How Leasing Contributes to Economic and Financial Sector

Development

IFC’s Experiences

Mamta ShahChief Financial OfficerCredit Review Department

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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

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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.

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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 offinancial statements.

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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 financedthrough leasing.

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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%).

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Leasing Industryin 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 5th 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.

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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.

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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:

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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:

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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:

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Economic Contribution of MSMEsin Select African Countries

Country

MSMEs % SME as %

of Total Enterprise

formal employment

Algeria 99 60

Egypt 99 55

Mali 99 45-55

Morocco 93 50-55

Mozambique 90 45-55

Nigeria 96 50-55Source: World Bank Group SME Department

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Importance of Leasingfor 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.

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IFC’s Experiencein the Leasing Sector

• IFC has 25 years experience with 179 leasing projects in 56 countries

• From 1977-2002, 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.

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IFC’s Roles in Promoting Leasing Companies

• Leasing regulatory framework

• Fiscal regime

• Legal issues

• Draft legislation

TechnicalAssistance

FeasibilityStudy

• Size of potential market

• Obstacles to growth

• Local funding

IdentifySponsors

• Local – with funding or distribution capability

• Foreign technical partner

BusinessPlan

• Structure company

• Organization and management

OperatingPoliciesAnd

Agreements

• Prudential guidelines

• Shareholders’ agreements

• Articles of association

Funding

• Local term funds

• Foreign funds

GovernanceAnd

Follow-upFinancial

• Board• Later loans• Rights issues• Bond

guarantees• Securitization

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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.

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Challenges Facingthe 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.

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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 thanfor deposit-taking institutions

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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

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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

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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 thedevelopment of the financial sector,and of the economy as a whole.