February 01, 2016

In this issue…

• Nigeria’s infrastructure sukuk will support growth but necessary investment highlights role for the private sector
• Islamic finance and good governance are mutually supportive

If Nigeria can increase the infrastructure stock to the global average share of the economy, the country has a significant opportunity to increase its economic growth. In doing so, issuing a sukuk, which the Securities and Exchange Commission and Debt Management Office in Nigeria have announced they will do in 2016, can help attract significantly more financing for infrastructure. The Director-General of the SEC, Mounir Gwarzo, told a local news agency that “the need for alternative sources of capital to finance infrastructure becomes increasingly more compelling with fragility of growth from major emerging markets”.

In order to understand the significance of infrastructure investment, and how the government could integrate sukuk into its long-term financing plan for infrastructure investment, it is useful to look at a hypothetical analysis over the long-term). For example, consider a 50-year time horizon (the length of time that the World Bank said it could take for water and sanitation to be provided to all in many African countries).[1] In Nigeria the stock of infrastructure today equals about 35% of gross domestic product (GDP) compared to 70% in most economies.

In order to double the share of infrastructure over a 50 year period, the overall stock of infrastructure will have to increase by 0.7% of GDP (not including the investment required to maintain existing infrastructure which will also rise). Adding this amount to the budget deficit each year (the deficit was estimated at 2.2% of GDP in 2015 according to the IMF’s Regional Economic Outlook) is possible but with just a small gap between domestic savings and existing investment levels, deficit financing of added infrastructure investment in the domestic market may lead to crowding out private investment.

If the necessary infrastructure investment was made, it would have huge impacts. The elasticity of GDP with respects to infrastructure ranges from between 0.07 and 0.15 which means a doubling of the infrastructure stock would increase GDP by 7% to 15%. As the slowdown in China’s growth demonstrates, there are limits to a quantitative focused infrastructure program as a growth strategy but for countries in Nigeria’s position where infrastructure stock is low, the elasticity of infrastructure investment is likely to be at the high end (or even above) the range established in empirical research.

The figure below shows the hypothetical return using an elasticity of 0.15 over a 50-year timeframe, and assuming that GDP growth begins at 4% per year and declines to 2% per year in 50 years (economic growth slows as economies get larger and as the marginal return on investment declines). As would be expected, the higher growth rate created by the added infrastructure spending leads to an economy that is 15% larger in 50 years—equivalent to $355 billion in additional growth in 2064 and a cumulative $6.4 trillion in added economic activity

[1] World Bank (2010) cited in McKinsey & Company. 2013. Infrastructure Productivity: How to save $1 trillion a year. Seoul: McKinsey Global Institute, footnote 2.

This dramatic impact is due to a relatively small annual change—the annualized growth rate rises just 0.29% as a result of the infrastructure increase. The most challenging aspect is how the infrastructure investment is paid for which makes the approach that includes sukuk one which can have significant benefits if designed in a way that facilitates the investment as well as the eventual recover of the costs involved.

Collection of user fees for infrastructure (particularly in the power sector) has been challenging in Nigeria which has been a significant driver of the power shortage. Tax collection has also been difficult both to pay for government services (Nigeria’s government revenue was just 10.7% of GDP between 2013 and 2015) and fund infrastructure improvements.[1] Public sector infrastructure cannot be measured merely by its short-term fiscal impact, but infrastructure that can have as dramatic an impact on the economic growth cannot be assumed to have a similar impact on the fiscal position if the government’s revenue share is low.

An annual increase by 0.7% of GDP to the infrastructure stock would require incremental investment of $50 billion over the first ten years. If the GDP growth could be fully captured to recover the costs of that investment, it would become net positive within just a few years as better infrastructure supported faster growth. However, assuming that all of the revenue generated from the incremental GDP growth was used to recover the costs, it would take until 2050 to recover the investment, not including any financing cost.

The best option for a financing structure would likely be some combination of public finance for infrastructure which leverages private sector capital as well with a focus of private sector involvement where the direct benefits created from the infrastructure can be most transparently measured and user fees most readily collected. It is unlikely, at least initially, that the private sector investment would be made through a sukuk but if the government financed a portion of its own contribution towards infrastructure development with a sukuk, it would provide a significant source of new sukuk.

To learn more about how sukuk can help transform Africa’s financial landscape, including through infrastructure investment, join us at #IFIF2016 in Khartoum, Sudan from February 9-10, 2016.

The public consultation period for the Singapore Exchange’s proposed requirements relating to sustainability reporting. The required components of a sustainability report under the new guidelines will include:

• Identification of material environmental, social and governance (ESG) factors;
• Policies, practices and performance with regards to material ESG factors for the company’s business;
• Targets for the next year;
• The company’s choice of reporting framework used for sustainability reports (international or industry relevant); and,
• A statement by the board of compliance with the reporting framework.

In past issues of Finance Forward, we have featured contributions from Magni Global, a governance-focused asset manager that ranks countries based on the effectiveness of the corporate governance standards. In previous articles, they have highlighted the connection between traditional ideas of corporate governance with Islamic values as well as looking specifically at the opportunity for Saudi Arabia to improve its governance to further benefit from a future upgrade to emerging market status with Tadawul now open to foreign investors.

Another way to look at the potential relationship between governance and Islamic finance that would also highlight complementarities from increasing the prevalence of integrated reporting and use of ESG factors. To do so, we looked to a few metrics associated with economic growth and business development and compared with the growth in Islamic finance across North Africa, the Middle East and South and Southeast Asia (the MENASEA region).

Not surprisingly, we found a strong linkage between countries with facilitative environments for economic growth and business expansion and those markets where Islamic finance has developed the most rapidly. To look at the relationship, we compared companies in the top 10 of the Islamic Finance Development Indicator (IFDI) quantitative development sub-indicator with four governance metrics (corruption, political stability, regulatory quality and rule of law) from the World Bank Worldwide Governance Indicators across 31 countries.

By comparing the average governance metrics against the development indicator for the top 10 markets, we find there is a notable difference between these markets and the other MENASEA markets. On average, the governance rankings put the countries with large Islamic finance presence in the 51^st percentile of all countries globally. By contrast, countries without large Islamic finance development are in the 33th percentile in the governance rankings.

This form of analysis doesn’t offer clues as to the causative relationship between governance and Islamic finance, but it does show how the two could plausibly be connected. In addition to Islamic values encouraging better governance (the biggest difference in rankings between the large Islamic finance markets and others in the MENASEA region was in rule of law and corruption), the presence of better governance can help Islamic finance become more established.

As countries continue to develop their ESG/sustainability/integrated reporting requirements for companies listed on their stock exchange, there is an opportunity to consider also how country level governance, even relatively broad metrics that were considered above, can support growth in Islamic finance.