Why Investor Risk Now Matters in Africa, And How to Address It

Paul Collier - 14th October 2010

The Annual Meetings of the World Bank and IMF convene both investors and governments. This year investors are interested in Africa. Partly, this is for want of anything better: Opportunities in the OECD are thin, and those in East Asia are already priced in. But Africa’s advantage is not just relative. Having brushed off the global crisis, it is performing better – growth in 2010 is estimated at 4.9 percent, and rising.

In the past, investment portfolios used to avoid Africa. Now investors recognise that exposure is warranted. But investors know that Africa is still risky, and that the severe downside risks are political. The result is currently a stand-off as predicted by the ‘bad news principle’. The principle deduces that in the face of large downside risks investors keep their options open. African governments have not recognised its implications. Improvements in the general business climate are insufficient: while they increase the NPV, they do not affect the value of maintaining the option. To get investors to commit, governments must address those severe downside risks. They have two ways of doing it.

One approach is for governments to ‘signal their type’. Potential investors struggle to discern whether, if they make an irreversible investment, the government will honour its promises or renege on them: is the government ‘good’ or ‘bad’? In turn, this creates a problem for a ‘good’ African government. Its problem is to distinguish itself from other governments that, while wanting to lure in investors, would then expropriate them by one of the many mechanisms available to governments. The good government’s problem is that anything it says can be perfectly imitated by the bad government. The theory of signalling gets round this problem of imitation. It tells us that an effective signal is an action that the bad government is not prepared to imitate. An unfortunate implication is that even for good governments such actions are likely to be painful. For example, in Africa power shortages are ubiquitous because electricity is underpriced to appease the politically influential urban middle class. Potential investors are all too aware of these shortages, so a good signal would be to raise the price of electricity.

The other approach to addressing the severe downside risks is for the government to build a commitment technology which locks it in to keeping its word. Most African governments face credibility problems, the result of decades of over-promising and under-performing. Thirty years ago OECD governments faced their own credibility problems concerning investor fears of inflation. They learnt to build a commitment technology against the resort to inflation by granting independence to central banks. African governments face different investor fears which central bank independence would not address. So they need to build different solutions. The underlying principle, however, will be the same: a commitment technology works by creating penalties for the government should it break its promise. Big proposed penalties are not enough: a promise is only credible if it is clear that the penalties will actually be imposed against the government. So, paradoxically, in order to get what it wants, namely investment, an African government must find ways of exposing itself to penalties, which, if it broke its promises, it could not evade. The most credible source of such penalties available to African governments is the international agencies, such as the African Development Bank or the World Bank. Bizarre as it sounds, a good government should ask these agencies to impose conditional penalties upon it. For example, neighbouring governments wishing to commit to open borders so as to ensure a large market for an investor, could sign an agreement to forego part of their IDA allocations should they impose border restrictions.

However, the international agencies themselves have credibility problems. Hence, they too need to build a commitment technology that makes the imposition of penalties credible. Fortunately, such a technology is readily available: political risk insurance. The World Bank already provides political risk insurance, but at present it is not used strategically in combination with commitment technology for governments. Where a government entered into a conditional penalty with the Bank, this should reduce the cost to an investor of insuring against the action that the government has committed not to do. The two technologies complement each other: the Bank has an incentive to impose the penalties because that will reduce its insurance pay-outs. The government has an incentive to enter the commitment because it is doubly effective with investors: reducing the objective risk and providing insurance against it. 

Neither of these approaches is politically easy for African governments. But they would be high-return investments in building trust.

This article originally appeared in Social Europe Journal.