Financing Opportunities and Challenges for Africa’s Informal Sector

Africa’s informal sector remains the largest in the world. According to the International Labor Organization, it claims almost 90 percent of the economy in sub-Saharan Africa and about two-thirds in North Africa (although there is significant heterogeneity in its size across countries). Previous CGD research estimates that the sector provides 90 percent of all new jobs and 70 percent of all employment across sub-Saharan Africa.

Against this background, Daouda moderated a CGD panel discussion on financing Africa’s informal economy earlier this month. Not only did the conversation focus on a hot topic, but also it brought together panelists with rich experience and expertise on the issue, including country officials, staff from international and pan-African institutions, and private sector representatives.

Available evidence reviewed by the panel suggested that African informal businesses struggle to secure access to traditional banking services. The majority of these businesses are run by young men and women in the agricultural sector, and, in some parts of the continent, informal workers constitute most cross-border traders. Given this context, there is a significant connection between the informal sector in Africa and trends relating to demographic change, gender inequality, and financial exclusion, and the effectiveness of regional trade policy initiatives on the continent.

Many policymakers and development partners have therefore been concerned about how effectively to push these businesses—many of which are micro-, small- and medium-sized enterprises (MSMEs)—into formality and improve their access to financing. Progress in this direction has proven challenging especially since many of these businesses have various motivations and incentives for remaining informal. In this context, improved access to finance could be, among other things, a way to incentivize them to embrace formality.

In this blog, we explore key takeaways from the panel discussion, with the terms “informal businesses” and “MSMEs” being used interchangeably.

1. Effectively address the risks associated with financing informal businesses

Private lenders face acute challenges with risk profiling when considering doing business with the informal sector. Risks of default on loan repayment are prevalent. These risks are aggravated by factors including lack of formal business address, poor and insecure collateral, uncertain asset recovery, volatility of income, agricultural performance, and asymmetries regarding information. Because of this, properly designed risk-sharing mechanisms like guarantees remain critical, and governments can and should play an important role in promoting them. Indeed, the state is not only uniquely placed to take the long-term perspective needed to cope with the lack of immediate return on investment, but it can also mandate designated, publicly funded institutions to contribute to risk-sharing. In many countries, public sector intervention has proven key in developing effective scoring systems to improve risk pricing and better guide lending decisions.

Capacity development plays an important role in risk mitigation, helping strengthen many MSMEs’ abilities to successfully mobilize funding. Many of these businesses are typically run by people who may benefit from sharpening their entrepreneurship skills. In Senegal, the public agency tasked with promoting entrepreneurship among women and youth, the General Delegation for Rapid Entrepreneurship of Women and Youth (DER), found training needs to be extensive among beneficiaries, about 75 percent of whom are female entrepreneurs. Most specifically, those operating in the informal sector have critical capacity development needs including business support for better accounting and marketing, more precise preparation of business plans, more effective risk management, and better operational performance. Besides informal businesses, capacity building may also be needed for lenders such as banks and microfinance institutions to better manage risks associated with lending to MSMEs.

2. Seize available opportunities, including digitalization and partnerships

Among the panel, there was a broad consensus about the central role of digitalization in driving businesses out of informality and helping improve their access to financing. Key potential benefits of leveraging digital technologies include reduced security risks, increased transparency, and lower transaction costs. In this context, the accelerated digital transition that many governments and companies embraced amid the COVID-19 pandemic bodes well for the future of MSMEs.

Leveraging strategic partnerships can also be a low-hanging fruit for making more financing available to MSMEs. This strategy appears to be common among national and multilateral institutions in their efforts to better serve SMEs. In Senegal, DER partnered with banks and microfinance institutions to develop co-financing mechanisms and extend more technical and financial support to MSMEs, benefiting thousands of young and women entrepreneurs previously trapped in the informal sector. Across Africa, women-owned and operated funds and companies are expected to benefit from an impact investment fund setup by the United Nations Economic Commission for Africa (UNECA) and the African Union, with support from other multilateral institutions and a major international bank. In partnership with domestic stakeholders, Afreximbank aims to use a recently established facility to support lending for creative industries such as Nollywood businesses, which are now exporting their products all over Africa and beyond. The experience of the African Guarantee Fund suggests that extending guarantees to investment funds for MSME and SME lending could be rewarding.

3. Develop innovative financing mechanisms

Digitalization and partnerships are not a panacea and may work better if supplemented by innovation. The good news is that there has been growing interest in developing innovative financing mechanisms across Africa, notably by leveraging technology. For instance, bond issuance for informal businesses is one of the financing solutions being explored by a working group formed by various actors from the public and private sectors. The idea of these “informal bonds” is to enable well-organized and well-governed business groups to facilitate access to financing for their members. Key proposed features of such a bond issue include:

• the provision of mutualized guarantees backed by a government agency, financial institutions, bilateral or multilateral partners, and beneficiaries,
• the use of mobile payment platforms,
• and the selection of a strategic issuer (who issues the bonds), possibly among microfinance institutions.

For such innovative financing schemes to attract investors and make a difference, large-scale implementation is required. For this very reason, caution needs to be exercised in rolling them out, notably by overcoming potential risks of correlation among assets held by informal businesses.

Ultimately, any financing solutions targeted at the informal sector may carry significant risks, including the risk of exclusion due to the digital divide, infrastructure bottlenecks, unequal access, and non-inclusive design. But, if designed inclusively, the potential they provide for creating opportunities for vulnerable individuals, women, and youth in the informal sector is worth taking these risks. Success on this front would create many positive spillovers, including for efforts to promote financial inclusion, support legal migration, and empower women.