.4 21.4 21.4 100.0 100.0 Private insurance com panies Awash Insurance Company 182.9 9.0 11.4 89 Africa Insurance Company Nile Insurance Company Nib Insurance Company Total GRAND TOTAL Average capitalization (ETB, million) Modal capitalization (ETB, million) 106.5 182.0 207.3 678.7 1,113.0 222.6 182.0 5.2 8.9 10.2 33.3 54.7 6.7 11.4 12.3 41.8 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 developm ent of the relevant m arket segm ent . The key indicators include the width and breadth of the segment, its capitalization and concentration (if appropriate), coverage and other relevant features. Regulatory environm ent . 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. Com position. This dimension is related to the type and characteristics of market participants and their capacities, including, where appropriate, providers of nonfinancial 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 o f 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/ opendata- 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 crosssectional 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, longterm 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 longterm 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 nonperforming 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 Definition Medium- and long- term business s outstanding loans to nonfinancial loans (assets) private firms with over three years maturity divided by assets, expressed as a percentage. Medium- and long- term business s outstanding loans to nonfinancial loans (loan portfolio) private firms with over three years maturity divided by the loan portfolio, expressed as a percentage Size 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 interest rates State 94 long- term loan Annual interest rate for medium- and long- term loans expressed as a percentage = 1 if a bank is state- owned and zero otherwise. 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 Ownership Size Capital NPL MLT interest rate Guarantees Constant Dependent variable: MLT loans to assets Coefficient estimate (t - Statistic) 0.927 (6.048)*** 0.015 (0.084) - .010 (- 0.053) - 0.226 (- 1.229) - 0.366 (- 1.777)* - 0.182 (- 1.072) 16.014 Dependent variable: MLT loans to portfolio Coefficient estimate (t - Statistic) 0.915 (5.564)*** - 0.80 (- 0.409) 0.038 (0.182) - 0.126 (- 0.579) - 0.005 (- 0.017) - 0.260 (- 1.581) 38.400 15 The private banks included Awash International Bank, Wegagen Bank, Dashen Bank, United Bank, Addis International Bank, Bank of Abyssinia 95 N Adjusted R Square F- Statistic (17.118)*** 9 0.836 36.572 (8.752)*** 9 0.811 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 m odel variables Size Capital NPL MTL interest rate Loan guarantee Pearson Correlation MLT loans to assets - .131 .187 - .271 - .368 - .659 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 Dim ensio n Rating 1 0 . Macro econom ic environm ent 0.1 GNI per capita (Atlas Low- income, method) $1,045 0.2 GDP growth (Change Very low of GDP on previous year, measured in percent) 0.3 Annual inflation rate i > 7% 0.4 Country credit risk C- D 0.5 Central bank Very tight monetary policy 0.6 Corruption (country Last quintile corruption ranking) 0.7 Security and rule of Insecure, weak rule law of law (last quintile in the Rule of Law Index) 1. Equity financing 1.1 Size of the stock market 98 Stock market does not exist; existing firms are unlisted 2 3 4 5 Lower- middle income ($1,045- $4,125) Low Upper- middle income ($4,125- $12,746) Average High High- income ($12,746 or more) Very high CCC- CC Tight BB- B Somewhat relaxed A- BBB Relaxed AAA- AA Very relaxed Fourth quintile Third quintile Second quintile First quintile Somewhat insecure, weak rule of law (fourth quintile in the Rule of Law Index) Relatively secure, somewhat strong rule of law (third quintile in the Rule of Law Index) Secure, reasonably strong rule of law (fourth quintile in the Rule of Law Index) Very secure, very strong rule of law (first quintile in the Rule of Law Index) Only primary stock market exists, low capitalization (less than 10% of GDP) Only primary stock market exists with low to medium capitalization (1030% of GDP) with large firms that use direct placement and some other Both primary and secondary markets exist with low to medium capitalization (1030% of GDP) and various stock listing methods Primary and secondary markets with medium to high capitalization (more than 30% of GDP) with a full range of stock listing methods methods of stock listing Medium concentration, open to large and medium firms Medium concentration, open to all size of firms 1.2 Accessibility of the stock market Very high concentration, open only to large firms High concentration, open only to large firms Low concentration, open to all size of firms; there is a special arrangement for SMEs Very high 1.3 Stock market liquidity (total value traded/ GDP) 1.4 Stock market regulation Very low Low Average High No regulation No dedicated regulatory authority and no dedicated regulation; some aspects of the stock market are regulated by other laws Dedicated regulatory authority exists; many aspects of the stock market are regulated Dedicated regulatory authority as well as other bodies supporting the stock market exist; most or all aspects of the stock market are regulated 1.5 Compliance of the regulation with the international standards (availability of information, accounting standards, investor protection) 1.6 Listing requirements Very low Low Dedicated regulatory authority may exist as well as dedicated regulation that regulates certain aspects of the stock market Average High Very high No stock market and no listing requirements exist Compliance with listing requirements takes significant efforts and does not allow medium- sized non- financial companies to get listed Compliance with listing requirements takes moderate effort and allows some medium- sized non- financial Compliance with listing requirements is relatively easy and allows most mediumand some sm all- sized non- financial Compliance with listing requirements is relatively easy and allows most medium- and sm allsized non- financial companies to get listed 99 1.7 Private equity providers (apart from public sector entities) Individuals communities 1.8 Average equity market risk premium (MRP) for small- and medium- sized infrastructure16 MRP > 14% 2. Debt financing 2.1 Domestic credit to private sector 2.2 Providers and insurers of long to medium term debt and Individuals, communities, private non- financial firms companies to get listed A small number of venture capital and/ or private equity firms with high sector concentration companies to get listed A number of venture capital and private equity firms with a broader sector coverage Less than 10% of GDP Commercial banks 11- 30% of GDP 31- 60% of GDP 61- 90% of GDP Commercial banks and institutional investors Commercial banks, institutional investors and financial firms sector Very high, with a few large national banks High Average Commercial banks, institutional investors, financial firms, lease companies Average to low 2.4 Banking sector risk 2.5 Banking sector regulation with respect to C- D Existing regulation is unfavorable, makes credit procedurally CCC- CC Existing regulation is somewhat unfavorable, makes BB- B Existing regulation is relatively favorable 2.3 Banking concentration 16 To be considered in combination with the average required rate of return on equity. 100 A- BBB Existing regulation is largely favorable A variety of private equity providers, both foreign and domestic, including impact investors and philanthropists, with a comprehensive sector coverage More than 90% of GDP Commercial banks, institutional investors, financial firms, lease companies, monoline insurers Low, with a variety of banks by size, region and specialization AAA- AA Existing regulation is favorable and contains specific medium- and long- term C&I credit 17 2.6 Banking sector liquidity ratio (liquid assets to total assets) 2.7 Medium to long- term loans to total gross loans 2.8 SME lending to total gross loans 2.9 Nonperforming loans to total medium to longterm loans 2.10 Term structure of interest rates (curve shape and actual rates) 2.11 Demand for medium to long term infrastructure credit 2.12 Credit rating availability 2.13 Use of technologies infrastructure 17 lending for difficult and economically unprofitable Very low, constraining credit or making it impossible 20% or less credit difficult profitable Low Low to average Average to high provisions to encourage private sector credit High 21- 30% 31- 40% 41- 50% More than 51% 5% or less 6- 10% 11- 15% 16- 20% More than 21% More than 11% 9- 11% 6- 8% 3- 5% 2% or less Steep upward slope Moderate slope Flat Downward slope Low Low to average Average Average to high High Not available Available only for large enterprises (with foreign participation or engaged in foreign trade) Mostly balance sheet lending and pledge of collateral Available for most large and some medium enterprises Available for all large and most medium enterprises Available for all large, medium , and qualifying sm all enterprises Mostly balance sheet lending, pledge of collateral and elements of asset- based lending Asset- based lending and credit scoring All lending technologies used depending on the borrower and type of investm ent Relationship lending and balance sheet lending but upward Slight slope upward Medium to long term loans are defined as loans with a maturity of above 5 years. 101 2.14 Application of project financing for infrastructure lending crediting (frequency) 2.15 Application of project financing for infrastructure lending (size of the project) 2.16 Regulation of capital goods leasing business Never Rarely Occasionally Quite often Often None Large (above $100M) Large to medium ($100M - $20M) Medium ($20M $5M) Medium to (below $5M) None Existing regulation is somewhat conducive Existing regulation is generally conducive Existing regulation is very conducive 2.17 Development of capital goods leasing business None Existing regulation is not conducive (significant constraints, high transaction costs, etc.) Weak development (only a few leasing companies offering services to large investors) Moderate development Strong development 2.18 Perception of risk of lending for infrastructure investm ent 2.19 Interest in application of project financing for infrastructure investment 2.20 Perception of the transaction costs of lending for small- and medium- sized infrastructure Very high High Average Average to low Very strong development (a large number of leasing companies of various types offering services to a broad range of investors of all sizes) Low or no risk Low or no interest Low to average Average High Very high Very high High Average Average to low Low or no costs 102 sm all 3. Public sector financing and non- financial suppo rt 3.1 Regulation of Subnational Subnational subnational borrowing borrowing is not borrowing is allowed allowed only for a few chosen subnational jurisdictions at one level and on a caseby- case basis 3.2 Development of the government bond market for subnational government securities (municipalities and parastatals) 3.3 Regulation of public and mixed public- private institutional investors (social security and pension funds, life and health insurance funds, property and causality insurance companies) 3.4 Level of institutional investm ent in infrastructure (except for residential property) 3.5 Regulation of publicprivate partnerships for infrastructure, particularly for subnational governments Subnational borrowing is allowed for certain subnational jurisdictions at more than one level of subnational government Highly concentrated with moderate capitalization Subnational borrowing is allowed for all subnational jurisdictions at more than one level of subnational government Moderately concentrated with moderate capitalization Subnational borrowing is allowed for all subnational jurisdictions at all levels None Highly concentrated with low capitalization Low concentration and high capitalization Institutional investors are not allowed to invest in individual infrastructure projects Institutional investors are allowed to invest in certain publicly funded infrastructure projects Institutional investors are allowed to invest in all publicly funded infrastructure projects Institutional investors are allowed to invest in publicly and privately funded infrastructure projects Institutional investors are encouraged to invest in publicly and privately funded infrastructure projects None A small proportion of assets (below 5%) 5- 10% of assets 11- 15% of assets 16- 20% or above None Existing regulation is not conducive (significant constraints, complexity and/ or Existing regulation is somewhat conducive Existing regulation is generally conducive Existing regulation is very conducive (broad scope of application, easy to implement, available 103 3.6 Average number of PPP deals for productive infrastructure, annually 3.7 National public sector support to private infrastructure investment through de- risking mechanisms None Public sector support is nonexistent or very limited and highly concentrated, eligibility criteria are stringent, the number of available mechanisms and instruments is small 3.8 Bilateral support to private infrastructure investm ent Bilateral support is non- existent or very limited and highly concentrated, eligibility criteria are stringent, the number of available mechanisms and instruments is small 104 ambiguity, limited scope of application, high transaction costs, etc.) Less than 10, only large national projects for governments at all levels) 11- 20 21- 30 Public sector support is somewhat weak Public sector support is moderately developed Public sector support is well developed Bilateral support is somewhat weak Bilateral sector support is moderately developed Bilateral sector support is well developed 31- 40, broad geographic and substantive coverage Public sector support is very well developed, characterized by a larger number of support mechanisms and various instruments, is widely available to a broad range of private investors and support various stages of project development Public sector support is very well developed, characterized by a larger number of support mechanisms and various instruments, is widely available to a broad range of private investors and support various 3.9 Multilateral support to private infrastructure investm ent Multilateral support is non- existent or very limited and highly concentrated, eligibility criteria are stringent, the number of available mechanisms and instruments is small Multilateral support is somewhat weak Multilateral support is moderately developed Multilateral support is well developed 3.10 Availability of dedicated technical and financial support to SMEs None Very limited, with a few mechanisms focusing primarily in one or two narrow areas of support and covering a sm all number of SMEs Somewhat limited, with a larger number of more varied mechanisms and covering a large number of SMEs 3.11 Availability of a pipeline of infrastructure projects sponsored by SMEs with institutions providing technical and/ or financial support None Limited number project proposals concen- trated in one or two sectors, covering a certain segment/ type of Larger number of project proposals with a greater sector and SME type coverage Developed support, with a large number of various support mechanisms and covering a substantive number of SMEs (e.g., 30% of registered SMEs) Substantive number of project proposals in various sectors relating to various types of SMEs stages of project development Public sector support is very well developed, characterized by a larger number of support mechanisms and various instruments, is widely available to a broad range of private investors and support various stages of project development Very developed support covering above 30% of registered SMEs Large number of project proposals in various sectors relating to various types of SMEs delivered by various providers 105 3.12 Availability of dedicated technical and financial support to cooperatives t 106 None SMEs delivered by a few providers Very limited, with a few mechanisms focusing primarily in one or two narrow areas of support and covering a sm all number of cooperatives Somewhat limited, with a larger number of more varied mechanisms and covering a larger number of cooperatives Developed, with a large number of various support mechanisms and covering a substa- ntive number of registered cooperatives (up to 50%) Very developed support covering above 50% of registered cooperatives 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 developm ent 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 sm all 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 Developm ent Fund P.O. Box 60130 Addis Ababa, Ethiopia Tel: + 251 912 506767 Web: w w w .uncdf.org

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