How Zanzibar can boost private financing and initiate capital markets

In Zanzibar, the Government has strong and unambiguous aspirations of promoting sustainable development and improving societal welfare. As such, the target is to accumulate a capital amounting to the United States Dollar (USD) 3.4 billion for financing strategic programmes, projects and initiatives (SPPI) between 2021 and 2026.

Particularly, these key components of socio-economic development have been identified as cornerstones for accelerating economic growth that will be inclusive in nature and sustainable human development: the blue economy sectors, infrastructure, as well as social welfare with respect to education, health, and social protection. Private and innovative financing options, either on their own or through Public Private Partnerships (PPPs) are poised to play a vital role in financing development investments; about USD 1 billion is anticipated to be amassed from these avenues.

Based on the financial economics perspective, investments made by the private investors take place in different forms and the private sector financing is typically rooted from diverse sources. In Zanzibar, the private sector financing has largely been derived from direct foreign investment (FDI) and handful local direct investment is notable in some cases.

However, the economy of Zanzibar, which is characterised by non-existence of the domestic capital markets and bank lending as the predominant source of capital, has not been successful in linking and integrating diverse large, small and institutional investors from domestic and foreign markets to accumulate significant capital. Under such circumstances, the main challenge facing Zanzibar’s economy is how to ascertain realistic.

The identification of private financing options and setting the favourable environment to attract private financing is crucial because traditionally public revenue generated domestically through revenue collection and internal borrowing, as well as external sources is rather inelastic and very limited.

This leaves a significant funding gap that in reality can be more quickly and efficiently be filled by the private and innovative financing sources. Emanating from this particular setting, the paper explores private and innovative options to finance development investments between fiscal year 2023/24 and 2025/26.

It examines ways to lessen the existing challenge faced by policy makers of the lack of available evidence on identifying the appropriate private and innovative financing options that fit the existing political-economy context to amplify capital formation by the private sector. Moreover, the paper proposes key issues to create readiness for operationalizing the private financing of strategic investments in Zanzibar.

Why is exploration of private financing options crucial for accumulating capital?

In Zanzibar, there is eagerness to catalyze domestic markets to improve the market efficiency to attract capital from the private investors to be allocated to the strategic investments. Past experiences indicate that the public revenue is not sufficient to finance the required development investments, and this situation advocated for a higher financing from the private investors.

Yet, the major challenge is that, apart from the foreign direct investors who are seemingly able to access capital from their countries of origin, the ability of local markets to accumulate significant capital is relatively frail.

Only about 32 per cent of the total number of investments registered by Zanzibar Investment Promotion Authority (ZIPA) from 2017 to 2021 were owned by the domestic investors and expected to accumulate capital of UDS 565 billion5 compared to the capital from foreign investors of USD 2 billion, according to the OCGS (2021). Such an amount of registered potential investments is remarkable for a small developing economy like Zanzibar, but unfortunately not many of these investments actually take place.

The economy of Zanzibar has been steady over the past decade with impressive economic growth and low inflation. Zanzibar has achieved an average of 6 per cent annual real GDP growth during the past 10 years.

In common with other SIDS, Zanzibar lacks resilience to the unpredictability of exogenous economic shocks with a rather undiversified economy. The economic growth is mostly driven by tourism sector which is the leading source of income, foreign currencies and foreign direct investments (FDIs). As of the year 2021, the tourism sector, for instance, contributed 47.1 per cent of the GDP (OCGS, 2022). The private sector is still at an infant stage and dominated by small and medium enterprises (SMEs), which is incapable of accumulating significant capital to be invested in large development projects.

Despite being able to achieve a relatively impressive economic performance, Zanzibar has underdeveloped capital markets, and as a result most of private investors mainly rely on banks as a leading source of capital, which tend to offer somewhat long-term corporate debt (for example, 7 years) at the interest rate of more than 14 per cent (Private Sector Development Policy, 2020). In this regard, they show a similar obstacle as small investors who over rely on banks as the leading source of external financing in other countries.

In Zanzibar, the local investors in Zanzibar face high cost of borrowing and limited access to external financial markets, and these challenges can be attributed to the information asymmetry and lack of domestic based investment vehicles to undertake the role of capital allocation.

Inactive domestic capital markets encompasses significant economic consequences as it increases the cost of capital, rises diversifiable market risk and restricts the utilization of sophisticated financing instruments – such as private equity (large shareholding, Crowd-funding from small equity holders, and venture capitalists); debt (Blue Bond; Diaspora Bonds; and Islamic based investment securities); and mezzanine financing – that are capable of catalyzing the domestic capital markets and also facilitating the integration of diverse investors, such as small, large, institutional, local and foreign.

What is most required for an economy like Zanzibar is the availability of investment tools that can make private sector financing thrive so that capital markets can allocate capital to the most profitable investments in the near future. In reality, this is difficult given that banks are not permitted to invest directly using various investments vehicles in Zanzibar.

The challenge for policy makers is then to find ways to boost the capital allocation from the unproductive investors to the more productive investors and at the same time, provide opportunities for a more dynamic capital markets with adequate instruments to accumulate capital from diverse investors in an innovative manner and exit options.

The above-described setting ultimately may incentivize Zanzibar to use private and innovative financing options containing many cross-border implications. Its economy is well positioned to eventually play a vital cross border service provider role linked to trade in the blue economy, for instance, through block chain tracking system, Islamic financing and offshore banking. Innovative financing options are also considered crucial due to their positive multiplier and spill-over effects on the overall economy. It is exceptionally crucial for Zanzibar, considering that it does not have autonomy of regulating banks and financial institutions, to identify realistic innovative and private financing options to escalate the magnitude of accumulated capital from domestic and foreign investors. Diverse large investors may limit the expropriation by controlling shareholders and reduce the agency costs.

Against this analytical backdrop, we argue that private and innovative financing options are pathways to finance development projects and catalysing domestic capital markets in Zanzibar. The inflow of FDI on its own may not provide sufficient capital required for financing development economic investments in Zanzibar. It is logical to assume that the most effective route to attract private and innovative financing is by having profitable, attractive and bankable investments. Capital formation in Zanzibar should involve building the confidence of the investors by creating an enabling environment for private investments to thrive and continue incentivizing investors through various “sweeteners”.

Creating readiness and operationalizing the private financing options

Investment cases and financial valuation which demonstrate feasibility of each economic project to generate appropriate investment return for the invested capital and to produce social benefits (in case of innovative financing option) are crucial for successful employment of innovative private financing options.

Propensity to magnify the capital pool from each financing option depends on specific investment cases to convince the investors and tap capital from the proposed investment instruments. This in due course will help to improve the effectiveness of capital allocation and market exit mechanisms, which is crucial for catalyzing the domestic capital markets and exit options to suit the investment holding preference of diverse investors.

Apparently, the Revolutionary Government of Zanzibar does acknowledge that private investors need to play a more visible role to finance development projects, and this implies ownership of means (and physical infrastructure). The main challenge, however, is how to do that in the absence of an active stock market as is the case at the moment.

In the long run, it will be optimal to have the stock market to create market liquidity. Before being able to do that, the creation of PPP Fund for development investments can fill this gap by creating an investment vehicle for small and large investors from both domestic and foreign markets to invest through all financial instruments, such as: equity, mezzanine financing and debt – direct lending and corporate and innovative bonds.

Evidence from financial valuation based on various risk adjusted return scenarios is a prerequisite to accumulate significant capital from both domestic and foreign investors to invest their funds. To attract more private financing and new innovative financing, the relevant government entities will make sure that they do much more than foster enabling business environment by unpacking projects that are expected to be financed and prepare investment valuation to demonstrate their expected cost of capital, specific risk, expected return, and options to expand or exit.

Crucial risk factors and their mitigation tools

Domestic Private Financing Options

Firstly, the potential risk of low participation of the locals in the capital formation through the domestic financial institutions and investing in the PPP Fund for development investments. This may be mitigated by providing instruments for large and small investors, and giving continued education and compelling investment cases to persuade private investors to invest.

Secondly, there are risks associated with domestic investors including economic risk and substantial change in the business environment. However, the creation of the PPP Fund will diminish such risks by having different investment portfolios for risk diversification. Lastly, the lack of credible credit rating mechanism often depresses markets’ ability to allocate capital in the economy. Mitigation measures can involve the effective utilisation of credit reference and rating.

External Private Sources for Development Investments

Numerous policy efforts and legal framework to create an optimal environment for foreign investors have been put in place in Zanzibar. Yet, there are three remaining major risks that continue to surface and threaten the existing opportunity for unlocking more capital from foreign investors.

1. An absence of financial instruments to tap capital from small individual investors, including diaspora who are scattered across the globe. The establishment of PPP Fund for Development Investments can lessen this risk by presenting various instrument vehicles loaded with different instruments to cater for diverse investors’ preference and risk appetite.
2. Foreign investors naturally would be concerned with the risk of PPP Fund not being managed by competent investment managers. To address this risk, the Fund should be managed by independent competent experts from inside and outside of Zanzibar hired based on skills and criteria set by its financers. The Fund can be listed at the Dar es Salaam Exchange (DSE) for issuance of its investment securities while the establishment of the stock market in Zanzibar is underway.
3. There is also liquidity risk, which is associated with the inactive capital market and lack of stock exchange for easy trading of the financial products. Active trading of the security issued by PPP Fund at the secondary markets can mitigate this risk.

Digital Transformation

It is obvious that private financing and digital transformation entail a two-way causal relationship for developing economies like Zanzibar. Efforts to attain development of the creative and digital economy to diversify and complement the service sector will be determined by the magnitude of the private capital, while the opposite is also true. Private financing and digital transformation are inseparable, the missing link is how to identify optimal practical ways to increase the fitness of Zanzibar to build a prosperous future through these determining factors.

ZiBi Team