In mid-March 1998, the United States House of Representatives passed the Africa Growth and Opportunity Act, a bill that is in many ways revolutionary. It radically redefines the economic relationship between Africa and the United States. Among its provisions is a clause that grants good manufactured in Africa duty free access to American markets. It also provides incentives and support for American firms doing business on the continent.

The importance of the bill lies in its capacity to provide the platform for Africa's economic transformation into a group of high performance economies, posting double-digit growth rates. On the back of this bill will come a significant influx of foreign investment, especially American, transforming Africa into something paralleling East Asia's miracle economies.  The possibilities, once the right set of investment decisions and government policies are put in place, are phenomenal.

However, before the investment drive begins, it is vital that African policy makers locate their thinking about the future within the current architecture of the global financial system and the lessons it yields up today.  The goal of my paper, is to help them do just that.  I will review the state of private capital flows today, the nature, extent and drivers of these flows, and the lessons they provide.  An examination of Africa's current experience within that system would occur in order to develop a perspective on how African policy makers can initiate changes that would enable them to maximize the benefits that the Growth and Opportunity Act is expected to create, and avoid the pitfalls highlighted by the recent East Asian financial crisis.

Private Capital Flow Facts in 1998

A financial revolution of sorts is under way in global markets.  The nature and extent of capital flows has undergone significant transformation since the crisis field days of the 1980s.  Today, private flows outnumber official flows by a factor of 5. In 1996, net private capital flows exceeded $260 billion.  At that level, it was six times greater than the value for 1990 and four times the historic peak of 1978-82.

Of all the aforementioned flows, developing country share in global foreign direct investment stands at 40 percent, a remarkable rise from 15 percent in 1990.  At the same time, developing country share of global portfolio equity currently stands at 30 percent of all flows, an astronomical jump from 2 percent in 1990.  In addition, the share of foreign capital in emerging market domestic investment is 20 percent in 1996, a jump from 4.1 percent in 1990. Second, the composition of capital flows has also evolved at the same time.  Currently, foreign direct investment plays a much more compelling role than it did a decade ago, while traditional bank lending has fallen at the same time.  Third, the recipients are now increasingly private sector actors and not government.  However twelve leading emerging markets account for 80 percent of flows in 1990-95, while new entrants (140 out of 166 developing countries) have access to the remaining 20 percent of flows. Fourth, flows of capital have withstood the Mexican and Asian crisis well, and even though American interest rates rose after Mexico, we have not seen a home coming of capital. 

Forces Shaping the Revolution

What are the forces driving the changes seen since 1990?  Surprisingly enough, it is largely the same forces as in the past.   First, investors are still searching for higher returns, that controlling for multiple risks, exceed those available from United States Treasury Bills.  The range of returns appears to average 16 - 18 percent in all developing countries, and almost 30 percent in Africa.  Second, investors are looking to diversify their risks, and in so doing raise the probability of a high returns on investment. 

There are two additional forces that the World Bank identifies as playing a significant role. These are internal and external financial deregulation in most countries. Most countries since the debt crisis have been undergoing some of the most extensive deregulation process in the recent economic history. Immediate examples include the transition economies, sub-Saharan Africa, East Asia, and Japan (the proposed Big Bang). Second, advances in communication technology, information technology, and financial instruments have supported the deepening of global financial flows. For example, telephone systems are more extensive and cheaper and telephony rates have risen.  The age of electronic mail is today. On Wall Street, the emergence of firms such as DE Shaw, an investment bank, that employs advanced computers and software to conduct arbitrage trading has also played a key role.  Spillovers from the development of Silicon Valley; the invention of new financial instruments that provide more sophisticated investment opportunities, and betters ways of hedging risk such as derivative instruments; and equally important; the proliferation of numerous infrastructure financing opportunities have also supported the process.  Together, these changes have created a new phase of structural changes that is driving the integration of global markets.

Beyond Integration: The Benefits & Costs

Economic actors around the world have chosen to tap into the financial flows for a variety of reasons.  To briefly review, they include: to raise investment, diversify risks, smooth consumption and investment, extract knowledge spillovers, develop more efficient resource allocation, and strengthen their domestic financial sector.  The experience has however not being without its costs.  As the recent Asian crisis demonstrate in chilling fashion, when investor confidence evaporates, the speed and depth of capital flight can be brutal.  And integration into global financial markets can expose distortions and institutional flaws of an economy with consequences akin to Mexico's peso crisis.  Cast in positive light, what these experiences have taught policy makers, are the real causes of financial problems.  Today, the body of knowledge about the origins of financial crashes is unquestionably more robust, thus ensuring that if governments act rationally, they can stave off many problems.  Below, we examine some of the causes of volatility in financial flows.

When Integration Goes Sour: The Sources of Volatility

While the costs of integration are obvious, especially to those facing the prospects of capital flight when investor confidence disappears, to avoid these, it is important that policy makers spend some time understanding the sources of investor doubt, flight of fancy, or skittishness.  It is important to understand the sources in order to control or minimize their occurrence.  There are two main sources of volatility, international and domestic. 

(I) International Factors

Changes in international interest rates and other asset returns, and terms-of trade changes can trigger capital outflow.  If Alan Greenspan where to authorize an American rate increase, it could trigger an inflow of funds back into the United States, especially into US T-Bills. Regarding terms of trade, case in point is oil; currently oil is at approximately $14 a barrel, from about $17 in January 1998.  For an exporting country, such a severe shift in terms of trade (ratio of export to import prices), since price of imports have not fallen, is cause for concern.  Levels of uncertainty will rise among investors as to the country's ability to pay its import bills; investor expectation that a budget deficit will ensue might lead to capital outflow.  Exit takes place perhaps because of concern as to how the government will finance the deficit: by printing currency (driving up inflation), borrowing on domestic or international markets.  The role of foreign investors cannot also be ruled out in the equation of determinants of volatility of capital flow.  Erratic investor behavior has also been identified as a cause of volatility.  Case in point is Southeast Asia where investors fled from Singapore, Hong Kong and Korea, once Thailand and Indonesia developed liquidity problems following currency devaluation.  At that stage, investor ability to differentiate between markets starts to diminish, and investors start viewing markets as one and the same!

(II) Domestic Factors

Domestic real shocks (sectoral shocks; sudden changes in weather conditions; the impact of El Nino on cocoa and coffee; cold snaps on orange juice.) can trigger capital outflow.  Another driver, domestic policy shocks, (sudden, unexplained shifts in government policy such as moving from a free float to fixed exchange rate; or suddenly re- instituting capital controls to stave off capital flight; will lead to fluctuation in capital inflows. 

Volatility's Discriminatory Nature

However not all economies experience volatility in the flows of capital. Some economies possess certain structural traits that exacerbate investor reaction to what may be short shocks.  The World Bank identifies four such traits that magnify volatility.  

1. Weakness in financial markets: such weakness may take the form of poor banking practices such as seen in Indonesia, China and Thailand, over-extension of the financial system leading to a proliferation of bad loans on the books, sectoral over lending, and absence of depth to the financial system.
2. Weakness in capital market structure: non-existence or inadequacy in the capital market structure, forcing investors to raise funds only in commercial bank.  It also means that the market for commercial paper is weak.
3. Emerging markets are marginal in international investors portfolios: when all is said and done, visualize the size of an typical emerging economy, then compare it to the American economy; or think about firms like Fidelity Mutual Funds, whose Magellan Fund manages about $59 billion. That fund alone exceeds the size of many developing country gross domestic product.
4. Asymmetric information problems between foreign and domestic investors:  sometimes there is an information gap between domestic and international investors with one group having more extensive access to data than other groups.  We see this quite acutely in Indonesia, and Thailand.  There is some evidence available that some domestic investors were privileged as to the dire straits in which their central banks were, the state of foreign reserves, and the level of bad loans in the financial system, and thus made adequate adjustments, namely liquidated assets before the currency collapse.   

The Sources of Financial Blessing

Then, what determines a country's access to private capital flows?  There are number of metric on which a potential investor would evaluate an economy.  If successful on all, it is more likely than not that a positive investment decision will be made.  According to World Bank research, these include: Open markets: transparency in labor, input, output, and financial markets is useful. In addition, an outward orientation does not appear to hurt either. Minimal regulation: the less bureaucracy heavy an economy is, the better. This argument is based on Anne Krueger and Jagdish Bhagwatis work that demonstrates that extensive regulation of an economy creates opportunities for rent seeking and distortionary economic activity.

Good infrastructure facilities: the existence of a good transport, and communication system is vital.  For example, one of the reasons investors cite about not doing significant levels of business in Africa is the fact that there are more telephones per person in Manhattan than in the entire African continent outside of Republic of South Africa. Low production costs: transaction costs must be kept to a minimum in order not to cut into the profits that nominally should come from economic activity.  If manager have to spend up to 70% of their time lobbying government officials as they do in Russia, and some other former Soviet economies, it creates additional costs that raise the cost of the product and must  be passed into the final price tag, or extracted from profits.

Political stability: economic activity is notoriously difficult to carry out in the midst of civil strife.  If a society is stable, with predictable government activity, clear costs and expectations, then investors do not have to think twice before locating there.  Consider this thought experiment: where would you be more willing to invest, Afghanistan under the Taliban, with warfare in the background, or Singapore with a government that is the least corrupt, most transparent and technocratic in the world?

The African Case: Evidence

Having discussed the theory, let's examine the case of the worlds most controversial region when it comes to the question of capital inflows. The Africa evidence, at least as gathered from the World Banks recent survey is fascinating.   First, countries with positive per capita growth received the largest flows.  Second, growing economies showed improved aggregate flows.  Third, the patterns of capital flow is differential; CFA countries, who suffered massive capital flight during the 1980s, have not fared well of late.  Cote d'Ivoire is however the exception.   Non-CFA countries that faced similar balance of payments challenges and capital flight in the 1980s, have recovered faster than the CFAs since 1990.

The Africa evidence becomes even more instructive when broken down by type of capital flow. 

A.  Foreign direct investment:  FDI has increased especially in non-CFA countries with positive per capita growth.  Angola, Botswana, Ghana, Mozambique and Uganda are leading recipients.  In 1994-95, FDI as a percentage of GDP compared favorably with Latin America and Asia.  In addition, the rate of FDI return during 1990-94 averaged 24 - 30 percent; for all developing countries, it was 16 -18 percent. 

B. Private Loan: Private loans from banks are still low or negative. After the debt crisis of 1980s, most commercial banks are not lending yet. They are trying to recover the ones they lent before.  It should however be emphasized that African economies with the exception of Nigeria and Cote d'Ivoire borrowed mostly from multilateral organizations such as the IBRD.  The reason for the dearth of commercial bank loans can be seen in country level credit ratings.  These are still low; most African banks have junk bond or BBB rating.  There are very few triple-A ratings.  The implications are clear: when you borrow, you will need to pay a significant premium above the London Interbank rate.

C. Portfolio equity flows: portfolio flows are still small but growing. Their growth is a powerful signal of rising investor interest and confidence.  Since 1994, 12 Africa oriented funds have emerged to manage over $1 billion in asset. Examples include the Morgan Stanley Africa Growth Fund, the New Africa Investment Fund, and The Calvert Africa Fund. In addition, the focus of these funds has expanded from South Africa to Botswana, Cote d'Ivoire, Ghana, Kenya, Mauritius, Zambia, and Zimbabwe. For African economies, the benefits are clear: improved liquidity, greater incentives for privatization, increased incentives for policy reforms and improvement of financial infrastructure.

Why Has Africa Being Wanting in Investment Flows?

Having extolled the progress thus far in deepening private capital flows into Africa, it is even more important that we understand why flows have been weak.  There are a number of factors that constrain investor enthusiasm.  These include political instability and weak macroeconomic fundamentals, weak or low growth, the size of markets, and a high degree of inward orientation.  Structurally, factors that inhibit investment include heavy regulations, corruption, slow progress on privatization, limitations on number of listed private firms, limited pool of investable assets poor infrastructure, high production costs, and high indebtedness (overhang effect). 

Reversing the Season of Financial Anomie

To ensure that Africa continues to attract private investment, it is vital that African policy makers claim as their own a reform agenda that among other things, call for the following:

A.  Micro reforms:

Micro reforms that reduce transactions costs, reduce corruption.  For example, efficient securities trading system.  There is a keen need for computerization of clearing system that would allow securities to clear within hours.  A number of countries have already embarked in that direction.  A significant amount of legal reform also needs to take place, in order to ensure that transactions distortions are minimized.  For example, corporate laws need to be reformed to allow more transactions like mergers and acquisitions,  bankruptcies, and leveraged buyouts.  The broader goal is to improve the transparency of property rights laws.  For the long term, African governments should encourage their best firms to explore listing on international exchanges, who often have more stringent disclosure and accounting requirements.  Aside from exposing these firms to global best practice, it creates knowledge spillovers, and broader investor perception of the listing firms home economy. 

B.  Macro reform

Policy makers need to put more emphasis on raising output growth, deepening openness, ensuring relative stability of real effective exchange rate (by using floating exchange rates), and maintaining low external debt.  These are conditions that foster high investment rates by domestic and international investors. At the same time, African governments need to embark on wider privatization of state-owned enterprises.  Far too many investors complain that enough has not been done to reduce the role of the state in the economy. I believe they are right. African economies stand to gain the most from a big bang approach to reform relative to a gradualist approach; too many opportunities for growth have been squandered while awaiting gradualist outcomes to reform;  African economies need to undertake speedy policy and structural reforms to attract private investors. Here the issue is one of shock therapy versus gradualism. Some countries believe you extract the best returns if you move slowly and take all stakeholders with you. A second school of thought argues that in order to reduce potential for manipulation and corruption you must push it through; also you reduce transaction and transition costs - the adjustment is swift and briefly painful, rather than spread out over years, during which external shocks could deepen costs even further. Nigeria is a classic case in point. 

Before the Transformation, Learn the Lessons of East Asia

Why are the lessons from Asia's financial crisis important to Africa?  To the cynics, Asia's experience since July 1997 is proof of the dangers associated with an export-led growth strategy.  While interesting, that analysis misses the point.  The real lesson Asia offers is this: export-led growth (in its various permutations) is successful so long as countries never forget the first principles of running a successful economy.

In essence, do countries run into problems because investors are irrational, or if the weakness of country-specific fundamentals deepened vulnerability to speculative attacks? Why does balance of payments crisis occur?  It appears that balance of payments crisis, triggered by self-fulfilling speculative currency attacks, take place with multiple equilibria.  Often triggered by one economy's weakness (e.g. Mexico, or Thailand), they spread to other economies only if these economies also exhibit fundamental weaknesses. This spreading is what is known as the Tequila (or contagion) effect. 

For an economy to become infected, its immune system must exhibit weakness.  Thus, Sachs et al (1995) put forward a hypothesis: vulnerability to balance of payments crisis can be anticipated by examining three fundamental variables.  These are a large appreciation of the real exchange rate, a weak banking system and low levels of foreign exchange reserves.  A real exchange rate appreciation during periods of high capital inflow automatically generates expectations of a subsequent devaluation. The weakness of a banking system (low supervision and examination) can become problematic following a surge in loans as expectations rise that risky projects would have been financed. In the event of a capital outflow, investors are likely to convert liquid domestic assets into a convertible currency, prompting additional capital flight.

As African states reform their economies to attract a higher percentage of global private capital flows, it is important that we keep in mind the lessons of two recent financial crisis, Mexico and Asia.  In the wake of the Mexican crisis, Harvard's Jeffrey Sachs and a group of other economists came up with a model of financial crisis that can give one a pretty good handle on why Asia is experiencing its difficulties.  The paper is somewhat technical but useful for clear thinking about financial crisis.  As I discuss it, I will present anecdotal evidence from the recent Asian crisis to illustrate.   Sachs et al argue that three central factors gave rise to Mexico (and arguably Asia's financial crisis).

1. overvalued real exchange rate: reports quietly sent to the Thai and Indonesian during 1996 and early 1997 made it clear that their currencies where overvalued by as much as 30 -60 percent.  They chose to ignore the data, preferring to be brazen and defend the currency.  At the same time, government spending continued to mount, further driving up the deficit, much of it financed by dollar denominated loans.
2. a recent lending boom in the financial sector (hints at less rigor in determining credit worthiness). A number of banks in southeast Asia had obtained loans denominated in dollars and lent them out to borrowers in local currency terms, often in economies where exchange rates and interest rates are fixed. That is fine so long as the risk profile of the loans is minimal.  Unfortunately in an effort to make large profits, many bankers in southeast Asia began to make loans to the real estate sector, a sectors with overvalued asset prices.  Once prices in the sector began to collapse (responding to pure demand and supply pressures), they could no longer repay their loans.  Since local borrowers cannot repay, international lenders cannot be repaid either.  Naturally, the contagion spreads and the rest is history.
3. low foreign reserves to defend a fixed exchange rate: depending on your school of thought, a fixed exchange rate is dangerous.  I do not like them as it means that when the markets believe a devaluation is coming, they will go 'short' on your currency. If you decide, like Hong Kong did to defend it, you will merely hand a free $25 billion to traders who went short on you.  For a variety of other reasons, its best to stick to a floating rate. 

Lessons from Asia

Are there any useful lessons that sub-Saharan African economies can learn from the East Asian crisis?  Four potential lessons, all linked to the efficient functioning of the financial system. 

a) First, if a government senses that her financial institutions are developing problems, she should not hesitate to decisively tackle the problem before it leads to an implosion of the relevant economy.  For example, take Nigeria's recent decision to close insolvent banks plagued. I would argue it was a wise decision. .  Their poor performance will hamper the effectiveness of other well run banks. What is central is that a financial system allocates credit efficiently.  If we have to liquidate badly functioning banks that contribute to the system's allocative inefficiency, so be it. In the medium to long term, the citizens will be the winners because their hard won savings will be channeled to investments that yield the highest returns and not those that politicians say they should go to. 

(b) A second lesson centers around the question of central bank independence.  The ability of central bankers to focus on single objectives such as price stability (and inflation control) is virtue that feeds into maintaining general macroeconomic stability.  Equally importantly, it signals to investors and other economic actors that the government's capacity to intervene in economic management for a variety of reasons is severely constrained. 

(c) A third lesson is on the need for an efficient financial system regulatory infrastructure.  One of the strengths of the American financial system is the regulatory excellence of the Federal Reserve Bank System.  Using numerous teams of bank examiners and regulators, they quickly spot flaws in the financial system that could be detrimental to the U.S economy, and potentially the global economy.  One of the criticisms leveled against Southeast Asia's economies is the weak regulatory structure for monitoring bank activity.  In the presence of a better regulatory system, the maturity, and interest mismatch, and numerous bad loans that plagued these institutions may have been spotted much earlier before they wrecked havoc.  In too many countries, the need for well trained and capitalized bank regulators and examiners is underestimated until the financial system approaches collapse under the weight of bad loans.  It is an unnecessary risk that African countries should not expose themselves to given the linkages between the financial system and the broader economy.

(d) Fourth, so long as one is willing to dispassionately examine the evidence, it becomes clear that balance of payments crisis are often self-induced.  Blaming the IMF will do no good.  The central lesson: lean up your house; do not leave an economic mess. And perhaps most importantly, the cold logic of the market will ensure that laggards are forced to shape up.  Corruption and cronyism, poor judgement of credit worthiness, and the sheer incredulity of attempting to defend a fixed exchange rate will break a country's economic back.  Tough lessons but one that increasingly a number of countries are learning.

Concluding Remarks

The world is starting to rethink Africa's role in global markets.  A new excitement is developing.  The new interest and its associated optimism is captured in a recently released report edited by Harvard economist Jeffrey Sachs and Klaus Schwab, President of the Word Economic Forum.  Ranking the economies based on data generated from measures of transparency in decision making, good governance, financing, labor, infrastructure and institutions, the report demonstrates that small, dynamic, stable economies with solid export bases perform best."  Or put another way, the economies that emulate the conditions undergirding the East Asian miracle. Thus, if their success is to be guaranteed in the medium to long term, it may be wise to internalize the lessons of the problems we see in Asia to prevent a repeat performance down the road.

The challenge African economies and technocrats will be facing the years ahead is this: how to exploit the growing investor interest in their markets to create a virtuous cycle of growth.  Second, how do you strengthen the institutional architecture of economies to prevent capital flight and minimize its consequences when it does take place.  To effectively tackle these challenges, it may be useful to retain in mind the strategic lessons World Bank researchers have noted:

  That developing countries need to pursue policies that would allow them to efficiently tap into global financial integration; that initial reactions to capital inflow will largely shape the patterns of future response;

that there is wisdom to curbing lending booms associated with capital inflows while redesigning the institutional structure of the financial system;

that it is wise to develop a well functioning financial system to reduce the risks of potential instability as well as attract global portfolio investment;

that developing countries need to build better shock absorbers and develop mechanism to respond to instability because they will remain highly vulnerable to external shocks for a while to come;

that international cooperation between regulators and adequate disclosure of information at all levels are increasingly important to ensuring safe and efficient markets

References

Sachs, Jeffrey, D., Aaron Tornell, and Andres Velasco. 1995. "Financial Crisis in Emerging markets: The Lessons from 1995." Brookings Papers on Economic Activity, 1:1996.

IMF. Prospective Link With EMU Poses Challenge For CFA Franc Zone IMF Survey January 12, 1998, 15-16.

World Bank. 1997. Private Capital Flows to Developing Countries. (New York: Oxford University Press)