Credit guarantee schemes in Africa are often hit or miss affairs with the guarantor often unable to pay claims. But a variation on the theme developed in Latin America appears to have come up trumps.

What is the rationale for a guarantee scheme that costs 20m naira to pay only 0.4m naira in claims, one moreover that would be insolvent if it paid all claims due? This is how a recent report on credit guarantees published by the Food and Agriculture Organisation (FAO), concluded its small chapter on Africa, which was almost entirely devoted to Nigeria's Agricultural Credit Guarantee Scheme.

What later emerged is that Nigeria is not the only country where the government had established a fund to guarantee certain bank loans, only to deny practically all claims for lack of capital. Malaysia provided another example of a virtuous guarantee scheme turned vicious. Most national guarantee schemes actually fail to produce 'additionality' in the form of more credit or better credit terms for the target groups - for instance specific sectors of the economy.

Even when they do produce additionality, guarantee schemes remain too expensive and thus unsustainable. A rare exception has been the scheme launched in Latin America by Accion International. Its originality lies in the fact that the fund, capitalised with both institutional and individual donations and loans from a development institution (USAID), is invested in government securities and used as collateral for guarantees made under standby letters of credit (LICs) issued by a first class international bank in favour of local banks.

These standby LICs cover a varying percentage of loans made to affiliates of Accion, which in turn on-lends the funds to micro borrowers at market rates. Explains the UN report, 'this mechanism achieves substantial leverage. Each dollar in the Bridge Fund supports a letter of credit by Citibank to a local bank for $1.30 ... the local bank issues a line of credit for $2.25-$2.90. As the loans are short term ... leverage can reach $8.80 per year'.

If handled with the same care, there is no reason why a similar scheme could not be replicated in Africa and so encourage the provision of credit to some of the most neglected segments of the population.

But the effect of credit guarantees can also extend beyond supporting particular economic groups. Based on a study of the development of mortgage, municipal debt and other bond guarantees in the US, the UN report concluded that guarantee schemes could also contribute to the development of financial markets. Moreover, they could become self-sustaining, even profitable.

What is needed is the ability to achieve economies of scale on both sides of the equation. Primarily, enough guarantees must be issued to amortise the huge capital investment required to set up guarantee schemes and also free resources for product diversification. In addition, guarantee schemes need deep and large debt markets to shed some of the risk associated with existing guarantees - thus permitting the offer of new guarantees.

Interestingly, the report stresses that in the US it was 'the government (which) first created the preconditions by establishing government sponsored enterprises to make secondary markets in home mortgages and by giving tax-exempt status to certain forms of municipal obligations... Only from this base market did the guarantee industry begin its relentless expansion into other areas of finance.'

To kickstart a similar process in developing countries, explained the report, international development organisations may be needed. And only a scheme operating on a regional basis could reach the required critical mass.

The focus of the UN report was on credit guarantees schemes for the benefit of small and medium-sized enterprises and microlenders. But guarantees already form part of many financing transactions, as will be confirmed by a quick glance at the most common forms and sources of guarantees available today.

Leading the group of non-commercial providers of guarantee are export credit agencies. They tend to intervene through the issuance of guarantees covering long-term loans made by commercial banks to buyers of a particular exported good.

Donors also provide investment insurance and other forms of credit enhancement on a bilateral or multilateral basis, either directly (eg, MIGA) or through related or affiliated institutions. Inversely, local government guarantees of large trade or project financing have all but disappeared in most developing countries with the advent of market liberalisation.

Transactions rely increasingly on the private sector to provide insurance and guarantees that cover specific commercial, political and market risks, to the extent that guarantees have now become an essential ingredient of some of the most sophisticated financial products.