Capital markets in east Africa: Developing the buy side
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An important step in building capital markets is to develop the “buy side” among local investors such as pension funds and insurance firms.

Local institutional investors with longer-term investment horizons, especially pension funds, can contribute to the development of local securities markets. The pools of savings these investors manage can be potentially important sources of longer-term finance – for infrastructure, for example, which in turn drives socioeconomic development.

A well-functioning buy side also reduces an economy’s reliance on foreign portfolio investors, increasing its resilience to shocks caused by sudden capital inflows and outflows.

The Milken Institute recently surveyed institutional investors in four East African Community (EAC) countries – Kenya, Rwanda, Tanzania, and Uganda – to ask how they are managing savings across asset classes and countries.

The residents of these countries are increasingly accessing pension and insurance products. By 2016, local institutional investors had doubled the total assets they were managing to $19bn compared to four years ago.

The findings show that while there are clear signs that these investors are taking a more diversified portfolio approach across asset classes in managing this growing pool of savings, there is still significant potential for them to diversify further.

Nearly 60 percent of surveyed investors hold some of their assets in listed equities, although surveyed insurers – life insurance firms, in particular – tend to hold a very tiny share in these securities. Nearly six in 10 surveyed pension funds hold no assets in corporate bonds.

Even in Kenya’s relatively developed capital market, pension funds only held an average of 2.5 percent. Survey participants accounted for just under half of total assets managed by the insurance and pension industries.

We also wanted to learn how regulatory, capacity, market development, and other factors influence how these investors manage their portfolios. We specifically wanted to understand the actual – versus perceived – obstacles investors face in further diversifying across asset classes and within the EAC.

In most cases, regulatory investment limits are not the binding constraint preventing investors from diversifying their portfolios. The share of portfolios they allocate to public equities and corporate bonds, for example, generally falls well below any national regulatory caps.

Most institutional investors also set their own internal targets or ceilings by asset class, and these often fall well below national ceilings – as do the actual investments. Restrictive or unclear regulations can create challenges for local institutional investors in some cases.

This tends to occur more when they look to invest across national borders within the EAC than across asset classes nationally. Mostly, however, the findings point to a lack of investable products and capacity constraints rather than lack of demand as explanation for the relatively low investment in private sector securities. Investors also desire more products designed to better match their investment aims.

Limited long-term investment vehicles can make it difficult for pension funds, in particular, to achieve a balanced portfolio where the terms of the assets they hold match their liabilities. Because pension funds tend to have liabilities that are longer-term, they are well suited to investing in assets with similar longer-term maturities and with less risk of unexpected liquidity demands. We also asked institutional investors in these countries about the types of financial instruments they might have an appetite for.

Three-quarters said they would be interested in a regional infrastructure “fund of funds” that would invest in cross-border projects in the EAC.

A fund of funds could pool resources from investors across the EAC and be structured to invest in a diverse portfolio of infrastructure projects across this region. Nearly two-thirds of participants said they also would also have strong appetite for a private equity/venture capital (PE/VC) regional fund.

An intraregional fund of funds investing specifically in PE/VC in the EAC could make it easier for local institutional investors to diversify – through the fund – into this new asset class while managing some of the associated risk. This kind of regional approach to creating investment vehicles geared to developing infrastructure in the EAC could also help develop the small institutional investor base in countries such as Rwanda. East Africa’s pension funds, in particular, would benefit from the opportunity to diversify their portfolios and invest in a pipeline of well-managed projects across the region. Forging closer regional links across the EAC’s capital markets may offer a way for small, less developed capital markets to achieve scale. The potential benefits associated with this regional approach to capital market development could include diversified risk in a wider market, more efficient and competitive markets, lower costs, and more opportunities to generate returns. Further cooperation and, ultimately, integration of stock markets in the EAC could provide a way for these markets to overcome some of the obstacles impeding their development. By pooling the resources of small local capital markets, regionalisation could boost liquidity and the ability of these markets to intermediate capital for private sector and infrastructure development. Investors would gain access to a broader range of securities. Issuers would gain access to a larger number of investors. Jacqueline Irving is a director in the Center for Financial Markets at the Milken Institute.

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