Although Africa is awash with private equity and “impact” investors, the continent’s transformation continues to lag. But local governments can play an important role.

by David Jackson, Director, Local Development Finance at UNCDF

Africa has seen over two decades of rising investment, including an exponential rise in foreign direct investment that has rebounded from the 2008 global financial crisis. But this investment is not accompanied by the requisite economic and social transformation that would allow the poorest countries to provide their citizens with the same type of sustainable opportunities seen in developed countries.

Let’s first look at some numbers. Last year, for instance, Chinese capital investment in Africa surpassed USD 14 billion, an all-time high. Half of the top 10 recipients of this investment are among the 34 African countries in the so-called Least Developed Country (LDC) grouping. European foreign direct investment, too, was very strong in 2016.

So money is coming in — yet the devil is in the detail. These investments are dominated by real estate in big cities, mega-projects with few links to the broader economy, commodities for export and some middle-class services, according to a recent U. N. report.

What we’re not yet seeing is a truly transformative impact from these investments. This would mean rising rural agricultural productivity accompanied by increasingly well-paid and specialized jobs in both urban and rural areas. It also would mean industrial infrastructure and public infrastructure in local processing, manufacturing, transport, housing — the sort of thing that Europe and China financed through central and local governments during their own transformations.

I would suggest that a key actor is ready and able to accelerate this process: local governments. Before discussing into how local authorities can play this part, however, let’s look at two key reasons why investment does not always lead to transformation.

[See: How Dakar (almost) got its first municipal bond to market]

The first reason is the type of investment. A scan of over 100 companies in the Global Impact Investing Network (GIIN) network reveals that most GIIN members do not operate in the infrastructure sector. Impact investors are institutions that seek social development impact alongside financial returns. They are either microfinance institutions, financial services providers or private-equity companies that seek exit and profit within five years, including high returns. Most transformative infrastructure investments, on the other hand, require 10 to 30 years of finance, and they typically offer relatively lower returns.

There are some infrastructure investors in GIIN; a good example is the national development banks, such as FMO of the Netherlands. Yet these often focus on larger projects, and they tend to require sovereign guarantees. They also are not investing at the scale required in the Least Developed Countries to drive transformation, possibly due to lack of information about bankable projects and an adversity to risk.

A second factor is the availability of funding in the secondary cities and rural areas of Least Developed Countries. Foreign direct investment rarely reaches these areas unless it is for commodity mining or “enclave” production, which often have few links to the local economy. Further, while impact investors may be present in some sectors, such as telecommunications, this does not always address the issue of transformation, tending instead to be more retail and consumer oriented.

Again, bilateral and international development banks currently are not working on this issue at scale. In part that’s because these institutions face obstacles around local currency risks with the direct financing of projects, thus tending to prefer sovereign loans to governments or guarantees by governments. These are not always forthcoming for transformative investments, however, due to a mal-pricing of risk.

[See: How risk accumulates in African cities — and ways to break the cycle]

This means that the risks may be a lot less than people think. In fact, investing in municipal development can be a solid investment.

Long-term and domestic

So if foreign direct investment and impact investing cannot necessarily drive the transformation of local economies in Africa, what can? One answer is African pension funds.

By their very nature, such funds are long-term and require stable, steady returns. Domestic pension funds do not face the challenge of foreign currency risk. It’s true that most African pension funds today are heavily invested in non-productive real estate and offshore hard-currency accounts. Yet what is the point of saving for a pension if your world is not a nice place to be once you retire?

Increasing the proportion of African domestic pension funds in transformative local investments that add value (and well-paid jobs) to the local economy could provide a more resilient economy that protects the investments of grandparents in retirement, many of whom play an important social role in childcare and other areas. There are many examples of real-estate crashes and currency devaluations destroying the savings base of African pension funds, and transformative local investments would hedge against this.

[See: How investable is your city? This index promises an answer]

It sounds like a no-brainer. So why aren’t African pension funds investing in transformation? There are a couple of reasons for this, and the first involves regulations, rules and culture. Liquidity requirements, conventional wisdom, investment strategies and asset allocation policies so far have limited the availability of funding.

Second, investments simply haven’t been presented in such a way that makes them attractive to pension funds. There are many potentially bankable transformative investments out there, but they either never make it beyond the drawing board or are not structured in a way that makes them viable for institutional investors like pensions funds.

And third, there is a lack of re-financing options and bonds that would provide greater liquidity and flexibility for financiers and infrastructure projects alike.

Local facilitators

Fortunately, there is a potentially key solution to overcoming these obstacles: local governments. Particularly in secondary cities and rural areas, local authorities can play a major role in accelerating the transformation of the world’s Least Developed Countries. Let’s look at this potential role in the context of the obstacles discussed earlier.

Type of investment: Local governments can address these obstacles first by participating directly in the identification of potential investments. Local economic development plans often highlight catalytic investments and can enable “clustering” and other incentives that increase the specialization of employment. These plans also often contain revenue-generating public or private investments such as hydropower and waste-disposal plants.

[See: The new urban imperative for secondary cities]

Where appropriate, local governments also can be the sponsors of investments. This would need to take place through well-structured public-private partnerships in which the investments operate on a commercial basis but the governance structure mandates a social purpose and can include representatives of all stakeholders. A good example is a USD 10 million transport hub and marketplace developed near the small town of Kigoma in Tanzania.

Finally, local governments can promote appropriate catalytic investments within their jurisdiction.

Availability of funding: Local governments can be long-term “anchor” tenants or customers of catalytic infrastructure. They can provide supportive labour market training, for instance, as well public infrastructure such as access roads. Well-structured governance of commercial investments can enable local governments to get around legislative and regulatory obstacles that would otherwise limit their access to capital. For example, in almost all Least Developed Countries, local governments are not able to borrow or issue bonds.

For example, Dakar in Senegal was ready to go, but the issuance did not receive a green light from the regulatory body. On the other hand, Kigoma, cited above, has gone ahead even though the municipality cannot borrow. That’s because the U. N. Capital Development Fund (UNCDF) supported a commercial structure that can borrow without indebting the local government — while retaining accountable governance.

[See: Explainer: What are ‘green bonds’ and why are cities so excited about them?]

Triple bottom line: Finally, local governments also can raise the bar and set much higher standards for impact investment. Importantly, they are in a position to determine their own impact measurements. One example is the UNCDF’s Local Climate Adaptive Living Facility (LoCAL), which sets a high benchmark for proven climate-resilient investments.

Likewise, the United Nations Convention on the Combat of Desertification is about to launch standards for land restoration and “re-greening”. Those standards will be initiated along with an associated mechanism called the Land Degradation Neutrality Fund, to be managed by the French asset manager Mirova. Local governments could play a major role in bringing projects for this fund — and providing the requisite monitoring to ensure that they meet required standards.

Market forces

Needless to say, there are obstacles to increasing the role of local authorities in these ways. Some will argue, for instance, that the involvement of local governments in catalytic transformative investments is a form of market distortion. Those views would suggest that it would be more efficient to let market forces decide on their own.

Yet market forces already are concentrating “impact investors” in the wrong places for sustainable transformation. Further, central and local governments have supported this type of catalytic investment during the “transformational” periods of a spectrum of countries including Canada, China, the European Union and the United States.

[See: New solutions to close the gap on municipal finance]

Pension funds are ideally situated to take advantage of increased local government involvement in transformative investments. Local governments provide stable partners, and the infrastructure investments they sponsor provide long-term, stable returns.

UNCDF is working with governments and regulators in the Least Developed Countries to attract pension fund finance for the pipeline of resilient investment opportunities generated through its local government partners. The purpose to provide solutions to the municipal infrastructure requirements of Africa’s secondary cities in line with the New Urban Agenda.

Ultimately, smart structuring combined with the right urban design will enable the exponential growth of African cities to drive better living standards — instead of “locking in poverty” in poor-quality housing, transport and access to employment.