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Introduction
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.
- 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.
- 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.
- 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.
- 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).
- 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.
- 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.
- 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)
By Jude
Uzonwanne, Department
of Economics, Swarthmore College, USA
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