The National Bank of Ethiopia (NBE) recently issued a circular on the legality of interest-bearing private loans, which will have a significant implication on access to finance and investment in Ethiopia. In the circular dated October 08, 2023, the NBE, in a far-fetched argument, equated “lending with interest” with “providing banking business without a license” and declared interest-bearing private loans to be illegal.
Theoretically, investors may structure their investments in different ways. Debt and equity are the major ones. There are also hybrid structures, such as convertible debts, that combine the elements of both debt and equity. The choice of investment structure depends on the stage of the investee and the risk tolerance of the investor.
It is common practice in different jurisdictions for investors to manage their risks through adopting different investment structuring tools. This is an important risk management strategy for investors to protect their capital. In Ethiopia, however, investors never had that luxury. The only viable option for investors to structure their investments is in the form of equity. Although debt seemed like an option from the outset, there were two major restrictions against debt structuring.
- Foreign Loan: The NBE has a special regulation dealing with foreign/external loans. This directive requires all external loans to be approved with the NBE before being entered. Not every business is eligible to get such financing. Either it needs to be an exporter, a foreign investor, or a business engaged in the manufacturing sector. The terms of this loan are also not freely negotiated between the parties, the rate of interest, other fees, and expenses on such loans cannot exceed six months LIBOR Plus 2% for foreign loans with maturity periods of up to 3 years; six-month LIBOR Plus 3% for maturity period between 3-5 years; and six-month LIBOR Plus 5% for loans with a maturity period of 5 years and above.
- Domestic Loan: the legal stand on domestic loans was not clear. The only provision related to peer-to-peer loans was the provisions of the Civil Code, which under Article 2479 provides that parties to a loan agreement cannot stipulate a rate of interest exceeding 12% per annum. The recently enacted Commercial Code also provides for the use of debentures as a means of finance only for share companies.
These restrictions were raised in the past as bottlenecks on investors’ structuring options and practically take debt structuring out of the equation for investors (both domestic and foreign). This is especially true when we take into consideration the macroeconomic situation of the country. With the inflation rate standing close to 30% and banks’ average lending rate set above 20%, there is no economic merit in private investors operating under the above restrictions. Aggravating all of this, NBE’s recently issued circular that criminalizes interest-bearing private loans makes it even more impractical to use debt as a structuring tool.
What are the Potential Impacts of this NBE Circular?
- A Threat to Access to Finance for Start-ups and SMEs – The government has been working on different reform measures to improve access to finance for start-ups and SMEs. The gap is mainly attributed to the inaccessibility of formal banking finance to this segment of the economy. The position of the NBE with the issuance of this circular is particularly going to affect start-ups and SMEs, as they often have difficulty qualifying for loans from traditional financial institutions.
- Impact on Investors – The NBE’s circular will also have a negative impact on investment in Ethiopia. Private investors often play an important role in providing financing to startups and SMEs. If investors are not allowed to structure their investments in any other form than equity, it could discourage investment in these companies due to the high risks associated with such investments.
- Encouraging Black Market Lending: Businesses that would need to finance themselves one way or another will likely turn to black market lenders, which typically charge high interest. This could ruin several businesses and force them to go out of business.
Conclusion
Overall, as reflected in the circular, it seems like NBE has taken a stand that protects the interests of the banking sector in the interest of the investment community. Businesses’ ability to access finance is correlated with a functioning regulatory framework that connects businesses with lenders and investors willing to take a risk. The country’s regulatory framework needs to be attractive to investors in terms of ensuring a variety of financing options, including debt, equity, and hybrid financing structures. In this regard, we expect a number of positive measures from the Ethiopian Capital Market Authority (ECMA) that will counter the effects of such circulars in terms of:
- Streamlining the regulatory framework for debt and equity instruments: The ECMA should make it easier for businesses to issue debt and equity securities by streamlining the regulatory process and reducing regulatory costs.
- Promoting other financing instruments that are tailored to the needs of Ethiopian businesses: The ECMA can play a role in developing and promoting specific financing instruments, such as asset-backed securities and other structured finance products, that are tailored to the needs of Ethiopian businesses. These products can help mobilize capital from domestic and international investors and provide businesses with access to a wider range of financing options.
By taking these measures, the ECMA can help to make Ethiopia’s regulatory framework more attractive to investors and ensure that businesses have access to the financing they need to grow and thrive.
