How Leasing Contributes to Economic and Financial Sector Development IFC’s Experiences Mamta Shah Chief Financial Officer Credit Review Department

2 Agenda Leasing defined Overview of the leasing industry worldwide Why has leasing grown so fast Impact of leasing –Economic development Micro, Small and Medium Sized Enterprises (MSMEs) –Financial sector development –IFC’s experience Role of the Regulator / Enabling environment Trends in Leasing Industry Conclusions

3 Leasing defined Two kinds of leases: –Operating lease or hire-purchase –Financial lease We will discuss only financial leasing. The difference between the two being that operating lease is not a means of financing equipment purchase – only short-term use of equipment: e.g., car rentals. Maintenance and obsolences risk lie with the leasing company as against the lessee in financial leasing.

4 Financial Leasing A contractual arrangement that allows one party (the lessee) to use an asset owned by the leasing company (the lessor) in exchange for specific periodic payments. This requires: –Separation of legal ownership from economic use –Credit analysis focuses on lessor’s cash generation capacity to finance lease payments rather than relying on credit history –Security is the asset itself As such, this product is particularly suitable for new Micro, Small or Medium Sized Enterprises (MSMEs) without a long credit history of financial statements.

5 Overview of the Leasing Industry Historically, leasing dates back to thousands of years – where the industry has developed from being a manufacturer’s selling technique to a stand- alone specialized financial service industry. First leasing firms started in the US in 50’s; then in Europe and Japan in the 60’s; and since the 70’s, leasing has been spreading to many developing nations In 2001, over US$476 billion of new vehicles, plant, machinery and equipment were financed through leasing.

6 Overview (Cont’d) Africa region accounted for US$3.8 bn less than 1% of total volume The top four countries in leasing volume are U.S., Japan, Germany, and the U.K. South Africa remains the largest leasing market in the Africa region with a volume of US$2.79 bn Substantial scope for future growth – globally, annual leasing volumes as a percentage of GDP average about 1.5% (U.S. 2.3%).

7 Leasing Industry in the Developing Countries Since the late 70’s, many developing nations have been developing their leasing industries. The most spectacular increases being in Asia, led by Korea –In 1994, South Korea’s leasing market was 5 th largest in the World – an industry which was started in 1975 with IFC’s investment in Korea’s first leasing firm. Growth of leasing in Africa, Asia and S. America exploded in the early 90’s but stagnated over the last 5 years.

8 Why has Leasing Grown so Fast Leasing has filled the gap for financing the un- met demand for a key sector in any Economy – MSME MSME are mostly shunned out from the formal banking sector due to high transactions costs, and as well as other considerations.

9 Why has Leasing Grown so Fast For Lessee: Fewer requirements about balance sheets. Leasing may be the only source of financing No outside security/collateral needed Low documentation cost Leasing can finance a higher % of equipment than bank loans Governments allow lessees to deduct full lease payments from their income before tax. Beneficial to both lessee and lessor:

10 Why has Leasing Grown so Fast For Lessor: Ownership of asset Transaction costs lower Lighter regulations, because they are not deposit taking institutions. Tax incentives, although they are eroding. Better control on utilization of funds. Beneficial to both lessee and lessor:

11 Why has Leasing Grown so Fast For Lessee: Fewer requirements about balance sheets. Leasing may be the only source of financing No outside security/collateral needed Low documentation cost Leasing can finance a higher % of equipment than bank loans Governments allow lessees to deduct full lease payments from their income before tax. For Lessor: Ownership of asset Transaction costs lower Lighter regulations, because they are not deposit taking institutions. Tax incentives, although they are eroding. Better control on utilization of funds. Beneficial to both lessee and lessor:

12 Economic Contribution of MSMEs in Select African Countries Country MSMEs %SME as % of Total Enterprise formal employment Algeria9960 Egypt9955 Mali Morocco Mozambique Nigeria Source: World Bank Group SME Department

13 Importance of Leasing for MSMEs Leasing may be the only source of financing as access to capital markets or bank loans is difficult given the small size of these companies and/or their unproven track record. Government support of leasing industry is thus an indirect support of MSMEs. Also, increases competition in financial services.

14 IFC’s Experience in the Leasing Sector IFC has 25 years experience with 179 leasing projects in 56 countries From , IFC approved 1.02 billion financing for leasing companies Key success factors for IFC’s leasing companies/transactions have been: strong sponsors, access to competitive local currency financing, stable and good legal and regulatory frameworks, and last but not least, good structuring of the financial transactions on IFC’s part. Most of IFC’s leasing projects have had strong positive impacts on private sector development particularly in the MSME sector, where they have pioneered financing for a previously under- served market segment. In most cases, IFC invested in the first leasing firms in a country.

15 IFC’s Roles in Promoting Leasing Companies Leasing regulatory framework Fiscal regime Legal issues Draft legislation Technical Assistance Feasibility Study Size of potential market Obstacles to growth Local funding Identify Sponsors Local – with funding or distribution capability Foreign technical partner Business Plan Structure company Organization and management Operating Policies And Agreements Prudential guidelines Shareholders’ agreements Articles of association Funding Local term funds Foreign funds Governance And Follow-up Financial Board Later loans Rights issues Bond guarantees Securitization

16 IFC’s Experience in Leasing (Cont’d) Impact on Broadening the Financial Sector Development: Leasing companies have helped develop capital markets by increasing financing options for segments of the market which previously relied on informal financing, supplier credit, and internal cash generation – Filled the gap left by banks Impact on Capital Markets: As leasing firms grow, their needs for diversified funding sources becomes eminent – leading to the use of securitization, issuances of bonds and other capital instruments. Increased Competition: The entry of leasing firms in financing the MSME has encouraged competition in many markets, whereby some of the banks started to go down- market in order to serve the smaller clients.

17 Challenges Facing the Leasing Industry Funding – Leasing companies are not deposit-taking institutions and access to long-term funding is a critical success factor Eroding tax benefits – the tax benefits of leasing are gradually eroding, opening the industry to strong competition from the banking sector. Regulatory environment changes – While the leasing industry typically has less stringent regulation, changes in law impact operations substantially. Lack of deep pocketed shareholders in the absence of capital markets. Too much concentration in a sector Lack of a robust secondary market for certain equipments. Risk management not managed.

18 Enabling Environment: Legal and Regulatory Aspects Strengthening Leasing Laws –Lessor’s ownership over the assets funded must be clearly stipulated with simple, effective and timely procedures for repossession if lessee defaults –Lessee and possession rights – to ensure uninterrupted use for the length of the lease –Central Registry of charges Supervision and Regulation –Restrict leasing to Licensed operators –Prudential Requirements – less strict than for deposit-taking institutions

19 Enabling Environment: Tax and Accounting Lessor – Lessors can typically take the benefit of depreciation expense as a shield against taxes. This advantage has been eroding in the recent past. Lessee – Lessees can offset their full lease payments against income before tax Sales Tax – Post contract sale of assets is typically exempt from sales tax Accounting – Accounting for Leases is done under IAS 17 internationally Cross Border Issues

20 Trends in Leasing Industry Customers: –Smarter –Diverse –Seek more Alternatives –Service Conscience –Understand Asset Management –Trending to Technology Products: –Assume/Manage more Risk –Solution Packages –Leases with Other Financing Packages –Venture Leasing Leasing Companies: –Specialization –Diversification –Consolidation –Globalization –Branding, Relationship, Image Building Rules and Regulations –Distinction Between Lease and Loans –Expanded Public Official Understanding –Global Harmonization of Accounting

21 Conclusions Leasing is an important source of funding for MSMEs, which are key drivers of economic development in developing countries. There is substantial scope for future growth in the industry, particularly in developing countries. However, the industry faces financial and regulatory challenges which must be addressed to promote its growth. IFC’s experience has shown that leasing is instrumental in assisting the development of the financial sector, and of the economy as a whole.