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Sunday, May 8, 2011

A perspective on Standard & Poor's negative ratings outlook on Cape Verde government debt

Standard and Poor's (S&P) assessed a B+ rating on the long-term sovereign debt of Cape Verde since December of 2008. A year later, in December 2009, S&P posted a negative ratings outlook on Cape Verde's debt. It is instructive to understand the context of the rating's outlook, its potential impact on foreign investors, and to describe the measures that could be undertaken by the Cape Verde government to reverse this outlook.

Context of Ratings Outlook
Cape Verde has long been recognized as one of the bright economic stars in Africa. It is rated within the Top 5 of the African nations in terms of governance and sustainable economic opportunities by the independent Ibrahim Foundation. It is also among Africa's leaders in Financial Freedom as determined by the World Heritage Foundation.

The economic vitality of the nation is reflected in its strong GDP growth and relatively high per capita income in the African context. Cape Verde also withstood the global financial crisis of 2008-2009 primarily because its banks and government were not exposed to the financial instruments that were backed by real estate in foreign markets where that sector experienced major corrections. But, certainly, there were some follow through effects on the Cape Verdean economy. For example, tourism receipts and remittances from Cape Verdean expats both declined - both tourism and remittances comprise a significant component of GDP.

As a result of the global economic crisis, Cape Verde's GDP growth declined from an average of 7-8% in the years before the global economic crisis to around 4% following the crisis. Thus, there was no recession in the Cape Verde economy and growth remains strong. The outlook for growth remains positive as the country continues to experience double digit growth in the tourism sector and as remittances from Cape Verdeans increase with the recovery of the global economies. S&P itself expects economic growth to return to pre-crisis levels (S&P Sees Return to Pre-Crisis Growth for Subordinated-Saharan Africa).

Yet there are economic imbalances that are unrelated to the global crisis. In particular, there are two factors that concern S&P. The primary factor is Cape Verde's continuing reliance on government borrowing to stimulate the economy, to make public investments and to provide social benefits (such as subsidizing food and gas prices). Indeed, it was in part due to the government's counter-cyclical spending to help offset the effects of the global crisis that lead to some deterioration of the debt burden. Cape Verde's debt to GDP ratio currently runs around 75%. However, this is lower than it was a decade ago, though it represents a greater burden than the 60% ratio achieved just prior to the global shock. While the current level is among the highest in Africa, it is not expected to rise in the near term. Notwithstanding the stability of the debt-to-GDP ratio, it is too high and exposes the government to the risk of future global fiscal shocks - it is not sustainable.

The second factor that leads to the fiscal imbalances is that Cape Verde is heavily reliant on imports. The country has few natural resources with which to earn current account revenues. It attempts to extract duties and fees from these imports but such revenues are insufficient to address the current account deficit.

Click this link to find =>> S&P's Report on Sub-Saharan African Sovereigns.


Impact on Investors
Outside of the usual considerations, the impact of the S&P ratings outlook on investors putting resources into Cape Verde should not be significant, unless the investor is considering projects in sectors that are heavily reliant on the government spending for success, either in the project's development phase or for the project's post-implementation phase.

The outlook has greater implication for the government itself in terms of the ongoing cost of financing and servicing its debt. Clearly, there could be potential steps the government might take to reduce its debt burden that could have a negative effect on investors. For example, borrowing from Cape Verde's banks to finance a potential project would increase costs and lower potential returns. Tax incentives for foreign investments may be reduced. Subsidies in the cost of living for the local residents may be reduced, resulting in price increases and less disposable income.

In summary, this is something that investors should be mindful of as they explore the economic sectors which are most conducive to successful and profitable investments. However, more important is the question which the government itself should address, and that is, besides the external aid the country already receives, what to do about the imbalances?

Suggested Courses of Government Action
There are a number of actions the government of Cape Verde can take or may already be taking to address the current account deficit and reduce the external debt burden. Here are several examples:

1. Grow Current Account Receipts from Tourists
  • Strategic Tourism. In order to grow current account receipts, Cape Verde should continue to focus on attracting tourists into the country. The tourism sector continues to experience strong growth. However, much of that is dominated by the lightly populated islands of Sal and Boa Vista where most tourists are secluded in "all inclusive" resorts where a significant portion of their dollars are spent on imports. Greater emphasis should be placed on bringing tourists into the largest island, Santiago, with better linkage of tourism expenditures to the local economy - Santiago is one of the few islands where locally produced goods (e.g. agricultural goods) are readily available for consumption.
  • Inter-Island Commerce. Inter-island travel, except by relatively expensive air travel and between islands in extremely close proximity, is very unreliable and schedules are limited. This hinders the movement of goods between the islands. It also hinders the movement of people who may wish to access services available on the islands. Improving inter-island commerce can be a significant catalyst for current accounts because it would allow Cape Verdean businesses to move locally produced goods more easily to where tourist dollars are available, and it could foster greater movement by tourists who arrive at one island to explore and spend more in other islands. The newly launched FastFerry service is a good example of a more modern and reliable marine service. Unfortunately, it is not servicing the islands where most of the tourists enter the country.
  • "Invest in Cape Verde" Promotion to Expats. Cape Verde receives significant inflows via foreign remittances from Cape Verdeans living outside Cape Verde, who outnumber those living in Cape Verde. Many of the expats visit Cape Verde. It is estimated that about 10-15% of "tourists" are Cape Verdean expats. The government should do more to further promote direct investments into the country from its expats while they are visiting the country. For example, while there are restrictions on marketing investments to foreign nationals at their foreign residences, Cape Verdean investment laws are the appropriate jurisdiction when marketing to prospective investors while they are in Cape Verde. Thus having brochures at the airport highlighting Bolsa de Valores (the Cape Verdean stock and bond exchange) is a simple step that can be taken to reach this captive audience. The creation of a Cape Verde unit investment trust may also go a long way to making this an easy step. Expats are more likely to consider this a permanent investment in their motherland and less likely to repatriate their investments in Cape Verde back to their foreign residences.
2. Create Innovative New Industries & Finance Capabilities
  • Manufacturing-for-Export Industries. Cape Verde has few natural resources. Fishing is one natural resource that presents an opportunity, though heavy over-fishing could damage the environment. Still, fisheries are an immediate opportunity that could lead to exports. However, a much more important natural resource are its people. They are a well educated and competent workforce. Labor is in abundant supply and is relatively cheap. Cape Verde should seek parties who are interested in building value-added manufacturing capabilities. This involves importation of most or all components to create a value-added final product which is then exported. Cape Verde already has the infrastructure to exploit this immediately. Even high-tech service industries are possible (models for which exist in India, Phillipines and Ireland).
  • Offshore Financial Center. There are several examples of small countries with limited resources which have provided the capabilities for financial companies to operate "offshore" to escape onerous restrictions or repressive tax regimes in foreign countries. Examples include Jersey, Mauritius, Bahamas, Bermuda, Cayman Islands and several small Caribbean islands. Cape Verde should study these offshore financial centers to assess the potential for establishing itself in the sector.
  • Investment Banking. While the Cape Verde financial exchanges are well developed and the legal and financial structure is accommodating, there are no investment banking facilities in place to bring together the suppliers and recipients of foreign capital investors. While investment banking should be a private undertaking, the government should take greater steps to facilitate the startup of this industry. This is an immediate opportunity which requires no new regulations.
  • Unit Investment Trust. The creation of a unit investment trust is permitted under the financial regulations of Cape Verde. The establishment of a UIT as a source of capital investment into Cape Verdean companies and projects across diverse sectors of the economy should encourage greater savings of the local population as well as attract individual foreign and expat investors. A successful example is found in the Caribbean island, Trinidad & Tobago, which established its UT in 1982, attracting US$6 million in its first year of operation. Today, the Trinidad & Tobago Unit Trust Corporation has US$3.8 billion of assets under management from 500,000 investors from 130 countries around the world. The need for a unit investment trust was deemed so important that it was established by an Act of the Parliament of that country in 1981. The initial capital of $US1 million was provided by the Central Bank, local banks and insurance companies, and the country's public pension funds. The Cape Verde government should not wait for a private institution to start a UIT. It is a vital initiative in which there is an overwhelming public interest. Starting a UIT itself will demonstrate the government's confidence in the private sector, and private investors will quickly follow its lead.
  • Letter of Credit Financing. This is covered in a separate post. In summary, rather than invest actual public dollars in private enterprises, the Cape Verde government can use its credit ratings to issue letters of credit to back private investors who can seek capital from foreign sources of capital such as banks and financial institutions to fund their projects in Cape Verde. While the government would remain equally liable as if it had invested actual dollars, no actual public funds are used. The risk analysis required would be in keeping with that exposure. However, the government can earn a fee from the letter of credit and thus enhance its current account revenues. This may help attract suitable private investors who might otherwise not be able to obtain funding in the absence of a letter of credit.
3. Other Potential Approaches
  • Securitization of Certain Revenues. The government should examine its sources of revenue and identify revenue streams that may be less strategic. While the proceeds of securitization should be taken into the capital budget as it represents the value of the future revenue, the enhanced capital budget can be redirected to more strategic public investments or restructuring initiatives aimed at reducing public expenditures.
  • Greater Privatization & Outsourcing. The government should identify any public programs, services and assets which can be better managed by private investors with the goal of full or partial privitization. In addition, it should identify services than can be outsourced to private investors and businesses on a competitive basis. This should not be done simply to cover the deficit or to benefit favored individuals. The key is technical efficiency and striking the right strategic balance bwteen public and private enterprise in the economy. The government may realize immediate short term benefits of an increased capital budget along with the long term benefits of reduced government expenditures, greater economic efficiency and effective distribution of wealth.
  • Sale of Public Buildings and Lands. Some buildings and lands that are not of future strategic value to the state should be sold off to private investors, provided that no harm will come to disadvantaged citizens.
  • Promotion of Vital Projects via RFP. There may be projects that the government is desirous of seeing initiated by the private sector. However, few private investors with expertize and capabilities in the associated industry sector will emerge unless they are specifically made aware of the opportunity, the incentives available for making such an undertaking, and access to potential sources of investment capital. Government must do a much better job of marketing these opportunities directly to suitable investors and inviting them to make a competitive bids via a request for proposal (RFP). A good example is the need to establish intra-island ferry services specifically aimed at moving tourists beyond the islands of Sal and Boa Vista (with clear advantages for locals desiring such services). There are many successful examples of such services in other parts of the world such as Mexico (between the mainland, Cozumel and Isla Mujeres), Washington state in the USA (connecting Seattle and the San Juan islands), Vancouver, Canada (between mainland and Vancouver Island).

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