Economic Report on Africa 2006 · 2014-06-09 · Economic Report on Africa 2006 Capital Flows and...

Economic Commission for Africa

Economic Report on

Africa 2006Capital Flows and Development Financing in Africa

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Edited, designed and printed by the ECA Publications and Conference Management Division (PCMS).

iiiTable of Contents

Table of Contents

Acronyms ix

Foreword xi

Acknowledgements xiii

Overview 1

1 Recent Economic Trends in Africa and Prospects for 2006 311.1 Introduction 31

1.2 Theglobaleconomywaslargelyfavourablein2005 32

1.3 OverallgrowthperformanceinAfricaremainedstrong 33

1.4 Macroeconomicbalancescontinuetoimprove 42

1.5 Despitehighgrowthperformance,importantdevelopmentchallengesremain 47

1.6 Growthprospectsfor2006arepositive 56

1.7 Conclusionandpolicyrecommendations 59

References 61

2 Capital flows to Africa and their impact on growth 632.1 Introduction 63

2.2 TrendsincapitalflowstoAfrica 65

2.3 DeterminantsofcapitalflowstoAfrica 77

2.4 ImpactofcapitalflowsonAfricangrowthandeconomicdevelopment 82

2.5 Conclusion 87

References 89

AppendixA:Tables 95

AppendixB:DebtReliefunderHIPCandMDRI 97

iv Economic Report on Africa 2006

3 Capital Flows and Factor Markets 993.1 Introduction 99

3.2 Foreigndirectinvestment(FDI)anddomesticlabourmarkets 100

3.3 FDIanddomesticinvestment 108

3.4 Officialdevelopmentassistanceanddomesticfactormarkets 110

3.5 Remittancesalsoplayanimportantroleininvestmentandjobcreation 112

3.6 Casestudies:FDI,domesticinvestmentandjobcreationinEthiopiaandGhana 114


References 124

4 Capital Flows and Economic Transformation 1274.1 Introduction 127

4.2 Africaneedsstructuraltransformation:whatcancapitalflowsdo? 129

4.3 KeyconstraintstostructuraltransformationinAfrica 137

4.4 ExperiencesofcapitalflowsandeconomictransformationinAfrica 144


References 153

5 Economic Policy, Institutional Environment and Capital Flows 1575.1 Introduction 157

5.2 Asoundmacroeconomicenvironmentisessentialforattractingcapitalflows 158

5.3 Thegainsfromeconomicreformsforcapitalflowshavebeensmall 161

5.4 Capitalinflowshaveposedchallengesformacroeconomicpolicymanagement 164

5.5 Africancountriesneedtofurtherconsolidatemacroeconomicstability 167

5.6 TheinstitutionalenvironmentforincreasingcapitalflowstoAfrica 168

5.7 Conclusion 175

References 177

6 Absorption Capacity and Management of Capital Flows 1836.1 Introduction 183

6.2 FinancialDevelopmentandAbsorptiveCapacity 183

6.3 Managingcapitalflows 194

6.4 PolicyRecommendations 199

References 201

vCapital Flows and Development Financing in Africa

Boxes1 ImportSubstitutionStrategies(ISSs)andAfrica’sfailedtransformation 12

2 ExportProcessingZoneinMauritius 14

3 Micro-levelinstitutionalreformsareimprovingbutmoreisneededtoencourageinvestment 17

4 ECA’scontributiontocapacitybuildingforcapitalmarketdevelopment 20

5 AidinflowsandtheexchangerateinAfricancountries 21

6 SouthAfricanexperiencewithcapitalandexchangeratemanagement 22

2.1 EquityflowstoSouthAfrica-anexception 71

2.2 Experienceswithdebtrelief:UgandaandMozambique 76

2.3 Nigeria’sdebtdeal 77

3.1 Wagepremiumsinforeign-ownedenterprises 105

3.2 Mobilizingremittancesthroughcollectivemigrantorganizations 114

3.3 Unilever’ssubsidiarycreatesthousandsofjobsinGhana 122

4.1 Importsubstitutionstrategies(ISSs)andAfrica’sfailedtransformation 144

5.1 ExperiencewithinflationtargetinginSouthAfrica 162

5.2 TheExportProcessingZoneinMauritius 176

5.3 China’ssuccessinattractingforeigncapital 177

6.1 ECA’scontributiontocapacitybuildingforcapitalmarketdevelopment 196

6.2 SouthAfricanexperiencewithcapitalandexchange-ratemanagement 198

vi Economic Report on Africa 2006

Figures1 ResourcegapsinAfricancountries,1980-2003(%ofGDP) 1

2 NetfinancialflowstoAfrica,1993-2005(billionUSD) 2

3 RealGDPgrowthrateinAfrica,2003-2005(%) 4

4 ResourceinflowstoAfrica,1980-2003(currentUSDbillion) 7

5 Corruption,RuleofLawandRegulatoryQualityinAfricaandotherregions,2004 15

6 Costofstartingabusinessandenforcingcontracts:Sub-SaharanAfricaandotherregions 16

1.1 RealGDPgrowthrateinAfrica,2003-2005 34

1.2 Top10andbottom5performersinAfricain2005(%realGDPgrowth) 35

1.3 GrowthofrealGDPinAfricanoil-vs.non-oileconomies,2003-2005 37

1.4 Growthbysub-region,2003-2005 39

1.5 Top10andbottom5performersinAfrica,1998-2005(%averageannualgrowth) 41

1.6 OfficialdevelopmentassistancetoAfrica(constant2003$billion) 46

1.7 Africancountrieswithatleast25%investment-GDPratio,2000-2003 48

1.8 Grossdomesticfixedinvestmentandsaving(%ofGDP)inAfrica,1975-2003 49

1.9 Top10andbottom5performersinhumandevelopment,%changeinHDIbetween1995and2003 51

1.10 Gendergapinenrolment(female/maleratio)in2002. 55

1.11 ProjectedrealGDPgrowthratesbysubregion,2006(%) 56

2.1 Resourcegapsin36Africancountries,1980-2003(%ofGDP) 63

2.2 ResourceinflowstoAfrica,1980-2003($billion) 65

2.3 ResourceoutflowsfromAfrica,1980-2003($billion) 66

2.4 ODAreceiptsbyAfricansubregion,1980-2003(%ofGNI) 68

2.5 InwardFDIandGNI,AfricacomparedtoWorld,1980-2003(%) 69

2.6 NetFDIinflowsandprofitrepatriationonFDI,1980-2003($billion) 70

viiCapital Flows and Development Financing in Africa

2.7 Workers’remittancesbyAfricansubregion,1980-2003(%ofGNI) 73

2.8 DebtstocksanddebtservicepaymentsofAfricanHIPCandnon-HIPCcountries,1980-2003(%ofGNI) 75

3.1 NetFDIinflowsandgrosscapitalformationinEthiopia($US),1990-2004(%ofGDP) 117

3.2 NetFDIandgrosscapitalformationinGhana($US),1990-2004(%GDP) 120

3.3 FDI’scontributiontogrosscapitalformationinGhanaandEthiopia,1990-2004(%GCF) 121

4.1 Agriculture’svalueaddedasapercentageofGDPinAfricaandotherregions,1970-2003(%ofGDP) 132

4.2 Industry’svalueadded,1970-2003(%ofGDP) 132

4.3 AgriculturalvalueaddedperworkerinSub-SaharanAfrica(constant$US2000) 133

4.4 AgriculturaluseoftractorsperworkerinAfricaandotherregions(1960-2004) 134

4.5 BilateralODAflowstoAfricabysector(%oftotal) 135

4.6 BilateralODAflowstotheenergysectorinAfrica($million) 135

4.7 Grosscapitalformation(%ofGDP) 139

4.8 EnergyproductioninSub-SaharanAfricaandothersub-regions,1971-2002(millionkwh) 142

4.9 AveragecapitalflowstoTunisia($USmillion) 148

4.10 ForeigndirectinvestmentinMauritius(BoP,currentmillionof$US) 150

5.1 RealEffectiveExchangeratesforSelectedAfricancountries 167

5.2 Corruption,RuleofLawandRegulatoryQualityinAfricaandOtherRegions,2004 171

6.1 Bankcredittotheprivatesector(%ofGDP)insub-SaharanAfrica 190

6.2 FDIandfinancialdevelopment,1994-2003 192

6.3 FDIandmanufacturingsectorgrowth,1994-2003 193

viii Economic Report on Africa 2006

Tables1 Summaryofgrowthperformanceover1999-2005 5

2 InterestratespreadsandinterestratedifferentialsinselectedAfricancountries 19

1.1 DistributionoffiscaldeficitsinAfrica,2004and2005(numberofcountries) 42

1.2 DistributionofinflationratesinAfrica,2003-2005(numberofcountries) 43

1.3 ProgressinachievingtheMDGsinAfrica 52

1.4 Gendergapineducation,1990-2002 54

A1 LevelandvariabilityofcapitalflowsaspercentofGNI(1980-2003) 95

A2 Selectedcapitalflightestimatesforsub-SaharanAfrica 96

3.1 Estimatesofemploymenteffectsofforeignversusdomesticinvestmentinsub-SaharanAfricancountries,1990-2002 104

3.2 InvestmentprojectsinoperationinEthiopia–July1992toJuly2005 118

3.3 EmploymentcreationinforeignversusdomesticprojectsinGhana,January2001–September2005 122

4.1 Correlationbetweencapitalflows,growthandindustry’sshareinGDP 138

4.2 Correlationbetweencapitalflows,growthandmanufacturing’sshareinGDP 138

4.3 Growthaccountingdecompositionbyregion,1960-2000average 140

4.4 IndicatorsofeconomicgrowthandtransformationinTunisia,MauritiusandNigeria,1970-2003 146

5.1 ComparisonofCorruptionPerceptionIndexacrossRegions,2005 172

6.1 Averageinterest-ratespreadandinterest-ratedifferentialinAfricancountries 191

6.2 Africancapitalmarkets:keycharacteristics 194

6.3 Financialrisks,andexamplesofwarningsignsandpolicyresponses 200

ix

Acronyms

AATIC Asia-AfricaTradeandInvestmentConferenceACGD AfricanCentreforGenderandDevelopmentAfDB AfricanDevelopmentBankAGOA AfricanGrowthandOpportunityActAIDS AcquiredImmunodeficiencySyndromeAPRM AfricanPeerReviewMechanismAU AfricanUnionBoP BalanceofPaymentsCMA CommonMonetaryAreaCOMESA CommonMarketforEasternandSouthernAfricaCOSATU CongressofSouthAfricanTradeUnionsCSO CivilSocietyOrganizationDAC DevelopmentAssistanceCommunityDRC DemocraticRepublicofCongoDFID DepartmentforInternationalDevelopment/UKECOWAS EconomicCommunityofWestAfricanStatesEIC EthiopianInvestmentCommissionEIU EconomistIntelligenceUnitEPZ ExportProcessingZoneEU EuropeanUnionFAO UnitedNationsFoodandAgricultureOrganizationFONDAD ForumonDebtandDevelopmentGCF GrossCapitalFormationGDI GrossDomesticinvestmentGDP GrossDomesticProductGDS GrossDomesticSavingsGIPC GhanaInvestmentCommissionGNI GrossNationalIncomeHDI HumanDevelopmentIndexHIV HumanImmunodeficiencyVirusHDI HumanDevelopmentIndexHIPC HeavilyIndebtedPoorCountry

Acronyms

x Economic Report on Africa 2006

ICT InformationandCommunicationTechnologyIDA InternationalDevelopmentAssociation/WBILO InternationalLabourOrganization/UNIMF InternationalMonetaryFundLDC LeastDevelopedCountryMENA MiddleEastandNorthAfricaMNC MultinationalCorporationNEPAD NewPartnershipforAfrica’sDevelopmentNER NetEnrolmentRateM&A MergersandAcquisitionsMDG MillenniumDevelopmentGoalMSE MediumandSmallEnterpriseMDG MillenniumDevelopmentGoalMDRI MultilateralDebtReliefInitiativeNEPAD NewPartnershipforAfrica’sDevelopmentNGO Non-governmentalOrganizationNICI NationalInformationandCommunicationInfrastructureODA OfficialDevelopmentAssistanceOECD OrganizationforEconomicCooperationandDevelopmentREC RegionalEconomicCommunityR&D ResearchandDevelopmentREER RealEffectiveExchangeRateSAP StructuralAdjustmentProgrammeSME SmallandmediumenterpriseSRO-CA SubregionalOfficeforCentralAfrica/ECASRO-WA SubregionalOfficeforWestAfrica/ECASRO-NA SubregionalOfficeforNorthAfrica/ECASRO-SA SubregionalOfficeforSouthernAfrica/ECASSA Sub-SaharanAfricaUN UnitedNationsUNDP UnitedNationsDevelopmentProgrammeUNEP UnitedNationsEnvironmentalProgrammeUNHCR UnitedNationsHighCommissionforRefugeesUNICEF UnitedNationsChildren’sFundUNCTAD UnitedNationsTradeandDevelopmentConferenceUNU UnitedNationsUniversityWAEMU WestAfricanEconomicandMonetaryUnionWFP UnitedNationsWorldFoodProgramme

xi

Continuingtheeconomicrecoverysincethemid-1990s,Africancountriesgener-ally recorded stronggrowth in2005, amajor turnaroundafterdecadesof eco-nomic stagnation. However, growth remains uneven across countries, and inmany countries, fast growthhasnotbeen accompaniedby substantial gains inemploymentorpovertyreduction.TheAfricancontinentthuscontinuestofacechallengesofachievingandsustaininghighergrowthratesaswellastranslatinggrowthintoemploymentandpovertyreduction.

ConstrainingtheabilityofAfricancountriestoaccelerateandsustaingrowtharevariousimbalances,betweenexportsandimports,betweenresourceinflowsanddebtpaymentsandbetweendomesticsavingsanddomesticinvestment.Africancountriesthusneedtomobilizemoredomesticandexternalfinancialresources,includingofficialandprivatecapitalflows,tofillthefinancinggapsinordertoaccelerategrowthandsustainhigherlevelsofgrowth.

Thisyear’sEconomic Report on Africa placescapitalflowsatthecentreofthedebateondevelopmentfinancingandexamineshowexternalcapitalcanhelpcountriesaccelerategrowthandreducepoverty.TheReport’sobjectiveistoshedlightonhowmoreandbetter-managedcapitalflowscouldhelpAfricancountriesachievetheirdevelopmentgoals.

The Report notes that African economies are still on the sidelines of financialglobalization.Capitalflowshavenotrespondedsignificantlytomacroeconomicreforms since the mid-1980s, and the volume of capital inflows – official andprivate–stillfallsshortofAfrica’sneedstofillitsresourcegaps.Moreover,capitalflowstoAfricaarehighlyvolatileandunpredictable,increasingmacroeconomicuncertainty and undermining government’s ability to design and sustain long-termdevelopmentplans.

Foreigncapitalinflowsareconcentratedinextractiveindustries,explaininginparttheir limited impacton employment andeconomic transformation. Efforts toattractadditionalexternalcapitaltoAfricamustbeaccompaniedbystrategiestoencouragemoresectoraldiversificationofforeigninvestment,especiallytargetingactivitieswithhighpotentialforemploymentgeneration.

EvenasAfricancountriesseekwaystoincreasetheinflowsofofficialandprivatecapital,theyneedtobeawareofthepotentialnegativeeffectsofasurgeintheseinflowsontheireconomies.TheReportpointsoutthatwithappropriatecapital

Foreword

Foreword

xii Economic Report on Africa 2006

managementstrategies,Africaneconomiescouldabsorbhigherexternalcapitalwithminimaladverseeffects. Inotherwords, there isampleroomfor scalingupexternalresourcestosupportAfrica’seffortstoaccelerategrowthandreducepoverty.

It ismybelief that theanalysisandrecommendations in thisyear’sReportwillbeavaluableinputtopolicymakersinAfricaandtheinternationaldevelopmentcommunity,intheireffortstomobilizetheincreasedfinancialresourcesneededtoachievetheinternationallyandnationallymandateddevelopmentgoals.

Abdoulie Janneh ExecutiveSecretary

xiii

This Economic Report on Africa 2006 was prepared under the general supervi-sionoftheformerandcurrentExecutiveSecretariesoftheUnitedNationsEco-nomicCommissionforAfrica(UNECA),K.Y.AmoakoandAbdoulieJanneh,respectively.AugustinFosu,DirectoroftheEconomicandSocialPolicyDivision(ESPD),UNECA,guidedtheteamthatproducedthereport.LedbyLéonceNdi-kumana,thisteamincludedKwabiaBoateng,AdamElhiraika,JulianaGonsalves,Kavazeva Katjomuise, Ralf Kruger, Emmanuel Nnadozie, Vanessa Steinmeyer,Reto Thoenen, SherVerick, and SusannaWolf. Adrian Gauci also contributedsignificantlytothereport.TheteamalsoappreciatestheresearchassistancefromDeresseDegefa,TsedaleDemissie,andThiekoroDoumbia,administrativeassist-ancebyRozaHabtewold,andsecretarialsupportbyAsnaketchAmdeandAzebMoguesse.

Thereportbenefitedgreatlyfromcommentsandsuggestionsprovidedbyinternalandexternalreviewers.Theinternalreviewerscomprisedprofessionalstafffromvarious divisions at Commission headquarters, as well as representatives fromits Subregional Offices (SROs). The in-depth reviews of the following externalreviewerswereparticularlyenriching,namely,IbiAjayi,ElizabethAsiedu,HaileKebret,andUnaOsiliOkonkwo.

Theeditorial,coordinationandmediaoutreachcontributionsmadebyMaxJar-rett,CristinaMüller,andMercyWambuioftheInformationandCommunicationSection(ICS),aswellasbyBruceRossLarsonofCommunicationsDevelopmentInc.(CDI)aregreatlyappreciated.WealsowishtoexpressappreciationtothestaffmembersoftheEnglishandFrenchTranslationandEditorialUnitsaswellasthestaffoftheDocumentPublishingandDistributionUnitofthePublicationsandConferenceManagementSection(PCMS),forediting,textprocessing,proofread-ing, translation, design and layout, quality control, print anddisseminationofERA2006.

Acknowledgements

Acknowledgments

�

African countries continue to face a perennial shortage of resources to financepublicandprivateinvestment,whichconstrainstheirabilitytoaccelerategrowth.

Thechronicresourcegaparisesfromimbalancesbetweenexportsandimports,betweenresource inflows and debt payments, and between domestic savings and domesticinvestment (figure 1). Resource shortages limit the ability of governments on thecontinenttoundertakepublicexpenditureininfrastructureandsocialservicesneededtoboostdomesticdemand,encourageprivatesectoractivity,andsustainhighlevelsofeconomicgrowth.

Figure �Resource gaps in African countries, 1980-2003 (% of GDP)

Source: World Bank 2005a.

Note: The ratios are GDP-weighted averages for 36 African countries with data for all indicators and all years.

Tofillthefinancinggapsandaccelerategrowth,Africancountriesneedtomobilizemore domestic and external financial resources.While official development assist-ance(ODA)hasincreasedrecentlyinnominalterms,theresourcesreceivedexcludingemergencyaidanddebtreliefincreasedonlymarginallyfromthepastdecade(UN2006).Andrealaidinflowsarestillbelowthe1990levels.AidtoSub-SaharanAfricahasdeclinedbothasapercentageofgrossnationalincome(GNI)andasapercentage

Overview

The perennial shortage

of investment constrains Africa’s

ability to accelerate growth

� Economic Report on Africa 2006

ofgrosscapitalformation(GCF)sincetheearly1990s.From6.5%in1990-94theaid/GNIratiodeclinedto5.3%in2000-03.Theaid/GCFratiofellfrom40.7%to27%duringthesameperiod(McKinley2005).

WhileAfricancountriesstilldependheavilyonofficialaid,itisencouragingtonotethattheyareattractingmoreprivatecapital.Indeed,netflowsofprivatecapitalhaverisenwhilenetofficialflowshavedeclinedandturnednegativeover thepastyears(figure2).Netprivateflowsrosefromanaverageof$6.8billionin1998-2002to$17billionin2005,whilenetofficialflowsdeclinedfromanetinflowof$1.2billiontoanetoutflowof$9.5billion.

Note,however,thatprivatecapitalflowsareunequallydistributedacrosstheconti-nent,withoil-richcountriestakingthelion’sshare.During2002-04Angola,Chad,EquatorialGuinea,andNigeriaaccountedforacombined39% oftotalforeigndirectinvestment(FDI)tothecontinent.Theoilsectoraloneaccountedformorethan90% ofFDIinAngola(UNCTAD2005a).

Figure �Net financial flows to Africa, 1993-2005 (billion USD)

Source: UN 2006.

Africa’sshareinglobalprivateflowsremainsverysmall,andprivatecapitalflowsarestill insufficient to compensate for the shortage in official financing.With privateflowsheavilyconcentratedinextractiveindustries,whicharenaturallycapitalinten-sive,theeffectonemploymentcreationremainslimited.Theconcentrationofforeigninvestments in extractive industries alsoperpetuatesAfricancountries’dependence

Still dependent on foreign aid,

Africa is attracting more private capital

�Overview

onprimarycommoditiesandexposesthemtotheadverseeffectsoffluctuationsininternationalcommodityprices.

Theyear2005wasmarkedbypositivedevelopments in the internationalcommu-nity’scommitmenttosupportnationalandregionaldevelopmentefforts inAfrica.NoteworthydevelopmentsincludetheglobalreviewoftheMillenniumDevelopmentGoals(MDGs)bytheUnitedNationsGeneralAssembly,thereportoftheCommis-sionforAfricaledbyPrimeMinisterTonyBlair,oftheUnitedKingdom,andtheG8meetingondevelopmentfinancingforAfrica.Theseeffortsneedtobesupportedbystrategies forenhancingefficiencyofaidutilisationandbetter targetingofpovertyreductioninnationaldevelopmentagendas.

Thisyear’sEconomic Report on Africa(ERA2006)placescapitalflowsatthecenterofthedebateondevelopmentfinancingandexamineshowtheseflowscanhelpAfricancountriestoaccelerategrowthandreducepoverty.TheobjectiveistoshedlightonwhetherandtowhatextentmoreandbettermanagedcapitalflowswillhelpAfri-cancountriesachievetheirdevelopmentgoals.Thereportfirstpresentsevidenceontherecentandmedium-termmacroeconomicperformanceofAfricaneconomies.Itthenevaluatesthetrendsandvolatilityofcapitalflowsandtheireffectsoneconomicgrowth.Next,itexploresthelinkagesbetweencapitalflowsanddomesticfactormar-kets–labormarketsandinvestment–withaviewtodrawinglessonsonstrategiestoharnesstheeffectsofforeigncapitalonhosteconomies.Thereportalsoexploresthepotentialofcapitalflowsinpromotingdiversificationofproductionandexportsandin facilitatingtheoverall transformationofAfricaneconomies. It furtherexaminestheroleofdomesticconditions,includingthemacroeconomicpolicyframeworkandtheinstitutionalenvironment,inbothattractingandabsorbingcapitalflows.Afterdiscussing strategies for minimizing financial fragility through appropriate capitalmanagementtechniques,ERA2006closeswithasummaryofthemainfindingsandkeypolicyrecommendations.

Macroeconomic performanceIn2005AfricaneconomiesrecordedanotherhighGDPgrowthrateof5.4%,follow-ingtherecord5.2%in2004,thehighestinalmostadecade(figure3).1Africa’sgrowthin2005wasthesameasthatoftransitioneconomies,higherthanLatinAmerica’s(4.3%),butlowerthanAsia’s(6.5%,excludingJapan).Onadisaggregatedlevel,asmanyas25Africancountriesrecordedfastergrowthin2005relativeto2004.

1 ThedatausedinthisdocumentarebasedonstatisticsrevisedinSeptember2006.


Figure �Real GDP growth rate in Africa, 2003-2005 (%)

Source: Economist Intelligence Unit (EIU), September 2006.

Thestronggrowthperformancein2005,asinrecentyears,representsamajorturna-roundfromdecadesofeconomicstagnation.Whatexplainsthestrongperformanceofthepasttwoyears?Afavourableglobaleconomicenvironmentwascharacterizedbyhighdemandfor(andpricesof )Africa’smajorexportcommodities.Performancewasgoodinsuchsectorsasagricultureandservices.Macroeconomicmanagementcon-tinuedtoimprove,resultinginlowerinflationandbetterfiscalandcurrentaccountbalances.Africancountriesalsoreceivedsubstantial inflowsofexternalresources—includingaid,debtreliefandforeigndirectinvestment—whichshouldcontributetohighergrowthincomingyears.

Asinpastyears,growthin2005wasunevenacrosscountriesandsub-regions.Bene-fitingfromhighoilprices,oilexporterscontinuedtodominate,growingfaster(6.2%)thannon-oileconomies(4.5%).Despitethehighgrowthratesgeneratedbytheoilboom,twobigquestionsremain.Howcanoilrevenuesbetranslatedintosustainablegrowth?Andhowcantheoilboombeconvertedintohigherlivingstandardsforthemajorityofthepopulation?

Africaisexpectedtocontinuewiththestronggrowthpostedoverthepasttwoyears–5.7%in2006,withNorthAfricaleadingallsub-regionswith6.6%.Asmanyas31countriesareanticipatedtoposthighergrowthratesin2006thanin2005.

InthemediumtermAfricancountriesareexpectedtocontinuetobenefitfromcon-tinuing improvements in macroeconomic balances owing to consistent economicreformsandfromcontinuingstrongworlddemandforAfricanexportcommodities.Savingsfromdebtreliefwillalsoboostthegrowthofeligiblecountries.

In 2005 the international

community mobilized to support Africa’s development

�Overview

ButAfricancountrieswillcontinuetofacechallengesthatarelikelytohampergrowth:higherworldinterestrates,weathershocks,inadequateinfrastructureandenergy,andtermsoftradeshocksaccentuatedbyalackofdiversification.Andwhiletheexpectedhighoilpriceswillbenefitoilexporters,theywillcompromisegrowthprospectsforoil-importingcountriesthroughhigherproductioncostsandinflation.

Despite recent robust growth, important development challenges remain

OnedisappointingfeatureoftherecentstrongGDPgrowthratesisthattheyhavenotbeenaccompaniedbymeaningfulgainsinjobcreation,raisingseriousconcernsaboutthecontinent’sabilitytoreducepoverty(UNECA2006).Themaincauses:

• Growthrateshavenotbeenhighenoughinmanycountriestogeneratesuf-ficient demand for labour. Indeed since 1999 only five African countries(9%ofthetotal)haveachievedaveragegrowthofrealGDPof7%,theratedeemedasrequiredtoreachthegoalofhalvingpovertyby2015(table1).

• ThehighvolatilityofGDPgrowthreducesincentivesforjobcreationintheprivatesectorduetotheuncertaintyoffutureprofitability.

• Economic activity has shifted away from agriculture into capital-intensivesectors,suchasminingandoilproduction.

• InmostAfricancountries,employmentcreationisnotintegratedintomac-roeconomicpolicyframeworksasanexplicitgoalofmacroeconomicpolicy.Ittendstobegivenlessimportancethanothernarrowerpolicygoals,suchascontrollinginflationandmanagingbudgetdeficits(Pollinandothers2006).

Table �Summary of growth performance over 1999-2005

GDP growth rate Number of countries Share of total (%)

Less than 3% 15 28.3

Between 3% and 5% 25 47.2

Between 5% and 7% 8 15.1

7% or more 5 9.4

Total 53 100.0

Source: Compiled from Economist Intelligence Unit, September 2006.

AlsoconstrainingpovertyreductionisthehighinequalityinmanyAfricancountries.Inequalitymanifestsitselfinvariousforms:inincomes,inassets,andinaccesstoedu-cation,healthservices,andlabourmarkets.Inadditiontoverticalinequality(acrossincomegroups),countryevidencecontinuestoshowsubstantialhorizontalinequality(acrosssocialgroupsandregions).2Empiricalevidencesuggeststhathighinequalitysub-

2 ForevidenceonregionalinequalityinUganda,seeNdikumanaandNanyonjo(2006)andDeningerandMpuga(2005).ForanillustrationofthepoliticaleconomydimensionofregionalinequalityinBurundi,seeNgarukoandNkurunziza(2000).

Growth rates have been

insufficient to generate

employment


stantiallyreducestherateoftransforminggrowthintopovertyreduction(Fosu2006).Therefore, in addition to strengthening strategies for accelerating growth, achievingbroad-baseddevelopmentmustremainapriorityofnationaleconomicpolicy.

Post-conflict countries face myriad policy priorities

Post-conflictcountriesfaceparticularchallengesarisingfromtheeffectsofwarandtheimmensefinancialneedsassociatedwithreconstruction,forcingpolicymakerstoconfrontmyriadpolicypriorities.Evenso,manypost-conflictcountrieshaverecordedhighgrowthratesinrecentyears,dueprimarilytotherestorationofpeacebutalsotogovernmenteffortstoinvestinreconstruction,oftenwithgeneroussupportfromthedonorcommunity.

Countriesstill inconflictfaceevenbiggerchallengesindevelopment,employmentcreation,andpovertyreduction.Insecurityinthesecountriesalsothreatenseconomicactivity andpolitical stability inneighbouring countries and the region.National,regional,andinternationaleffortsmustbeinitiatedandsustainedtoachievepeacefulsettlementofconflictsandestablishinstitutionalmechanismsofdemocraticgovern-anceasawayofpreventingfutureconflicts(FosuandCollier2005).

Capital flows and development financing

The challenge of chronic resource gaps

Africancountriesfacelargeresourcegapscharacterizedbylargedomesticsavingandinvestment discrepancies and chronic current account deficits (see figure 1). Lowdomesticsavingsarearesultoflowprivateincome,highandchronicbudgetdeficits,andtheinefficiencyofdomesticfinancialsystemsinmobilizingresources.Thenarrowexportbasecombinedwiththedeteriorationofthetermsoftradehasmadeitdifficultforexportstokeeppacewithimports,resultingincurrentaccountdeficits.

The shortage of resources constrains investment and growth on the continent. In2000UNCTADestimated that the investment rate inSub-SaharanAfricahad toincreaseto22-25%from20%inthe1990storeachasustainablegrowthrateof6%(UNCTAD2000).Veryfewcountrieshaveachievedthoseinvestmentrates.Of46countrieswithadequatedata,onlynineachievedinvestmentratesofatleast25%ofGDPduring2000-03(WorldBank2005a).3

3 Theninecountrieswithinvestmentsratesofatleast25%ofGDPin2000-03areTunisia(25%),Gabon (27%), Seychelles (29%), Mozambique (32%), Angola (34%), São Tomé and Príncipe(36%),Mauritania(36%),Lesotho(38%),andChad(46%).

Conflict-driven insecurity threatens

economic activity

�Overview

Theresourcegapsneedtobefilledbycapitalflowsfromabroad, includingofficialdevelopmentassistance(ODA),debtandprivatecapitalflows,suchasforeigndirectinvestment(FDI),portfolioinvestment,andremittances,withODAremainingthedominantsourceofexternalcapitalinmostAfricancountries(figure4).Aggregatefiguresobscuresignificantcross-countryvariationswithinAfrica.Thetopfivelargestrecipientsofaidoverthe1995-2003wereEgyptwith$1.6billionayear,Mozam-bique$1.1billion,Ethiopia$911million,theDemocraticRepublicofCongo$864million, andUganda$752million (WorldBank2005a).Thesefive countries as agroupreceivedanaverageof32%oftheannualaidinflowstothecontinentoverthisperiod.Thetop10recipientsreceivedmorethan50%ofthecontinent’stotalaid.

AlthoughODA is the largest inflow formostAfricancountries,FDIhasbeenmoreimportantsince1980forseveralcountries,includingAngola,EquatorialGuinea,Nigeria,Seychelles,andSouthAfrica.ForNorthAfricancountries,aswellasLesothoandSwazi-land,workerremittanceshavebecomethemostimportantsourceofexternalcapital.

PortfolioflowstoAfricaareverylowbecauseofunderdevelopedequitymarkets.OnlySouthAfrica receives ameaningful volumebecauseof itsdeveloped stockmarket.PortfolioflowstoSouthAfricaincreasedespeciallyafterthedemocratictransitionof1994,peakingat$9billionin1999(WorldBank2005b).

Figure �Resource inflows to Africa, 1980-2003 (current USD billion)�

Source: World Bank 2005b.

Note: The figure includes 46 African countries with adequate data. Angola, Cape Verde, Eritrea, Libya, Mozambique, Namibia, and South Africa are excluded due to lack of data.

4 Totalcapitalflowstothecontinentarehigherthanthosereportedinfigure4.Forexample,totalODAtothecontinentstoodat$26billionin2003,whileODAflowstothe46countriesincludedinfigure4amountedto$21billioninthatyear.

Underdeveloped equity markets limit

portfolio flows to Africa


There are signs of increasing diversification of the source and destination of FDI

WhileforeigndirectinvestmenttoAfricahasrisenovertherecentyears,mostinvest-mentsarestillconcentratedintheprimarysector,especiallyoilandminerals.Evenso,therearesignsofincreasingdiversificationinthesectoralallocationofFDI,especiallytowards manufacturing, agro-industries, textiles, and services. For example, 46%ofChinese investmentson the continent for1979-2000went intomanufacturing(WorldBank2004).AndFDItonon-oilproducingcountrieshas increased,espe-cially since the mid-1990s (Ndikumana 2003a). For example, between 1994 and2003,FDItoMozambiqueincreasedfrom$35millionto$336millionandthattoTanzaniafrom$50millionto$243million(WorldBank2005b).

TraditionallyforeigninvestorstoAfricacamefromEuropeandtolesserextentfromNorthAmerica.Lately,AsianinvestorsfromChina,India,Malaysia,andSouthKoreahavebeenincreasinglyengagedinAfricancountries.Intra-AfricaFDIisalsoincreas-ing,ledbySouthAfricancompanyinvestments,particularlyinSouthernAfrica.Allthis is desirable fromadevelopmentperspective since it providesopportunities todiversifythesourcesofFDI.Moreover,investorsfromtheSoutharemorefamiliarwithadevelopingcountry’senvironment.

Remittances constitute an important potential source of external capital

Remittanceshavebeenrecognizedonlyrecentlyasapotentialsourceoffinancingfordevelopment.TheamountofreportedremittancestoAfricahasincreasedfrom$5.9billionin1980to$14.9billionin2003,withmorethantwo-thirdsgoingtoNorthAfrica (IMF 2005a). In some countries, remittances are large relative to GDP orotherfinancialflows.Forexample,remittancesexceeded5%ofgrossnationalincomeinEgypt,Gambia,Lesotho,Morocco,andSwazilandover1980-2003(WorldBank2005b).InCapeVerdeworkerremittancesrepresentedalmosteighttimesthevolumeofinwardFDIoverthesameperiod.ForAfricaasawhole,remittancesamountedto2.5%ofgrossnationalincomein2003,butunlikeotherregions,itsratiohasnotincreasedsignificantlyoverthepast25years(WorldBank2005b).Actualremittancesaremuchhigherthantheofficialfiguressuggest,though,giventhatanimportantpartoftheremittancesistransferredinformallyandnotrecorded.

Workerremittancesareaparticularlyattractiveformofforeigncapitalbecausetheyaremorestablethanotherforms.Targetedtoreachthefinalrecipients,theyareimmunefromtherisksofdiversionthatmayoccurwithofficialdevelopmentaid(AdamsandPage2003;Lucas2005).Theyarealsoanetfinancialgaintotherecipientcountry.Andtheyhelpmitigate theeffectsofeconomicshocksandshortfalls inhouseholdincome,allowinghouseholdstosmooththeirconsumption.Remittancesmayhelphouseholds undertake greater risk and move out of subsistence. African countriesthusneedtodesignstrategiesforattractinganddirectingremittancesaspartoftheir

10 countries received more

than 50% of the continent’s total aid from 1995 to 2003

�Overview

broadernationalagendaformobilizingdevelopmentfinanceandincreasingdomesticinvestment.

Capital flight constitutes a drain on national resources

Theanalysisof capitalflows toand fromAfrica reveals a curiousparadox.Africancountrieshaveaccumulatedlargevolumesofdebt,presumablytofilltheirresourcegapandfinancetheirdevelopmentneeds.Buttheycontinuetoexperiencemassivecapitalflight,somefinancedbyborrowedfunds.Indeed,empiricalevidencesuggestsquiteironicallythatSub-SaharanAfricaisa“netcreditor”totherestoftheworld—inthesensethattheprivateassetsheldabroadbyAfricansexceedthecontinent’sliabili-tiestotherestoftheworld(BoyceandNdikumana2001;NdikumanaandBoyce2003).ThiscapitalflightdeprivesAfricaofasizableportionoftheresourcesitneedsfordevelopmentfinancing.Italsounderminesdomesticinvestmentandthusreduceslong-term growth. Debates on development financing and financial stability mustpayattentiontodomesticandinternationalstrategiesforcurbingcapitalflightandrepatriatingstolenfundsaswellasenticingtherepatriationoflegitimateprivatecapi-talheldabroad.

TheobservedtrendsofcapitalflowstoAfricaraiseconcernsaboutAfrica’sabilitytomeetitslong-termdevelopmentgoals.Thevolumeofcapitalinflows–officialandprivate–stillfallsshortofAfrica’sneedstofillitsresourcegaps.Andthevolatilityandunpredictabilityofexternalresourcesincreasesmacroeconomicuncertaintyandunderminesgovernment’sabilitytodesignandsustainlong-termdevelopmentplans.Indeed,byintroducinginstabilityintoprivateinvestmentorimports,suchvolatilitymayadverselyaffectgrowth(Fosu2001a).

TheforegoingdiscussionsuggeststhatAfricancountriesneedstrategiestoclosetheresourcegaps,especiallybypursuingeffortsinfourareas.

• First, theyneedtodesignandimplementstrategies to increasetheflowofprivatecapital,especiallytargetinglong-termstableflows,whileencouragingsectoraldiversificationintheallocationofforeigninvestment.

• Second, they need to forge multi-actor and multi-dimensional partner-shipswithbothdevelopedcountriesandadvancedcountriesintheSouthtoincreasethevolumeofnon-debt-generatingexternalresources.AnincreaseinexternalfundingintheformofgrantsisessentialtoAfricaneffortstoachievehighergrowthrateswhileavoidingnewroundsofdebtcrisis.

• Third,theyneedtodesignandimplementstrategiestoretaincapitalathomeand prevent capital flight as a prominent part of the national agenda forresourcemobilization.

• Fourth, they need to raise domestic revenue collection. This will involvemeasuresforreducingcorruptionintaxadministration,increasingautonomyofthetaxauthority,establishingclearandmeasurableperformancetargetsin

Despite large volumes of debt,

African economies experience massive

capital flight

�0 Economic Report on Africa 2006

revenuemobilization,improvingtechnicalcapacityofthetaxauthority,andbroadeningthetaxbase.

Capital flows can influence domestic factor markets and conversely

The relationship between capital flows and domestic factor markets can run bothways.Whiledomesticfactormarketsinfluencecapitalinflows,thevolumeandnatureofcapitalinflowsalsoaffectfactormarkets.

Labor market conditions are an important determinant of capital inflows

BecauseforeigndirectinvestmentinAfricahaslargelybeenconcentratedinthecapi-tal-intensivenatural resource sectors,wages andother characteristicsof the labourmarkethavealimitedimpactonforeigninvestment(Asiedu2004).However,labormarketconditionswillplayanincreasingroleinthefuturegiventheobservedtrendtowardsdiversificationof thedestinationof foreign capital. Indeed, investment inmanufacturingandservicesectorsissensitivetolabormarketconditions.

Marketrigiditiesconstituteamajordeterrenttoforeigninvestment.Africancountriesappeartohaveahigherdegreeoflabourmarketregulationthanotherregions.Theaverageemploymentrigidityindexinthe38Africancountrieswithadequatedatais53.2onascalefrom0to100,thehighestofallregions(WorldBank2006).Comparethatwiththeaverageindexof26.2forEastAsiaandthePacificand40.3forLatinAmericaandtheCaribbean.FortheSub-Saharanregiontheindexrangesfrom10inZambia,theAfricancountrywiththemostflexiblelabourmarket,to90inNigerandtheDemocraticRepublicofCongo,thecountrieswiththemostrigidlabourregula-tions.

Endowmentsinhumancapitalareimportantforattractingforeigncapital,especiallyforeigndirectinvestment(Noorbakhshandothers2001).Foreigninvestorsseekmar-ketswithhighlyqualifiedworkers tomaximize theproductivityof investment. InmanyAfricancountriesthelackofskilledlabourimpedesforeigncapital,especiallyinmanufacturingandservicesectors(Asiedu2002,2005).ThequalityofhumancapitalalsoinfluencestheproductivityandoverallgrowthimpactofFDI(Borenszteinandothers 1998), and low endowments of human capital in Sub-Saharan Africa mayexplainthelimitedgainsfromFDI.

FDI can crowd domestic investment in—or out

Oneissuethathasreceivedsomeattentionintheliteratureiswhetherforeigninvest-mentsincreaseordecreasedomesticinvestmentactivity(UNCTAD1999).Foreigndirectinvestmenthashigherpotentialforstimulatingdomesticinvestmentthanotherformsof private capital inflows (Mody andMurshid2005;Bosworth andCollins

Market rigidities constitute a major

deterrent to foreign investment

��Overview

1999).TheeffectsofFDIondomesticinvestmentmayoccurthroughdownstreamorupstreamlinkages.

InmanyAfrican countries thebulkofFDIflows into thenatural resource sector,though there are signsof gradual shift towards services andmanufacturing sectors(UNCTAD2004).Giventhatthenaturalresourcesectorhasfewlinkageswiththerestoftheeconomy,theconcentrationofFDIinthissectormayexplainthelimitedeffectofFDIondomesticinvestmentinAfrica.

Foreigninvestmentcancrowdoutdomesticinvestmentinvariousways.Onepos-siblemechanismisthepreferentialtreatmentoftenprovidedtoforeigninvestorsintaxbreaks,cashgrants,dutyexemptions,andsubsidies,whicharenotavailableforlocal investors.FDImayalso crowdoutdomestic investment indirectly throughadverseeffectsonfinancialmarketsandexchangerateappreciation.Ifmultinationalcompaniesborrowindomesticfinancialmarkets, thiscanraise interestratesanddepressinvestment.Moreover,largeinflowsofFDImayleadtheexchangeratetoappreciate and reduce the competitiveness of export-oriented domestic investors(UNCTAD1999;AgosinandMayer2000).However,FDIinnon-extractivesec-torsinAfricatendstocrowddomesticinvestmentinratherthanout(AgosinandMayer2000).

But FDI also follows domestic investment

TherelationshipbetweenFDIanddomestic investment can runbothways.Highdomestic investment signals high profitability and a conducive domestic climate,whichstimulatesforeigninvestment(ModyandMurshid2005).Moreover,foreigncompaniesmayseekjointventureswithdomesticinvestors,whichisoftentheinitialformofforeigninvestmentencouragedbygovernmentsindevelopingcountries.Theimplicationisthatpolicymakersshouldaimatimprovingincentivesforinvestmentgenerally,topromotebothdomesticandforeigninvestment.BecauseFDIhasgoodpotentialfortechnologicaladvancement,itmaybedesirabletoprovidespecialmeas-urestoattractit.Butthecomplementaritywithdomesticinvestmentshouldbethebasisfortaxandotherincentives(Fosu2001b).

Theforegoingdiscussionsuggestsseveralpolicyrecommendations:

• Through the use of targeted policies and incentives, governments shouldencourageinvestmentsinmorelabour-intensivesectors,suchasfoodprocess-ing,manufacturing,andservices(Pollinandothers2006).

• Labourmarketregulationsshouldbestreamlinedtoencourageinvestmentbybothdomesticandforeignfirms,whileprotectingworkers’rights.

• Africangovernmentsshouldinvestmoreineducationandskilldevelopmentandadoptmeasurestoretainhumancapital,inordertoattractinvestmentsinhighervalue-addedactivities.

Governments should encourage

investment in labour intensive sectors

�� Economic Report on Africa 2006

• Theyshouldalsoensurethatfavourabletreatmentofforeigninvestmentdoesnotprovideunfairadvantagetoforeigninvestorsoverdomesticinvestors.

Capital flows have had a limited impact on economic transformation in Africa

Toachievesustainablegrowth,Africancountriesneedtotransformtheireconomies.Theyalsoneedtodiversifytheireconomicbaseandlimittheirdependenceonpri-marycommoditiestoreducetheirvulnerabilitytoshocks.Sofar,thepaceofstruc-turaltransformationinAfricahasbeenveryslow.AlthoughtheshareofagricultureinGDPhasdeclinedoverthelastfourdecades,thedeclinewasmainlytheresultofincreasesinthesharesofsectorsotherthanindustry–mainlyservices–andreflectsthe lack of effective policies and incentives to direct investment towardsdomesticindustrialactivities.InmanyAfricancountriesoilandmineralresourcesaccountforalargepartoftheincreaseinindustry’sshareinGDP.Havingrevenuesfromnaturalresourcescontributetoeconomictransformationdependsonusingthoserevenuestofinanceinvestmentinothersectors,specificallymanufacturingandhumanandphysi-calinfrastructure.

Many factors explain the slow economic transformation inAfrican economies.Thefirstfactoristhelackofcoherentnationaltradeandindustrialpoliciesspe-cifically aimedatpromotingdiversification. Indeed, successful economic trans-formation in emerging economies, especially inAsia,was theoutcomeof con-certednationaleffortstoboostgrowthandinternationalcompetitiveness.WhilemanyAfricancountrieshavealsoengagedinindustrialpolicies,includingimportsubstitutionstrategies,theoutcomeshavenotbeenencouraging(box1).Inmorerecent years, economic reforms have focused on macroeconomic stabilization,whichhelpedmanyAfricancountries improve theirgrowth records.But, therehasgenerallybeennoclear integrationwithsectoralpoliciestopromotingeco-

Box �Import Substitution Strategies (ISSs) and Africa’s failed transformation

From independence to the early 1980s, most African countries adopted a range of ISSs accom-

panied by restrictive policies, including tariff and non-tariff protection, exchange control and im-

port licensing. Initially ISSs produced positive effects on manufacturing output and employment.

During the 1970s, Africa maintained an average annual rate of industrial growth of 5.5%, but the

industrial growth rate declined to 2.5% during 1980-1984 and 0.4% in 1985-1987. Eventually,

ISSs failed because of poor economic management. The production of final goods relied heav-

ily on imported inputs, adding pressure on the balance of payments. Moreover, the small size

of domestic markets limited the scope for expansion of new industries. In the end, instead of

increasing productivity, ISS strategies insulated local firms from international competition and

induced rent-seeking behaviour. Source: UNECA 2004.

Economic reform has helped many African countries improve growth

records

��Overview

nomictransformation.Sothereformdividendsinstructuraltransformationhavebeenverysmall,withAfricancountriesremainingvulnerable tofluctuations inprimarycommodityprices.

Otherimportantconstraintstostructuraltransformationincludethelackofskilledlabour,inadequatephysicalinfrastructure,unreliableenergysupply,andsmallsizeofdomesticmarketsthatlimitspotentialdemandfornewproducts.

An appropriate policy mix is needed to enhance capital flows for economic transformation

Officialdevelopmentassistance,thedominantformofcapitalinflowstoAfrica,hasbeendirectedprimarilytowardsthesocialsectorratherthanthe“productive”sectors,suchasinfrastructure.Whileinvestmentinthesocialsectorcancontributetosustain-ablegrowth(Ranis,Stewart,andRamirez2000),economictransformationrequiressignificantinvestmentintheproductivesectors.Furthermore,FDItoSub-SaharanAfricaisdirectedmainlytoextractivesectors,especiallyoil.Giventhelimitedlink-agesbetweenextractiveindustriesandtherestoftheeconomy,FDItothesesectorsisunlikelytoengendereconomictransformation.

Topromotestructuraltransformationandmaximizethecontributionofcapitalflowstothisprocess,Africancountriesneedto:

• AdoptanappropriatepolicymixtodirectODAandFDItowardsdirectlyproductiveactivities,especiallynon-extractivesectors.

• Mainstreameconomictransformationobjectivesinindustrialandtradepoli-ciesandintheoveralldevelopmentagenda.

• Ensurethattradeliberalizationstrategiesaresupportedbymeasuresthatbuildtradecapacityandraiseproductivityandcompetitivenessthroughtechnol-ogytransferandadoption.

• Upgradethephysicalinfrastructure,whichnowhamperseconomictransfor-mation.

• Enhanceregionalintegrationtofacilitatetheintraregionalmovementofcapi-talandlabourandexpandmarketsforlocalproducers.

Capital flows have not responded to macroeconomic reforms

Themacroeconomicreformssincethe1980swereexpectedto inducehighercapi-tal inflowsby raising risk-adjusted returnson investment.However, so farAfricancountrieshavenotreapedsubstantialbenefits.Theyhavereceivedonlyasmallshareofthesubstantialriseinprivatecapitalflowstodevelopingcountriessincethe1990s

Africa remains largely on the

sidelines of financial globalization


(UNCTAD2005a,2005b).Indeed,Africaremainslargelyonthesidelinesoffinan-cialglobalization.

WhatfactorsexplainAfrica’slimitedsuccessinreapingthebenefitsofmacroeconomicreformsintermsofgreatercapitalinflows?MostAfricancountrieshavesmallmar-kets,poorphysical infrastructure,unreliableenergysupply,unskilled labor,macro-economicinstability,inefficientlegalsystems,highpoliticalinstability,andpoorgov-ernance,especiallywithhighcorruption—alldeterring foreign investment (Asiedu2002,2004).ItisclearthatmacroeconomicreformsalonearenotenoughtoenticeforeigncapitalinflowsintoAfricancountries.

The weak institutional environment is a major hindrance to capital inflows

Inadditiontosoundmacroeconomicpolicy,attractingcapitalflowsrequiresasoundinstitutionalenvironment.Institutionscanaffectcapitalflowsdirectlybyprovidinganenablingenvironment,especiallythrough goodgovernance.Forexample,thesuc-cessofMauritiusinattractingcapitalflowsintoitsExportProcessingZoneactivitieswaspartlydue to institutional reforms thatpromoted social andpolitical stability,thusminimizinguncertainty(box2).

Box �Export Processing Zone in Mauritius

In creating the Export Processing Zone (EPZ), the government of Mauritius recognized that there

would be winners and losers, especially industrialists who for years had been favoured by pro-

tectionist arrangements. By addressing the needs of the industrialists through negotiation, the

government earned their support for the reforms. The EPZ generated new trade and employment

opportunities, while protecting interest groups. As a result, Mauritius benefited from high levels

of capital flows that boosted trade and investment.

Source: Rodrik 2000.

Attracting capital flows

requires a sound institutional

environment

Institutions affect capital flows indirectly through their impact on other variables,particularlyeconomicgrowthand thequalityof thebusiness environment.Soundinstitutionspromotegrowthandimprovethequalityofthebusinessenvironment,whichinturnattractscapital.

Africancountriesgenerallyscoreverypoorlyoninstitutionalquality,andthismaypartlyexplainwhytheyhavehadlittlesuccessinattractingcapitalflows.Sub-SaharanAfricarankstowardthebottominstandardmeasuresofinstitutionalquality(figure5).Highcorruption,weakenforcementoftheruleoflaw,andinefficientregulationincrease the cost of doing business, which discourages both domestic and foreigninvestment.

��Overview

Figure �Corruption, Rule of Law and Regulatory Quality in Africa and other regions, 200�

Source: Kaufmann, Kraay, and Mastruzzi 2005.

Thecostofdoingbusiness is significantlyhigher inAfrica than inother regions(figure6).Thecostofstartingabusinessis215%ofpercapitaincomeinSub-Saha-ranAfrica,thehighestintheworld,morethanfivetimesthatofSouthAsia(41%),whichisthelowestinthedevelopingworld.Thecostofenforcingdebtcontractsisalsoamongthehighestamongdevelopingregions.Theseinstitutionalinefficien-ciespartlyexplainwhySub-SaharanAfricahaslaggedbehindinbothdomesticandforeigndirectinvestment.

The cost of doing business is

significantly higher in Africa than in

other regions


Figure �Cost of starting a business and enforcing contracts: Sub-Saharan Africa and other regions

Source: World Bank 2006.

Institutional reform is thus a key to attracting capital flows

Toincreasecapitalflows,Africancountriesmustdevelopeffective institutions thatminimizetransactioncostsassociatedwith internationalcapitalandalleviate infor-mationrisksandothermarketimperfections,thusimprovingmarketefficiency.So,institutional reformsat themacroeconomicandmicroeconomic levels shouldbeakeypartofnationalstrategiesforattractingforeignprivatecapitalandencouragingdomesticinvestment(box3).

Financial deepening enhances the capacity to attract and absorb capital flows

The financial system influences both the volume of foreign capital flows and theimpactofforeigncapitaloneconomicgrowth.Threerelationshipsareworthempha-sizing(Lehmanandothers 2004;Feldstein1994;DiGiovanni2005).

• Financialdevelopmentisadeterminantofcapitalinflowsbecausethedeeperthefinancialsystem,thebroadertherangeofinvestmentopportunitiesandthereforethehighertheincentivesforforeigninvestorstoenterthecountry.

• Financialdevelopmentisamajorcomponentofthehostcountry’sabsorptioncapacity.

Microlevel institutional reform

has improved investment climate

��Overview

• Financial development is a key channel of the growth effects of foreigncapital.

ThesethreerelationshipsareessentialinunderstandingboththepoorperformanceofAfricainattractingforeignprivatecapitalandthelimitedeffectsofforeigndirectinvestmentoneconomicgrowth.

Financialdevelopmentis importanttoacountry’sabsorptioncapacityfortworea-sons. First, the depth of the financial system allows the country to intermediateforeigncapitalwithminimalstrainonmonetaryandexchangeratepolicy.Alargeanddeepfinancialsystemminimizestheexchangerateappreciationeffectsofcapitalinflows and gives more degrees of maneuver to the central bank in sterilizing theinflows tominimize the inflationary impact. InmanyAfricancountries, thebondmarketiseithernonexistentorverythin,whichlimitsthenumberoftoolsbywhichthecentralbankcancontroltheinflationaryandexchangerateappreciationeffectsofforeigncapitalinflows.Forexample,thelargeincreaseindomesticinterestratesinUgandabetween1998and2000(from5%toalmost20%)waspartlyaresultoflargeaidinflowsthatcouldnotbeabsorbedgiventhinfinancialmarkets(NkusuandSayek2004).EvidencefromotherAfricancountriesshowssimilareffects(Buffieandothers2004).

Second,andmoreimportant,anefficientfinancialsystemallowsacountrytomaxi-mizetechnologytransfersandspillovereffectsofforeigncapitalinthehosteconomy.Intheabsenceofadequatefinance,theseeffectsmaynotmaterializeatall,andsectorsreceivingFDImayremaineconomic islands,with feweffectsonoverall economicactivity.InthemajorityofAfricancountriesthe lackofaccesstofinancehasbeenidentifiedasanimportantconstrainttobusinessformationandexpansion(BigstenandOthers1999;GunningandMengistae2001).Indeed,accordingtoafirmsurveyoftransnationalcorporations,28%ofthefirmsidentifiedlackoffinanceasoneofthe

Box �Micro-level institutional reforms are improving but more is needed to encourage investment

Some African countries have made substantial progress in micro-level institutional reforms aimed

at improving the investment climate. For example, reforms of the tax system in Ghana, Kenya,

and Uganda have increased transparency and reduced the complexity of tax procedures (Ndiku-

mana and Nannyonjo 2006). Such reforms contribute to improving the investment climate while

increasing compliance and boosting government revenue. But, extensive reforms of tax systems

are still needed in many countries to reduce business costs and uncertainty (UNECA 2005).

Moreover, African countries need to deepen reforms that address other micro-level constraints

to private investment, such as poor infrastructure and unreliable energy supply.

Lack of access to finance severely

constrains business formation


mostimportantconstraintstoFDIinSub-SaharanAfrica,rankingthirdaftercorrup-tion(49%)andaccesstoglobalmarkets(38%)(UNCTAD2000).5

Byfacilitatingtheabsorptionofforeigncapital,financialintermediationenhancesthegrowtheffectsofforeignprivatecapital.ThereisgrowingconsensusthatFDIaffectseconomicgrowthlessthroughdirectinvestmenteffectsandmorethroughefficiency(ortotalproductivity)effects(ModyandMurshid2005;Durham2004;OmranandBoldol2003).TheproductivityeffectsofFDIongrowthoccurthroughtwomainchannels.First,marginalproductivityofcapitalincreasesinsectorsdirectlyreceivingforeigndirectinvestment.Second,thepositiveeffectsonthemarginalproductivityofcapitalinothersectorsintheeconomy—the“socialproductivity”effects—com-pound these “private productivity” effects (Mody and Murshid 2005; Alfaro andothers2004).

DespitesubstantialeffortstoreformandliberalizeAfricanfinancialsystems,theevi-dencestillpointsto important impedimentstotheefficientmobilizationandallo-cationofdomesticandforeignresources(SenbetandOtchere2006;NissankeandAryeetey1998;Ndikumana2003b;KaneandRice2001;Senbet2001).FinancialsystemsinmostAfricancountriesaredominatedbyasmallnumberofbanksthatcommandheavymarketpower,underminingefficiencyinresourceallocation.Forexample,inBurundithreeleadingbanksaccountforover70%ofdeposits,loans,andassets(Nzobonimpa,Nkurunziza,andNdikumana2006).Themarketshareofthetopfourbanksisashighas75%inUganda,65%inGhana,and49%inTanzania(SenbetandOtchere2005).

Theoligopolisticstructureofthebankingsystemcontributestohighcostsoffunds,evidentinhighinterestratespreads.Contrarytoexpectations,reformsinthebank-ingsystemhavebeenaccompaniedbyariseinthespreadbetweenthelendinginterestrateandthedepositinterestrate—aswellasanincreaseinthegapbetweendomesticinterestratesandworld interestrates.Theinterestratespreads in1996-2003weretwicethoseinthe1980sinsomecountries(table2).ItisclearthatfinancialreformsinmanyAfricancountrieshavebeenaccompaniedbylessefficiencyinfinancialinter-mediation—andnotmore.

5 AlsoseeAsiedu(2002,2004),AsieduandLien(2004),andMorisset(2000)forfurtherempiricalevidenceonconstraintstoFDIinAfrica.

In many countries financial reform is accompanied by less efficiency in

intermediation

��Overview

Table �Interest rate spreads and interest rate differentials in selected African countries

Interest rate spread Interest rate differential with the US

1980-89 1990-95 1996-2003 1980-89 1990-95 1996-2003

Algeria n.a. 3.0 3.0 -9.1 -17.1 2.7

Kenya 3.5 9.0 13.3 -3.1 -2.0 5.8

Malawi 7.6 7.6 20.4 -9.2 -9.9 9.2

Nigeria 2.4 6.6 8.2 n.a. -37.8 0.0

Seychelles 5.8 6.3 6.5 2.9 12.3 2.3

Sierra Leone 7.0 14.9 15.7 -53.4 -21.9 4.5

South Africa 3.8 4.0 5.0 -5.1 0.8 4.3

Swaziland 5.8 6.2 7.4 -5.9 -1.9 1.1

Tanzania 9.7 15.9 15.3 n.a. 5.0 -2.5

Uganda 7.9 7.4 11.4 -94.3 1.4 4.9

Zambia 5.7 15.4 18.1 -52.8 -43.7 7.2

Zimbabwe 7.9 3.2 22.3 -8.4 -4.1 -10.3

Source: Calculated using data from IMF 2005.

Note: The averages are computed from quarterly series. The interest rate differential for an African country is obtained by subtracting the US real interest rate from the African country’s real interest rate.

Inefficiencyinthefinancialsystemreducesboththeflowofforeigncapitalandtheimpactofcapitalflowsoneconomicgrowth.So,nationalstrategiesforincreasingthegainsfromfinancialintegrationmustincludepoliciesforimprovingfinancialinter-mediation.

Regional financial integration will allow the continent to attract and absorb more foreign capital

A developed capital market is essential for attracting a diversified pool of invest-ments.YetmanyAfricancountriesdonothaveequitymarkets,andeventhosethatexist are still very shallow and illiquid (Ndikumana 2003b). One way to increasetheviabilityofcapitalmarketsistopromoteregionalequitymarkets,especiallybydrawingonexistingeconomicregionalintegration.Financialintegrationwillprovidemoreinvestmentopportunities,increasingthescopeforportfoliodiversification.Byexpandingthescopeofinvestmentopportunities,regionalcapitalmarketswillattractmoreglobalinvestorsinterestedinthehigherreturnsthatAfricanmarketsofferbutwhonowarediscouragedbytheilliquidityofnationalcapitalmarketsandtheexpo-suretosovereignrisk.Theemergenceandconsolidationofregionalfinancialmarkets

Equity markets remain undeveloped

on the continent


willfacilitatetheestablishmentandexploitationofcrucialsynergiesbetweencapitalmarketsandnationalbankingsystems.

Oneconstrainttodevelopmentofnationalandregionalfinancialmarketsisthelackofcapacityofmarketoperatorsandregulators(Senbet2001).Governments,incol-laborationwiththeirdevelopmentpartners,needtoinitiatestrategiesforovercomingthisconstraintthroughtrainingandlearningfromexperienceincountrieswithmoreadvanced financial markets. Initiatives such as ECA’s capital market developmentprojectsneedtobestrengthenedandmultiplied(box4).

Box �ECA’s contribution to capacity building for capital market development

To alleviate the capacity constraint in capital market development, ECA launched a capital mar-

kets development project in 2002. The main objectives are to:

• Strengthen the capacity of African capital market regulators and operators.

• Strengthen the capacity of African capital markets to achieve regional integration.

• Enhance the capacity of capital market associations to promote regional integration.

• Increase awareness of African countries of the role of capital markets in national devel-

opment and poverty reduction.

The main activities are trainining workshops for market operators and regulators. In ad-

dition, the project organizes expert meetings and conferences bringing together researchers,

captial market practitioners, and policy makers to assess progress and draw policy recommen-

dations on the way forward in the area of capital market development at the national and regional

levels.

Developing financial markets

requires greater capacity of market

operators and regulators

The adverse effects of scaling up external resources are real but avoidable

AsAfricancountriesseektoincreasetheinflowofbothofficialandprivatecapital,they alsoneed tobe awareof thepotentialnegative effectsof a surge in foreigncapitalonthereceivingeconomy.Onesetofeffectsthathasbeenemphasizedintheliteratureisthe“Dutchdisease,”wherebyinflowsraiseinflationandcausetherealexchangeratetoappreciate,thusunderminingdomesticproductionandinterna-tionalcompetitiveness.

ButtherearemanyreasonsforAfricancountriestosustainandbenefitfroma“scal-ingup”ofexternal resources (McKinley2005).Giventhesubstantial idlecapacityinAfricaneconomies,ifexternalresourcesareappropriatelyusedtostimulateboth

��Overview

publicsectorandprivatesectorproduction,theinflationaryandexchangerateeffectswillbeminimal.Inparticular,ifexternalresourcesfinancetheimportofcapitalgoodsaswellaspublicinvestment,thesupply-sideeffectswilloffsetthedemand-sideeffects,minimizingtheinflationaryandexchangerateappreciationimpact.Indeed,astudyoffiveAfricancountriesthathavereceived largevolumesofaid(Ethiopia,Ghana,Mozambique,Tanzania, and Uganda) found that these experienced exchange ratedepreciationratherthanappreciation(IMF2005b)(box5).Inotherwords,thestudyfoundnoDutchDisease.

AproblemwithhighinflowsofresourcestoAfricaseemstobethattheresourceseitherhavebeenallocatedtounproductiveusesorhavenotbeenabsorbedinthesystem—butinsteadtuckedawayinidlereserves(McKinley2005;IMF2005b;Rodrik2006).Thedebateondevelopmentfinancingthereforemustpayspecialattentiontostrate-giesforefficientlymanagingresourcestomaximizegrowtheffectsofforeignresources.Strategiestoimprovethepredictabilityofinflowswillalsominimizemacroeconomicandfinancialinstabilityinthereceivingeconomies.

African countries need to establish capital management and monitoring mechanisms to minimize financial risk

Given the increasingpaceoffinancialglobalizationand the implied larger risksoffinancialcrisis,Africancountriesneedtoestablishprudentialregulationmechanismsforminimizingtheexposuretosuchrisks.Theyneedstrategiesthattiltthestructureofcapitalflowsinfavoroflong-termcapital,6asameansofacceleratingeconomic

6 Evidencesuggeststhatappropriatecapitalcontrolmeasurescanalterthecompositionofcapitalflowsevenwhentheycannotaffectthevolumeofflows(MontielandReinhart1999;Ahmedandothers2005).

Box �Aid inflows and the exchange rate in African countries

The effects of aid inflows on the exchange rate are influenced by decisions in the recipient coun-

try on the absorption and spending of aid. For example, in Ethiopia, aid supported an exchange

rate peg against the dollar through international reserve accumulation. In Ghana, aid increased

foreign exchange reserves, which constituted a buffer against volatility of inflows. In both cases,

absorption and spending of aid were low. In Mozambique, Tanzania, and Uganda by contrast

aid financed higher government spending, causing a surge in domestic liquidity. This led to infla-

tion, especially in Mozambique. In Tanzania and Uganda, inflation was contained by sterilization

through Treasury Bill sales, but this caused interest rates to rise. During aid surge episodes, real

exchange rate depreciation ranged from 1.5% in Mozambique in 2000 to 6.5% in Uganda in

2001. Only Ghana observed a mild real exchange rate appreciation. The exchange rate deprecia-

tion helped boost exports, including non-traditional exports in Uganda and Ethiopia.

Source: IMF 2005b.

Africa needs strategies that tilt

the structure of capital flows in favor of long-term capital


growthandstructuraltransformationthroughthediversificationofeconomicactiv-ity.Theyalsoneedtominimizeexchangeratevolatilityarisingfromtheinstabilityofcapitalinflowsandoutflows.Andtheyneedtominimizetheriskoffinancialcrisisthroughcontrolsofcapitalinflowsaimedespeciallyatlengtheningthedebtmaturity(Calvo2001;FosuandSenbet2001).

Appropriate capital management strategies can insulate the current account fromtheeffectsoffinancialmarketvolatility.Onestrategyistoestablishadualexchangeratesystemconsistingofdifferentialtreatmentoffinancialtransactionsandcurrentaccounttransactions.ThishasbeenseffectiveatleastintheshortruninSouthAfrica(box6).

Appropriate capital management strategies can also reduce the likelihood of debtcrisesbyreducingtheriskofexcessivedevaluationofthenationalcurrency,especiallybyminimizingtheriskofexcessiveforeigncurrencyborrowingbydomesticprivateactors(Epstein,Grabel,andJomo2005;LeFortandLehman2003).Finally,capitalmanagement strategiesareneeded to retain savings inAfricancountries, especiallybypreventingcapitalflightboththrough increasedfinancial stabilityandenforcedtransparencyininternationalcapitalmovement.

Capital management strategies need to be complemented with domestic financialregulation to minimize the risk of financial distress (Senbet 2001). African coun-triesneedsoundbankingregulationtoenforceadequatebankcapitalization,promotecompetition, ensure speedy and transparent reporting on the health of individualfinancialinstitutions,andpreventcontagionofbankingdistressthroughtimelybankrestructuringbycapitalization,merger,orliquidation(KaneandRice2001).Build-ingsounddomesticbankingsystemswillenhancetheabilityofAfricancountriestosustainshockstointernationalcapitalflows.

Box �South African experience with capital and exchange rate management

The South African capital and exchange rate regime has undergone five major phases since

the 1960s (Aron, Elbadawi, and Kahn 2000). Until 1978, the rand was pegged alternatively to

the dollar and the pound, and capital account transactions were strictly controlled. In 1979, the

government adopted a dual exchange rate system whereby current account transactions were

executed at a controlled-float exchange rate, the commercial rand, while equity capital was

transacted at a freely floating exchange rate, the financial rand. The system was abolished under

a controlled float system in 1983 and reintroduced in 1985, lasting until 1995. The exchange rate

regime was unified again in 1995 during a systematic move toward a market-based exchange

rate system. Foreign exchange and capital controls were motivated by the need to retain domes-

tic savings, prevent the loss of foreign exchange through transfer of assets abroad by residents,

and encourage repatriation of capital. The evidence suggests that the dual exchange rate sys-

tem to some extent insulated the current account from volatility of the rand (Farell 2001).

Capital management strategies are

needed to retain savings

��Overview

Threemaincategoriesoffinancialriskrequiremanaging:currency,flight,andfragilityrisk.Aseriesofwarningindicators(trip wires)andappropriatepolicyinterventions(speed bumps)canaddresseachtypeofrisk(Grabel2004).Itisimportantforeachcountrytodesignthesepolicytools insuchawaythattheyareflexibleenoughtoallowadaptationtochangesinmacroeconomicandfinancialcircumstances.Africancountriesneedsystematicmonitoringmechanismsandasetofwarningsignstohedgeagainstfinancialriskandguideappropriatepolicyresponsestofinancialshocks.

ConclusionAfrica’s growth in the last two years is an important turnaround from decades ofstagnation.Butthegrowthratesremainbelowthelevelsneededtoachievenationaldevelopmentgoals,especiallyemploymentcreationandpovertyreduction.So,Afri-cancountriesstillfacethechallengesofachievingandsustaininghighergrowthrates,aswellastranslatingthegrowthintopovertyreductionandhumandevelopment.

To meet these challenges, African countries need, among other things, to attract,retain,andefficientlymanagehighervolumesofexternalresourcestofilltheirchronicresourcegaps.Theevidencereviewedinthisreportshowsthatthecontinentremainsonthesidelinesoffinancialglobalization,heavilyindebtedanddependentonofficialdevelopmentassistance,whileprivatecapitalflowsremainvolatileandconcentratedprimarilyinextractiveindustries.Capitalflowshavehadlittleimpactoneconomictransformation,andtheireffectsondomesticlabormarketshavealsobeenlimited.

Thereportidentifiesstrategiestoincreaseboththevolumeofcapitalflowsandthebenefitsfromtheseflowsineconomicgrowthandtransformation.Someareasthatdeserveparticularattentionfrompolicymakersarehighlightedhere.

• African countries need to improve the investment climate to encourage both domestic and foreign investment. Thiswillinvolveactionsatthepolitical,mac-roeconomicandmicroeconomiclevels.Consolidationreformsatthepoliticalandmacrolevelswillalleviatepoliticalandmacroeconomicuncertaintyandreducesovereignrisk.Atthemicrolevel,thegoalistominimizefactorcosts,especiallythroughreliableenergysupplyandadequatepublicinfrastructure.African countries also need to streamline the regulatory environment toreducemarketrigiditieswhileprotectingworkersandenforcingpropertyandcreditorrights.

• Macroeconomic frameworks need to be more flexible and expanded to include the goals of accelerating growth and creating employment. Withinanexpandedmacroeconomicframework,capitalflowpolicieswillserveasaninstrumentforachievingthebroadergoalsofacoherentnationaldevelopmentstrategy.

• Capital flow policies need to be better integrated into national industrial policy. Toenhancetheimpactofcapitalflowsoneconomictransformation,African

At the micro level, the goal is to minimize

factor costs


countriesneedtoprovideincentivesforgreenfieldforeigndirectinvestments,especially those that are export oriented andhave largepositive effects onemploymentcreation.

• Each country needs to identify and target sectors that have high potential for employment creation. Tomaximizetheeffectsofcapitalflowsonemploymentcreation, countries need quantitative measures of the employment impactofinvestmentacrosssectors.Governmentscanthenusethisinformationtodesignincentivemechanismsthatwillhelpchannelforeigncapitalintosec-torswiththehighestemploymentcreationpotential.

• Promoting regional financial integration will help overcome the constraint of underdeveloped financial markets.Africancountriesneedtocapitalizeonexist-ingregionalintegrationarrangementstofosterfinancialintegration,whichwillexpandthescopeforinvestmentandresourcemobilization,increasingtheattractivenessofAfricanmarketsintheeyesofforeigninvestors.

• African countries need mechanisms for monitoring and managing capital flows to minimize the risks of financial instability. Toachievethis,Africangovernmentsshoulddevelopadequatestatisticalcapacitytotrackcapitalflowsandmoni-torwarningsignsoffinancialfragility.

• African countries need to design strategies to increase the contribution of the diaspora to economic development. African governments should establishmechanismsandincentivestoincreasethevolumeofremittancesandencour-agehigherallocationsofremittancestoinvestment.Inaddition,improvingthereturnstohumancapitaliscrucialforretaininghumancapital,whichisessentialforachievingandsustaininghigherlevelsofeconomicgrowth.

��Overview

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��

1.1 IntroductionIn2005,African economies recorded another strongperformance, continuing themomentumofstronggrowthachievedin2004.1Thecontinentbenefitedfromrisingglobaldemandforprimarycommodities,includingoil,whichresultedinhighexportearnings for resource-rich countries. In addition, African economies continued toreapthebenefitsfrommacroeconomicreform,whichtranslatedintoconsolidationofmacroeconomicbalanceswithlowinflationrates,decliningbudgetdeficits,stabiliza-tionofexchangeratesandimprovementsincurrentaccountbalances.

The continent also benefited from substantial inflows of external financing in theform of official development assistance (ODA), including debt relief, and foreigndirectinvestment(FDI),whichshouldboosteconomicgrowthinthecomingyears.The Multilateral Debt Relief Initiative (MDRI) announced at the G8 Summit inGleneaglesin2005providedmuchneededrelieffor13sub-SaharanAfrican(SSA)countries.However,itisclearthatthisdebtreliefpackageisnotenoughandthatmoreexternalfundingwillbeneededtohelpAfricancountriesincreasegrowthratesandachievemeaningfulreductioninpoverty.

Indeed,whiletherecentconsecutivehighgrowthratesrepresentamajorturnaround,thelevelsofgrowthrecordedarestillnotenoughtoachievetheMillenniumDevel-opmentGoal(MDG)ofhalvingpovertyby2015.In2005,onlytencountriesreal-ized growth rates of 7 per cent or higher: Angola (19.1%), Burkina Faso (7.5%),theRepublicofCongo(7.7%),EquatorialGuinea(9.3%),Ethiopia(8.9%),Liberia(8%),Libya (8.5%),Mozambique (7.5%),SierraLeone (7.3%),andSudan(8%).Ofthetencountriesthatrecordedhighgrowthin2005,onlythreemaintainedanaveragegrowthrateof7percentinthemediumterm(overthe1998-2005period):Angola,EquatorialGuineaandMozambique.Itisclearthatwhilehighgrowthratesarerecordedinseveralcountries,veryfewareabletosustainhighperformanceforanextendedperiod.Thus,thevolatilityofgrowthremainsanobstacletothegoalofacceleratingpovertyreduction.

1 ThedatausedforrecentmacroeconomicperformanceinthischapteraremainlyfromtheInternationalMonetaryFund(IMF)andtheEconomistIntelligenceUnit(EIU).Dataonsocialandhumandevelopmentarefromvari-oussources,includingtheWorldBank’sWorld Development Indicators2005andUnitedNationsDevelopmentProgramme’s(UNDP)Human Development Report2005.

Recent Economic Trends in Africa and Prospects for 2006�

Africa needs more external

funding to increase growth rates and achieve poverty

reduction


A major weakness of the recent growth performance in Africa is that it is mainlydrivenbyextractiveindustries,especiallyoilandminerals.Thisexposesresource-richeconomiestotheadverseeffectsoffluctuationsininternationalcommodityprices,inadditiontothenegativeeffectsofexchangerateappreciationonexportcompeti-tiveness.Thefutureofresource-ledgrowthremainsuncertaingiventhevagariesofinternationalcommoditymarkets.Moreover,giventheweakemploymentgainsfromresource-basedeconomicexpansion,therecentpatternsofgrowtharenotlikelytogeneratemeaningfulincreasesinlivingstandardsforthemajorityofthepopulation.

A major challenge for African countries is the ability to sustain reasonable levelsofGrossDomesticProduct (GDP)growthoveranextendedperiod. Witherraticgrowthrates,Africancountrieswillnotbeabletogenerateenoughdecentemploy-mentopportunitiestoincreasepercapitaincomeandreducepoverty.

Theobjectiveofthischapteristoprovideanoverviewoftherecentperformanceaswellas futuregrowthprospects forAfricaneconomiesat thecontinentalandsubregionallevels.Thechapterdiscussesthemainfactorsbehindtherecentperformanceandfac-torsthatarelikelytoinfluencethemedium-termgrowthprospects.Italsoidentifieskeychallengesintheareaofsocialdevelopmentandsuggestspolicyresponses.

1.2 The global economy was largely favourable in 2005Althoughtheworldeconomysloweddownin2005relative to2004(from5%to4.3%),itdisplayedresilienceinthefaceoftheincreaseinenergyprices.Thestrongperformancewasdrivenby risingdomesticdemand in theUnitedStates,Canada,ChinaandIndia.ThispartlyhelpedtooffsetweakergrowthinJapan(2.8%)duetoslowinventoryaccumulation,theEurozone(1.2%)duetoweakhouseholdspending,andintheUnitedKingdom(1.75%),whichexperiencedadecelerationofprivateandgovernmentconsumption.GrowthinLatinAmericaslowedin2005relativeto2004(from5.8%to4.2%),duetolowerimportdemandfromChinaandindustrializedeconomies.Growthalsodeceleratedrelativeto2004intransitioneconomies(from6.7%to5.3%)andinAsia(from7%to6.5%).

Thestrongoverallglobalgrowthperformancehasfuelled large increases inoilandcommodityprices. However, thehighoilpriceshavenot spilledover intohigherwagedemandsandlong-terminflationexpectationsappearwellanchored.Asaresult,contagionofoil pricehikes tonon-oil priceshas remainedminimal. Indeed, coreinflationhasremainedstableintheUnitedStates(around2%)andhastrendeddownintheEurozone.

Manydevelopmentswitnessedin2005intheworldeconomyhaveimportantimpli-cationsforAfricaneconomies intheshorttomediumterm.Thesustainedrise in

Volatility of growth is an

obstacle to poverty reduction

��Recent Economic Trends in Africa and Prospects for 2006

oilpriceswillcontinuetoputpressureonenergycostsforallthecountriesandontheimportbillforoil-importingones.Therisingshort-terminterestratesdrivenbymonetarypolicytightening,especiallyintheUnitedStates,implyhighercostsofdebtservicing,especiallyforcountrieswithhighproportionsofshort-termdebtintotalforeignliabilities.WhilethewideningUStradedeficitwillcontributetoweakeningthedollar,thismaybeoffsetbytheeffectsofrisinginterestratesandstrongrecovery,whichwillcausethedollartoappreciate,resultinginhigherimportcostsandawors-eneddebtserviceburdenforAfricancountries.

Another major concern is the current account imbalances which are predicted towidenoverthenexttwoyears(OECD2005;UN2006). TheUSexternaldeficitissettoriseto7percentofGDPin2007,whileJapanandChinawillregisterveryhighsurpluses.Theseimbalancesraisetherisksofdisorderlyadjustments,withrisksoflargeexchangeratefluctuations,assetpricecollapse,andinterestratehikes.Theserisksputintoquestionthesustainabilityofcurrentworldgrowthrates.

Theyear2005wasmarkedbyasubstantialincreaseinODA,withaidfromtheDevel-opmentAssistanceCommunity(DAC)oftheOrganizationforEconomicCoopera-tionDevelopment(OECD)risingby31.4%toarecordhighof$106billion.Thisincrease reflecteddebt relief, including large sums to Iraq (about$14billion) andNigeria($5billion)aswellasaidtocountriesaffectedbythetsunamiin2004(about$2.2billion).

Theyear2005wasalsomarkedbyanumberofpositivedevelopmentsintheinter-nationalcommunitywith regard tocommitment to supportnationalandregionaldevelopmenteffortsinAfrica.Noteworthydevelopmentsinclude:theglobalreviewofMDGsbytheUnitedNationsGeneralAssembly,thereportoftheCommissionforAfricaledbythePrimeMinisteroftheUnitedKingdom,TonyBlair,andthefocusoflastyear’sG8meetingondevelopmentfinancingforAfrica.Theseeffortstoincreasegrowthneedtobesupportedbystrategiesforenhancingtheefficiencyofaidutiliza-tionandbettertargetingofpovertyreductioninnationaldevelopmentagendas.

1.3 Overall growth performance in Africa remained strong

Many countries registered better performance in �00� than in �00�

In2005,Africaneconomiesrecordedanotherstrongperformance(5.4%),exceedingtherecordgrowthachievedin2004(5.2%),andmorethanapercentagepointabovethatof2003(4%).Seefigure1.1.2Comparatively,Africa’sgrowthwasthesameas

2 ThedatausedinthisdocumentareupdatedtoSeptember2006.

Strategies are needed for enhancing the

efficiency of aid utilization


thatof transitioneconomies,higher than thatofLatinAmerica (4.3%)and lowerthanthatofAsia(6.5%,excludingJapan).Onadisaggregatedlevel,asmanyas25Africancountriesrecordedimprovementsingrowthratesin2005relativeto2004.

The strong growth performance achieved in 2005, as in recent years, represents amajorturnaroundfromdecadesofeconomicdeclineandstagnation.AkeydriverofthisrecoveryistheimprovementinmacroeconomicmanagementinmanyAfricancountries,whichresultedinlowerinflationratesandconsolidationoffiscalbalances.Anotherfavourablefactoristheincreaseininternationalpricesofkeyexportcom-moditiesforAfrica,especiallycrudeoil,duetostronggrowthinglobaldemand.

The total commodityprice index increasedby an averageof about30per cent in2005relativeto2004,ledbycrudeoilprices,whichrosebymorethan40percentcomparedto13percentfornon-energycommodityprices.Amongnon-energycom-modities,thepricesofmetalsandmineralsincreasedby25.4percentwhilethoseofagriculturalproducts,rawmaterialsandfertilizersroseby7.6,7.1and6.6percentrespectively.Incontrast,exportpricesofcotton,tea,andcocoacontinuedtodecline,mainlyduetoglobalexcesssupply.

Figure �.�Real GDP growth rate in Africa, 2003-2005

Source: Economist Intelligence Unit (EIU), September 2006.

In2005,thetop10growthperformersachievedthe7percentgrowthratethresholdneededtoachievetheMDGs(figure1.2).Onehalfofthehighperformersareoil-exportingeconomies,reflectingtheimpactonexportrevenuesofhighoilpricesandproduction.However,itisnotablethattheotherhalfarenon-oileconomies:BurkinaFaso,Ethiopia,Liberia,Mozambique,andSierraLeone.Highgrowthinthesecoun-

Improvements in macroeconomic

management have resulted in lower

inflation rates and consolidation of

fiscal balances


trieswasmainlyduetostrongperformanceintheagriculturalsector(BurkinaFaso,Ethiopia, Mozambique, and Sierra Leone), the service sector (Sierra Leone andMozambique),andrecoveryintheminingsector(SierraLeone).

ZimbabweandSeychellesexhibitedtheweakestperformancesin2005asin2004,asaresultofcontinuinginstabilityinZimbabweandtheadverseeffectsofthetsunamiandweakperformanceintourismandintunaexportsinSeychelles.SlowgrowthinTogowasattributabletopoliticalcrisisandadeclineinphosphateandcottonproduction.PoliticalinstabilityadverselyaffectedoverallgrowthperformanceinCôted’Ivoire.

Figure �.�Top 10 and bottom 5 performers in Africa in 2005 (% real GDP growth)

Source: Computed from EIU data, September 2006.


The gains from Africa’s oil boom are still limited

Overthelastfewyears,Africahasbeeninthemidstofanoilboom,resultingbothfromlargeincreasesinoilpricesandthesubstantialinfluxofinvestmentsinpetro-leumexplorationandproduction(USDepartmentofEnergy,1999).Thisnewoilboomspreadacrossthecontinent,withallsubregionscomingoutasnetcrudeoilexporters,with theexceptionofEastAfrica. Thedominantproducersandnetoilexportersare(indescendingorderofsharesintotalproduction)Nigeria,Libya,Alge-ria,Egypt,andAngola.Gabon,Congo,andCameroonarealsonetoilexporters.OilproductionalsostartedrecentlyinMauritania.

African oil has been the subject of substantial interest from major oil consumers,especiallytheUSandthefast-growingAsianeconomiesledbyChinaandIndia.OilexplorationinAfricaisexpandingfasterthaninanyotherregionoftheworldandAfricanoilproducersenjoylargegapsbetweenpotentialreservesandcurrentoutput.ThecontinentisthereforeseenasaviablealternativetotraditionalsourcessuchastheMiddleEast.Theworld’slargestconsumerofoil,USAisderiving15percentofitsoilimportsfromAfrica.China,thesecondlargestconsumerofoil,buys28percentofitsoilfromAfricancountries,especiallyAngola,NigeriaandSudan.In2004,China’sinvestmentsinAfrica–mostlyinoilexplorationandproduction–represented$900millionoutofthecontinent’stotalof$15billion.

ThemassiveexportrevenuesandFDIintheoilsectorexplainthehighgrowthratesrecorded by oil-producing African economies. In 2005, as a continuation of therecenttrend,Africanoileconomiesasagroupgrewat6.2percentcomparedto4.5percentfornon-oileconomies(figure1.3).Theoilproducersasagroupcontributed53.4percentofthecontinent’s5.3percentgrowthrate.Therefore,itisfairtosaythat oil production is playing an important role in the continent’s overall growthperformance.

Oil production is playing an important

role in Africa’s overall growth

performance


Figure �.�Growth of real GDP in African oil- vs. non-oil economies, 2003-2005

Source: EIU, September 2006.

However,despitethehighgrowthratesgeneratedbytheoilboom,severalquestionsremain,especiallythesustainabilityofthesegrowthratesandtheoverallimpactoneconomicdevelopment.Forhighoilpricestotranslateintohighergrowthrates–evenintheshortrun–itisnecessarythattherevenuesbespenttoboostoveralleconomicactivityandproductioncapacityinawiderangeofsectors.Ifthehigherrevenuesarestoredinidleforeignexchangereservesatthecentralbankorspentonunproductiveimports,thentheeffectsongrowthwillbeminimal.Thebiggerchallengesare:

• Howtotranslateoilrevenuesintosustainablegrowth;and• Howtoconverttheoilboomintohigherlivingstandardsforthemajorityof

thepopulation.

Totranslatetheoilboomintosustainedhighgrowthrates,theoilrevenuesneedtobe used to finance domestic investment, including infrastructure, and to diversifyeconomicactivitybyfinancingnewinvestmentsinnon-oilactivities.Moreover,thesustainabilityofoil-drivengrowthrequiresefficientmanagementofoilrevenuestohedgeagainsttheadverseeffectsofpricefluctuations.

Thebiggestchallengeistotranslatetheoilboomintopovertyreduction.Eventhelargestoil-producingcountriesinAfricastillfaceabjectpovertydespitethemassiveoilrevenuescollectedovertheyears.InAngola,70percentofthepopulationlivesbelowthepovertyline.InGabon,withoneofthehighestpercapitaincomesonthe

Africa’s oil boom needs to be

translated into poverty reduction


continent,highincomeinequalityhaskepthalfofthepopulationinpoverty.Thedevelopmentofrentier economieshaspreventedtheexpansionofemployment-gener-atingactivities,thuskeepingthemajorityofthepopulationonthesidelinesoftheoil-ledprosperity.

An important issue for oil-rich economies is the efficiency of the management ofoilrevenues.Insomeofthesecountries,lackoftransparencyandaccountabilityonthepartofbothgovernmentsandoilcompanieshasperpetuatedembezzlementandmisuseofoilrevenues.Overall,whileoilresourcesareapotentsourceforeconomicprosperityforthecontinent,specificmeasuresareneededtoensurethattheinducedgrowthissustainedoveranextendedperiod,thatthehighoilrevenuesareinvestedtopromotediversificationofeconomicactivity,andthatthegainsarebroadlysharedamongallsegmentsofthepopulation.

Subregional growth performance remains uneven

Aggregate economic performance exhibits substantial variations across subregions.EastAfricaledsubregionalgrowthperformanceforthesecondconsecutiveyearwithrealGDPgrowth at6per cent in2005,down from6.4per cent in2004 (figure1.4).In2005,onehalfofthetwelvecountriesofthesubregion(withadequatedata)3showed improved growth over that of 2004. The top performers were Ethiopia(8.9%),Tanzania(6.8%),theDemocraticRepublicofCongo(DRC)(6.5%),Kenya(5.2%),andUganda(5.5%).Growthwasdrivenbyagriculturalproduction,bothintraditionalcashcropssuchascoffeeinEthiopia,RwandaandUgandaandinotherproductssuchashorticultureinKenya.

Other factorsofstrongperformance includehighmineralproduction(DRC),andgains fromimprovedpolitical stability (BurundiandDRC). InComoros,growthwassustainedbydonorsupportwhilegrowthinDjiboutiwasboostedbypublicandprivateinvestmentsinnewportfacilities.Eritrea’seconomicgrowthwaslowpartlybecauseofdroughtsthatadverselyaffectedagriculturalproduction.

3 ExcludingSomaliaforwhichtherearenoadequatedata.

Oil revenues should promote

economic diversification


Figure �.�Growth by sub-region, 2003-2005


GrowthinNorthAfricaremainedstrongin2005,improvingslightlyfrom5.2percentto5.3percentrelativeto2004.GrowthinthesubregionwasdrivenmainlybythestrongperformanceoftheoilsectorinAlgeria,Egypt,andSudan.NorthAfricasuf-feredfromunfavourableweatherconditions(especiallyinMauritania,Morocco,andTunisia).Furthermore,theendoftheMultifibreAgreementonTextileandClothingendedinJanuary2005.Morocco,theonlynon-oilproducerinthesubregion,expe-riencedconsiderableslowdowninrealGDPgrowthfrom4.2percentin2004to1.5percentin2005duetosharpcontractioninagriculturaloutput.EgyptandSudanwere the least affectedbybadweather conditions.Weak export growthof textilesimpactednegativelyonGDPgrowthinTunisia,whichdeclinedfrom6percentin2004to4.2percentin2005.However,thesubregionexhibitedstrongperformanceintheservicesector,especiallyinMauritania,Morocco,andTunisia.

Central Africa was the worse performing subregion in 2005, with growth declin-ingfrom6.3percentin2004to3.6percentin2005.Growthdeceleratedinfourcountries:Cameroon(thelargesteconomythataccountsformorethan50percentof the subregion’soutput),Chad,EquatorialGuinea, andSãoToméandPríncipe.TheCentralAfricanRepublic,theRepublicofCongo,andGabonrecordedimprove-ments(from1.3%to2.2%,3.6%to7.7%,and1.4%to2.9%,respectively).The


modestgainsinperformanceintheCentralAfricanRepublicarepartlyattributabletoimprovementinpoliticalstability.GrowthintheRepublicofCongowasdrivenbytheoilsector.Gabonbenefitedfromgoodperformanceinthetertiarysector(tel-ecommunications)andtimberexports(UNECA,SRO-CA,2006).ChadandEqua-torialGuineabothexperiencedmarkedslowdowns,from29.7percentto5.9percentandfrom32.9percentto9.3percent,respectively,duetothecompletionofmajorinvestmentprojectsintheoilsector.

GrowthinSouthernAfricapickedupfrom5.1percentin2004to5.8percentin2005 owing mainly to higher growth in Angola, Mozambique, South Africa, andZambia.At19.1percent,Angolawasthefastest-growingeconomyinAfricain2005,thankstohigheroilrevenues.SouthAfrica’shighergrowthwasduetohigherdomes-ticdemandandexportsaswellasbetterperformanceintourism.GrowthinZambiaimprovedrelative to2004(from5.4%to5.8%)as theadverseeffectsofdroughtsin theagricultural sectorwereoffsetbypositiveoutcomes inother sectors suchasincreased copperproduction. Zimbabwe’s economy continued to contract (-4%),bringingtherealGDPlevelto38percentbelowthatof1999.

Growth inWestAfrica improved in 2005 from4.8% to5.5%,markedby a pre-dominanceofthetertiarysector(UNECA,SRO-WA,2006).Atadisaggregatedlevel,substantial increases in growth were registered in a number of countries: BurkinaFaso(4.6%to7.5%),CapeVerde(4.4%to6.8%),Liberia(from2.4%to8%),Mali(from2.2%to6%),andNiger(from0%to4.5%).HighGDPgrowthrateswerealsorecordedinSenegal(6.1%),SierraLeone(7.3%),Nigeria(6.5%),andGambia(5.0%).Twocountries experiencednotabledeclines ingrowth rates:Côted’Ivoire(from1.6%to1%)andGuineaBissau(4.3%to2.3%).SocialandpoliticaltensionsinTogo,Côted’Ivoire,andGuineaBissauwerepartlyresponsibleforthepooreco-nomicperformance.

Some countries have maintained high growth over the medium term

Figure 1.5 presents average growth rates over the 1998-2005 period.4 Six of thetop ten performers in 2005 are also among the top ten performers over the pasteightyears:Angola,BurkinaFaso,EquatorialGuinea,Ethiopia,Mozambique,andSudan.Côted’Ivoire,SeychellesandZimbabweareamongtheweakestperformersin2005andoverthepasteightyears.Themedium-termevidencealsoindicatesthathighgrowthisnotrestrictedtooil-richcountries.Sixoutofthetoptenperform-ersarenon-oilexporters:Botswana,BurkinaFaso,Ethiopia,Mozambique,Rwanda,andSenegal.Growthinthesecountrieswasdrivenbytheeffectsofcomprehensiveandsustainedeconomicreformsaswellaspoliticalstabilityinpost-conflictcountriessuchasMozambiqueandRwanda.Thesepost-conflictcountrieshavemovedfromrecoverytogenuinegrowthasaresultofthesereforms.4 Thechoiceofthisperiodisgovernedbydataconsistency.

Post-conflict countries have

moved from recovery to

genuine growth


Thegroupofleastdevelopedcountries(LDCs)5inAfricahasperformedparticularlywell,recordinganaveragegrowthrateof5.3percentduringthe1998-2005period,higherthantheSSAaverage(3.7%)andtheaverageforthecontinent(4%)(UNECA2006a).Atadisaggregatedlevel,oil-producingAfricanLDCsoutperformednon-oilproducers(7.5%and4.3%,respectively)whilelandlockedAfricanLDCsperformedworseintermsofgrowth(3.8%).

Figure �.�Top 10 and bottom 5 performers in Africa, 1998-2005 (% average annual growth)


5 34ofthe53AfricancountriesareLDCs.


1.4 Macroeconomic balances continue to improve

Fiscal balance has improved

One of the positive features of recent economic growth in Africa is improvementinthefiscalbalanceinmanycountries.TheaveragefiscalpositiononthecontinentimprovedfromadeficitofonepercentofGDPin2004toasurplusof0.6percentin2005.Thenumberofcountrieswithfiscalsurplusesincreasedfrom9in2004to12in2005(table1.1).Thecontinent’simprovementinfiscalpositionwasmainlydrivenbythesizeablefiscalsurplusesrecordedbyoilproducers:Libya(20.6%ofGDP),Equa-torial Guinea (13.6%), the Republic of Congo (13.7%), Algeria (13.8%), Gabon(8.3%), Cameroon (3.4%) and Nigeria (0.3%). However, five non-oil economiesalso recordedfiscal surpluses: SãoTomé andPríncipe (44.8%), Seychelles (8.0%),Botswana(2.6%),Lesotho(2.0%),andKenya(0.3%).

Nevertheless,fiscalimbalancesremainacriticalprobleminalargenumberofAfricancountries.Asmanyas28countriesrecordedfiscaldeficitsin2005comparedto31in2004.Moreover,manycountriesstilldependheavilyonODAtofinancetheirbudg-ets,whichraisesconcernswithregardtothesustainabilityoftheirdevelopmentpro-grammes.Therefore,fiscalconsolidation,includingstrategiesforincreasingdomesticrevenuemobilization,mustremainhighontheagendaforeconomicreformsonthecontinent.

Table �.�Distribution of fiscal deficits in Africa, 200� and 2005 (number of countries)

2004 2005

Countries with surpluses 9 12

Less than 5 per cent 4 6

5 per cent to 10 per cent 3 2

More than 10 per cent 2 5

Countries with deficits 31 28

Less than 5 per cent 22 17

5 per cent to 10 per cent 8 11

More than 10 per cent 1 0

Total number of countries 40 40

Source: EIU, June 2006.

Fiscal consolidation must remain high on

Africa’s economic reform agenda


Single-digit inflation was contained in most countries

In 2005, the inflation outlook remained satisfactory with a majority of countriesrecording single-digit inflation rates (table 1.2). After declining from 10.8 percentto8.1percentbetween2003and2004,themeaninflationforthecontinentincreasedslightlyto8.5percentin2005.Inflationresultsweredrivenbypressuresfromoilprices,effectsofweathershocksonagriculturalproduction,andhighdomes-ticdemand.Inflationarypressureswerecontainedbytheeffectsofmacroeconomicpoliciesaimedatcontainingpublicexpendituresandmoneygrowth.Thesepolicieshelpedtocontaintheeffectsofthesurgeinoilrevenuesanddevelopmentassistanceinflows.

In2005,16countriesexperiencedinflationabove10percent,comparedto17in2004.Nonetheless,inflationincreasedin33outof51countries,includingeightofthe13oil-producingcountries:Cameroon,Chad,Côted’Ivoire,Egypt,EquatorialGuinea,Libya,Nigeria,andSudan.InflationremainedhighinAngolaat23percent,butthisrepresentedamajorimprovementfrom2004(43.6%)andamajorachievementfromthetriple-digit inflationratesexperienceduntil2002.GuineaandDRCexperiencedspikesininflation(from17.5%to31.4%andfrom4.0%to21.4%,respectively)dueto,amongotherfactors,continueddepreciationoftheGuineafrancandinternationaloilprices,andsupply-sidebottlenecks,alegacyofthecivilwarinDRC.

Table �.�Distribution of inflation rates in Africa, 2003-2005 (number of countries)

Range 2003 2004 2005

Less than 5 per cent 25 30 21

Between 5 and 10 per cent (10% excluded) 14 6 14

Between 10 and 20 per cent (20% excluded) 7 12 12

20 per cent and higher 5 3 4

Total number of countries 51 51 51

Source: IMF, 2006. World Economic Outlook Database, September 2006.

Developments in the balance of payments are positive

Thecontinent’stradesurplus(goodsandservicescombined)hasincreasedsince2003,mainlybecauseofrisinginternationaloilpricescoupledwithexpansionincrudeoilproduction.Africa’stradesurplusincreasedto$31.6billionin2005from$13.0bil-lionin2004asaresultofa49.2percentincreaseintheregion’soiltradesurplus(IMF2005).Strongperformanceinmerchandisetradeandnetcurrenttransfersresultedinacurrentaccountsurplusforthecontinentforthesecondconsecutiveyear.

Inflation pressures

mitigated by macroeconomic

policies


Overallperformanceatthecontinentallevelshowssubstantialvariationsacrosscoun-tries.Non-oileconomiesinparticularcontinuetoexperiencecurrentaccountdeficits,whichareaccentuatedbyrisingoilprices.Indeed,outofthe37non-oileconomieswithadequatedata,only11experiencedanimprovementincurrentaccountbalancefrom2004to2005.Itisclearthattheaggregatetradesurplusatthecontinentallevelislargelydrivenbyoilrevenues,whichraisesconcernsaboutthesustainabilityofsuchasurplus.

External debt remains high

Africa’stotalexternaldebtstockstoodat$282billionin2005,downfrom$305.8billionin2004(IMF2006).Debtserviceobligationsareontherisesince2002andstoodat$34.6billion,followingadeclinefrom$32.8billionin1997to$21.3billionin2002.However,inrelativeterms,theaveragedebtburdenforthecontinenthasbeendecliningsincetheearly1990s.Fromapeakof31percentin1992,thedebtservice/exportsratiodeclinedto11.2percentin2005.Thedebt/GDPratiodeclinedfrom74percentin1994to35percentin2005.

Theseaggregatemeasuresmaskwidecross-countryvariationsandareinfluencedbymovementsofdebtandexportsamonglargecountries,especiallyoilexporterssuchasAlgeriaandNigeria.Atthedisaggregatedlevel,debtserviceobligationscontinuetorepresentamajordrainonnationalresources,withmanyAfricancountriesspendingmoreondebtservicethanonsocialservicessuchaseducationandhealth.Thus,debtisstillverymuchacriticalconstrainttodevelopmentofthecontinent.

Toalleviatethedebtburden,theG8,atitsSummitinGleneaglesin2005,committedtocancellationofthedebtof14AfricancountriesthathadalreadyreachedtheHighlyIndebtedPoorCountries(HIPC)completionpoints.ThesewereBenin,BurkinaFaso,Ethiopia,Ghana,Madagascar,Mali,Mauritania,Mozambique,Niger,Rwanda,Sen-egal,Tanzania,UgandaandZambia.Thesecountrieswereexpectedtostartbenefit-ingfromcompletedebtcancellationbeginningbyearly2006,whichshouldimprovetheirdebtpositioninthecomingyears.However,whilethesemeasuresareastepintherightdirection,theyareinsufficienttomeetthedevelopmentfinancingneedsofAfricancountries.Manylow-andmiddle-incomecountriesarenotbeneficiariesoftheMDRI.ThedebtowedbySSAcountriesthatqualifyfordebtwriteoffsundertheMDRIrepresentsonly25percentofthecontinent’sdebtstock.

AddressingAfrica’sdebtproblemsrequiresacomprehensive strategy.Suchan inte-gratedapproachwouldenhancegrowth,increaseexports,andraisedomesticsavings.ItwouldthusreducetheneedofAfricancountriesformoreaidorborrowinginthefuture.Thestrategyshouldinclude:

• Extendingdebtrelieftoallpoorcountries(especiallythoserecoveringfromconflict);

Debt service obligations are a

major drain on social services, such as

education and health


• Increasing new development aid so that debt relief is additional to, not asubstituteforconventionaldevelopmentaid(Ndikumana2004);

• Strictmechanismsthatguaranteethattheresourcesreleasedbydebtreliefareinvestedindirectlyproductiveactivities(especiallyinfrastructureandsocialservices);and

• Increasing access of African exports toWestern markets, including prefer-entialtreatmentarrangementsand,mostimportantly,theremovaloftradebarriersinWesterncountries(e.g.,removaloffarmproductsubsidies).

Official development assistance is rising but more is still needed

TotalODAtoAfricacontinuesitsrecoveryfromthelongdeclineexperiencedbetween1990and2001 (figure1.6). ODAfromalldevelopmentpartners stoodat$26.5billionin2004comparedto$15.7billionin2000(inconstant2000dollars).Theincreaseinaidsince2001camefromDACandothermultilateraldonors.However,the rise inaid from2003 to2004derivedmostly frommultilateralorganizations,notablytheWorldBank,theAfricanDevelopmentBankandUNAgencies,includ-ingWorldFoodProgramme(WFP),UnitedNationsChildren’sFund(UNICEF)andUnitedNationsHighCommissionforRefugees(UNHCR).Thisgroupcontributed$2.2billion(innominalvalue)tothe2003-2004aidincrease.DACdonorsdisbursedameagre$146.1millionwhilenon-DACbilateraldonorshaveactuallyreducedaidtoAfricaforthreeconsecutiveyears.

WhileODAhasincreasedrecentlyinnominalterms,theresourcesreceivedexcludingemergencyaidanddebtreliefincreasedonlymarginallyfromthepastdecade(UN2006).Moreover,inrealterms,aidinflowsarestillbelowthe1990levelof$33.3bil-lion.AidtoSSAhasdeclinedbothasapercentageofGrossNationalIncome(GNI)andasapercentageofGrossCapitalFormation(GCF)sincetheearly1990s.From6.5% in1990-1994, the aid/GNI ratiodeclined to5.3% in2000-2003.Theaid/GCFratiodeclinedfrom40.7%to27%duringthesameperiod(McKinley2005).

ToachieveandsustainhigherlevelsofGDPgrowthratesandtoacceleratepovertyreduction,African countrieswillneedhigher volumesof aid in the comingyears.Withimprovementsinmacroeconomicpoliciesandinstitutions,andstrongcommit-mentbygovernmentstotargetgrowthandpovertyactivitiesintheallocationofaid,itispossibleforAfricancountriestoabsorbhigherlevelsofaidandreapmorebenefitsfromaid(seeCommissionforAfrica,2005;MillenniumProject,2005).Therefore,scalingupaidisnotonlynecessarytoachievedevelopmenttargetsbutitisalsofea-siblewith regard to absorption capacity in receiving countries.Newaid,however,shouldbeintheformofgrantstopreventanewroundofexternalpaymentcrisis.Topreventexcessivedependenceonaid,Africancountriesalsoneedtoboosteffortstoincreasedomesticrevenuemobilization.

Africa needs to increase domestic revenue to prevent

excessive dependence

on aid


Figure �.�Official development assistance to Africa (constant 2003 $billion)

Source: OECD. 2005. International Development Statistics online databases

Foreign direct investment remains low and concentrated

During2002-2004,Africareceivedalittleover2percentofFDIinflowsintheworldandlessthan10percentofflowstodevelopingeconomies(seechapter2).FDItoAfricaamountedto$30billion,upfrom$18.1billionin2004.ThedistributionofFDIflowswasunevenacrosssubregions,withNorthAfricareceivingabout30percentofthetotalcomparedto10percentforEastAfrica.EastAfricasawthelargestincrease inFDI(54.1%),whileSouthernAfricarecordedmorethan31.5percentdecline in FDI from 2003 to 2004. Natural resource-rich countries continued todominateinFDIinflows,withoilexporterscapturingover65percentoftheannualFDIinflowstoAfricabetween2002and2004.

TheheavyconcentrationofFDIinextractiveindustriesraisesconcernswithregardto the impact on employment and poverty reduction as well as potential adverseeffects on the environment. Given that production technology in these sectors ishighlycapital intensive, investment isgenerallyaccompaniedbylittle jobcreation.Moreover,productioninthesesectorscarriesinsufficientspillovereffectsontherestoftheeconomyasoutputisexportedwithlittlevalueadded.Investmentsinextractiveindustries,especiallyoil,alsotendtocreateenvironmentalhazardswithdetrimentaleffectsonthewellbeingoflocalpopulations.Theseadverseeffectstotheeconomy,theenvironmentandsocietyneedtobeaddressedbyappropriateregulation.

Appropriate regulation is

needed to address the detrimental

impact of extractive industries on the

economy and the environment


Exchange rates remained stable in �00�

MostAfricancurrenciesremainedstablein2005.Inparticular,theCFAfrancwasstablein2005,withanappreciationofonly0.2percentagainsttheUSdollar.Onlythreecurrenciesexperiencedanappreciationofmorethan5percent:theEgyptianpound(6.8%), theSudanesedinar (5.5%),andtheZambiankwacha(6.6%).TheappreciationoftheEgyptianpoundwasduetostrongforeignexchangeinflowsandmajorimprovementsinthepolicyframeworkthatboostedconfidenceinthenationalcurrency(SRO-NA,2006).TheZambiankwachaappreciatedbecauseofhighcopperexports,andgrowinginvestorconfidence,especiallyfollowingthecountry’squalifica-tionfordebtrelief.TheSudanesedinarappreciatedbecauseofliberalizationoftheexchangerateregime,oilexportrevenue,andsubstantialcapitalinflowsintheformofFDIandremittances.

The stability of exchange rates is an important achievement given the number ofappreciationrisksfacedbymanycountries.Inparticular,thesurgeinoilrevenuesandthehighinflowsofaidputpressureonnationalcurrencies,causingthemtoappreci-ate.Theobservedresultsarepartlyattributabletoeffortsbymonetaryauthoritiestosterilizetheinflowsthroughappropriatemarketinterventions.

1.5 Despite high growth performance, important development challenges remain

Saving and investment rates remain low

AmongthefactorsexplainingtheinabilitytoachieveandsustainhighgrowthratesinmanyAfricancountriesislowdomesticinvestment.Averagegrossdomesticfixedinvestmentforthecontinentwasonly20percentinthe2000-2003period.Domes-tic investmenthasnot recovered from thedecline in the early 1980s andhasnotrespondedtoeconomicreformsaimedatmacroeconomicstabilization. Outof46countrieswithadequatedata,onlynineachievedhigh investment rates, that is, atleast25percentofGDPduring2000-2003(figure1.7).

Majorconstraintstoinvestmentarehighinterestratesandgenerallackofaccesstocredit,especiallyformediumandsmallenterprises(MSEs).ThecostofdoingbusinessinAfricaneconomiesisalsogenerallyperceivedasbeingmuchhigherthaninotherregions,thusdiscouragingbothdomesticinvestmentandFDI(UNECA2005).

SavingratesarealsolowinmostAfricancountries,mostlyduetolowincomesandinefficiencies in savings mobilization by financial systems. Only seven countriesrecordedanaveragesavingrateof25percentorhigherduring2000-2003.However,lowsavingratesprovideonlyapartialexplanationforthelowlevelsofinvestment.

High interest rates, lack of

access to credit and the cost of doing business

discourage domestic investment and FDI


Whilesavingrateshaveincreasedsincethemid-1990s,thishasnotbeenaccompa-nied by substantial recovery in investment (figure 1.8). In addition to the cost ofdoingbusiness,anothercauseoftheweaklinkagebetweensavingandinvestmentinAfricaisthatfinancialsystemsareinefficientandfailtoallocatecapitaloptimallyintheeconomy(SenbetandOtchere2005).

Figure �.�African countries with at least 25% investment-GDP ratio, 2000-2003

Source: World Development Indicators 2005.


Figure �.�Gross domestic fixed investment and saving (% of GDP) in Africa, 1975-2003

Source: World Development Indicators 2005.

Note: This figure includes 26 African countries with adequate data on savings and fixed investment over 1975-2003.

Job creation remains a challenge

AnotherdisappointingfeatureoftherecentgrowthrecordinAfricaisthatgrowthhasnotbeenaccompaniedbysubstantialgainsinjobcreation,whichraisesseriouscon-cernsaboutthecontinent’sabilitytoachievemeaningfulpovertyreduction(UNECA2006b).Thefirstcauseofthelowemploymentperformanceonthecontinentistheinability to sustainhighgrowthoveranextendedperiod. HighvolatilityofGDPgrowthreducesincentivesforjobcreationintheprivatesectorduetotheuncertaintyoffutureprofitability.

Thesecondcauseisthatgrowthrateshavenotbeenhighenoughinmanycountriestogenerateenoughdemandforlabour.Inaddition,inmanycountries,GDPgrowthhasnotkeptpacewithgrowthofthelabourforce.Indeed,thestrongaverageper-formanceatthecontinentallevelmaskswidedisparityacrosscountries,withmanycountriesstuckinalow-growthequilibria.

Thethirdcauseofpooremploymentperformanceistheshiftofeconomicactivityawayfromagricultureintocapital-intensivesectorssuchasminingandoilproduction.From1994to2003,35outof51countries(withadequatedata)experiencedadeclineintheshareofagricultureinGDP(WorldBank2005).Thisshiftofeconomicactivityawayfromagriculturehasbeenaccompaniedbylittleornoincreaseinproductivityintheagriculturalsectorandverylowabsorptionoflabourintothenon-agriculturalsector,resultinginhighunder-unemploymentintherural/agriculturalsector.

Africa’s economic growth has not been

accompanied by substantial gains in

job creation


The human development record is still low

Whilethedevelopingworldingeneralhasmadesignificantprogresstowardsachiev-ingtheMDGsoverthepastdecade,mostAfricancountriesarestilllaggingbehindinbothinvestmentsandoutcomesinkeyareasofsocialandeconomicdevelopment(UNECA2005a). SSAistheonlyregionofthedevelopingworldwherethepov-ertyheadcounthasincreasedsince1980(UNECA2005b).SSAalsohasthehighestnumberofpeoplelackingaccesstocleandrinkingwater(269million)andsanitation(407million),(UNDP2006).Inthe2005Human Development Report,30ofthe32countriesclassifiedinthe“lowhumandevelopment”categorybasedontheHumanDevelopmentIndex(HDI)6arefromSSA(UNDP2005).Thelevelofhumandevel-opmentinSSAisnotonlylowerthaninotherpartsoftheworld,butitisalsopro-gressingataslowerpacesincethemid-1980s.

Despite recent stronggrowth, thereareconcernsabout its impacton socialdevel-opment and its sustainability in the medium term. While African countries haveachievedhighergrowthratesthaninpreviousdecades,theseratesstill fallshortofthethresholdrequiredtoacceleratepovertyalleviationandachievetheMDGs.Onamedium-termbasis,onlyfourcountriesmetthesevenpercentgrowththreshold(figure1.5):EquatorialGuinea,Chad,Angola,andMozambique.Overall,veryfewAfricancountrieshavebeenabletosustainsufficientlyhigheconomicgrowthrates,whichlargelyexplainstheslowprogressinsocialdevelopment.

Animportantcauseoftheslowprogressinhumandevelopmentisthefactthatgrowthhasnotbeenaccompaniedbysignificantjobcreation.Theconcentrationofgrowthincapital-intensivesectorssuchasoilandminingandtheshiftawayfromagriculturewithoutabsorptionof thedisplaced labour,havecontributedto job lossesandtheworseningoflivingstandards.

Nevertheless,therearelargevariationsinperformanceinhumandevelopmentacrossthecontinent.ManyAfricancountriesregisteredsubstantial increasesinHDIoverthepastyears,whileothersexperienceddeteriorationinlivingstandards(seefigure1.9).Notethatsixof thetopperformers inhumandevelopmentalsorankamongthe top performers in medium-termgrowth as indicated infigure 1.5 (EquatorialGuinea,Ethiopia,Mozambique,Rwanda,Sudan,andUganda).Topperformersinhumandevelopmentincludepost-conflictcountries,suchasRwanda,Uganda,andMozambique,whichalsopostedhighgrowthratesinthepastfewyears.ThedeclineinHDIinSouthernAfricancountriesasshowninfigure1.9canbeattributedtotheworseninghealthsituationduetoHIV/AIDS.7

6 HDImeasuresacountry’sachievementsinthreeaspectsofhumandevelopment:longevity,knowledge,andadecentstandardofliving.Longevityismeasuredbylifeexpectancyatbirth;knowledgeismeasuredbyacom-binationoftheadultliteracyrateandthecombinedgrossprimary,secondary,andtertiaryenrolmentratio;andstandardofliving,asmeasuredbyGDPpercapita.

7 In2003,southernAfricancountriesexhibitinghighHIV/AIDSprevalencerateswere:Botswana(37.3%),Leso-tho(28.9%),SouthAfrica(21.5%),andSwaziland(38.8%).

Africa’s growth rates still fall short of the

MDG threshold


Figure �.�Top 10 and bottom 5 performers in human development, % change in HDI between 1995 and 2003

Source: UNDP, Human Development Report 2005

WhilemanyAfricancountriesareexperiencingworseningsocialconditions,severalhave made progress toward meeting the MDGs, as measured by gains in variousdimensions of social development, such as higher access to clean water and sani-tation, increase in literacy, reduction in maternal and child mortality, and overallimprovementinlifeexpectancy(UNECA2005).Forexample,outofthe51coun-trieswithadequatedata,childmortalitydeclinedin34,stagnatedin9,andincreased


in8countries(table1.3).8Progressinsocialdevelopmentishamperedbyinequality,withpoorerfamiliesexperiencingslowerprogressthanrichhouseholds.Forexample,about38percentofchildren fromthepoorest20percentofAfricanhouseholdsdo not go to school, compared to 12 per cent for the richest 20 per cent of thehouseholds(UN2005).Similardisparitiesareobservedintheareaofimmunizationandaccesstobasicsocialservices(UNDP2005).Theevidencesuggeststhatwhileprogresshasbeenmadeinsomecountries,allAfricancountriesstillneedtoincreaseeffortstoaccelerateprogresstowardsachievingtheMDGs.

Table �.�Progress in achieving the MDGs in Africa

Goals Countries that are likely to achieve the targets

Goal 1: Eradicate extreme

poverty and hunger

Poverty: Botswana, Burkina Faso, Cameroon, Ghana, Lesotho,

Mauritius, South Africa, Uganda and North African countries except

Mauritania and Sudan.

Child malnutrition: Botswana, Chad, Egypt, Gambia, and Tunisia.

Overall undernourishment: Angola, Ghana, Malawi, Mauritius and

North African countries except Sudan.

Goal 2: Achieve universal

primary education

Net enrolment and completion rates: Algeria, Botswana, Cape

Verde, Egypt, Gabon, Mauritius, Namibia, Swaziland, Rwanda, São

Tomé and Principe, Seychelles, South Africa, Togo, Tunisia, and

Zimbabwe

Goal 3: Promote gender

equality

Primary level education: Botswana, Lesotho, Mauritius, Namibia,

Rwanda, Swaziland, South Africa, Malawi, Zambia and Zimbabwe.

Secondary level: Algeria, Botswana, Lesotho, Libya, Namibia,

Zimbabwe, Mauritius, Swaziland, South Africa, Rwanda and Tunisia

Goal 4: Reduce child mortality Cape Verde, Mauritius, Malawi, Seychelles and North African

countries except Mauritania and Sudan.

Goal 5: Reduce maternal

mortality

Botswana, Cape Verde, Gambia, Mauritius and North African

countries except Mauritania and Sudan.

Goal 6: Combat HIV/AIDS,

malaria and other diseases

HIV/AIDS: Botswana, Uganda and Zimbabwe. Malaria: Benin,

Cameroon, Central African Republic, Comoros, Gambia, Guinea-

Bissau, Kenya and Rwanda.

Tuberculosis: Angola, Gabon, Gambia, Madagascar, South

Africa, Swaziland, Zambia and North African countries except

Mauritania and Sudan in all the three cases (HIV/AIDS, Malaria, and

Tuberculosis)

8 Note that the progress report in table 1.3 is based on performance over 1990-2000 and does not take intoaccountprogressandsetbacks thereafter.Forexample,MauritaniaandSudanexperiencedregression inchildhealthstatusduetotheeffectsofpoliticalinstability.

Progress in social development is

hampered by inequality


Goals Countries that are likely to achieve the targets

Goal 7: Ensure environmental

sustainability

Sustainable development (forest area): Cape Verde, Gambia,

Swaziland and North African countries except Mauritania and

Sudan.

Access to safe drinking water (rural): Algeria, Botswana, Burundi,

Central African Republic, Egypt, Gambia, Ghana, Mauritius, Malawi,

Sudan, Tanzania, and Namibia.

Access to sanitation (urban): Algeria, Benin, Cameroon, Egypt,

Ghana, Libya, Malawi, Mauritius, Morocco, South Africa and Tunisia.

Source: UNECA, 2005. Survey of Economic and Social Conditions in Africa 200�-2005. Addis Ababa, Ethiopia.

Inequality remains high and hampers progress in poverty reduction

Another important challenge that limits progress in poverty reduction is the highlevelsofinequalityinmanyAfricancountries.Inequalitymanifestsitselfinvariousforms:incomeinequality,assetinequality,andinequalityinaccesstoeducation,healthservices,and labourmarkets.Moreover, inadditiontovertical inequality,evidencecontinuestoshowsubstantialhorizontal inequalityacrossthecontinent.Empiricalevidencesuggeststhathighinequalitysubstantiallyreducestherateatwhichgrowthistransformedintopovertyreduction(Fosu2006).Therefore,inadditiontostrength-ening strategies for accelerating growth, achievement of broad-based developmentmustremainoneoftheprioritiesindebatesovernationaleconomicpolicy.

Progress in closing the gender gap is still not enough

Africancountriescontinuetoexhibitpervasivegenderinequalityinbasicrights,accesstoproductiveresourcesandeconomicopportunities,andlackofpoliticalvoice.Theinternationaldevelopmentcommunityhascometotherealizationthattheissueofgender inequalitycanno longerberelegatedtothedomainofadvocacy,butmustoccupythecentrestageintheeconomicdevelopmentpolicydiscourse(WorldBank2001).Thefocusongenderinequalityisillustratedbythelargeandgrowingnumberofnationalandinternationaldeclarationsandconventionsontheissue.However,actual implementationof thesedeclarations remainsweak, perhapsbecause of thelackofeffectiveinstitutionalbacking.

ThereareimportantreasonswhyAfricanpolicymakersshouldpayattentiontogenderinequalityandseekwaystoeliminateit.Oneoverridingreasonisthatwhilegenderinequalityharmswomenprimarily,italsoimposesheavycostsonsocietyasawhole.Inequalities inbasic rights andaccess to schooling, credit and jobsaffectnotonlywomenandgirlsbuttheentiresociety.

Accelerating growth and broad-based

development must remain a priority


Itisencouragingthatthroughoutthecontinent,therearevisiblegainsinclosingthegendergap,especiallyineducation.Girlenrolmentratesinelementaryandsecond-aryschoolshaveincreasedsubstantially,andoftenfasterthanthoseofboys(table1.4).Consequently,theratiosoffemaletomaleenrolmentandprimaryschoolcompletionrateshaveincreasedinmanycountries.

Itisalsoclearthatsomecountriesstillexhibitlargegendergapsineducationregard-lessoftheprogressachievedoverthepastyears.Womenareespeciallylaggingbehindinhighereducation,withonlyafewcountriesreachinggenderparityinrecentyears(figure1.10).

Table �.�Gender gap in education, 1990-2002

Ratio of girls to boys in primary school

Ratio of young literate females to males (% of

age 14-25)

Ratio of female to male primary completion rate

2002 % change 1990-2002

2002 % change 1990-2002

2002 % change 1990-2002

Algeria 98.6 18.3 91.1 15.1 0.99 16.3

Burundi 79.4 -2.9 96.9 26.3 0.72 -16.0

Chad 58.8 41.9 84.4 30.7 0.47 108.4

Comoros 82.2 15.7 79.5 2.2 0.89 n.a.

Djibouti 71.2 1.7 91.2 16.7 0.84 n.a.

Ethiopia n.a. n.a. 82.1 24.3 0.54 n.a.

Ghana 91.0 18.5 95.7 11.9 1.05 38.7

Madagascar n.a. n.a. 92.5 8.1 1.03 -0.4

Malawi 92.5 14.7 76.7 13.5 0.96 23.6

Mali 71.3 22.5 n.a. n.a. 0.64 -0.7

Mauritania 93.8 38.9 72.7 12.0 0.90 38.1

Morocco 87.8 25.2 79.2 28.2 0.89 30.8

Mozambique 79.0 8.2 64.3 34.2 0.67 3.0

Niger 69.0 24.0 44.4 18.8 0.71 25.3

Rwanda 94.8 -1.6 96.9 12.1 0.95 -5.3

Senegal 87.1 27.2 72.5 20.1 0.81 n.a.

South Africa 100.4 -2.7 100.0 0.2 1.06 n.a.

Sudan 85.8 10.9 88.5 23.7 0.85 4.5

Swaziland 94.4 -2.1 101.8 0.9 1.05 -3.3

Uganda 96.3 24.7 85.7 13.1 0.86 n.a.

Zimbabwe 95.4 -0.7 97.3 2.9 0.94 0.0

Source: World Bank, World Bank African Database 2005 CD ROM and World Development Indicators 2005 CD ROM

Inequalities in basic rights and access

to schooling, credit and jobs affect not

only women and girls but the entire

society


Figure �.�0Gender gap in enrolment (female/male ratio) in 2002.

Source: World Bank, World Development Indicators 2005.

Note: The figure includes only countries with adequate data.

The case of conflict and post-conflict countries

Post-conflictcountriesfaceparticularchallengesarisingfromtheeffectsofwarandtheimmensefinancialneedsassociatedwithreconstruction.Thesecountriesarefacedwiththechallengeofmakingmyriadpolicypriorities,frominfrastructureandenergy


to social servicedeliveryandfrommacroeconomicstabilizationtomicro-levelandregulatory reforms. Nonetheless,manypost-conflict countrieshave recordedhighgrowth rates in recentyears,dueprimarily to the restorationofpeace,but also togovernmenteffortstoinvestinreconstructionoftenwithgeneroussupportfromthedonorcommunity.9CountriessuchasMozambique,Rwanda,andUgandaaregoodexamplesofeconomiesachievingstrongperformanceintheirpost-conflictera.

Countriesthatarestillinconflictfaceevenbiggerchallengeswithregardtodevel-opment,employmentcreationandpovertyreduction.Insecurityinthesecountriesalso threatens economic activity andpolitical stability inneighbouring countriesandbeyond.Effortsatthenational,regional,andinternationallevelmustbeiniti-atedandsustainedtoachievepeacefulsettlementofconflictsandalsotoestablishinstitutionalmechanismsofdemocraticgovernanceasawayofpreventingfutureconflicts(Fosu2005).

1.6 Growth prospects for 2006 are positiveAfricaisexpectedtocontinuewiththestronggrowthperformancepostedoverthepasttwoyears.Thegrowthrateisprojectedat5.7percentin2006,withNorthAfricaleadingallthesubregionswithagrowthrateof6.6percent(figure1.11).Asmanyas31countriesareanticipatedtoposthighergrowththanin2005.Growthperformancewillbedrivenbyseveralfactors,whicharediscussedbelow.

Figure �.��Projected real GDP growth rates by subregion, 2006 (%)


9 A.K.Fosu,andP.Collier,eds.(2005).Post-Conflict Economies in Africa.NewYork:PalgraveMacmillan.

Peaceful settlements of conflicts must

be initiated and sustained for meaningful

development and poverty reduction


Favourable factors for growth

Oil export revenues are expected to remain high

Oil-rich countries are expected to benefit from continued strong performance inexportsthankstohighinternationaloilprices.However,thegainsfromtheoilboomaccruing tooil economieswillbecounterbalancedby theadverseeffectsofhigherenergycostsongrowthamongnon-oileconomies.

Global demand will support higher exports

GlobaldemandforAfricanproducts–especiallyoil,mineralsandagricultural–isexpectedtoremainupbeatduetoeconomicrecoveryinmajorindustrialcountries.Tourism will also benefit from strong growth in industrialized countries. WhilegrowthintheEuroareaisexpectedtobemoderate,theUnitedStatesandemergingAsianeconomies–ledbyChina–arelikelytoexperiencesubstantialgrowthinthecomingtwoyears(BoardofGovernorsoftheFederalReserveSystem,2006).

Delivery of promised new aid and debt relief will boost domestic expenditure

Deliveryof thepromised aid anddebt reliefwill allowAfrican countries toboostexpendituresinkeysectorsincludinginfrastructureandsocialservices.Higherinvest-mentsinpublicinfrastructurewillcontributetoloweringprivateproductioncosts,whichwill improvetheinvestmentclimate.Thiswillboostprivateinvestmentandleadtohighereconomicgrowthrates.

Better macroeconomic fundamentals will serve to contain long-term inflation expectations

Successinconsolidatingmacroeconomicmanagementwillhelpnotonlyincontain-inginflationintheshortrun,butalsoincontaininglong-terminflationexpectations.Thiswillinturnhelpinmaintaininglowlong-terminterestrates,thusreducingthecostoflong-termborrowingforthegovernmentandtheprivatesector.Containinglong-terminflationexpectations isalsonecessary tominimize the lastingeffectsofshort-termshockstothepricelevel,suchasenergypricehikes.

Improved political stability

SomecountriessuchasBurundi,theDRC,LiberiaandSierraLeone,areexpectedtobenefitfromimprovementsinpoliticalstability.Consolidationofpoliticalstabil-itywillnecessitatesupportfromtheinternationalcommunitybothfinanciallyand


politically.Thedividendsfromsuchsupportarehighintermsofeconomicrecoveryandpeacebuilding,bothatthecountryandregionallevels.

Constraints to medium-term growth

The rise in world interest rates will increase the cost of debt servicing

Tocontaininflationarypressures,theUnitedStatesandothermajorindustrialcoun-trieswilllikelypursuetheir“prudent”tighteningofmonetarypolicybyraisingshort-term interest rates (FRB 2005). Higher world interest rates will raise the cost ofexternaldebtserviceforAfricancountries,whichwilldampengrowth.

Droughts remain a threat to agricultural production

Agriculturalproductionisexpectedtobeseverelyaffectedbyclimaticshocks,includ-ingdroughts,floods,anddesertificationintheSahel.

The HIV/AIDS pandemic remains a threat to labour supply and labour productivity

Economic growth in many countries will be compromised by the increasingspreadoftheHIV/AIDSpandemic,whichundermineslaboursupplyandlabourproductivity.

Insufficient economic diversification remains an important source of vulnerability to shocks

Lack of diversification of production and exports constitutes an important sourceofpotential instabilityandvulnerability to shocks. Oileconomiesareparticularlyvulnerable to swings in internationalprices. Competitivepressure fromemergingeconomies,suchasChinaandIndia,isachallengetomanufacturingsectorgrowth.

Inefficient and inadequate public infrastructure remains a constraint to private sector growth and economic diversification

Lackofefficientpublicinfrastructureandunreliableenergysupplyunderminepro-ductivityandinternationalcompetitiveness,whichultimatelyslowsdowneconomicgrowth.


1.7 Conclusion and policy recommendationsTheevidencesurveyedinthischaptercallsforanumberofpolicyrecommendations,includingthefollowing:

Consolidating macroeconomic management

At the macroeconomic policy level, African countries need to continue to pursuefiscaldisciplineandprudentmonetarypolicytoconsolidatemacroeconomicstabil-ity.Efficientmacroeconomicmanagementwill,amongothergains,reduceinflationexpectations,whichwillminimizelong-termeffectsofsupplyshockssuchasoilpriceincreases.

Promoting economic diversification

The concentration of growth in natural resource sectors exposes African countriestoterms-of-tradeshocks.Effortsmustbeenhancedtopromotenewinvestmentsinmanufacturingandservicesectorstoreducevulnerabilitytothesetypesofshocksanddependencyoncommodityexports.

Alleviating energy and public infrastructure bottlenecks

The provision of public infrastructure and reliable energy sources is essential forunlocking the potential of the private sector and increasing access to social serv-icesandmarketsforthepoor;itisanimportantelementofthepovertyeradicationagenda.Improvementofthestockofinfrastructureandcreationofreliableenergysupplysourcesmustthenrisetothelevelofnationalprioritytoincreaseeconomicgrowthinthemediumterm.

Achieving greater gender equity

Effortstoincreasegenderequityinbasicrights,accesstoproductiveresourcesandeconomicopportunities,andpoliticalvoicemustbesupportedandintensifiedatthenational,regionalandinternationallevels.

Intensifying efforts at regional integration

Effortsatregionalintegrationneedtobeintensifiedasameansofexpandingtradeopportunitiesandincreasingthecontinent’sleverageinworldtradenegotiations.

Addressing climate shocks

Africancountriesneedto invest instrategiesformanagingclimaterisk inordertoincreasetheirpreparednessinhandlingclimateshocks.


Curbing the spread of the HIV/AIDS pandemic

PublicinvestmentsinpreventiveandeducationalprogrammestofightthespreadofHIV/AIDSwillhelptocurbtheupwardtrendoftheepidemicwhileatthesametimecreatingjobsforthosewhowillbeemployedinthoseprogrammes.

Emphasizing job creation as a means of accelerating poverty eradication

Inadditiontoraisingtheoverallratesofeconomicgrowth,Africancountriesneedtodesignstrategiesforincreasingtheemploymentgainsfromgrowth.Thiswillrequirebothhigherpublicinvestmentsinlabour-intensiveinfrastructureandservice-deliveryprogrammesaswellasprovidingincentivestotheprivatesectortoincreasetheoveralllabourintensityofproduction.

In addition, policymakers must integrate job creation in national macroeconomicframeworks.Thiswillrequire,amongotherthings,systematictrackingoftheeffectsofmonetaryandfiscalpolicyonemploymentattheeconomy-widelevelandatthesectorallevel.


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CommissionforAfrica,2005.Our Common Interest: Report of the Commission for Africa.March2005

Fosu,A.K.,2006.“InequalityandtheGrowth-PovertyNexus:SpecificationEmpiricsUsingAfricanData.”Applied Economic Letters,forthcoming.

__________2005.“Post-ConflictEconomiesinAfrica:SynthesisandLessons,”inFosu,A.K.andP.Collier,eds.(2005).Post-Conflict Economies in Africa.NewYork:PalgraveMacmillan.

IMF,2006.WorldEconomicOutlookDatabase,April2006.

McKinley,T.,2005.“Whyis‘theDutchDisease’AlwaysaDisease?TheMacroeco-nomic Consequences of Scaling up ODA.” UNDP, International Poverty Centre,WorkingPaperNo.10(November).

OECD,2005.Economic Outlook,No.78.PreliminaryEdition.(25November).

Senbet,L.andIOtchere,2005.“FinancialSectorReformsinAfrica. PerspectivesonIssuesandPolicies.”PaperpresentedattheAnnualWorldBankConferenceonDevelopmentEconomics,Dakar,January2005.

UNDP,2005.Human Development Report.NewYork:UnitedNations.

__________2006.Annual Report 2006.NewYork:UNDP

UNECA, 2005a. The Millennium Development Goals in Africa: Progress and Chal-lenges.AddisAbaba:UNECA.

__________2005b.Economic Report on Africa 2005.AddisAbaba:UNECA.

__________ 2006a. “Challenges and Opportunities for African Least DevelopedCountries.”ProgressReporton the Implementationof theBrusselsProgrammeofActionforAfricanLeastDevelopedCountries,Mid-termReview2001-2005(Febru-ary).

__________ 2006b. “Meeting the Challenge of Employment in Africa.” Paperprepared for the 39th session of the Commission Conference of African MinistersofFinance,Planning andDevelopment,Ouagadougou,BurkinaFaso,10-14May2006.

UNECA,CentralAfricaSubregionalOffice,2006.“L’évolutionéconomiqueenAfri-queCentraleen2004-2005etPrévisionspour2006.”Yaoundé,Cameroon.

UNECA,NorthAfricaSubregionalOffice,2006.”LesConditionsEconomiquesetSocialesenAfriqueduNorden2005.”Rabat,Morroco.


UNECA,WestAfricaSubregionalOffice,2006.“ReportonEconomicandSocialConditionsinWestAfricain2005andProspectsfor2006”,Niamey,Mali.

UnitedNations,2005.The Millennium Development Goals Report.NewYork:UnitedNations.

__________2006.World Economic Situation and Prospects 2006.NewYork:UnitedNations.

USDepartmentofEnergy,1999.Energy in Africa.EnergyInformationAdministra-tion,DepartmentofEnergy

WorldBank,2005.World Development Indicators2005.CDROMedition.

��

2.1 IntroductionAlthoughinflowsofcapitaltoAfricahaveincreasedrecently,theystillfallshortoftheresourcesneededtofundattainmentoftheinternationallyagreeddevelopmentgoals.Inboth2004and2005,averageGDPgrowthinAfricareached5percent,stillfall-ingshortof7percent,theraterequiredtomeettheMDGs.Thus,themobilizationandmoreeffectiveuseofbothdomesticresourcesandinternationalflowshavebeengiventoppriorityintheMonterreyConsensus.AsAfricaneconomiesareincreasinglyinterwovenwiththeglobaleconomicsystem,nationaldevelopmenteffortsneedtobesupportedbyanenablinginternationaleconomicenvironment(UN2002).

Figure 2.1 illustrates the resource gaps in Africa. Due to low private savings andchronicgovernmentbudgetdeficits,manyAfricancountriesfaceashortageoffundstomeettheirinvestmentneedsandmoregenerally,theirdevelopmentgoals.UnitedNationsConferenceonTradeandDevelopment (UNCTAD2000)estimated thattheinvestmentrateinSSAhastoincreaseto22-25percentfromthelevelsbelow20percentduringthe1990storeachasustainablegrowthrateof6percent.

Figure �.�Resource gaps in 36 African countries, 1980-2003 (% of GDP)


Note: GDS = Gross Domestic Savings, GDI = Gross Domestic Investment. The aggregation is based on 36 countries for which all indicators were available for all years. Weighted averages were used to calculate shares of GDP.

Capital flows to Africa and their impact on growth �

Average GDP still falls short of the rate required to meet the

MDGs


Changesinsavingrateshavemainlybeendrivenbythepublicsector,whichshowedadeterioratingperformanceinthe1990s,andonlyrecentlyimprovedforsomecoun-tries (see chapter 1). The fact that private savings are low is not only due to lownationalincomebutalsototheunderdevelopmentofthefinancialsystem.House-holdsurveysshowthatmanyhouseholdshaveassetsofaround30percentoftheirincomesbuttheyaremainlyintheformofdurablegoodssuchasgold(i.e.jewellery)andfabrics,andnotintheformofbanksavings,whichcouldbeusedforproductiveinvestment(Aryeetey2005).

Anotherdimensionoftheseresourcegapsisthesubstantialcurrentaccountdeficitsarisingfromfailureofexportrevenuestokeepupwithimports(figure2.1).Currentaccountproblemsare especiallypronouncedamongcountries thatdependon rawmaterialexports(UNECA2005b).

Theresourcegapsneedtobefilledbycapitalflowsfromabroad,includingdevelop-mentaid,debtreliefandprivatecapitalflows,suchasFDI,portfolioinvestment,andremittances.ThedebateonpromotingsustainabledevelopmentinAfricamustthere-foreincludeadiscussionofstrategiestoattractcapitalflowstothecontinent.

SeveralattemptshavebeenmadetoestimatetheresourcesnecessarytoachievetheMDGs.Theyrangefrom$50billionayearinthe“ZedilloReport”oftheHigh-LevelPanelonFinancingforDevelopmenttomorethan$76billionayearbytheWorldBankandUNDP(ReddyandHeuty2005).1Asgovernmentrevenuesandprivatesavingsremaintoolowtocovertheseexpenses,externalfinanceisneeded.However,itisnotsufficienttoincreasefinancialflowstoAfricainordertoaccelerategrowthandreducepoverty.Itisnecessarytoallocateandutilizetheseresourcesefficientlytomaximizetheirimpactongrowthandwelfare.

Inordertoformabasisfortheremainderofthisreport,thischapterexaminesthetrendsandpatternsofcapitalflowstoAfricaandtheextenttowhichthesecapitalflowsmeetthefinancingneedsofAfricancountries.ThechapteralsoinvestigatesthedeterminantsofflowsandtheirimpactonAfricaneconomies.Themainfindingsaresummarizedbelow.

Since 2000 capital inflows in the form of aid, workers remittances and FDI haveincreasedconsiderably,by54percentuntil2003.Theirvolatility,whichishighestforprivateflows,hamperstheirgrowtheffects.Thecontinenthasalsoexperiencedsubstantial resource outflows in the form of debt service, capital flight and profitremittances.

AidisthemostimportantinflowformostAfricancountriesandismainlyusedforsocialservices.However,ithasalsocontributedtoAfrica’sindebtedness.Thus,cur-

1 Theseestimatesarenotveryreliableastheyarebasedonpoorqualitydataanddonottakeintoaccountinter-linkagesbetweenthedifferentgoalsoreconomiesofscaleorscope.Inaddition,resourcerequirementsmightbechangedconsiderablybyfutureshocks(ReddyandHeuty2005).

Efficient utilization of financial

flows to Africa is key to maximum

input on growth and welfare

��Capital flows to Africa and their impact on growth

rentdebtreductioneffortshavetoensurethattheresourcesfreedareusedtoboostproductiveactivitiestomakedebtlevelssustainable.

WhilemostFDIisstillconcentratedintheprimaryresourcesector,somediversifica-tionintermsofsectorsandoriginisobservable.Africaisstilloutsideoftheforeigninvestors’radarscreenmuchmorethanotherregions,despiterelativelyhighratesofreturnoninvestmentinAfrica.RemittancesarealsoconcentratedinafewAfricancountries,mainlyinNorthernAfrica.Theyarerelativelystable,countercyclicalanddirectly reducepoverty.Currently, theyaremainlyused forconsumptionbut theyalso can increaseproductivity through investment in schooling, better agriculturalinputsandsmallbusinesses.

2.2 Trends in capital flows to AfricaAllmajorcapitalflowstoAfricahave increasedconsiderablysince1980,especiallyFDI,whichincreasedeightfoldovertheperiod1980-2003(figure2.2).Formostofthetime,ODAhasbeenthemostimportantsourceofcapitalinflows,followedbyworkers’ remittancesandFDI.Portfolio investmentaccounts foraminor shareincapitalflows,exceptforSouthAfrica,whichisexcludedfromfigure2.2.In2003,ODA accounted for 46 per cent of all capital inflows to Africa, whereas workersremittancesaccountedfor30percent,FDIfor24percentandportfolioflowsforonly0.15percent(excludingSouthAfrica).

Figure �.�Resource inflows to Africa, 1980-2003 ($ billion)


Note: 46 countries are included in the figure: Seven countries (Angola, Cape Verde, Eritrea, Libya, Mozambique, Namibia and South Africa) were dropped from this calculation due to missing data.

Remittances can increase productivity

through investment in schooling,

better agricultural inputs and small

businesses


Figure �.�Resource outflows from Africa, 1980-2003 ($ billion)


Note: forty-six countries are included in the figure: Seven countries (Angola, Cape Verde, Eritrea, Libya, Mozam-bique, Namibia and South Africa) were dropped from this calculation because there are missing data.

Themainoutflowfrommostcountriesisdebtservice(figure2.3).Between1984and1986,debtservicepaymentswerehigherthantheinflowsofODA,FDI,remittancesand portfolio investment combined. Other outflows consist of profit repatriationfromFDI,whichaccountedforapproximatelyonethirdofdebtservicepaymentsin2003,buthasbeenincreasingrapidlysincethebeginningofthe1990s.Inadditiontotheseofficiallyregisteredflows,thereiscapitalflight,whichisestimatedtoamounttobetween$3and$13billionperyear.

These aggregate figures obscure significant cross-country differences within Africa.AlthoughODAis themost important inflowformostAfricancountries,FDIhasbeenmoreimportantbetween1980and2003forseveralcountries,namelyAngola,EquatorialGuinea,Nigeria,SeychellesandSouthAfrica.ForNorthAfricancoun-tries,aswellasLesothoandSwaziland,workers’remittancesarethemostimportantinflows.

The role of aid in external financing varies considerably

Afteradeclineinthe1990s,ODAtoAfricahasbeenincreasingagainsince2002(seechapter1).AtGleneagles,theG-8countriescommittedanadditional$50billion,ofwhich50percentshouldgotoAfrica.ODAhasalreadyincreasedfrom0.25percentofGNIin2004to0.33percentin2005andisestimatedtoincreasefurthertoaround0.4percentby2010(OECD2006).


In2003,percapitaODAtoAfricawas$31,thirdtoOceaniaandEuropeandtwicetheaverageforallaidrecipients.2Inabsoluteterms,thetopfiverecipientsbetween2000and2004weretheDemocraticRepublicofCongo(8percentofallODAtoAfrica),MozambiqueEthiopia,Egypt,andTanzania(6percenteach).However,intermsofpercapitaODA,thefivecountrieswiththehighestallocationwereCapeVerde,SãoToméandPríncipe,Seychelles,Djibouti,andMauritania(OECD2006),allcountrieswithsmallpopulations.

Ingeneral,ODAisnotequallydistributedamongtheAfricansubregions(figure2.4).Formostofthe1980to2003period,SouthernAfricawasthelargestrecipientbothintermsofODAasashareofGNIandinpercapitaterms($38in2003).ItwasfollowedbyEastAfricawith$24percapita.WestandCentralAfricabothreceived6percentofGNIasODAwiththeformergetting$20percapitaandthelattergetting$32percapita.NorthAfricareceivedthelowestshare,bothasashareofGNIandonapercapitabasis(averageof$18).

Withrespecttothesectoraldistribution,thelargestpercentageofODAtoAfricain2002/2003wenttosocialinfrastructureandservices(34percent),includingeduca-tionandhealth.Anotherimportantsectorwaseconomicinfrastructureandservices(21percent),includingtransportandenergy.Togetherwithsupportforproduction(12 per cent), aid allocation to these sectors was expected not only to reduce thefinancinggapbutalsocontributetofuturegrowthperspectives.

Abouthalfofthetotalaidtobasichealthandeducationwastargetedtowardsgender-specificconcerns,suchasempowermentofwomen.However,onlyarelativelysmallshareofaidprojectsforinfrastructurehadgenderequalityasaprincipalorsignificantobjective (OECD2005,2006). Increasingly,ODAisgiven in the formofbudgetsupportinsteadofprojectandprogrammeaid,makingitsusemoreflexibleforrecipi-entsandreducingtheproblemsoftiedaid.3

2 Theamountofgrantsreportedbydonorspartlyincludesdebtforgiveness,whichisnotassociatedwithanactualtransferofresources(Birdsall,ClaessensandDiwan2002).

3 Tiedaidmeansthatatleastpartoftheamountreceivedhastobespentbypurchasinggoodsandservicesfromthedonorcountry.Thisreducestheefficiencyofaid.

ODI to Africa is estimated to increase

to 0.4% by 2010


Figure �.�ODA receipts by African subregion, 1980-2003 (% of GNI)


InmanyAfricancountries,alargeshareofpublicinvestment(e.g.ininfrastructure)andsocialexpenditure(especiallyeducationandhealth)isfinancedbyaid,makingthesecrucialsectorsvulnerabletoaidvolatility.Ingeneral,thevolatilityofprogrammeaid ishigher than thatofproject assistance.4As the latter isdesigned topromoteinvestmentinphysicalandhumancapital,itsvolatilityislikelytohaveseverenegativeeffectsonlong-termdevelopment(FieldingandMavrotas2005).

FDI is the most volatile form of capital flows

Highvolatilityofcapitalflowscausesseverebalance-of-paymentproblems,increasesmacroeconomicuncertainty,andunderminesgovernment’sabilitytodesignandsus-tain long-term development plans. Indeed, by introducing instability into privateinvestmentorimports,suchvolatilitymayadverselyaffectgrowth(Fosu2001).Onaverage,FDIflowsarethemostvolatile, followedbyworkersremittances,whereasODAflowsarethe leastvolatile(tableA1).5Otherprivatecapital inflows(exclud-ing FDI) are more volatile than FDI (Morrissey and Osei 2004; IMF 2005a). Inthe1990s,thevolatilityofcapital inflowsgenerallyincreased(Osei,Morrisseyand

4 Aidvolatilityismeasuredbyshockstoaid,basedonexpectationsaboutthechangeinaidasaresultofthechangeinsomemacroeconomicvariables.

5 Volatility ismeasuredbytheaveragecoefficientofvariation,definedas thestandarddeviationexpressedasapercentageofthemeanvalueovertime.PortfolioinvestmentisexcludedhereasitisnotveryrelevantformostAfricancountriesandthereforedataarescarce.


Lensink2002).Thevolatilityofthecombinedinflowsofaid,FDIandremittancesissmallerthantheindividualvolatilities,meaningthattheindividualvolatilitiesoffseteachothertosomeextent.

AsFDItothecontinentislargelydrivenbyinvestmentsintonaturalresourceexploi-tationinalimitednumberofverylargeprojects,thevolatilityofFDIisquitehigh.ForChad,forinstance,thecoefficientofvariationis205(tableA1).OthercausesofhighvolatilityincludethelowlevelofFDIitself,thesmallnumberofFDIprojects,andpoliticalinstability.

Thevolatilityofcapitalflowsvariesgreatlyacrosscountries(appendixA,tableA.1).Ingeneral,thevolatilityofaidislowestformostcountrieswhencomparedtoremit-tancesandtoFDI.However,forcountriessuchasCapeVerde,Lesotho,orSwaziland,whichhavearelativelyhighshareofremittancesinGNI,thevolatilityofremittancesislowest.Aidvolatilityishigherforcountriesthatdependheavilyonaid(BulirandHamann2003),butthatseemstobetrueforotherflowsaswell,atleastinthecaseofAfricancountries.

Equity flows remain unevenly distributed

Ingeneral,equityflows(FDIandportfolioinvestmentflows)toAfricaremainlow.Africa’sshareinworldFDIremainsataround3percent,withapeakat4percentinthemid-1980s.ThissharehasfollowedthesametrendasAfrica’seconomicweight,asmeasuredbyitsshareinworldGDP(figure2.5).

Figure �.�Inward FDI and GNI, Africa compared to World, 1980-2003 (%)


Note: The figure includes only 39 countries with consistent data.

Political instability and the small

number of FDI projects contribute

to high FDI volatility


In2004,FDIinflowstoAfricaincreasedby2percentfromthepreviousyearandstood at $18 billion. However, FDI to Africa in 2004 was more natural resourcedriventhaneverbefore.Thesub-sectors“Mining”,“OilandGas”and“PetroleumRefining”takentogetheraccountedfor$4billionoutof$4.6billioninFDItothecontinentintheformofcross-bordermergersandacquisitions(M&As).Afewoil-richcountriesbenefitedfromlargeFDIinflows.Overthe2002-2004period,invest-mentsinAngola,Chad,EquatorialGuineaandNigeriaaloneaccountedfor39percentofoverallFDItoAfrica.Theoilsectoraccountedfor90percentofFDIinflowsormoreinAngola,EquatorialGuineaandNigeria(UNCTAD2005).

However,insomeAfricancountries,suchasEgypt,Morocco,LesothoandMozam-bique,FDIhasrecentlyriseninmanufacturing,agro-industries,textilesandservices.Someoftheseinvestmentsaredrivenbypreferentialaccesstodeveloped-countrymar-kets,suchastheAfricanGrowthandOpportunityAct(AGOA)oftheUnitedStatesand theCotonouAgreementof theEuropeanUnion (EU),which raises concernsaboutsustainability(UNECA2005a).

Traditionally,foreigninvestorstoAfricacamefromEuropeand,toalesserextent,fromNorthAmerica.Lately,AsianinvestorsfromcountriessuchasChina,India,MalaysiaandSouthKoreahave increasingly engaged inAfrican countries.For example,46.3percentofChineseinvestmentsonthecontinentfortheperiod1979-2000wentintomanufacturing(WorldBank2004).SouthAfricancompaniesarealsoinvestingincreas-ingly inotherAfrican countries,particularly inSouthernAfrica.These aredesirabledevelopmentsfromadevelopmentperspectivesincetheyprovidechancestodiversifythesourcesofFDI.Moreover,investorsfromthesecountriesarefamiliarwithadevelop-ing-countryenvironmentandaremorelikelytouseappropriatetechnologyandtailortheirproductsandservicestolow-incomecountrycustomers.

Figure �.�Net FDI inflows and profit repatriation on FDI, 1980-2003 ($ billion)


Asian investors will help

Africa diversify FDI sources


FDIisassociatedwithoutflowsofprofits,whichcanbequitehigh.Figure2.6showsthat,forsomeyears,profitrepatriationswereevenhigherthanthenetinflowofFDI.Onlysincethesecondhalfofthe1990swerenetFDIinflowsintoAfricancountriesmarkedlyhigherthanprofitrepatriationsfromthecontinent.Thus,thechallengeisnotonlyhowtoattractmoreFDIbutalsohowtoencouragesustainedinvestmentinAfricaneconomies,soastoincreasethepositiveeffectsonemploymentcreation,technologytransferandlinkageswithdomesticinvestment.

Ingeneral,portfolioinvestmentsarenegligibleinAfricacomparedtootherflows(figure2.2).Notethatfigure2.2doesnot includedata forSouthAfrica,whichonitsownaccounted foraround$3.2billion inportfolio investment inflowsannuallyover theperiod1994-2003(WorldBank2005a).SouthAfrica’sequityinvestmentstructureisdominatedbyportfolioinvestment,aninvestmentcategorythatisnegligibleforotherAfricancountriesandevenatypicalforcountrieswithsimilarriskattributes(box2.1).

Remittances: a form of private capital flows on the rise

Remittanceshavebeenrecognizedonlyrecentlyasapotentialsourceoffinancingfordevelopment.TheamountofreportedremittancestoAfricahasincreasedfrom$5.9billionin1980to$14.9billionin2003.6Africareceivedabout15percentofglobal

6 However,remittancestoallcountriesgrewfive-foldoverthesameperiod(IMF2005a).

Box �.�Equity flows to South Africa - an exception

For the period 1994-2002, FDI inflows into South Africa totalled about 1.5 per cent of GDP per

year, whereas portfolio inflows amounted to about 3.5 per cent of GDP. In fact, portfolio flows

to South Africa dominated the overall portfolio flows to Africa, with its share being 89 per cent

or more in eight out of the ten years between 1994-2003. However, for most of the years since

1990, South Africa has recorded net outflows of portfolio investment.

The weak FDI performance of South Africa can be explained by a number of unfavourable

policies, especially insufficient trade liberalization, exchange rate volatility and capital controls.

However, in 2005, FDI inflows were larger than portfolio inflows, going into the banking, com-

modities and equipment sectors, due to increased sales of state-owned assets.

South Africa is the third largest foreign investor in Africa. Geographically, this investment

is highly concentrated in Southern Africa, which accounts for 90 per cent of South African FDI

within Africa. In seven Southern African Development Community (SADC) countries, South Africa

is the number one investor and in five countries, South African FDI makes up more than 50 per

cent of all FDI. The strong engagement of South Africa in this regard should give some impetus to

regional integration. South African FDI to the rest of the continent is targeting natural resources

and basic industries (including steel and other non-ferrous metals) and utilities.

Sources: Ahmed, Arezki and Funke 2005; World Bank 2005a; Page and te Velde 2004; South African Reserve Bank 2006.


remittances,withmorethantwothirdsgoingtoNorthAfrica.Thistrendisexpectedtocontinuefortworeasons.First,aspopulationsareaging in industrialcountries,thesecountrieswillneedtomeettheirexcessdemandforlabourwithhigherimmigra-tionfromdevelopingcountries.Second,unemploymentindevelopingcountrieswillcontinuetoexertpressureonmigrationtotheindustrialcountries.

For Africa as a whole, remittances represented 2.5 per cent of GNI in 2003, butunlikeotherregions,thissharehasnotincreasedsignificantlyoverthepast25years(WorldBank2005a).Withanimportantpartremittedthroughinformalchannelsandthereforeunreported,itisestimatedthatactualremittancesareatleasttwicetheofficialfigures(IMF2005a;WorldBank2005a;DocquierandRapoport2004).

InanumberofAfricancountries,workers’remittancesarelargerelativetootherfinan-cialflows(tableA1).Forsomecountries,suchasEgypt,Gambia,Lesotho,Moroccoand Swaziland, remittances exceed 5 per cent of GNI, representing a multiple ofinwardFDI.Forexample,workers’ remittances representedalmosteight times thevolumeofinwardFDIinCapeVerdeover1980-2003.Egyptranksamongthetopfivelargestrecipientsofremittancesinthedevelopingworld(WorldBank2005a).

Thereareconsiderablevariationsacrosssubregionswithrespecttothevolumeofremit-tances.NorthAfricahasthehighestremittance/GNIratio,withapeakofalmost8percentin1992,ledbyEgyptwhoseremittancesincreasedbyonethird.Since1996,theratio for thesubregionfluctuatedaround4percent.ForEastAfricaandevenmoresoforWestAfrica,theratioofremittancestoGNIhassubstantiallyincreasedsincethebeginningofthe1990s,reaching3percentinWestAfrica.However,forSouthernAfricaandCentralAfrica,theratiohasbeenverylowandflat(figure2.7).


Figure �.�Workers’ remittances by African subregion, 1980 - 2003 (% of GNI)


Workers’remittancesareimportantforanumberofreasons.Remittancesaremorestablethanotherprivatecapitalflows.Remittancesdirectedatproductiveactivitiesarealsorelativelystablesincemigrantsarelesslikelythanforeigninvestorstowithdrawtheirinvestments,eveninthepresenceofeconomicadversity.Unlikeotherprivateflows,remittanceinflowsarecounter-cyclical,whichallowsrecipienthouseholdstosmoothconsumption.Finally,remittancesdonotincreaseacountry’sindebtedness.(Chami,FullenkampandJahjah2005;IMF2005a).

Around80percentofremittancesinAfricaareusedforconsumptionandschoolingandhelploosenthebudgetconstraintsoftheirrecipients.Thus,remittancescontrib-utetoincreasedhumancapitalaccumulation.Thereisalsoevidencethatremittancesareusedforprivateinvestmentandinfrastructureatthecommunitylevel(UNECA2005a;IMF2005a).

Capital flight deprives the continent of much needed resources

Theanalysisofcapitalflows toand fromAfrica revealsacuriousparadox.Ontheonehand,Africancountrieshaveaccumulatedlargevolumesofdebt,presumablytofilltheirresourcegapandfinancetheirdevelopmentneeds.Ontheotherhand,thecontinentcontinuestoexperienceheavyfinancialhaemorrhageintheformofcapi-

Migrants are less likely than

foreign investors to withdraw their

investments


talflight,someofwhichisfinancedbyborrowedfunds.Indeed,empiricalevidencesuggestsquiteironicallythatSSAisa“netcreditor”totherestoftheworldinthesensethattheprivateassetsheldabroadbyAfricansexceedthecontinent’sliabilitiesvis-à-vistherestoftheworld(BoyceandNdikumana2001;NdikumanaandBoyce2003).Comparedtopopulationsinotherdevelopingregions,Africanstendtoexhibitasignificantlyhigherpreferenceforforeignassetsrelativetodomesticassets,with40percentofprivateassetsheldabroad(Collier,HoefflerandPattillo2001).

CapitalflightdeprivesAfricaofasizableportionoftheveryresourcesitneedsfordevelopment financing.Table A.2 shows the estimated amounts of capital flightfromSSA.Theestimatesvarysubstantially, reflectingdifferences inmethodologyand sample coverage. Ajayi (1997) estimates capital flight to be around $6 bil-lionperyearbetween1980and1991,whereasSalisu(2005)estimatestheannualamountat$13billionbetween1991and2004.ThedifferenceincapitalflightaspercentageofGDPismuchsmaller:5.1percentinAjayi’scalculationsand7percentinSalisu’scalculations.

External debt: relief is progressing

Africa’sdebtaccumulationhasquitealonghistory.Atindependence,Africanecono-miesweremainlydependentonprimarycommoditiesandexternalfinance.Atthetimeofthefirstoilshock,Africangovernmentshadjust increasedpublicexpendi-ture,financedbyrevenuesfromcommodities.Whencommoditypricessubsequentlydeclined,theywereunabletosustainexpenditurelevels.Loanswereeasilyavailabledue to largeoil revenues, low interest rates in internationalmarkets and increasedcreditworthinessbasedonexpectedincreasesincommodityprices.AsthetermsoftradeofAfricancountriesdeterioratedandrealinternationalinterestratesincreased,debtservicingstartedtobecomedifficult,leadingtoaccumulationofarrears.

Thereschedulingofdebtduetoinabilitytopayalldebtservicesalsocontributedtotheincreaseindebtstocks.AsmanyAfricancountriesfacedseveremacroeconomicdifficultiesatthebeginningofthe1980s,theyhadtorelyonIMFandWorldBankstructural adjustment loans to finance their imports. In addition, bilateral donorscontinuedlending,partlytoenableAfricancountriestoservicetheirdebtsandpartlytopromotetheirownexports.Despitethesedebtreliefefforts,absolutedebtservicepaymentsbyAfricaincreased1.7timesduringthe1890sand1990s,whichisabouthalftheincreaseforalldevelopingcountries(AbregoandRoss2002).

The1996HIPC initiativeand the subsequentenhancedHIPC initiativeprovideddebtreliefofapproximatelytwothirdsofthenetpresentvalueofdebtandreduceddebtservicepaymentsof27decision-pointcountriesbyabouthalftolessthan8percentofexportsin2004(seeappendixB).AlmostallAfricanLDCsareeligibleforHIPCdebtreliefiftheyhaveasatisfactorytrackrecordofpolicyperformanceunderrespective IMF and International Development Association (IDA) supported pro-grammesandapovertyreductionstrategy(IMF/IDA2006).TheexceptionsareCape

Capital flight deprives

Africa of a sizable portion of the very resources it needs

for development financing


Verde,Djibouti,EquatorialGuineaandLesotho,whicharenothighlyindebted(seetableA1),aswellasAngola,whichhad64percentofprivatedebtin2003.

Figure �.�Debt stocks and debt service payments of African HIPC and non-HIPC countries, 1980-2003 (% of GNI)


Note: The figures are weighted averages of 18 African non-HIPC countries and 19 African HIPC countries that had reached their decision point by 2003.

Thedebtserviceratiofordecision-pointHIPCcountrieswashigherthanforotherHIPCcountries as they generally serviced their debts to fulfil the conditions.ForAfricandecision-pointcountries,theratioofpoverty-reducingexpenditurestogov-ernment revenuehas increased from33per cent in1999 to49per cent in2004(AbregoandRoss2002;WorldBank2005d).ThedebtstockasapercentageofGNIwasconsiderablyhigher forAfricanHIPCcountries in themid-1990s,whichwasitselfacriterionforparticipatingintheinitiative(figure2.8).Despitethisfact,thedebtservicetoGNIratiowaslowerforHIPCcountriesastheydidnotfulfiltheirobligations.

Between1994and2000,therewasnotmuchchangeintheratioofdebtstocktoGNIforAfricanHIPCcountriesbut,thereafter,itdeclinedfrom127percentto103percentin2003.Theshiftfromloanstowardsgrantscontributedtothedeclineinthedebtburdensincethemid-1990s(Birdsall,ClaessensandDiwan2002).However,theexperienceofdifferentAfricancountrieswithHIPCreliefwasquitediverseastheexamplesofUgandaandMozambique show(box2.2).Over the sameperiod, theratioofthedebtstocktoGNIforAfricannon-HIPCsonlydeclinedby7percent.However,ithaddeclinedmuchmoreintheperiodbefore,indicatingthatnon-HIPC

The shift from loans to grants

contributed to the decline in the debt

burden since the mid-90s


countrieshadbenefitedmuchmorefromtraditionaldebtrelief.Thisispartlyduetotheirdebtstructure,withaconsiderablylowershareofmultilateraldebt.

Thestructureofdebthaschangedconsiderablyoverthepastdecades.Theshareofdebtowedtomultilateralinstitutions(WorldBank,AfricanDevelopmentBankandIMF)increasedfrom15percent in1980to25percent in2003,whereasprivatenon-guaranteeddebtonlyamountedto5percentofthetotaldebtstockforSSAin2003(Alemajehu2002).

In2005, theHIPC initiativewas supplementedby theMDRIof theG-8,whichallowsfor100percentmultilateraldebtrelief(seeappendixB).Itisestimatedthatthenetpresentvalueofdebtasapercentageofexportsforthe18completion-pointcountrieswould fall from140percent (afterHIPCrelief ) to52percent startingfromJanuary2006(IMF2005c).AsofJune2006,the14AfricancountriesthathavereachedHIPCcompletionpointhavealreadyhadtheirdebttotheIMFcancelledandareeligibleforimmediatedebtreliefbytheWorldBankandtheAfricanDevel-opmentBank(IMF2006).However,asthisinitiativeonlydealswithdebtowedtomultilateralinstitutions,itcannotbeexpectedtosolveallofAfrica’sdebtproblems.Africancountriesneedtoexploreotherstrategiesfordealingwithexternaldebt.AnexampleofdebtreductionwithoutHIPCdebtreliefisNigeria,whichusedoilrev-enuestobuybackitsdebt(box2.3).

Box �.�Experiences with debt relief: Uganda and Mozambique

Uganda and Mozambique were among the first recipients of debt relief under the HIPC initiative,

reaching the decision point in 1997 and 1998, respectively. Whereas Mozambique’s net present

value of debt has declined from over $6 billion in 1998 to $4.4 billion in 2005, Uganda’s debt

stock has continued to increase, reaching $4.8 billion or 60 per cent of GDP in June 2005. Ugan-

da’s debt service reached 18 per cent of exports of goods and services in June 2005, compared

to only 3 per cent for Mozambique. What explains these different experiences?

Mozambique reached the completion point of the enhanced HIPC initiative in September

2001. More than $2 billion of debt were cancelled. In 2000, a banking crisis led to the temporary

suspension of HIPC debt relief and to an increase in debt as the Government had to bail out

banks. The debt stock to exports ratio is still expected to be around 150 per cent for the period

2002-2010, which is the threshold for unsustainability.

Uganda reached the completion point of the enhanced HIPC initiative in May 2000 and was

granted debt relief of $1 billion. But while bilateral creditors provided debt relief quickly, debt re-

lief by multilateral creditors was slower and the debts of non-Paris Club members such as Libya,

India and China as well as commercial creditors were not significantly reduced. In addition, new

loans from multilateral donors were needed to cope with exogenous shocks, such as droughts

and deterioration of the terms of trade.

Source: EIU 2006a,b; IMF/IDA 2000, 2005.


Althoughthelevelofdebthasdeclined,especiallyfortheHIPCcountries,debtsus-tainability in the long termremains an issue. Inparticular, theneed fornewbor-rowingwillbehigher for countrieswith lowGDPgrowth rates (Cerra,Rishi andSaxena 2005). The degree of structural transformation will determine a country’sfuturerepaymentcapacities,e.g.throughexports.Inthisrespect,secondgenerationPovertyReductionStrategyPapers(PRSPs)thatareexpectedtolaythefoundationsforpro-poorgrowthplayacrucialrole.7Inaddition,thetermsofnewborrowingplayaroleforthesustainabilityoffuturedebts.However,therearealsofactorsbeyondthecontrolofAfricangovernmentssuchascommoditypriceshocksandarmedconflictsthatwillaffectdebtsustainability(AbregoandRoss2002).Thus,Africancountriesneed tohave a “prudent strategy for future borrowing tailored to country-specificcircumstances,especiallythequalityofitsinstitutions,anditsvulnerabilitytoshocks”(UNECA2003).

2.3 Determinants of capital flows to AfricaTheobservedtrendsinvolumeandcompositionofcapitalflowstoAfricaraisesomeimportantempiricalandpolicyquestions.Thefactorsthatdrivethelevelandcom-positionofcapitalflowsareabasis forthediscussionofpolicy implications intheremainderofthisreport.Theempiricalliteratureidentifiesseveralfactorsthatdrivecapitalflows,whichareoftenclassifiedintotwobroadcategories:pullfactors,whichare related todomestic conditions; andpush factors,whichare related to externalconditions.Inthisreport,wefocusonthepullfactors,whichincludethesizeofthe

7 Onthesideofcreditorsanddonors,thereisaneedtoensurethatdebtreliefisadditionaltoaidflowsinordertoreallyfreeresourcesforspendingoneducation,healthandinfrastructure,thataresupposedtoimprovetheconditionsforfastergrowth(AbregoandRoss2002).

Box �.�Nigeria’s debt deal

In 2005, Nigeria signed an agreement leading to the settlement of its debt with the Paris Club. As

a first step towards the cancellation of $18 billion of Nigeria’s debt under the Naples terms, Nige-

ria paid the first instalment of $6.3 billion in 2005 to clear its arrears. In April 2006, the remaining

Paris Club debt was bought back at 24 cents on the dollar, amounting to another $4.6 billion.

The money for these payments comes from foreign-exchange reserves that covered almost two

years of imports due to the increase in oil prices. By this agreement, Nigeria’s debt was reduced

from $34 billion in 2005 to approximately $5 billion in 2006, mainly towards the World Bank and

the private sector. In 2006, expenditure on education increased as a result of lower debt service

payments. The country’s credit ratings have already improved, which will allow the Government

to borrow at more favourable terms and attract more FDI. Nigeria’s debt deal represents a best

practice in debt management and the use of windfall revenues from commodity exports.

Source: UNECA 2005b; EIU 2006c.

Nigeria used oil revenues to buy

back its debt


economy,GDPgrowth,thequalityofpublicinfrastructure,thedepthandefficiencyofcapitalmarkets,opennesstotradeandfinance,politicalstabilityandthequalityofinstitutionsingeneral,labourcosts,andexchangerateandpricestability.

Aid allocation is driven by donor priorities

Theempiricalliteraturesuggeststhatthemajordeterminantsofbilateralaiddisburse-mentarepercapitaGDP,HDI,civilliberties,opennessandthesizeoftheeconomy(AlesinaandDollar2000).Thereiswideconsensusthatthegeo-politicalinterestsofbilateraldonorshavehadarelativelyhighimpactonaidallocationamongrecipients(AlesinaandDollar2000;Riddell1992). Inaddition, thereexistsadouble stand-ardconcerningtheuseofgoodgovernanceasapreconditionfordevelopmentaid.Countrieswitheconomicimportancearelesslikelytobesubjecttostandardssetbythedonorcommunity,whilethesecriteriaaremoreoftenenforcedforsmallandlessstrategicallyimportantcountries(WolfandSpoden2000).

Thereisalsoevidencethatmoreaidisgiventocountrieswithhigherdebttoenablethemtoservicetheirdebts.Birdsall,ClaessensandDiwan(2002)findthatcountrieswithhighmultilateraldebtbutbadpoliciesreceiveabout2.5percentagepointsmoreinnet aid transfers than the average.Thus, it seems thatdonorshave applied lessselectivityforcountrieswithhighmultilateraldebt.

Asaidvolatilitycancausesignificantproblemsforrecipientcountries,itisimportanttolookatthefactorsthatdetermineaidvolatility.Thereisempiricalevidencethatthesefactorsdifferaccordingtothetypeofaid.Thevolatilityofsector-specificaidtendstodeclinewithanincreaseinaidasaproportionofGNIandanimprovementintheinstitutionalqualityoftheaidrecipient.It increaseswithpercapita incomeandtradeopenness.Incontrast,thequalityofinstitutionsandthedegreeofopennesshavenosignificanteffectonthevolatilityofprogrammeaidthatisnotallocatedtoaspecificsector.However,thevolatilityofprogrammeaidisnegativelyassociatedwiththeaidtoGNIratioandpositivelyassociatedwithpercapitaincome,asinthecaseofsector-specificaid(FieldingandMavrotas2005).

Beyond natural resources: Africa’s attractiveness to equity flows

Portfolioinvestmentsrespondtothemarketsizeandsophisticationofthefinancialmarket. A study on portfolio investment flows between a set of 14 industrializedcountries for the period 1989-1996 shows that portfolio diversification is not animportantdeterminantofsuchflows(PortesandRey2005).Moreover,thesizeofthe targetedmarketaswellas thesophisticationof thefinancialmarkets insourceanddestination country contribute to portfolio investment. In addition, informa-tionfrictionsseemtobethedominantforceshapingtheinternationaldistributionofportfolioinvestmentflows.

Donors applied less

selectivity for countries with high

multilateral debt


In the samevein,a recentexaminationof factors influencing the investmentdeci-sionsofUSmutualfundmanagerssuggeststhatopendeveloping-countrymarketswith strong accounting standards, shareholder rights and legal framework attractmoreinvestment(Aggarwal,KlapperandWysocki2005).Allofthesefindingspro-videsomeinsightintowhyAfricahasnotreceivedlargeamountsofportfolioinvest-ments.WhileportfoliodiversificationwouldbeamajoradvantageforAfricanequitymarkets,poortechnologyandinformationfrictionspreventAfricaneconomiesfromattractinglargeflowsofportfolioinvestments.

Determinants of FDI include a sound macroeconomic environment, political sta-bilityandafavourablebusinessclimate.However,itisonlyrecentlythatempiricalstudieshavefocusedspecificallyonthedeterminantsofFDIinAfrica.Asiedu(2002)arguesthatthedeterminantsareindeeddifferentforAfricaincomparisontootherregions.ResultsfrompaneldataanalysissuggestthatahigherreturntoinvestmentandbetterinfrastructurehaveapositiveimpactonFDItocountriesoutsideSSA,buthavenosignificantimpactonFDIinSSA.

Similarly, although openness to international trade promotes FDI in the overallsample,theimpactofopennessonFDIislesspronouncedforAfricancountries.Inarecentpaper,Asiedu(2006)extendstheanalysisbylookingatinstitutional,policyandpoliticalvariablesandconcludes thatnatural resourcesand largemarketspro-moteFDI.However, lower inflation,good infrastructure,aneducatedpopulation,opennesstoFDI,lesscorruption,politicalstabilityandareliablelegalsystemhaveasimilareffect,suggestingthatevensmallornaturalresource-poorAfricancountriescanattractFDIbyimprovingtheirinstitutionsandpolicyenvironment.

FortheAfricancontinentasawhole,resource-seekingFDIisthedominanttypeofforeigninvestment.TherecentincreaseinFDItoAfricaisdriventoalargeextentbyattemptsbyindustrializedcountriesandChinatodiversifyawayfromtheirdepend-enceontheMiddleEastregionforoil.Market-seekingFDIhasbeeninsignificantforAfricainthepastbecauseitsmarketsareverysmall.FDIhasincreasedconsiderablyinrecentyearsintheservicessector,especiallyinenergyandinformationandcom-munication technology (ICT). (UNECA2005a).Efficiency-seekingFDIhasbeengrowingintherecentpastdueinparttopreferentialtradeagreementssuchasAGOAoftheUnitedStates.Itremainstobeseenhowsustainabletheseinvestmentsareinthelongrunwhentradepreferencesareremoved.

AccordingtotheevidencegatheredbytheWorldBank(2005c),thebusinessenviron-mentislessconduciveforinvestmentinSSAthaninanyotherdevelopingregionintheworld.Forinstance,thecostsforstartingabusinessamountupto225percentofGNIpercapita,morethanthreetimesthelevelforthenextdevelopingregion(LatinAmericaandtheCaribbeanwith60percent).Otherobstaclesincludepropertyrightsand labour regulations (see chapters3,4 and6).Theevidence suggests anurgentneedtocomplementmacroeconomicreformswithmicroeconomicreformsaimedatimprovingthebusinessenvironment.

Improving institutions and

policy environment can attract FDI


Foreigninvestmentsinthenaturalresourcessectortendtobebetterinsulatedfrompolitical instabilityaswellasfrommacroeconomicturbulencesandtheweakbusi-ness climate in Africa. The dominance of resource-seeking FDI is therefore also areflectionofthepoormacroeconomicenvironmentandtheweakbusinessclimate.Forinstance,tradebarriersandotherobstaclesposedbyAfricancountrieshavelittleeffectonresource-seekingFDI,buttheyhaveanegativeeffectonefficiency-seekingFDI(Faini2004:8).

Workers’ remittances: between altruism and investment

Themaindeterminantofworkers’remittancesisthenumberofmigrantslivingabroad.Thecharacteristicsofthesemigrants,especiallytheirlevelofeducationandthedes-tination countrywill also affect their earnings and therefore their ability to remit.Thedistancebetweensourceanddestinationcountriesalsohasanegativeimpactonbothmigrationandremittances,aslongdistancesmakeitmoredifficulttomaintainextensiveeconomicandsociallinks(AdamsandPage2005).

Theoretically, thedeterminantsof remittancesdependon themotivation to transferfunds in thecountryoforigin -altruismor investment.8 Ingeneral, remittancesarehigherwhennegativeshocksoccurinthehomecountryasneedsaregreaterandpeoplearepushedtoemigrate.Therefore,GDPgrowthinthehomecountrynegativelyaffectsremittances,ifthemainmotiveistohelpthefamilyinthehomecountry.

However,the“portfolio”choicetheoryimpliesapositiverelationshipbetweenremit-tancesusedforinvestmentandGDPgrowthashighergrowthimpliesbetterbusinessopportunities,butanegative relationshipwithmacroeconomicandpolitical insta-bility.Economicpoliciesandinstitutionssuchasexchangeraterestrictionscanalsodiscourageremittances.Incontrast,greaterfinancial sectordevelopmentwillmakeremittingeasierandencourageremittances.However,theempiricalevidenceisscant,especiallyinthecaseofAfricancountries(Chami,FullenkampandJahjah2005;IMF2005a).

Capital flight responds to risky environments and financing opportunities

In theory, capital flightmaybe viewed as aportfoliodecisionby individualswhochoosetoholdassetsabroadinsteadofinvestingdomestically.Thedeterminantsofcapitalflightidentifiedintheliteraturebelongtooneofthefollowinggroupsoffac-tors(NdikumanaandBoyce2003;Cerra,RishiandSaxena2005:5;Salisu2005):

8 The literatureproposes two explanations for transfers bymigrants to their country of origin.The “altruism”approachisbasedontheeconomicsofthefamily.Underthisview,remittancesaredrivenbyconcernsofthemigrantforthewelfareofhisfamilyinthecountryoforigin.The“portfolio”approachsuggeststhatmigrantsallocatetheirsavingsbetweenhomecountryandhostcountry.Thus,remittancesaredrivenbyaninvestmentmotive(IMF2005b).

There is an urgent need to compliment

macroeconomic reforms with

microeconomic reforms aimed

at improving the business environment


• Macroeconomicenvironment:lowgrowthandhighinflationtriggercapitalflight;

• Fiscalpolicies:Poorgovernmentperformance,asexpressed,forinstance,byalargebudgetdeficit,isassociatedwithgreatercapitalflight.Moreover,theuncertainty associated with government tax policies is positively linked tocapitalflight(HermesandLensink2001);

• Risksandreturnstoinvestment:Studiesthattestthetheoryofcapitalflightasaportfoliochoicehaveusedinterestratedifferentials,exchangerateover-valuations,andmeasuresofriskperception.However,theevidenceforAfri-cancountriesremainsscant;

• Capital inflows, particularly debt: The empirical literature contains strongevidenceofthe“revolvingdoor”relationshipbetweenexternalborrowingandcapitalflight,wherebydebtinflowstendtostimulatecapitalflightbychang-ingexpectationsaboutfuturereturnstodomesticinvestmentwhileprovid-ingresourcesforcapitalflight.However,causalitymightalsoruntheotherway,i.e.theflightofdomesticsavings,forexample,duetoweakinstitutions,increasestheresourcegapandthustriggerstheneedforadditionalborrow-ing.Whilemoststudiesfocusondebtflows,themagnitudeofthedebtstockwasfoundtobethemoreimportantcauseforcapitalflight(Collier,Hoefflerand Pattillo 2001). Another capital inflow associated with capital flight isdevelopmentaid(Lensink,HermesandMurinde2000);and

• Politicalfactorsandthequalityofinstitutions:Politicalriskandcorruptionhavebeenfoundtoaffectcapitalflight.Reducingtheoutflowofcapitalthusrequires the building of appropriate institutions to promote stability andreduceinvestmentrisk(Fosu,KrishnanandNdikumana2004;CommissionforAfrica2005).Inaddition,Cerra,RishiandSaxena(2005)findthatthelink between capital flight and debt inflows is stronger for countries withweakinstitutionsandhigh-incomeinequality.

Good governance plays an important role in the composition of capital flows

Good governance is found to be an important determinant of both private andpublic capitalflows (chapter5). Specifically, the level of corruption canhave animpactoncapitalinflowsandoutflowsthroughdifferentchannels.Oneimportanteffect of corruption is that it decreases the ability of governments to collect taxrevenue.Thiswill in turn lead to greaterneeds forfinancingpublic expenditurethroughothersources,mainlyaidandgovernmentloans,whichmightcontributetotheaccumulationofdebt.

Empiricalevidenceshowsthatmorecorruptcountriesaremorelikelytoimposecapi-talcontrols,whichwillthenreduceprivateinflowsandmightinducemorecapital

Corruption reduces inward FDI


flight(BaiandWei2000).ThereisstrongempiricalevidencethatcorruptionreducesinwardFDIconsiderablyandthatitinducesforeigninvestorstofavourjointventuresoverwhollyownedsubsidiaries(Wei2000).9However, intheextractive industries,weakgovernancemightattractFDIasforeigninvestorsmightgetmorefavourabletreatment(CommissionforAfrica2005).

Inaddition,theextentofcorruptioninacountrymayskewthecompositionofcapi-tal inflows towards more short-term flows, which will increase its vulnerability tointernationalfinancialcrisesandmightincreasetheriskofacurrencycrisis.Sincethenegativeeffectsofcorruptionincreasewiththefrequencyofinteractionsbetweentheinvestorandlocalbureaucrats,FDIislikelytobemoreaffectedbycorruptionthanportfolioinvestment.FDIinvolvesgreatersunkcosts,whichweakenstheinvestors’bargainingpowerandmakesFDImorepronetopaymentofbribes.Empiricalevi-dencefromdevelopinganddevelopedcountriesshowsthatcorruptionreducestheshareofFDIinprivatecapitalinflowsrelativetoportfolioinvestment(Wei2000).

2.4 Impact of capital flows on African growth and economic developmentTheultimategoalofincreasedcapitalflowsistoenhancedevelopment.Oneimpor-tant empirical challenge is todetermine the channels throughwhich capital flowsaffecteconomicperformance.Anunderstandingoftheexactchannelsisessentialtodesigningpoliciestomaximizetheeffectsofcapitalflowsontheeconomy.Onepos-siblechannelisthroughthelinkagesbetweendifferentcapitalinflowsanddomesticinvestment.Otherpotentialchannelsofthepositiveeffectsofcapitalflowsongrowthand development include exports, diversification of economic activity, increase ofemploymentandwages,improvementofhumancapital,technologicalprogress,andincreaseofthecorporatetaxbase.

However, capital inflowscanalsohavenegative effectsonAfricaneconomies.Themostimportanteffectsarethereductionofcompetitivenessthrough“DutchDisease”effectsandincreasedvulnerabilitycausedbythehighvolatilityandunpredictabilityof capital flows. An inflow of capital increases the demand for the domestic cur-rency.Theincreaseddemandfornon-tradablescanleadtoanappreciationoftherealexchangerate.This in turncouldreduce thecompetitivenessofacountry’sexportindustryandmakeimportscheaper,whichdeterioratesthecountry’sexternalposition(seechapter6).

Theseeffectsofcapitalinflowsoncompetitivenesscanbemitigatedbyspecificfeaturesofthehosteconomy.AsunemploymentisrelativelyhighinmostAfricancountries,anincreaseindemandfornon-tradablesdoesnotnecessarilyincreasetheproduction

9 Differentmeasuresofcorruptionbasedontheperceptionofexpertsininternationalconsultingfirmsorbusinessexecutivesareusedinthesestudies.

FDI involves sunk costs, which

weakens bargaining power and makes FDI more prone to payment of bribes


costsofexportgoods.Ifimports,especiallyofcapitalgoods,areincreased,thepres-sureontheexchangeratewillbelower.Ifcapitalinflowsareinvestedinpublicgoodstheproductivityintheprivatesectorwillincrease.Whetherarealappreciationwillhaveanegativeeffectonthegrowthpotentialdependsontheproductionstructureandonproductivitygrowth(McKinley2005;Heller2005).Moreover,withregardtospecifictypesofcapitalflows,particularchannelsalsocomeintothepicture.

Aid can increase growth but has diminishing returns

Aidisexpectedtoincreaselong-termgrowthasitcanfillboththesavings-investmentgapandtheforeignexchangegap.Inaddition,itcanincreaseproductivitybyfacili-tatingtechnologytransferandhumancapitalformation.Themainchannelsthroughwhich aid might have an impact on growth are through investment and imports.Ifaidfinancesproductiveinvestment,thiswillcontributetogrowth.Ifaidenablesimportsofcapitalgoodsandimportedinputsitincreasesproduction.However,ifaidisfungiblesothatfundsintendedforinvestmentareusedforconsumptionitseffec-tivenesswillbereduced(Gomanee,GirmaandMorrissey2005).

However, there are various reasons why larger amounts of aid do not necessarilyincreaseeconomicgrowth.Aidmayallowgovernmentstoputoffnecessaryreformssuch as reforming the tax system. Countries depending largely on aid tend to bevulnerable to sudden changes of donor policies. In addition, high levels of aid ingeneralimplythatalargenumberofdonorsareinvolved(morethan40forKenyaandZambia).Negotiationswithmanydonorsareaburdenonthelimitedcapacityofrecipientgovernmentsandthelackofaidcoordinationonthesideofdonorandrecipientcanhamperthesuccessofprogrammes(Lancaster1999).

Overthepastdecade,aheateddebateontheeffectsofaidongrowthanddevelop-menthasemerged.ThestudybyBurnsideandDollar(2000)whoseresultsenteredtheAssessing Aid report(WorldBank1998)stressesthattheeffectofaiddependsonthepolicyenvironment.Theauthorsarguethataidaddstoinvestmentwhereaspolicydeterminestheproductivityofthisinvestment.Goodgovernanceinrecipientcoun-triesalsoincreasesaccountabilityofaidutilization(CommissionforAfrica2005).

However, the study by Burnside and Dollar (2000) has been criticized by a largenumberofresearchers.10Anumberofrecentstudiesfindapositiveandstatisticallysignificanteffectofaidongrowth,largelythroughaid-financedinvestment(LuandRam2001;HansenandTarp2001;Gomanee,GirmaandMorrissey2005).Severalstudiesfinddecreasingreturnstoaid,astheimpactofaidongrowthbecomesnega-tiveafteracertainthreshold level is reached.IntermsofratioofaidtoGDP,thisthresholdlevelliesbetween15and45percentandhasbeenreachedbyasubstantialnumber of African countries (table A1; also see McGillivray, Feeney, Hermes and10 Researchersarguethattheeconometricresultsarehighlydrivenbytheeconometricspecification,definitionof

variablesandthetimespanofthedatausedandarethereforetoofragiletosupportBurnsideandDollar’sargu-ment(forasummaryofthisdebateseeMcGillivray,Feeney,HermesandLensink2005).

Larger amounts of aid do not

necessarily increase economic growth


Lensink2005).Thus,animprovementintheefficiencyofaidisasimportantasanincreaseinthevolumeofaid.

FDI can provide a bundle of capital, technology and know-how for development

FDIhasrecentlybeenpraisedforbeingadesirableformofforeigncapitalindevel-opingcountries.Itscontributiontonarrowingthecapitalandforeignexchangegapsisnotable.FDIhasthepotentialtodomuchmore,becauseitisnotonlyaflowoffinancialcapital,butconsistsofabundleofcapital,technologyandknow-how.Thereis evidence that FDI increases growth in developing countries, primarily throughimprovementsintotalfactorproductivity(Collins2004).

Even thoughphysical capital accumulation throughFDI is obvious, its size varieswiththemodeofentryintoacountry.Inthecaseofgreenfieldinvestments,i.e.whenanaffiliateisbuiltupasanewcompanywithoutanypredecessors,physicalcapitalaccumulationhastotakeplace.Incontrast,inthecaseofatakeover,i.e.whenafor-eigninvestorbuysanexistingcompanyinthehostcountry,noinvestmentinphysicalcapital takesplace.Nevertheless, in the long run, there seems tobeno significantdifference in termsofphysical capital accumulationbetween the two typesdue tosignificantfollow-upinvestmentsinthecaseoftakeovers.

Sincetechnicalprogressisthemostimportantdriveroflongruneconomicgrowth,FDIhasamajoradvantageoverotherformsofcapitalinflowsintermsofcontribu-tionstogrowth,becauseofitspotentialtoupgradeexistingtechnologiesandintro-ducenewones(LallandNarula2004).Thistransferoftechnologywillbelimitedtotheaffiliateoftheinvestingforeigncompanyinthefirstplace,butovertime,produc-tion technology, knowledge aboutmarket access andmanagement techniqueswillspillovertoothercompaniesinthehostcountry.Chapter3ofthisreportprovidesamorein-depthdiscussionofthelinkagebetweenforeigninvestmentanddomesticinvestment.

InthecaseofAfricancountries,thedominanceofresource-seekingFDImayexplaintheweaklinkagesbetweenFDIanddomesticinvestment.Naturalresourceextractingcompaniestendtohaveextremelyfewlinkageswiththedomesticeconomy.Foreignoil companies operate ‘economic islands’ in an economy, sometimes even literallyislands,whenonethinksaboutoffshoreoilplatformsfromwhichtheoilisexporteddirectlyvia largetransportvessels.Thedominanceofresource-seekingFDIanditslimitedinteractionwiththedomesticeconomyalsopreventsmanyAfricancountriesfromreapingoneofthemostdesirableoutcomesofFDI,namelyemployment.FDIintoothersectorstendstohavesizableindirectemploymenteffects,oftenestimatedto be twice as high as the employment generated in the foreign affiliates (Asiedu2004).OnepositiveeffectofallformsofFDIistheirpotentialtobroadenthetaxbaseofacountry.

Resource seeking FDI, such as in oil prevents many

African countries from reaping

employment benefits


Remittances reduce poverty

Thereareanumberofchannelsthroughwhichremittancesmightaffectgrowthanddevelopment.Astheyaretargetedtomeetspecificneedsoftherecipients,theyreducepovertydirectly.Forexample,inEgypttheyaccountfor15percentoftotalincomeofpoorhouseholds(Adams1991).InBurkinaFaso,onethirdofallhouseholds,espe-ciallythepoorest,receiveremittancesandalmost20percentofhouseholdincomesare from remittances (Konseiga 2005). In Lesotho, the poverty headcount wouldincreasebymorethan10percentifremittanceswerecompletelyremoved.AstravelcoststoEuropeandNorthAmericaarequitehigh,mostmigrantscomefromincomegroupsabovethepovertylineandtheirremittanceswillnotdirectlybenefitthepoor-estmost(AdamsandPage2003).

Ifremittancesareusedforconsumptiontherewillalsobeamultipliereffect.Throughincreaseddemandespeciallyintheruralareasgrowthcouldincreaseandpovertybereduced.Asaconsiderableportionofremittancesisusedforschoolfees,thisshouldincreaseproductivitythroughhumancapitalaccumulation.Inaddition,remittancescontributetobetterhealthandthereforeimprovelong-termgrowthprospects(ÖzdenandSchiff2005).

AlthoughdataontheuseofremittancesinAfricaarenotavailable,thereissomeanec-dotalevidencethatshowsthatremittanceflowsareincreasinglybeingusedforinvest-mentpurposes,especiallyforfinancingSMEs.Forexample,intheirstudyonSSA,Russell, Jacobsen andDeane (1990) found that once subsistenceneedshavebeenmet, remittances are used for investment purposes including education, livestock,farmingandsmall-scalebusinessdevelopment.SimilarfindingshavebeenreportedforMaliwhereremittancesfinanceirrigationschemes(FinleyandSow1998).ThisisalsocorroboratedbythefindingsbyChilivumbu(1985)inZambiawhereremit-tanceshavebeenusedtofinanceagriculturalinputs.Recentevidenceconfirmsthatinvestmentincreaseswithremittances,includinghousingconstruction(ÖzdenandSchiff2005).

Remittancescontributetoalleviatingthecreditconstraint,thusallowingincreasinginvestment (UNECA 2005a). Remittances need not be invested by the recipientsthemselves.Savedremittancescouldimproveaccesstocapitalforotherbusinessesifthebankingsystemfulfilsitsroleofintermediatingfunds(seechapter6).Remittancescanalsohaveapositive impactontechnologicalchangeinagriculturalproductionandtherefore increasegrowththroughhigherproductivity.EvidencefromBurkinaFasoindicatesthatremittancesareusedtoimproveagriculturalandnaturalresourcemanagement(Konseiga2005).

Remittances significantly reducepoverty indevelopingcountries. Ina studyof71countries,AdamsandPage(2005)findthata10percentincreaseinworkersremit-tancespercapitaleadstoa3.5percentdeclineintheshareofpeoplelivinginpoverty.Inaddition,remittancesreducethevulnerabilitytoshocksaswellasthevolatilityof

Remittances reduce

vulnerability to shocks


countrywide output, consumption and investment and thus help to stabilize eco-nomicactivity.

External debt hampers private investment

Theoretically,itcanbearguedthatexternaldebtcanpromotegrowthtotheextentthatthepublicinvestmentfinancedbytheseloansiscomplementarytoprivateinvest-ment.However,aheavydebtburdencreatestheexpectationofhighertaxesinthefutureandthusreducestheincentivetoinvest(Chowdhury2001).

Largedebtburdensareusuallyassociatedwithnegativeeffectsongrowth.Debt islikelytoreducepublicinvestmentinbothphysicalandhumancapital,whichreducestheproductivityofprivateinvestmentandslowsdowntotalcapitalaccumulation.Inaddition,highdebtservicecanreducethecapacitytoimport,whichreducesoutputthroughashortageofimportedinputsandconstrainsinvestmentbecauseofalackofcapitalgoods.

Areductionindebtservicepaymentshasapositive impactoninvestment.Patillo,PoirsonandRicci(2001)findthatdebtreductionunderHIPCmightincreasepercapitagrowthbyonepercentagepoint,mainlythroughincreasingtheefficiencyofinvestment.However,debtservicereductionhasapositiveeffectoninvestmentandgrowthonlyifitisnotoffsetbyareductioninaidinflows.Ifthereductionindebtserviceisoffsetbyadecreaseinaiditmightevenreduceinvestmentrates.Thiscon-firmstheimportanceofadditionalityindebtreliefefforts(Hansen2004).

DebthasanegativeeffectongrowthinSSAnotprimarilythroughareductionofinvestmentbutthroughitsnegativeeffectontheproductivityof investment(Fosu1996).Furthermore,debthasasignificantnegativeeffectongrowthforbothHIPCand non-HIPC countries (Chowdhury 2001). Consequently, there is a need tobroadenthedebtforgivenessinitiative.

Instability of capital flows reduces growth effects

Theeffectofaiduncertaintyongrowthiswellestablished(LensinkandMorrissey2000).Foreignaidisnotlikelytohaveadirectimpactongrowthbutratheraidwillaffectdeterminantsofgrowthlikeinvestment,governmentrevenueandexpenditure.Thelevelaswellasvariabilityoruncertaintyofaidarelikelytoaffectinvestment.Theinstabilityofaiddisbursementsmayalterfiscalbehaviour,possiblycausingadecreaseinpublicinvestment.

Instabilityofcapitalflowsdiscourages investmentandhampers thegrowtheffects.Short-termportfolioinvestmentisassociatedwiththehighestvolatilityandhassig-nificantlycontributedtotheAsiancrisisattheendofthe1990s.However,thevola-tilityofaid,remittances,andFDI,whicharemoreimportantforAfricaneconomies,canalsoaffectgrowthastheymightinduceexchangeratevolatility.Thevolatilityof

If the reduction in debt

service is offset by a decrease in aid it might even reduce

investment rates


allcapitalflowsisnegativelycorrelatedwithGDPgrowthinlow-incomecountries(AizenmanandPinto2005;Osei,MorrisseyandLensink2002).

2.5 Conclusion TheobservedtrendsincapitalflowstoAfricaraiseseriousconcernsaboutthesustain-abilityofexternalresources,andtheimplicationsfordevelopmentfinancing.Devel-opmentaidhasnotalwaysbeentailoredtowardstheprioritiesofrecipientsandhashadalimitedeffectongrowthandpoverty.Furthermore,Africancountriescannotcontinuetofinancetheirresourcegapbyfurtheraccumulationofexternaldebt.Debtserviceobligationsarecompoundedbytheproblemofcapitalflightwherebyasub-stantial fractionofborrowedresourcesarediverted intoprivateassetsheldabroad.WhilethevolumeofprivateflowstoAfricaremainslow,theyalsoaremorevolatile,whichcompromisesthesustainabilityoffinancingoftheresourcegap.

Africanpolicymakersneedtoimproveconditionsforcapitalinflows(UNECA2005band2006):

• Aslocalandforeigninvestors,includingtheAfricanDiaspora,arelookingforthesameinvestmentconditions,itiscrucialtoimprovethebusinessenviron-ment, infrastructureandgovernance to increaseFDIandremittances.Theportionofcapitalinflowsthatexceedsimportsislikelytoincreaseinflationand thereby reducecompetitiveness.These relationshipshave tobecloselymonitoredwhenmanagingcapitalinflows.Asriskperceptionisalsocrucial,countryriskratingsshouldbeconductedformoreAfricancountries;

• Withrespecttoremittances,strategiestochannelmoreofthemintoinvest-menthavetobedeveloped.TheopeningofrepresentationsofdomesticbanksinthemaindestinationcountrieshasbeeneffectiveinMoroccotochannelmoreworkers’remittancesthroughofficialchannels;

• ToincreasetheeffectivenessofaidAfricancountriesneedtoimproveinsti-tutionsthat increasetheaccountabilitytowardstheirownpeopleandthusensureparticipationandownership;

• Theavailabilityandqualityofstatisticaldataonexternalcapitalflows,debt,andotherkeyeconomicvariableshavetobeimprovedforpolicymakerstomaketimelyandwell-informeddecisionsthattakeaccountofinternalaswellasexternalfactorsinfluencingtheirpolicyoptions;and

• Corruption-fightingmeasureshavetobesteppeduporextended,asagoalofitsownaswellasameanstomakecountriesmoreattractiveforforeigninvestorsandtoincreasetheefficiencyofaidallocatedtoit.

African countries cannot continue

to finance their resource gap by

further accumulation of external debt


Inaddition,industrialcountrieshavetohonourtheircommitmentswithregardtotheMonterreyConsensusandotherinternationalconventionstoimprovefinancingfordevelopmentinAfrica:

• AstheflowsofFDItowardsdevelopingcountriesremainunevenlydistrib-uted,developedcountriesshouldstepupmeasurestofacilitatetheflowofFDItoAfricancountries,throughexportcredits,riskguaranteesandbusi-nessdevelopmentservices;

• Asaidwillremainimportanttofinancespendingonhealth,educationandinfrastructuretoachievetheMDGs,developedcountriesshouldmakeeveryefforttoreachthetargetof0.7percentofGNIforODAassoonaspossibleandtoreduceaidvolatility;

• Non-HIPCAfricancountrieswithunsustainabledebtlevelsshouldbecon-sideredfordebtrelief.Itisalsocrucialthatconventionalresourcesarepro-videdinadditiontodebtreliefinordertoaccelerategrowthandreducepov-erty;and

• Ascorruptionhasanegativeeffectoncapitalflowsandmightskewthecom-positiontowardsmorevolatileflows,thefightagainstcorruptionshouldhavehigh priority in all countries as stated in the United Nations ConventionAgainstCorruption.Inthisrespect,industrialcountrieshavetoincreasetheireffortstoreducecorruptionoftheirfirmsininternationaltransactions.


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Appendix A: Tables Table A�Level and variability of capital flows as per cent of GNI (1980-2003)

Aid FDI Workers remittances Debt service Average Coeff. Var Average Coeff. Var Average Coeff. Var Average Coeff. Var

Algeria 0.4 42.7 0.4 149.9 1.6 56.3 11.3 33.2Angola 6.1 81.6 11.1 110.8 14.2 60.5Benin 11.0 32.4 1.4 121.1 4.5 30.0 2.5 38.2Botswana 4.7 74.9 2.7 132.1 2.5 79.1 2.2 46.4Burkina Faso 13.9 23.1 0.2 104.1 4.9 47.3 1.6 22.6Burundi 18.7 44.0 0.2 197.1 3.2 36.3Cameroon 4.6 44.6 0.8 154.3 0.2 57.3 5.2 21.9Cape Verde 26.9 31.6 2.2 115.8 16.5 18.0 2.6 24.0Central African Republic 13.0 31.0 0.4 139.2 1.8 53.2Chad 13.4 30.6 6.2 205.5 1.2 54.9Comoros 22.7 45.5 0.4 209.8 4.1 40.8 1.2 58.0Congo, Dem. Rep. 9.4 206.0 0.3 318.6 3.4 113.7Congo, Rep. 7.5 87.3 5.1 141.8 0.1 148.0 12.9 67.4Côte d’Ivoire 5.4 81.3 1.2 104.0 0.8 57.6 13.4 31.3Djibouti 14.7 22.0 0.7 50.3 0.3 282.8 1.9 23.2Egypt, Arab Rep. 4.9 65.3 1.8 59.0 8.2 46.4 5.3 44.7Equatorial Guinea 26.5 67.2 43.1 142.1 3.7 94.5Eritrea 22.6 31.4 3.7 130.4 0.1 175.0 0.5 100.4Ethiopia 11.9 42.3 0.7 183.6 0.3 68.5 2.4 46.6Gabon 2.0 56.8 0.0 132.6 7.8 35.5Gambia, The 24.3 54.3 3.9 120.1 5.1 46.4 7.5 48.0Ghana 8.8 38.0 1.1 105.5 0.3 100.5 5.9 38.4Guinea 10.5 27.7 0.7 86.2 0.3 239.8 4.4 29.5Guinea-Bissau 49.6 27.0 1.0 125.4 1.2 202.8 5.4 44.9Kenya 7.9 51.6 0.4 81.5 2.2 61.6 8.3 30.1Lesotho 10.7 37.8 6.2 128.6 34.7 28.0 3.3 52.7Liberia 16.3 41.9 11.5 206.4 3.0 94.6Madagascar 10.7 40.0 0.5 118.2 0.3 57.9 4.4 62.2Malawi 22.5 35.6 0.6 160.2 6.4 45.4Mali 18.2 23.7 1.3 156.8 3.9 20.6 3.0 36.8Mauritania 24.8 18.9 2.5 174.7 0.6 142.9 10.2 27.5Mauritius 2.1 74.6 0.9 132.8 1.7 119.4 7.3 40.1Morocco 2.9 55.8 1.6 120.6 7.1 16.4 10.1 17.4Mozambique 31.9 68.7 2.5 131.5 2.1 39.6 3.5 49.8Niger 14.9 27.6 0.5 176.3 0.5 33.1 4.9 58.2Nigeria 0.6 71.0 3.1 78.3 1.8 111.2 7.6 52.2Rwanda 20.2 91.0 0.5 80.1 0.3 115.0 1.1 32.3São Tomé & Príncipe 72.9 65.6 2.6 194.4 1.1 140.6 7.1 43.8Senegal 12.5 23.5 0.9 132.1 3.5 36.5 6.2 28.1Seychelles 6.9 64.7 7.2 27.5 0.4 193.0 6.2 79.4Sierra Leone 18.8 66.2 0.9 147.4 5.5 76.2Somalia 53.5 17.1 1.5 187.4 3.3 59.1South Africa 0.3 25.1 0.6 250.4 0.1 59.7 3.3 23.6Sudan 5.5 50.8 1.3 177.0 3.4 66.6 1.1 95.9Swaziland 4.5 47.2 4.8 73.6 8.3 40.2 3.5 54.1Tanzania 18.2 33.0 1.9 92.7 0.1 136.1 3.3 41.8Togo 10.7 42.6 1.5 98.9 2.1 80.2 5.8 73.9Tunisia 2.0 44.8 2.2 54.5 4.3 13.4 8.9 19.0Uganda 11.7 47.9 1.2 111.3 1.2 207.2 3.2 38.4Zambia 19.6 62.6 3.1 77.0 12.7 119.2Zimbabwe 4.6 50.8 0.7 264.6 0.1 180.0 7.1 51.2Average 4.4 49.5 1.4 152.4 2.6 65.9 6.2 38.3Source: Calculated with data from World Bank 2005a and 2005b.

Note: Averages are weighted by GNI.


Table A�Selected capital flight estimates for sub-Saharan Africa

Ajayi Hermes, Lensink

and Murinde+

Ndikumana and Boyce

Salisu

Sample size (number of countries) 22 46 30 46

Period 1980-91 1976-97 1970-96 1991-2004

Definition KF = CA

+ FDI +

∆RES +

∆DEBTADJ

+ ∆RESADJ

+ ∆FAB

KF = ∆DEBT

+ FDI – (CA

+ ∆RES)*

KF = ∆DEBTADJ

+ FDI – (CA +

∆RES)

+ MISINV

KF =

∆DEBT +

FDI – (CA

+ ∆RES)

Average annual capital flight ($

billion)

5.8 2.9 10.1 13.1

Capital flight as per cent of GDP,

annual

5.1 2.6 6.4 7.6

Sources: Ajayi, 1997; Hermes, Lensink and Murinde 2002; Ndikumana and Boyce 2003; Salisu 2005.

Notes:

*Theexactformulavariesslightlybypaperoftheseauthors.+++EstimatesarebasedonadatasetECAgratefullyreceivedfromtheauthors.KF estimatedcapitalflight∆DEBT stockofgrossexternaldebtFDI netforeigndirectinvestmentCA currentaccountbalance/deficit∆RES changeinthestockofinternationalreserves∆RESADJ changeintotalreservesminusgold∆FAB changeinforeignassetsofbanks∆DEBTADJ changeinthecountry’sstockofexternaldebt(adjustedforcross-currencyexchangeratefluctuations,to

takeintoaccountthefactthatdebtisdenominatedinvariouscurrenciesandthenaggregatedinUSD)

MISINV nettrademisinvoicing


Appendix B: Debt Relief under HIPC and MDRI

In1996theWorldBankandtheIMFlaunchedtheHeavilyIndebtedPoorCoun-tries(HIPC)initiative,whichforthefirsttimeinvolveddebtrelieffrommultilateralfinancialinstitutions.Heavilyindebtedcountriesaredefinedashavinganetpresentvalueofdebtabove150percentofexportsorabove250percentofgovernmentrevenues.Theinitiativewasenhancedin1999(HIPCII)toprovidefasteranddeeperdebtrelieftoalargernumberofcountries.AsofJune200633Africancountriesareintheprocess,ofwhich11havereachedtheirdecisionpoints(seetable)and14havereachedcompletionpoint.

In2005,theHIPCinitiativewassupplementedbytheMultilateralDebtReliefIni-tiative(MDRI)oftheG-8,whichallowsfor100percentdebtreliefbytheIMF,theInternationalDevelopmentAssociation (IDA)of theWorldBankand theAfricanDevelopmentFund(ADF)ofdebtincurredbeforeJanuary2005forcountriescom-pletingtheHIPCprocess.Inprincipleall33AfricanHIPCcountriesareeligiblebutonlythe14post-completionpointHIPCsareeligibleforimmediatedebtrelief.

TheIMFhasalreadydelivered100percentdebtreliefamountingto$2.6billionto14Africancountriesinthefirsthalfof2006.Asthisreliefonlyappliedtodebtout-standingatend-2004,allcountriesbutEthiopiastillhavesmallIMFdebtsnow.Onaverage,MDRIrelief fromtheIMFhada limitedimpactonoverall indebtedness.Externaldebtstocksonlydecreasedby5percentonaverage,althoughforindividualcountriessuchasZambiatheratewas17percent.TheADBhasapproved$8.5bil-lionforfinancingdebtrelief,whichwasexpectedtobecomeeffectivebymid-2006.TheInternationalDevelopmentAssociation(IDA)oftheWorldBankhasapprovedthecancellationof$37billionforallHIPCcountriesover40years,startinginJuly2006.

Although currently only14African countries have reached theHIPCcompletionpoint,thisnumberisexpectedtoincreaseinthenearfuture.Thepre-decisionpointcountriesandEritrea,thathasbeenincludedunderthesunsetclause,fulfilthecri-teriaoflowGDPpercapitaandhighindebtedness.TheCentralAfricanRepublic,Côted’IvoireandTogohavealsometthepolicycriterionandarepreparingPRSPsorInterim-PRSPs.Comoros,Eritrea,Liberia,SomaliaandSudanhavenothadanIMF-andIDA-supportedprogrammesince1996andthreecountrieshaveprotractedarrears.Mostof these countrieshavebeen affectedby conflict, buthavenowalsostartedtomakeprogresstowardsdecisionpoint.


African HIPC countries (33)

HIPC completion point (14)

HIPC decision point (11)

HIPC pre-decision point (7)

Potential new HIPC countries (1)

Benin

Burkina Faso

Ethiopia

Ghana

Madagascar

Mali

Mauritania

Mozambique

Niger

Rwanda

Senegal

Tanzania

Uganda

Zambia

Burundi

Cameroon

Chad

Democratic Republic

of Congo

Republic of Congo

The Gambia

Guinea

Guinea-Bissau

Malawi

São Tomé & Príncipe

Sierra Leone

Central African

Republic

Comoros

Côte d’Ivoire

Liberia

Somalia

Sudan

Togo

Eritrea

Sources: IMF 2006; IMF/IDA 2006; World Bank, AfDB.

��

3.1 IntroductionCapitalflowsintheformofFDI,ODA,remittances,andtoamuchlesserextent,portfolio investments, have important implications for both domestic investmentandlocallabourmarketsinAfrica.Capitalflowscanstimulatedomesticinvestmentandproductivity,resultinginjobcreationinthehostcountry.Causalityalsorunsintheotherdirectioninsofarasthecharacteristicsoffactormarkets,especiallylabourmarket conditions, influence the type, the amount and the stabilityof inflows. Inanincreasinglycompetitiveglobaleconomy,thelevelofeducationandskillsofthelabourforceareimportantdeterminantsofprivatecapitalflows.

TheaimofthischapteristosummarizethesedifferentlinkagesbetweencapitalflowsandfactormarketswithaviewtohighlightingareasthatAfricangovernmentscantargettoharnessthebenefitsofcapitalflows.Thekeymessagesemanatingfromthischapterare:

• Capitalflowscanpotentiallyhavesignificanteffectsondomesticinvestmentandemployment,andhence,ondevelopmentingeneral;

• Factorcostsandregulationsareimportantdeterminantsofcapitalinflows;• Africangovernmentsneedtoestablishpoliciestoenhancetheeffectsofcapi-

talflowsonoveralldevelopmentandpovertyreductionincludingmeasuressuchaspromotingforeigninvestmentinlabour-intensivesectors,improvingthefunctioningofthedomesticlabourmarket,andinvestingineducationandskills;and

• AfricancountriesalsoneedtochannelODAflowsandremittancestowardsinvestment-related activities, which stimulate economic growth and jobcreation.

Theremainderofthechapterisstructuredasfollows:insection3.2therelationshipbetweendomesticlabourmarketsandFDIisexplored,addressingboththeimpactoflabourcostsandinstitutionsoncapitalflows,anissuealsotakenupinchapter2ofthisreport.Conversely,theeffectsofFDIonthelabourmarketintermsofjobcreationandwagesarealsoexplored.Insection3.3,thelinkagesbetweenFDIanddomesticinvestmentareinvestigated.Section3.4examinestheconnectionbetweenODA and domestic factor markets, while section 3.5 discusses the links between

Capital Flows and Factor Markets �

In an increasingly competitive global economy, the level

of education and skills of the labour

force are important determinants of

private capital flows


remittancesandfactormarkets.Section3.6presentsthecasestudiesofEthiopiaandGhanatoillustratesomeoftherelationshipsbetweenFDIanddomesticfactormar-kets.Section3.7concludesandprovidespolicyrecommendations.

3.2 Foreign direct investment (FDI) and domestic labour markets In this section, four aspectsof the relationshipbetweenFDIanddomestic labourmarketsareconsidered:

• HowlabourmarketconditionsandregulationsaffectFDI;• TheroleofhumancapitalindeterminingFDIflows;• TheimpactofFDIonthequantityandqualityofemployment;and• TheimpactofFDIonthelevelanddistributionofwages.

The impact of local labour market conditions and regulations on FDI

As summarized in chapter 2, empirical research has identified various factors thatdeterminethetype,magnitude,stabilityanddestinationofforeigninvestment.Theseincludeeconomicgrowthandpercapitaincome,infrastructure,thedegreeofindus-trialization,governmentpoliciesandincentives,andlabourmarketconditionsandregulations(JavorcikandSpatareanu2005;Billington1999).

Thefocusinthissectionisontheroleofdomesticlabourmarkets,whichconsistoftwocomponents:thedirectcostoflabour(wageandnon-wageremuneration,taxa-tion, social securitycontributionsand insurance);andthe indirectcosts stemmingfrom labour market regulations such as legislation relating to hiring, firing, hoursworked,andunionization.

Labour costs are an important determinant of foreign investment

Foreigninvestorscanbeattractedtoaparticularlocationbecauseoflowwages,whichimplyhigherprofitabilityofinvestment.Askilledlabourforcemayalsobeamagnetforforeigncompaniesasthistranslatesintohigherproductivityofinvestment.Thecombinationoflabourcosts,skillsandproductivityconstitutesadecisivefactorforforeigninvestors.

TheimportanceoflabourcostsasadeterminantalsodependsonthetypeofFDI.Asdiscussedinchapter2,therearetwomaintypesofFDI:verticalandhorizontalFDI.Inthefirsttype,multinationalcorporations(MNCs)areattractedtoaspecificloca-tionbecauseoffactorpricedifferences–inthiscontext,relativewages.Inthecaseof

The combination of labour costs, skills

and productivity constitutes a

decisive factor for foreign investors

�0�Capital Flows and Factor Markets

horizontalFDI,MNCsinvestindifferentlocationsasaconsequenceofcostlytradebarriers;thatis,investmentsaremarketseeking.Thus,anincreaseinlabourcostsisexpectedtohaveastrongernegativeeffectonverticalFDIthanonhorizontalinvest-ments(Kucera2002).

TheempiricalevidencefortheimpactoflabourcostsonFDIflowsis,however,atbestmixed.Forexample,Asiedu(2002)reportsthatdifferentcross-countrystudiesfindthat labourcostscanhaveeitherapositive,negativeor insignificanteffectonFDI.However,asarguedinKucera(2002),theevidence“leanstowardssuggestingthathigherlabourcostsnegativelyaffectFDI”(Kuceraibid,p.4).Theeffectsareevenstrongerinstudiesthathavecontrolledfordifferencesinlabourproductivity.

Excessive regulation may be an even greater deterrent of FDI

Thecost of labour for investors is also influencedby thenature of labourmarketregulations inplace,and inparticular, theflexibilityofemployment.Forexample,employmentprotectioncandeteremployersingeneralfromhiringworkers(OECD2004). If legislation prevents or constrains dismissal, employers will subsequentlyhavelowerincentivestohireinthefirstplace.Theseregulationscanaffecttheincen-tivesforforeigncompaniestoinvestinaspecificlocation.

Labourlawscanalsopotentiallyhaveapositiveeffectoneconomicgrowthandulti-mately,on foreign investment.As summarized inKucera (2002), labour standards(freedomofassociation,collectivebargaining,preventionofchildlabourandgenderdiscrimination) can impact economic growth through a number of channels. Forexample,labourlawsthatreducegenderinequalityorpromoteeconomicandpolit-ical stability can increase economic growth, and as a consequence, private capitalflows.Intermsofmoredirectlinkages,preventingindustrialdisputescanhelpattractforeigncompaniestoinvest,whichappearstobeabarrierforinvestorsincountriessuchasSouthAfrica(Asiedu2005).

JavorcikandSpatareanu(2005)offeroneofthefewstudiesthatinvestigatetheimpactoflabour-marketregulationsonFDI.Usingfirm-leveldatafor19WesternandEast-ernEuropeancountries, theseauthorsfindthatgreater labourmarketflexibility inthehostcountryinabsoluteandrelativetermsiscorrelatedwithhigherFDIflows.Incontrast,Kucera (2002)findsno support for thehypothesis that foreign inves-torsfavourcountrieswithlowerlabourstandards.Theresultsinthisstudy,infact,indicate thatunionizationratesarenot related toFDIflows,while thecorrelationbetweenFDIandstrongercivillibertiesandpoliticalrightsispositive.Thisevidencesuggeststhatthebenefitsofsoundlabourstandardsoutweighthecosts.

The relationship between labour market regulations and FDI in Africa

FDIinAfricahaslargelybeenconcentratedinthenaturalresourcessector,whichiscapital-intensive.Therefore,wagesandothercharacteristicsofthelabourmarketareunlikelytohavehadasignificantimpactoninvestment.Theempiricalevidencefor

Labour laws that reduce gender

inequality or promote economic

and political stability can increase

economic growth

�0� Economic Report on Africa 2006

theimpactoflabourmarketregulationsis,unfortunately,scarce,especiallyforAfri-cancountries.

Lookingatavailablecountry-leveldata,Africancountriesappeartohaveahighdegreeoflabourmarketregulationcomparedwithotherregions.Theaverageemploymentrigidityindexin38Africancountries,whereadequatedataareavailable,is53.2onascalefrom0to100,thehighestofallregions.1Incomparison,theaveragestandsat26.2inEastAsiaandPacificand40.3inLatinAmericaandtheCaribbean.FortheSSAsubregion,theindexrangesfrom10inZambia,theAfricancountrywiththemostflexiblelabourmarket,to90inNigerandDemocraticRepublicofCongo,countrieswiththemostrigidlabourregulations.

TwootherindicatorsofrigiditiesinthelabourmarketcompiledaspartoftheWorldBank’sDoing Business Databasearehiringcostsasapercentageof salaryandfiringcosts in terms of number of weeks of wages. Hiring costs in Africa are, on aver-age,12.8percentofthesalary,thoughitrangesfrom0inBotswana,EthiopiaandLesotho to27.4 inBeninand27.5 inAlgeria.Similarly,while theaveragecostoffiringamountsto55.3weeksofwages,itvariesfromonly4weeksinNigeriato176weeksinZambiaand188.3weeksinSierraLeone.Highhiringandfiringcostsareadeterrentforforeigninvestors.

However, the enforcement of labour market regulations is typically weak in mostAfricancountries.Forexample,inNiger,therateofcompliancewiththeminimumwageandhoursofworkregulationsisonly2percent,withonlyslightlyhigherratesforcompliancewithsocialsecurityobligationsandhealthandsafetyrules(Maldo-nado1995).Asaconsequence,suchpoliciesmaynothaveanydiscernibleimpactoncapitalflows.

FDI and labour market outcomes

Oneofthekeybenefitsofforeigninvestmentis jobcreation,thoughthis isbynomeansguaranteed,sincetheimpactofFDIonthedomestic labourmarketcanbepositive,neutralornegative.Assumingthatunskilledlabouristheabundantfactorindevelopingcountries,FDIshouldtheoreticallybeconcentratedinsectorsthatuselow-skilledlabourintensively,suchastextilesandsimpleassemblyoperations(Vivarelli2004).Thisimpliesthatforeigninvestmentincreasesthedemandforunskilledwork-ers,andasaresult,theirwages.

However, as underscored in chapter 2 of this report, the majority of recent FDIflowstoAfricahavebeenconcentratedinthenaturalresourcessector.Therefore,theemploymenteffectsofsuchinvestmentsareunlikelytobelarge.Nonetheless,AfricancountriesneedtobeawareoftheemploymentimpactofFDIinordertofocuspoli-

1 SeetheWorldBank’sDoing Business Databaseformoreinformation:http://rru.worldbank.org/DoingBusiness/.Theindexisanaverageofthreesub-indexes:adifficulty-of-hiringindex,arigidity-of-hours index,andadif-ficulty-of-firingindex.

African countries need to focus

investment policies to more labour-

intensive industries


ciesonattractinginvestmentstomorelabour-intensiveindustries. Specifically,thenumberofjobscreateddependsonarangeoffactorsincludingthefollowing:

• Theproportionofforeignworkersbroughtinbytheforeign-ownedcompany,whichdeterminesthepotentialnumberofjobsavailableforlocalworkers;

• Greenfieldinvestments,whichentailanincreaseinthehostcountry’scapitalstock,aremorelikelytocreatejobs,whilemergersandacquisitionstendtoresultinredundancies(Lall2004);

• Themorecapital-intensivethetechnologyusedinproduction,forexampleinthenaturalresourcesector,thesmallertheemploymenteffectsresultingfromtheinvestment;

• ForverticalFDI,animportantissueistheorientationoftradeandindustrialpoliciesinthehostcountry.Incountrieswithexport-orientedregimesandareadysupplyofcheaplabour,foreigninvestmentislikelytogenerateasig-nificantnumberofjobs(Lall2004).Ofcourse,thesefactorsareimportantdeterminantsofFDIinthefirstplace;

• Higherproductivityof foreign investment reduces thedemandfor labour;and

• Thelabourmarketconditionsintermsofcostsandregulationsalsoinfluencethenumberof jobscreated throughforeign investment. Ifhiringcostsarehigh,forexample,companiesgenerallywillhirefeweremployeesandsubsti-tutecapitalforlabour.

Over the long-term,thedirectemploymenteffectsof foreign investmenthingeonsuchfactorsashowthecompanycontinuestoinvestintechnologyandcapacity,thegrowthinproductdemand,thesupplyofskills,wagedevelopment,otherinputcostsandlabourmarketregulations,theavailabilityofinfrastructure,andchangestotheglobalmarket(UNCTAD1999).

Besidesthejobsdirectlycreatedbyforeign-ownedcompanies,FDIalsocontributestoemploymentthroughindirectchannels,whichcaninfactbelargerthanthedirecteffects, resulting in largemultipliereffects.Someexamples include(seeUNCTAD1999andLall2004):

• Jobs created invertically linkedfirmsand through sub-contracting,whichdependsonthedemandbyforeign-ownedcompaniesformaterials,servicesandcomponentssourcedlocally;

• There canbepositive (technology spillovers) effects ondomestic competi-tion;

• Atthesametime,since foreigncompanies tendtobemoreefficient, theirentry into themarket couldpushdomestic companies out of themarket,resultinginjoblosses.Thedebateabouttheevidencefor“crowding-out”isexploredfurtherinsection3.3below;

Capital flows can also

increase incomes, consumption and

investment, which in turn stimulate

job creation


• Overthelongerterm,moreFDIcouldbeattractedinordertosupplytheinitialinvestmentortocompetewiththeincumbent.Theseinvestmentshavecorrespondingeffectsonemploymentinthehostcountry;and

• Finally,capitalflowscanalsoincreaseincomesandsubsequentlyconsump-tionandinvestment,whichinturnstimulatejobcreation.

The employment effects of FDI

ThereisverylittlequantificationoftheimpactofFDIonemploymentinAfricancoun-tries.AstudybyIyanda(1999)onFDIflowsinNamibiarevealsthatforeveryworkeremployedbyaforeignaffiliate,another2-4jobswerecreated.Incomparison,themoregeneralstudybyAaron(1999)findsthatFDIindevelopingcountriescreatedabout26milliondirectand41.6indirectjobsin1997,suggestingamultipliereffectof1.6.

Usinga sampleofSSA in theWorld Bank Development Indicators Database revealsthatthereisevidenceofapositivecorrelationbetweenthegrowthofthelabourforceandtheratioofFDItoGDPoverthe1990-2002period.ThissuggeststhatAfricancountries,whichattracthigherinflowsofforeigninvestment,tendalsotoexperiencehigherratesofemploymentgrowth.

AnotherquestionexploredintheliteratureiswhetherFDIgeneratesmoreemploy-mentthandomesticinvestment.Inthisregard,Spiezia(2004)findsthattheimpactof FDI on employment is increasing with per capita income, and in low-incomecountries,theeffectofFDIisinfactinsignificant.However,ourownevidenceusingasampleofSSAcountriessuggeststhatthereisasignificantimpactofFDIonthegrowthofthelabourforce,thoughthemagnitudeofthiseffectissmallerthanitisfordomesticinvestment(table3.1).2

Table �.�Estimates of employment effects of foreign versus domestic investment in sub-Saharan African countries, 1990-2002

Dependent variable: growth of labour force

Covariate Coefficient

FDI/GDP 0.036**

(0.011)

DI/GDP 0.048*

(0.015)

R2 0.11

F 3.64**

No. of observations 363

* - significant at 10%

** - significant at 5%; robust standard errors are provided in parentheses; the econometric specification includes time dummies; FDI = foreign direct investment and DI=domestic investment.

2 However,oncetime-invarianteffectssuchascountry-specificfactorsarecontrolledfor,thecoefficientestimatesforbothvariablesFDI/GDPandDI/GDPbecomeinsignificant.

African countries with more FDI tend also to experience

higher rates of employment growth


Capital flows have implications for both wages and inequality

Inadditiontotheirimpactonemployment,FDIflowscanalsoaffectthelevelanddistribution of wages. It is possible that foreign companies pay higher wages andprovidebetterconditionsthantheirdomesticcounterparts.Alternatively,thesecom-paniescouldtakeadvantageof laxregulationsandexcess supplyof labourtokeepwagesdownforcertaintypesofworkers,sometimesbelowthelevelinthelocallabourmarket.However,theliteraturefindsquiteunanimouslythatmultinationalcorpora-tionspayhigherwagesthantheirdomesticcounterparts(Lipsey2002).Thevarioushypothesesexplainingtheexistenceofawagepremiuminforeign-ownedfirmsarelistedinbox3.1.

UsingdataonindividualwagesinthemanufacturingindustryforfiveAfricancoun-tries(Cameroon,Ghana,Kenya,ZambiaandZimbabwe)intheearly1990s,teVeldeand Morrissey (2003) investigate whether foreign-owned firms pay higher wages.Theyfindthatforeignownershipisindeedassociatedwithawagepremiumof20-40percent,thoughthesefiguresdropto8-23percentoncesectoralandregionallocationareaccountedforintheeconometricanalysis.Moreover,thewagepremiumincreases with educational attainment suggested that skilled workers benefited themost.Asiedu(2004)presentsevidencethatsuggeststhatthewagepremiumrangesfrom10percentinCôted’Ivoiretoabout130percentinMorocco.

FDIcanalsoresultinhigherwagesindomesticfirmsasaconsequenceofspillovers,whicharefeasibleinlabourmarketswherethesupplyoflabourisnotperfectlyelastic.TheempiricalevidenceforthiseffectismixedaccordingtoLipsey(2002),butoverall,

Box �.�Wage premiums in foreign-owned enterprises

There are a number of hypotheses put forward as explanations for a wage premium in foreign-

owned firms:

• Foreign firms may pay wages that are higher than the market-clearing rate – referred

to as efficiency wages – to ensure higher productivity of workers. Reasons for such

efficiency wages include:

- Higher wages increase worker’s effort in a situation where monitoring is im-

perfect;

- Higher wages can improve loyalty and reduce worker turnover;

- Higher wages attract better workers; and

- Higher wages ensure that workers are well fed and more productive.

• Foreign-owned firms pay higher wages because they acquire higher-wage plants or

firms or because they are concentrated in high-wage industries or regions of a country

(Lipsey 2002).

• MNCs are more profitable and share rents with their workers (Scheve and Slaughter

2003).


FDIactivity tendstohaveapositive impactonaveragewages(includingwages inbothforeign-anddomestic-ownedfirms).However,thiscouldreducecompetitive-nessinthetradablesectorandcontributetojoblossesinthedomesticeconomy.

Foreigninvestmentcanaffectthedistributionofwagesthroughitsrelativedemandforskills,andsoimpactwithin-countryonincomeinequality.Forexample,ifFDIismoreskill-intensivethandomesticinvestmentsonaggregateinthehostcountry,suchinvest-mentsincreasethedemandfortherelativelyskilledworkersand,correspondingly,theirwages.Vivarelli (2004) summarizes the empirical evidence fromvarious studies andconcludesthatthereisnoclearlinkbetweenFDIflowsandwithin-countryinequality.

Implications for the status of vulnerable groups

Relatedtothisdistributionalaspectishowcapitalflowsaffectspecificgroupsintheeconomy,particularlywomen.For example, some argue that capital flows such asFDIhaveimprovedthesituationofwomenbycreatingjobsforthem,particularlyinexportprocessingzones(EPZs),whichinturnprovidethesewomenwithabetterstatusinsociety,besidesassistingtheirfamiliesingettingoutofpoverty.Incontrast,ithasalsobeensuggestedthatforeigninvestorsseeklow-costlocationsandemploywomenbecausetheyareabletopaythemlowerwagesandsubjectthemtoharsherworkingconditions(UNCTAD1999).

Moregenerally,foreigninvestmentcaninfluencetheconditionsintheworkplaceinsuchareasasjobsecurity,hoursworked,provisionsforholidays,sick/maternity/pater-nityleave,andoccupationalhealthandsafety.

African labour markets are typically segmented such that a minority work in theformaleconomy,whereconditionsand salaries tend tobebetter,while the restofthepopulationareconfinedtotheinformalsegment,whichischaracterizedbylowerwages,longerhours,lesssecurityandlittleprotection.Sinceforeigncompaniesaremorelikelytoformlinkageswithdomesticenterprisesintheformaleconomy,foreigninvestmentwillhelptoimproveopportunitiesinthissegmentofthedomesticecon-omy.ThisimpliesthatFDImaycontributetoincreasingformalizationoftheecon-omy.However,inthecaseofAfricaneconomies,suchformalizationisconstrainedbyover-regulation,poorinfrastructure,lackofaccesstoaneducatedlabourforce,andotherconstraints.

Human capital and FDI

Skills and education are important determinants of FDI

TheimportanceofhumancapitalforFDIhasincreasedaseconomieshaveshiftedmoreandmoretoknowledge-intensiveproductiontechnologies.Asaconsequence,multinationalcorporationsareincreasinglylookingforawell-educatedlabourforce,

Foreign investment can influence the conditions in the

workplace


notjustlowlabourcosts.Infact,theavailabilityandcostoflow-skilledworkersisnowlessrelevantforFDIthantheavailabilityofhigh-skilledworkers.Foreigninves-tors are seeking the right combinationofwages, skills andproductivity.ThismayexplainwhycountriessuchasIndiahaveattractedsignificantinflowsofFDIintheITsector,whichrequiresastockofwell-trainedscientistsandtechnicians.

Anumberof studieshave investigated the roleofhumancapital as adeterminantofFDI.3Borenszteinetal.(1998)findthatthere isastrongcomplementaryeffectbetweenFDIandhumancapitalsuchthatinvestmentshavehighproductivityonlywhenthehostcountryhasaminimumthresholdstockofhumancapital.Noorba-khshetal.(2001)alsofindthathumancapitalisoneofthemoreimportantdetermi-nantsofFDIinflows.Theresultsshowthattheimpactofeducationwasthestrongestintheearly1990s(thelatestperiodinthestudy)reflectingtheshiftofinvestmentstoservicesandtechnology-intensivemanufacturing.Asiedu(2005)findsthathavinganeducatedpopulationhelpsattractFDIinflowstoAfricancountries,inadditiontothepresenceofnaturalresourcesandlargemarkets,lowinflation,goodinfrastructure,opennesstoFDI,goodgovernance,politicalstabilityandareliablelegalsystem.

HumancapitalinAfricaremainsatlowlevels,thoughcountrieshavemadeconsider-ableprogress inrecentyears.Inparticular,theliteraturesuggeststhatgovernmentsneedtofocusonnotonlyexpandingaccesstoeducation,butalsoondevelopingcur-riculathatarealignedwiththedemandsofemployers.

FDI can also contribute to human resource development in the host country

Ingeneral,firmsinbothdevelopedanddevelopingcountriesunder-investintrainingbecauseofmarketfailuresresultingfromcreditconstraints,lackofinformation/aware-nessandlabourturnover.Theseconstraintsarelessbindingforlargerfirms,implyingthat most foreign-owned companies are in a better position to train in comparisonwithdomesticfirms.MNCsareinparticularkeenondevelopingtheskillsoftheirlocalemployeesthrougheducationandtraining(Noorbakhshetal.1999;Miyamoto2003).

Asiedu(2004)presentsfiguresontheprovisionofformaltrainingtoworkersinfourAfricacountries(Ghana,Kenya,ZambiaandZimbabwe),whichillustratethatfor-eign-ownedfirmsaremorelikelytotraintheiremployeesthantheirdomesticcoun-terparts.Forexample,in1995,46.2percentofwhollyforeign-ownedfirmsinKenyaprovidedtrainingcomparedwith16.1percentofwhollydomestic-ownedfirms.

Governmentsshouldencouragemultinationalstoundertakehumanresourcedevel-opmentinordertofacilitatetechnologytransfer.Suchtrainingspilloverscanoccurviavertical(backwardandforward)linkageswithdomesticfirms.Spilloverscanalsoresultfromemployeesofmultinationalcorporations(MNCs)seekingworkindomes-ticenterprises(labourturnover)orfromthosestartinguptheirownspin-offs(Miya-moto2003).

3 SeeMiyamoto(2003)forareviewoftheliterature

Foreign investors are seeking the

right combination of wages, skills and

productivity


3.3 FDI and domestic investmentTherehasbeenaconsiderabledebateabouttherelationshipbetweenforeigncapitalanddomesticinvestment.Inthisdebate,thetwokeyquestionsaskedare:(a)DoesFDI“crowd-out”or“crowd-in”domesticinvestment?And(b)Howdoesdomesticinvestmentinfluenceforeigncapitalflows?

The impact of FDI on domestic investment

Crowding-in or crowding-out?

Thequestioniswhetherforeigninvestmentleadstoadecreaseindomesticinvestmentactivity,whichistermedcrowding-out,orinanincrease,i.e.crowding-in(UNCTAD1999). Crowding-out or crowding-in of domestic investment can occur via prod-uctmarketsorfinancialmarkets(UNCTAD,ibid).Inthefirstcase,foreigninvest-mentcanstimulatedomestic investmentactivitythroughdownstreamorupstreamlinkages.For instance, amultinational corporationmay source rawmaterials fromdomesticsuppliersoritmayoutsourceparticularactivitiestofirmsinthehostcoun-try.However,inmanyAfricancountries,thebulkofFDIhasflowedintothenaturalresourcessector,whichhasfewlinkages,andtherefore,theindirecteffectofFDIondomesticinvestmentislikelytobemarginalinsucheconomies.

Foreigninvestmentcanalsohaveadverseeffectsonfinancialmarketsinthehostcoun-try.IfMNCsborrowinthedomesticfinancialmarket,thiscanpushupinterestrates,whichsubsequentlycrowdsoutborrowingbydomesticcompanies.Moreover,ifthecapitalflowscomingintothecountryarerelativelylarge,thismayleadtoanapprecia-tionoftherealexchangerateandreduceexportcompetitivenessandincentivesfordomesticinvestment(UNCTAD1999).ThislattereffectisstrongerforM&Asthanfornewinvestments(AgosinandMayer2000).

AgosinandMayer(2000)suggestthatifFDIindevelopingcountriesfollowsexistingsectoralcomposition(investinginestablishedsectors),foreigncapitalismorelikelytoresultincrowding-outsincetheforeigninvestorswillbecompetingwithdomesticproducers.Crowding-in ismore likely tooccurwhenthe investmentsaremade innon-existingsectors,sothatMNCsintroducenewgoodsandservices,whichdonotcompetewithdomesticfirmsanddisplacethemfromthemarket.

Anotherpossiblemechanismforcrowding-outstemsfromthepreferentialtreatmentprovidedtoforeigninvestorsintermsoftaxbreaks,cashgrants,dutyexemptionsandsubsidies,whicharenotavailableforlocalinvestors.Themainjustificationforprovid-ingsuchincentivestopromoteinwardFDIistotakeadvantageofspilloversofforeigntechnologyandskillstolocalindustry(BlomstroemandKokko2003).However,thisdifferentialtreatmentofinvestorscanincreasethecompetitivenessofforeigncompa-niesandcontributetocrowding-outofdomesticfirmsinthelocalmarket.

Crowding-out or crowding-in of

domestic investment can occur via

product markets or financial markets


The2003UNCTADWorld Investment Reporthighlightsanumberofmechanismsforcrowding-out.Firstly,localfirmsarecrowdedoutofthemarketbecauseforeign-ownedfirmsaremoreefficientandproducegoodsofbetterquality.Secondly,domes-ticfirmsaredisplacedbecauseMNCshavebetteraccesstofinancialresources.Finally,foreign-ownedfirmsmayengageinanti-competitivebehaviour(UNCTAD2003b).Thefirstscenariohasapositiveinitialimpactonwelfare,whilethesecondandthirdhaveanegativeeffect.Therefore,itisimportanttobeabletodistinguishbetweenthetwochannels, thoughthis isempiricallydifficult to identify. IfFDIhasanegativeimpactondomestic investment,Africangovernments clearlyneed to consider theappropriatenessofsuchprojects.

Does foreign investment crowd-in or crowd-out

FDItendstostimulatedomesticinvestment(Spiezia2004).Borenszteinetal.(1998)find,forexample,thatforeverydollarofFDI,thereisacorrespondingincreaseintotalinvestmentbybetween$1.5and$2.3.TheresultspresentedinBosworthandCollins (1999) indicate that FDI and international bank lending have the largestimpactondomesticinvestment,whiletheeffectsofportfolioflowsareweaker.

The World Investment Report 2003 produced by UNCTAD (2003b) reviews theevidence forcrowding-outandfinds that it ismixed. In theearlierWorld Invest-ment Report 1999,econometricevidencewaspresentedshowingthattheeffectofFDIismostlyneutral,withsomecasesofcrowding-outandsomeofcrowding-in(UNCTAD1999).

AgosinandMayer(2000)findaneutralimpactofFDIontotalinvestmentinAfrica,butcrowding-inintheAsianregionandcrowding-outinLatinAmericaduringtheperiod1970-1996.

However,breakingdowntheperiodintosmallerintervalsdoesindicate,forexample,thatFDIinAfricacrowdedindomesticinvestmentsafter1975.Disaggregatingthedatatothecountry-levelrevealsevenmoreheterogeneity intheimpactofFDIondomesticinvestment.IntermsoftheAfricancountriesusedinthesample,thereisevidenceofcrowding-ininCôted’Ivoire,GhanaandSenegal,crowding-outintheCentralAfricanRepublic,Nigeria,SierraLeoneandZimbabwe,while theeffect isneutralinGabon,Kenya,Morocco,NigerandTunisia.

Capital flows, instability and domestic investment

Anotherchannelforexternalcapitalflowstoaffectdomesticinvestmentisthroughthevolatilityofflows,inadditiontothelevels(Fosu1991,2001).Anexplanationforthiseffectisprovidedbytheoptionvalueoftheoryofinvestment(DixitandPindyck1994).Thisapproachconsiderstheimpactofuncertaintyoninvestmentthatisirre-versible,whichimpliesthatitiseasiertoincreasethecapitalstockthantosellit.Con-

If FDI has a negative impact on domestic investment, African

governments clearly need to consider the

appropriateness of such projects

��0 Economic Report on Africa 2006

sequently,thereisanoptionvaluetowaitingratherthaninvesting.Forexample,ifdomesticsuppliersbasetheir(irreversible)investmentdecisionontheirexpectationsaboutFDIinaparticularindustry,uncertaintyabouttheseflowswoulddeterthemfromcarryingoutsuchaninvestment.

Furthermore,instabilityintheexchangerategeneratedbyexternalcapitalflowscanhaveanegativeimpactoninvestment.BleaneyandGreenaway(2001)findsupport-iveevidenceforthiseffectinasampleof14SSAcountriesovertheperiodfrom1980to1995.

The domestic investment climate influences capital flows

Agoodinvestmentclimateisessentialforgrowthoftheprivatesector,whichplaysapivotalroleinjobcreationand,hence,povertyreductioninalldevelopingecono-mies.Suchaninvestmentclimatedependsbothonfactorsthatgovernmentscannotinfluence,suchasgeographyandconsumerpreferencesandthosethataredeterminedbygovernmentpolicies and laws.The latter includesmacroeconomicandpoliticalstability, security of property rights, sensible regulation and taxation, provision ofinfrastructure, functioning finance and labour markets, a skilled labour force andgoodgovernanceaspectssuchas lowlevelsofcorruption(WorldBank2005).Thepresenceofsuchaninvestmentclimatewillhelppromotedomesticinvestmentand,ultimately,economicgrowth.ThissubsequentlyactsasapositivesignalforforeigninvestorsandhelpstoattractFDI.

Besides this indirect link, it is also possible that foreign companies seek out jointventureswithdomesticpartners,whichisoftentheinitialformofforeigninvestmentallowedbygovernmentsofdevelopingcountries.

3.4 Official development assistance and domestic factor marketsToidentifytheimpactofODAondomesticlabourmarketsandinvestmentactivity,itisnecessarytostartwiththegeneraldebateaboutaidflowsandeconomicgrowth,beforeturningtospecificlinkages.

Aid can theoretically stimulate growth, investment and job creation

Oneofthemostdiscussedandanalysedissuesfacinggovernments,donorsandresearch-ersiswhetheraidpromoteseconomicgrowth.Thisrelationshipwasforaconsiderabletimebasedonthetwo-gapmodelfirstproposedbyCheneryandStout(1966), inwhichthegapsbetweensavingsandinvestmentandbetweenforeignexchangeearn-

Instability in the exchange rate generated by

external capital flows can have a

negative impact on investment

��Capital Flows and Factor Markets

ingsandimportrequirementswereshowntoconstraineconomicgrowth(DollarandEasterly1999,Gomaneeetal.2005andGuptaetal.2006).Insuchasituation,flowsofcapitalintheformofaidcanfinancethesegaps,resultinginhigherlevelsofinvest-mentand,ultimately,inincreasedeconomicgrowth.

Anothermechanismforaidinflowstoincreasedomesticinvestmentisthroughtherelationshipbetweenpublicinvestmentfinancedbyaidflowsandprivateinvest-ment. Similar to the crowding-out hypothesis for FDI flows, it is possible thataid-financed public investment can stimulate or hinder private investment. Forinstance,aidcouldfinanceinfrastructureinvestments,whichinturnsupportpri-vate investors. There is empirical evidence to suggest that public investment inSSAtendstocrowdinprivateinvestment,reflectingthecomplementarityofthetwotypesofinvestment(Guptaetal.2006).Evidently,thesizeoftheeffectwilldependonhowmuchaidisallocatedtopublicinvestment.Asdiscussedinchapter2,only14percentofODAinAfricain2001/2002wenttoeconomicinfrastruc-tureandservices.

Therefore,apartfromthedirecthiringofpersonnelinthehostcountry,aidflowscanpotentiallystimulatejobcreationthroughincreased(publicandprivate)investmentandacceleratedeconomicgrowth.

Aid flows can also negatively affect the economy

However,aidmayalsohaveanegativeimpactontherecipientcountry’seconomy.Thegeneralargumenthereisthataidinflowsincreasethedemandfornon-trad-able resources such as skilled labour and public services including health careandeducation.Ifthereislittleexcesssupplyoftheseinputsintheeconomy,theincreased demand will push up prices of the non-tradables vis-à-vis tradables.Thesubsequentappreciationoftherealexchangerate(RER)inturndamagesthecompetitivenessofthetradablegoodssector,aneffectreferredtoas“DutchDis-ease”.Thislossofcompetitivenessleadstoafallininvestmentandjobdestruc-tion in the tradable sector, and ultimately, to reallocation of resources to thenon-tradable sector.Thiseffect is likely tobe strongerwhen trade is restricted,theeconomyisclosetofullcapacity,andconsumersareconstrainedinswitchingbetweendomesticandimportedgoods(Guptaetal.2006).Overall,theimpactofaidwilldependonthetypeofassistance,howitisspentandtheefficiencyoftheexpenditure.

Summary of the evidence on the aid-growth relationship

Burnside and Dollar (2000) find that the relationship between aid and growth isindeedpositive,thoughmorerecentstudiessuggestthatthereisnoclearassociation.Focusingon the investment channel,Gomanee et al. (2005)find that foreign aidhasasignificantpositiveeffectongrowthinasampleof25SSAcountriesoverthe

Aid flows can potentially stimulate

job creation through increased

investment and accelerated

economic growth


periodfrom1970to1997.Theresultsindicatethataonepercentagepointincreaseintheaid/GNPratioisassociatedwithaone-quarterofapercentagepointincreaseingrowth.

RajanandSubramanian(2005)explorethechannelthroughwhichaidaffectscom-petitiveness and hence economic growth via wage inflation, which results fromincreasedlabourdemand,especiallyforskilledlabour.Basedonthishypothesis,theauthors investigatewhether labour-intensive industries, i.e. thosemore affectedbyhigherwages,growrelativelyslowerincountrieswithhighaidinflows.Theresultsindicatethataidinflowsareindeedassociatedwithadeclineintheshareoflabour-intensiveandtradableindustriesinthemanufacturingsector.

Aidaffects the real exchange rate and its subsequent impactoneconomicgrowth;(Guptaetal.2006)reportthattherelationshipbetweenaidinflowsandrealexchangerate appreciation is ambiguous, with some studies showing positive effects, whileothersfindnegativeeffects.Forinstance,astudybytheIMFfoundthatasurgeinaidinfiveAfricancountries(Ethiopia,Ghana,Mozambique,Tanzania,Uganda)actuallyresultedinadepreciation,notanappreciation,intherealexchangerateinthefollow-ingyear,bybetween1.5-6.5percent(IMF2005a).4

Otherstudieshavefocusedonthedirect impactofrealexchangerateappreciationoneconomicgrowth.Usingapanelof14SSAcountriesovertheperiod1980-1995,BleaneyandGreenaway(2001)findthatbothgrowthandinvestmentarenegativelyaffectedbyanovervaluedrealexchangerate,whileinvestmentisalsohinderedbyrealexchangerateinstability.

3.5 Remittances also play an important role in investment and job creation

Remittances can promote development

Byreducingbudgetconstraints,remittancescanplayanimportantroleinfinancingdevelopment through their impact on savings and investment. The resources pro-videdbyremittancescansubsequentlysupportconsumption,housing,educationandsmallbusinessformation(IMF2005b).Moreover,remittancescanserveasinsuranceagainstriskincarryingoutnewproductiveactivitiesandsettingupbusinesses(WorldBank2003).Overall,remittancescandirectlypromoteinvestmentandjobcreation,andindirectlyviaitslong-termpositiveeffectsoneconomicgrowth.Hence,remit-tancesinAfricacancontributetopovertyreduction,anissuediscussedinchapter2.

Asalsodiscussedinchapter2ofthisreport,remittancesareanimportantsourceofcapitalinAfrica.Thoughapproximately80percentofremittancesareusedfor

4 SeeKasekendeandAtingi-Ego(1999)forevidenceonthesituationinUganda


consumptionandschooling, theyarealso increasinglybeingallocatedto invest-ment. For example, the impact of remittances is now evident in the construc-tionsectorinmanyAfricancountries,particularlyinrealestate,whichisamajoremployer of unskilledworkers inurban areas.However, even if remittances areusedforconsumptionsmoothing,theycanincreasethedemandforlocalproducts,andthroughmultipliereffects,promoteemploymentandinvestment.Moreover,byinvestinginthehumancapitaloffamilymembersthroughfundingofeduca-tion,theremittancescanimprovetheproductivityandemploymentchancesofthenextgeneration.

Thoughmostremittancestargetfamilymembers,itisalsopossibletomobilizeremit-tances from a community of migrants, which can subsequently be used for moresubstantialprojects.TheMexicanhometownassociationsintheUnitedStatesareagoodexampleofhowcollectiveremittancescanbeusedforbothcharitablepurposesandtofinanceproductiveinvestments(box3.2).

Potential adverse effects of remittances

Onepotentialnegativeeffectofremittancesisthroughthe“DutchDisease”chan-nel discussed above, in relation to the impact of aid on economic competitive-ness.However,itisgenerallyfoundthat,unlikeODAornaturalresourcerevenues,remittancesdonothaveanyadverseeffectsonacountry’scompetitiveness (IMF2005b). For instance, Rajan and Subramanian (2005) find that, contrary to theresultsforaid,thereisnoevidencethatremittancesinSSAreducecompetitivenessof the tradable sector via an appreciationof the real exchange rate.Remittancescanbedistinguishedfromotherformsofcapitalflowssincetheyarenotsubjecttoconditionalitiesorrepayments,andtherearenoleakagesastheresourcesgodirectlytothetargetedrecipient.

The role of domestic factor markets in determining remittances

Theconditions in the labourmarketandtheavailabilityof investmentopportuni-tiescanactasadeterminantofremittances.Firstly,ifthedomesticlabourmarketischaracterizedbyunemploymentorunderemployment,theincentiveinthefirstplacetomigrateishigher.Oncethemigrantsarelocatedoverseas,theycontinuetosup-portfamilymembersremainingbehindwholackdecentemploymentopportunities.Secondly,higherreturnstocapitalinthemigrant’shomecountryshouldencouragemoreinvestment-orientedremittances.Thisinturnrequiresaconduciveinvestmentclimateandanefficientfinancialsystemtoattractinvestmentstothecountry.

Remittances can improve the productivity and

employment chances of the next

generation


3.6 Case studies: FDI, domestic investment and job creation in Ethiopia and GhanaThissectionpresentstwoAfricancasestudies–EthiopiaandGhana–tohighlightinparticulartherelationshipbetweenFDIanddomesticinvestmentandjobcreation.

Ethiopia

Investment conditions in Ethiopia

Asaresource-poorcountrythatreceivesconsiderableexternalcapitalinflows,Ethio-piaisausefulcasestudytodiscusstheeffectsofFDIondomesticinvestmentandthelocallabourmarket.

Althoughtheprivate sector remainsundeveloped, theGovernmenthasmadecon-siderableattemptsinrecentyearstoattractprivatecapitalflowsintheformofFDI.UNCTAD/ICC(2004)identifiesthreemainpositivefactorsthatshouldattractfor-eigninvestmenttothecountry:marketsize(Ethiopia is thesecondlargestAfricancountry),climate,areasonablebusinessenvironment,andlowlevelsofcorruption.Thekeysectorsforforeigninvestmentareagricultureandagro-basedindustries(flo-

Box �.�Mobilizing remittances through collective migrant organizations

Remittances are typically transfers from migrants to other individuals or families in their coun-

try of origin. However, through community associations, church groups, refugee organizations,

ethnic professional bodies and even virtual organizations, migrants also transfer collective remit-

tances, usually targeting their community as a whole back home.

The most prominent example of this type of initiative are the hometown associations estab-

lished by Mexicans in the United States, which have financed projects in Mexico in a number of

areas such as charity, infrastructure such as road construction and provision of water and other

utilities, and human development.

Numerous African migrant associations have also emerged in recent years. For example,

many French migrants originating from the Kayes region of Mali have formed such associations,

which have contributed, in turn, to the development of villages and rural areas back in Mali. It

is estimated that over a period of ten years, these organizations financed a total of 146 projects

representing 16.6 million francs, and have funded around 64 per cent of the infrastructure in the

villages of the Kayes region.

Sources: Inter-American Development Bank website; Libercier and Schneider (1996); Sander and Maimbo (2003)

Migrants also transfer collective

remittances, usually targeting their

community as a whole back home


ricultureandhorticulture),miningandhydropower,lightmanufacturingincludingleathergoodsandready-madegarments,tourism,andotherservices.

TheEthiopianGovernmentprovidessomeincentivesforforeigninvestorsincludingsomeexemptionfromimportandexportdutiesandprofittax.

The Ethiopian labour market

Labourcosts areonaverage low inEthiopia.According to theWorld Development Indicators,theaverageGDPperworkerinEthiopiawas$1,716.1in2004,wellbelowtheSSAaverageof$4,412.3.5However,adjustingforlabourproductivityrevealsthatotherdevelopingcountriesaremorecompetitiveintermsoflabourcosts.Thisisanimportantfactorindetermininglabour-intensiveforeigninvestment.

OneoftheprimarycausesoflowproductivityinEthiopiaistheinadequatelevelofhumancapital.Infact,inalldimensionsofeducation,EthiopialagsbehindtheAfri-canregion.Forexample,thenetenrolmentrate(NER)inprimaryschoolisonly46.4percentinEthiopia,comparedwithanaverageof64.1percentinSSA.6Moreover,only50.6percentofthatagegroupfinishprimaryschoolinEthiopia,comparedwith61.7percent inthewholeregion.Intermsofoutcomes,theadult literacyrate inEthiopiawas41.5percentonaveragefortheperiod2000-2004,whichis23percent-agepointslowerthantheratefortheSSAregion.

Ashighlightedinsection3.2,anotherimportantdeterminantofforeigninvestmentis labour-market regulation. The principle source of labour law in Ethiopia is thenewLabourProclamationadoptedin2004.Subsequently,theLabourProclamationincorporatesanumberofarticlesthataddressdismissalprotection,regulationofsev-erancepay and compensation, disabilitypayments anddependentbenefits.7Thereis,however,nominimumwage legislation inEthiopia,and thus, foreign investorsarenotconstrainedfromsettinglowwagesforunskilledworkers,whoareinexcesssupplyinthecountry.

TheLabourProclamationalsoprovidesa fullguarantee for freedomofassociationandintroducesasystemofcollectivebargainingandsettlementsoflabourdisputes.TheEthiopianlegislationalsoregulatesfixed-termcontracts.Genderequalityisguar-anteedbytheConstitution,whiletheLabourProclamationhasprovisionsforpenal-izingsexualdiscriminationintheworkplace.Ethiopiahasalsoratified21ILOcon-ventions.

WithrespecttothelabourmarketrigiditiesstemmingfromtheLabourProclamationandotherformsoflegislation,Ethiopiafaresquitewellincomparisonwiththerestof

5 Notethatthisdoesnotcontrolfordifferencesinsectoralcompositionofoutput.Figuresareinconstant2000international$inpurchasingpowerparityterms.

6 Thenetenrolmentrate(NER)isthenumberofpupilsinthetheoreticalagegroupwhoareenrolledexpressedasapercentageofthesamepopulation.Figuresarefor2004.

Source: World Development Indicators,onlinedatabase.7 Seehttp://www.ilo.org/public/english/dialogue/ifpdial/ll/observatory/profiles/eth.htm


SSA.Ethiopiahasavalueof41fortheoverallrigidityofemploymentindex,whichislowerthantheregionalaverageof53.1.Theothersub-indexes(difficultyofhiring,difficultyoffiring,andrigidityofhours)areallbelowtheaverageforSSA.HiringcostasapercentageofthesalaryinEthiopiaiszerowhileitis11.8percentinSSA.Firingcosts(weeksofwages)represent40.2weeksofsalarycomparedwithanaverageof53.4weeksfortheSSAaswhole.

At least on paper, Ethiopia has put labour laws in place and standards that pro-videprotectionforworkerswithoutoverlyrestrictingthefunctioningofthelabourmarket.However,asoftenisthecase,incountrieswherelegalsystemsandenforce-mentareweak,compliancewiththeseprovisionsistypicallylax.Theseissuesraisethequestionofwhetherornottheselawsarebindingand,inturn,whethertheycreatecostsforforeigncompanies,thusdeterringforeigninvestmentinEthiopia.Moreover,theselawsonlyapplytotheformalsector,whichaccountsforasmallproportionofemploymentinAfrica,particularlyinEthiopia.

FDI and domestic investment in Ethiopia

Followingthereformsundertakenintheearly1990s,netFDIinflowsintoEthiopiaaccelerated in 1997 when it reached $289 million (4.5 per cent of GDP), beforefallingagainin1999.8ForeigninvestmenthasrecoveredsincethewarwithEritreaandasof2004inflowsamountedto$545millionor6.8percentofGDP.Figure3.1illustratesthetrendsinbothnetFDIinflowsandgrosscapitalformation(GCF)asapercentageofGDPovertheperiod1990-2004.Thereappearstobeevidencethatsince2000FDIishelpingtoraiseGCFintheEthiopianeconomy.

8 ThespikeinFDIinflowsin1997and1998wastheresultofalargehotelinvestment.

Since 2000, FDI is helping to raise GCF in the

Ethiopian economy


Figure �.�Net FDI inflows and gross capital formation in Ethiopia ($US), 1990-200� (% of GDP)

Source: World Bank, 2006

Turningtothedata fromtheEthiopianInvestmentCommissionasreproduced intable 3.2, there were a total of 318 foreign projects in operation over the periodJuly1992-July2005,with272(85.5percent)beingwhollyforeignownedandtheremainderjointventureswithadomesticfirm.Thiscompareswith2,444domesticprivate and 22 public investment projects. The average capital invested in foreignprojectswas28.41millionbirr($3.28millionatcurrentprices)perwhollyforeignowned and 34.74 million birr ($4.01 million) for joint ventures. In comparison,domesticprojectsweremuch smaller, averaging6.28millionbirr ($0.72million).Overtheperiod1998/1999–2004/2005,FDIinEthiopiawasconcentratedincashcropsfarming,accountingfor16percentofflows.


Table 3.2Investment projects in operation in Ethiopia – July 1992 to July 2005

Domestic Foreign Public Grand total

Wholly

Foreign

Joint with

Domestic

Total No.

Total no. of

projects

2,444 272 46 318 22 2,784

Average

Capital (million

birr)

6.28 28.41 34.74 29.33 211.04 10.53

Total

employment

(number of

workers)

159.52 223.34 138.70 211.09 218.73 165.88

Permanent

workers

37.17 120.08 104.33 117.81 192.23 47.61

Temporary

workers

122.35 103.25 34.37 93.29 26.50 118.28

Share of

temporary

workers

76.70 46.23 24.78 44.19 12.12 71.30

Labour intensity

(worker per

million birr)

25.4 7.9 4.0 7.2 1.0 15.8

Source: Ethiopian Investment Commission (EIC); Capital in million of birr

OnedirectchanneloftheimpactofFDIondomestic investmentisthroughjointventures.AccordingtoEICdata,14.5percentor46projectsinEthiopiaovertheperiodJuly1992toJuly2005werejointventures.Theseinvestmentswithdomesticpartnersaveraged34.7millionbirr,generating138.7jobsperproject.

FDI and job creation in Ethiopia

ForeigninvestmentprojectsinEthiopiacreatedatotalof67,128jobsfromJuly1992toJuly2005, representing14.5percentofall jobscreatedduring thisperiod.9 Incomparison,domesticandpublicprojectsgenerated389,876and4,812jobs,respec-tively.Onaverage,eachforeignprojectgenerated211jobs,118permanentpositionsand93temporaryjobs.Domesticinvestmentsresultedinfewerjobs(average160),whilepublicprojectstendedtoemploymoreworkers(219).

Thelabourintensity(theratioofworkerstocapitalinvested)ishighestindomesticprojects(25.4workerspermillionbirr),whichalsohavethehighestshareoftempo-9 90.5percentwereinwhollyforeign-ownedprojects.Totalnumberofjobscreated(foreign,domesticandpublic)

fromJuly1992toJuly2005=461,816.


raryworkers,themajorityofwhomareunskilled.Foreigninvestmentprojectsarelesslabour-intensivethandomesticinvestment,thoughmoresothanpublicprojects.Foreverymillionbirrinvestedbyaforeigncompanyinwholly-ownedprojectsinEthio-pia,4jobsarecreated,comparedwith25jobsindomestic-ownedprojects.

Over the period 1998/1999-2004/2005, FDI in Ethiopia created the most jobs(temporaryandpermanent)inthecashcropssector(79,338jobs),followedbyrealestatedevelopment(37,397jobs).Boththesesectorsarelabour-intensiveandlargelyemployunskilledworkers.

Therefore,thesefiguresindicatethat,ingeneral,foreigninvestmentsinEthiopiaareanimportantvehicleforjobcreationandmayalsocontributetodecreasinginequalitythroughincreasedrelativedemandforunskilledworkers.However,domesticinvest-mentremainsmorelabourintensiveandthereforehasalargerimpactonemploymentintermsofquantity,thoughnotnecessarilyintermsofdecentjobs.

Ghana

Investment conditions in Ghana

IncomparisontoEthiopia,Ghanaisacountryrichinnaturalresources,particularlygold.However,GhanahashaddifficultiesinattractingsustainedinflowsofFDI,inspiteofthepotentialintheminingsector.Otherpromisingbutstillundevelopedsec-torsforattractingFDIareagro-processingandagriculture,andlightmanufacturingforlocalandregionalmarkets(UNCTAD2003a).

TheGhanaianGovernment adoptedanewmining law in1986,whichmotivatedasubstantialincreaseofforeigninvestmentintheminingsector.Subsequently,theGovernmentpromulgated theInvestmentPromotionCentreAct1994to regulateFDIinallsectorsexceptinminerals,oilandgas,andfreetradezones(FTZs),withthe aim of facilitating the setting-up of businesses and attracting FDI. Incentivesarealsoprovidedforwould-beforeigninvestorsintheformoftaxholidays,capitalallowances,locationincentives,andcustomsdutyexemptions.TherearealsospecialincentivesforexportersandintheFTZs.However,investors,especiallyintheFTZs,havepointedoutthatthesetargetedincentivesdonotadequatelycompensateforthepoorinfrastructureandotherconstrainingfactors(UNCTAD2003a).

AnotherimportantchannelforattractingFDIinGhanahasbeenprivatization,whichreacheditspeakwiththepartialsaleoftheAshantiGoldfieldsCorporation(AGC)totheSouthAfricanminingcompanyLonminfor$233millionin1994(UNCTAD2003a).

Foreign investments in Ethiopia are an

important vehicle for job creation


The Ghanaian labour market

LabourcostsarehigherinGhanathaninEthiopiaandinSSAonaverage.However,theGhanaianlabourforce isalsomuchmoreeducatedwiththeadult literacyratereaching74percent,comparedwith41.5percentinEthiopia(period2000-2004).Nonetheless,foreigninvestorsstatethatthelevelofeducationandskillsisstilltooinsufficienttomeettheirrequirements(UNCTAD2003a).

WithregardstolabourlawsinGhana,labourrightsprovisionsaregenerallynegoti-atedunderfirm-specificcollectivebargainingagreements,whichcanbecomplicatedandlengthy(UNCTAD2003a).Ghanaalsohasinplaceaminimumwage,thoughitslevelislow(aroundUS$1.30perdayin2003)andisthereforeunlikelytohaveasubstantialeffectonthedemandforunskilledworkers.

In general,Ghanaian employment regulations are less restrictive than the regionalaverage.Theemploymentrigidityindexis34forGhana,comparedto41forEthiopiaand53forSSA.Specifically,hiringismoreflexibleandthenumberofhoursworkedlessrigidinGhana,thoughfiringismoreconstrainedincomparisonwithEthiopia.

The impact of FDI on domestic investment in Ghana

Afterpeakingat$233millionor4.3percentofGDPin1994,FDIinGhanahasfluctuatedconsiderably(figure3.2).Asillustratedinfigure3.3,thecontributionofFDI to gross capital formation inGhana exceeded thatofEthiopia from1990 to1996,beforetheratioinEthiopiaincreasedrapidlytoover25percent.FDIisnowclearlyamoreimportantsourceofcapitalformationinEthiopiathaninGhana.

Figure �.�Net FDI and gross capital formation in Ghana ($US), 1990-200� (% GDP)



FDI and job creation in Ghana

Given that most of FDI in Ghana has been confined historically to the naturalresourcessector,itisnotsurprisingthatforeignprojectshavenotresultedinsig-nificantjobcreation.MostjobscreatedbyFDIinGhanawerethereforeasaresultofprojectsinothersectors.Itisencouragingthatrecentdatarevealthatthemanu-facturingandservicesectorshaveattractedthelargestshareofforeigninvestment(GIPC2005).Forexample,overtheperiodJanuary2001toSeptember2005,themajorityofjobsinnewforeignprojectswerecreatedinthemanufacturingsector(table3.3).Incomparison,domesticprojectsresultedinmorejobsintheservicesector.Overall,thesefiguresillustratethatthoughFDIcreatedatotalof2,844jobsoverthealmost5-yearperiod,thenumberisdwarfedbythosecreatedindomesticprojects(38,562jobs).

Figure �.�FDI’s contribution to gross capital formation in Ghana and Ethiopia, 1990-200� (% GCF)


The majority of jobs in new

foreign projects in Ghana were created in the manufacturing

sector


Table �.�Employment creation in foreign versus domestic projects in Ghana, January 2001 – September 2005

Sector Domestic Foreign

Number of jobs Share Number of jobs Share

Manufacturing 10,511 27.3 877 30.8

Services 11,517 29.9 587 20.6

Building and

construction

4,185 10.8 341 12.00

Agriculture 4,375 11.3 217 7.6

Tourism 2,929 7.6 275 9.7

General trade 4,041 10.5 453 15.9

Export trade 1,004 2.6 94 3.3

Total 38,562 100.0 2,844 100.0

Source: GIPC (2005)

TheimpactofFDIonjobcreationisnotconfinedtoitsdirecteffectonemployment,butalsoincludesjobscreatedindirectlythroughlinkagesandmultipliereffects.Box3.3providesanexampleofthesedirectandindirecteffectsinthecaseofUnilever’sinvestmentinGhana.

Box �.�Unilever’s subsidiary creates thousands of jobs in Ghana

Unilever Ghana Ltd. operates a highly integrated business in Ghana, involving the purchase

of raw materials, the processing, packaging and subsequent distribution of soap and cleaning

products. Altogether, Unilever employs around 1,200 farmers in Ghana in two oil palm planta-

tions in addition to another 800 in their processing factory. Moreover, it is estimated that for

every worker directly employed with Unilever, an extra three are employed indirectly through an

independent entrepreneurs’ distribution network.

Source: UNCTAD (2003a)

The impact of FDI on job creation

also includes jobs created indirectly

through linkages and multiplier effects


3.7 Conclusion and policy recommendationsBasedontheanalysisinthischapter,anumberofkeyfindingscanbehighlighted:

• Since most FDI in Africa has been concentrated in the natural resourcessector, fewjobshavebeencreatedbysuch investments.There is someevi-dencethatforeignfirmspayawagepremiuminAfrica;

• LabourcostsandregulationsinAfricancountriesareimportantdeterminantsofcapitalflowsandaconstrainttoFDI;

• Undevelopedhumancapital isamajorconstrainttoforeigninvestment inAfricancountries;

• TheinvestmentclimateinAfricaremainsadeterrenttobothdomesticandforeigninvestment;and

• Though official development aid and workers’ remittances are importantinAfrica,evidenceof their relationshipwithdomestic labourmarketsandinvestmentremainslimited.

Overall, African governments need to promote capital flows to increase economicgrowthandjobcreation,andreducepoverty.Thefollowingpolicyrecommendationsarepartofthisagenda:

• Thefirstandoverridingpriorityistodevelopaconduciveinvestmentclimatethrough good governance, sensible regulation and taxation, infrastructure,accesstofinanceandinvestmentineducationandskilldevelopment;

• Through the use of targeted policies and incentives, governments shouldencourageinvestmentsinmorelabour-intensivesectorssuchasfoodprocess-ing,manufacturingandservices(tourism);

• Labourmarketregulationsshouldbestreamlinedtoencourageinvestmentbybothdomesticandforeignfirms,whileprotectingworkers’rights;

• Governmentsshouldimproveemploymentconditionsespeciallyintheinfor-malsector;

• Governmentsshouldinvestmoreineducationandskillsinordertoattractinvestmentsinhighervalue-addedactivities.Trainingatthefirmlevelandbyprivateprovidersshouldalsobeencouraged;

• Governmentsshouldensurethatfavourabletreatmentofforeigninvestmentdoes not provide unfair advantage to foreign investors vis-à-vis domesticinvestors;and

• Governments should design incentives to encourage more investment-ori-entedremittances.Financialinstitutionsmayplayanimportantroleinfacili-tatingtransfersofremittancesandindesigninginvestmentinstrumentstar-getingtheDiaspora.


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��

4.1 IntroductionAfrica needs economic transformation in order to achieve sustainable growth andreduce its dependenceonprimary commodityproduction and exports.EconomictransformationisaprocessthatalterstherelativecontributionofeconomicsectorstoGDPandemploymentover time.Thisprocessoccurs through twomainchan-nels:first,reallocationoffactorsofproductionfromlessproductivesectorstomoreproductiveones;andsecond,diversificationoftheeconomyawayfromprimarycom-moditysectors(agriculture,oilandminerals)intoindustryandservices(BerthelemyandSoderling2001).

Giventhestronglinkagesofindustrywithothereconomicsectors,increasesintheshare of industry in GDP have the greatest potential to contribute to sustainablegrowthandstructuralchange.Weusethetermeconomictransformationinthischap-ter to refer to a growth process associated with an increasing share of industry inGDP.1Economictransformationismoreeffective-intermsofemploymentcreationandreducingvulnerabilitytoshocks-whenincreases in industry’scontributiontooutput are driven by increased manufacturing output rather than increases in theoutputofextractivesectorssuchasoilandminerals.Therefore,thesharesofmanu-facturingoutputinGDPandtotalexportsmaybeusedasadditionalindicatorsofeconomictransformation.

ThepaceofstructuraltransformationinAfricahasbeenveryslow.Althoughtheshareofagriculture inGDPdeclinedover the last fourdecades, thisdeclinewasmainlytheresultofincreasesinthesharesofsectorsotherthanindustry–mainlyservices–andreflectsthelackofadequatepoliciesandincentivestodirectinvestmenttowardsdomestic industrial activities. Meanwhile, in many African countries increases inindustry’sshareinGDPoriginatelargelyfromproductionofoilandminerals.Thecontributionofrevenuesfromtheseactivitiestoeconomictransformationdepends

1 Economicactivityisexpectedtoshiftovertimefromtheprimary(agricultureandindustry)sectorstothesec-ondary(servicesandtertiary)sectors.Relativesaturationintheconsumptionofindustrialcommoditiesnormallyinducesexpansionoftheservicesector,whichrequireshighinvestmentinsuchareasasinformationtechnology,exportprocessing,andfinancialservices(HayamiandGodo,2005:38).TypicallyinvestmentintheseareasislowinAfrica,whichlimitsopportunitiesforgenuineeconomictransformation.Whilethischapterfocusesonindustryasadriverofeconomictransformation,werecognizethat,insomecountries,servicesmayalsoplayanimportantrole.

Capital Flows and Economic Transformation �

In many African countries increases

in industry’s share in GDP originate

largely from production of oil

and minerals.


cruciallyontheextenttowhichtheyareusedtofinanceinvestmentinothersectors,specificallymanufacturing.

Thechapterexaminesthekeyfactorsthatenhancetheroleofcapitalflowsineco-nomictransformation.Sustainedeconomictransformationdependscruciallyonthequalityandquantityofphysicalandhumancapital.Factoraccumulation, in turn,requiresaconduciveinstitutionalframeworkandaninvestmentclimatethatprovidesnecessaryincentivestoattractbothdomesticandexternalcapital.ThesamefactorsthatconstrainAfrica’sgrowth-suchasslowaccumulationofcapital,slowproduc-tivitygrowth,weakinstitutionalenvironment,andinfrastructuredeficiencies-alsoinhibitstructuraltransformation.

Capitalflows,official andprivate,have thepotential to influence economic trans-formationmainlythroughcapitalaccumulationandproductivityenhancement.Infact, there isa two-waycausationbetweencapitalflowsandeconomictransforma-tion.Whileofficialcapitalflowsmayenhanceeconomicgrowthandtransformationbyfacilitatingthedevelopmentofhumanandphysicalinfrastructure,privatecapitalflows are likely to followeconomic transformationandgo to countrieswithgoodindustrialandtradestrategies.Consequently,targetedpolicyinterventionsthatfostereconomictransformationwillindirectlyhelptoattractthesetypesofcapitalflows.

Experiences of successful transformation in East Asian economies as well as someAfricancountriesindicatethatcapitalflowshavetobeadequatelymanagedtogener-atepositivespillovereffectstotherestoftheeconomy.Thepositiveeffectsofcapi-talflowsarisefromtargetedstrategiesaimedatharnessingforeigncapital,includinginvestmentsinhumancapitalaccumulation,physicalinfrastructureandothermeas-uresthatimprovetheinvestmentenvironment.

Thenext section examines the state of, andneed for, economic transformation inAfrica2.Thesectionthendiscussestheroleofcapitalflowsineconomictransforma-tionandprovidesaquantitativeassessmentofthisroleinthecontextofAfrica.Sec-tion4.3analyzestheconstraintsthathavetobeaddressedforstrengtheningthelinkbetweencapitalflowsandeconomictransformationonthecontinent.ExperiencesoftworelativelysuccessfulAfricancountries,MauritiusandTunisia,arehighlightedinsection4.4alongwiththecaseofNigeria,wherestructuraltransformationfailedtomaterializedespitehugeeconomicpotential.Section4.5summarizeskeyfindingsandpolicyrecommendations.

2 Duetodatalimitations,thediscussioninsomepartsofthechapterfocusesexclusivelyonSSA.Themaindatasources,theWorldDevelopmentIndicatorsandtheAfricaDatabaseoftheWorldBank,reportaggregatedataforNorthAfricaaspartoftheMiddleEastandNorthAfricasubregion.

Sustained economic transformation

depends crucially on the quality and

quantity of physical and human capital

��Capital Flows and Economic Transformation

4.2 Africa needs structural transformation: what can capital flows do?

Structural transformation is essential for reducing poverty and vulnerability to shocks

AmongthereasonsforAfricancountries’failureinreducingpovertyanderadicatinghungeristheirinabilitytodiversifytheireconomiesandachievesustainableeconomicgrowth.ThemajorityofthelabourforceinAfricaisengagedinagriculture,whichischaracterizedbylowproductivity.Meanwhile,exportearningsdependheavilyoncommodityexportsandarehighlyvolatileduetotermsoftradechangesandnaturalshocks.

AlthoughAfricaneconomiesaregenerallyconsideredasagrarian,thereisalargevaria-tionacrosscountriesintheroleofagriculture.Inmanycountries,miningandservicesplayanevenmoreimportantrole.In2003,thecontributionofagricultureasaper-centagetoGDPinAfricavariedbetween2.4percentinBotswanaand60.8percentintheCentralAfricanRepublic(WorldBank2005).

Unlikeotherregions,suchasEastandSouthernAsia,theshareofthevalueaddedofagricultureinGDPinAfricahasnotchangedsignificantlyoverthelastthreedecades(figure4.1).Industry’sshareinAfrica’sGDPfluctuatedbetween29and34percentbetween 1970 and 2003 with no clear trend over time. In comparison, East Asiaindustry’svalueaddedrosefromabout38percentto48percentofGDPoverthesameperiod(figure4.2).Further,theshareofmanufacturinginAfricahasdecreasedslightlyfromaround16percentduringthe1970sand1980stoanaverageof13.4percentbetween2000and2004.

TheshareofmanufacturinginAfrica’smerchandiseexportsalmostdoubledbetween1970-1974and2000-2003,from10percenttoover20percent.Incomparison,theshareofmanufacturingexportsinEastAsia’smerchandiseexportsrosefromabout33percentin1980-1984toabout80percentin2000-2003.Promotingmanufacturedexportsisimportantinviewofthefactthattheyhaveapositiveimpactonthegrowthof thenon-export sectoraswellasoverallGDP(Fosu1990).Incontrast,primaryexportshavebeenunabletostimulategrowthinthenon-exportsectorofadevelopingeconomy(Fosu1996).

The share of the value added of agriculture in

GDP in Africa has not changed

significantly over the last three decades


Figure �.�Agriculture’s value added as a percentage of GDP in Africa and other regions, 1970-2003 (% of GDP)


Figure �.�Industry’s value added, 1970-2003 (% of GDP)


Primarycommoditydependenceincreasesvulnerabilitytoshocks,whichraisesuncer-taintyandretardsgrowth.PrimarycommoditypricevolatilityledtolargetermsoftradeshocksthatcontributedtolowergrowthratesinmanyAfricancountries.Itis


estimatedthata44percentannualdeclineinthepriceofaprimarycommoditycangeneratealossofalmost7percentofGDP(Collier2003).Instabilityintheoutputofprimarycommoditiesandpricesalsogeneratesuncertaintieswithregardtofiscalsol-vency,whichunderminesmacroeconomicmanagement, increases investmentrisks,andleadstodebtoverhang.

Moreimportantly,inmanyAfricancountriestherentsgeneratedbyprimarycom-modities,especiallyoil,havebeenassociatedwithpoorgovernanceandpolicyenvi-ronment because they enable corrupt governments to reward constituencies, fundinefficient public-works programmes and buy off opponents (Herbst and Soludo2001).Availabilityofoilrevenuereducesincentivesforgovernmentstoinitiateandsustainpoliciestoencouragebroadgrowth.Thus,agricultureandmanufacturingareoftenneglectedinoil/mineral-dependentcountries.

Productivity increases in agriculture paired with improved absorptive capacity inother sectorsallowthereleaseof farm labour to industryandother sectors,whichisthestartingpointforeconomictransformation.ThisprocesscouldnothappeninAfricabecauseagriculturalproductivityperworkerhasnotchangedovertime(figure4.3).Amongthereasonsforthislowproductivityisminimumuseoftechnologyinagriculture.Forinstance,theuseoftractorsperworkerhasevendecreasedinAfricaovertime;in1961,417agriculturalworkerssharedonetractorcomparedwith806agriculturalworkersin2002.Overthesameperiod,theuseoftractorsinSouthAsiahasbeenmultipliedby25times(figure4.4).Policiestoaccelerateeconomictrans-formationinAfricashouldbeaccompaniedwithmoreeffortstoimproveagriculturalproductivitythroughmoreandbetteruseoftechnology.

Figure �.�Agricultural value added per worker in Sub-Saharan Africa (constant $US 2000)

Source: World Development Indicators 2005

Africa needs to improve agricultural productivity through more and better use

of technology


Figure �.�Agricultural use of tractors per worker in Africa and other regions (1960-200�)


Capital flows can boost economic transformation

Africancountriesfaceashortageoffundstomeettheirinvestmentanddevelopmentneeds.Thisresourcegapmustbefilledbycapitalinflows,composedofFDI,portfolioinvestment,ODA,netborrowing,debtreliefandremittances.Thesedifferenttypesofcapitalflowshavedifferentimpactsontheeconomy.

ODAflows can foster economic transformationby assisting recipient countries tofinancephysical,humanandinstitutionalinfrastructure(seechapters2and3forfur-therdiscussion).Whenpoorlymanaged,ODAflowscanhavenegativeconsequencesincludingchroniccurrentaccountimbalance,inflationarypressure,realexchangerateappreciationanddecliningexports-the“DutchDisease”phenomenon(seechapter5).ThisphenomenonisparticularlylikelyinsmallcountrieswithhighODA-GDPratios(Laplagneetal.2001).Inaddition,ODAmayundermineordelaycriticalinsti-tutional andpolicy reformsandenablewasteful spendingbycorruptgovernments(Erixon2005).

AvailabledataindicatethatthecurrentODAstructureisnotlikelytodirectlyinflu-enceeconomictransformationinAfrica.Thebulkoftheseflowshasbeendirectedtowardssocialinfrastructureandservices(mainlyeducation,healthandpopulation,water supply and sanitation) and very little ODA has been directed to economicinfrastructure and services and productive sectors (transport and communication,industry,miningandconstruction)(figure4.5).In2004,ODAflowstotheenergy

When poorly managed,

ODA flows can have negative

consequences


sectorwereonly30percentofthe1991level,whenODAflowstothissectorpeakedatabout$1.4billion(figure4.6).

Figure �.�Bilateral ODA flows to Africa by sector (% of total)

Source: Development Assistance Committee, OECD, 2006

Figure �.�Bilateral ODA flows to the energy sector in Africa ($ million)

Source: Development Assistance Committee, OECD, 2006.


Infrastructure development is a key factor for enabling economic transformation.Therefore,Africaneedstomobilizemoreresourcestoupgradeitsphysicalinfrastruc-ture.To this end,donors andAfricangovernments should reconsider theirpriori-tieswithregardtoODAallocationtakingintoaccountpotentialsynergiesbetweeninvestmentininfrastructureandothersectors.Forexample,ithasbeenobservedthatimprovingroadsinremoteareashasimprovedaccesstoschoolsandhealthcarefacili-tiesinsomecountries(AU/UNECA2005).

WhenODAflowsareproperlymanagedtobuildor strengthen infrastructureandinstitutions,privatecapitalflowsarelikelytofollow.Privatecapitalusuallyflowstocountrieswhere thebusinessenvironmentand investmentclimateareperceivedasattractiveintermsofmacroeconomicandpoliticalstability,infrastructureandavail-abilityoffactorsofproductionandaccesstomarkets.AnexceptionisextractiveFDI,especially inoilandmineral sectors,whichcangeneratequickreturnseven in theabsenceofgoodinfrastructureandinstitutionsandinthepresenceofmarketfailures(seechapter3).

FDI is generally expected to enhance economic growth through improvements intechnology, efficiency and productivity (Lim 2001), but the direction of causalitycan runbothways (Chowdhury andMavrotas2006).Moreover,whileFDIflowsmightbeassociatedwitheconomicsuccess,theydonotexertanindependenteffectongrowth(CarkovicandLevine2002).FDIpromotesgrowthincountrieswithsuf-ficientlydevelopedfinancialsystems(seechapter6),agreaterdegreeoftradeopen-ness,andanadequatelevelofhumanresourcesdevelopment(Balasubramanyametal1999).

Indeed FDI has a greater potential than other forms of private capital flows toincreasetherateoftechnicalprogressintherecipientcountrythroughknowledgediffusion.Thiscanimproveefficiencyandproductivityinlocalfirmsthatcancopynewtechnologyor learnhowtouseexistingtechnologyandresourcesmoreeffi-cientlyinordertocompeteinglobalmarkets(Lim2001).However,thesespillovereffects can only happen when the host country has an adequate level of humancapital(seechapter3).

ThecurrentsectoraldistributionofFDIexacerbatesnaturalresourcedependenceandundermines economic transformation on the continent. The 24 African countriesclassifiedbytheWorldBankasoilandmineral-dependenthaveonaverageaccountedforclosetothree-quartersofannualFDIinflowstoAfricaoverthepasttwodecades.The primary sector accounted for nearly 50 per cent of FDI flows between 1996and 2000. In 2005, the share of the petroleum industry exceeded 90 per cent oftotalinflowstoAngola,EquatorialGuineaandNigeria.InEgypt,arelativelymorediversifiedeconomy,theshareofFDIflowstotheoilindustrywasstill64percent(UNCTAD2005).

Inbrief,FDIflowstoAfricahavebeenbelowexpectationsintermsofbothvolumeandcomposition(seechapter2).EffortstoattractmoreFDIshouldbeaccompanied

Infrastructure development is a key factor for

enabling economic transformation


withstrategiestostimulatebroad-basedgrowthandeconomicdiversification.Intheabsenceofsuchstrategies,FDIwillcontinuetobeconcentrated inenclavesectorswithnoorlittleoveralldevelopmentalimpact(UNCTAD2005).

Withregardtootherprivatecapitalflows,ithasbeenobservedthatportfolioinvest-mentsnormallyflowtocountrieswithwell-establishedcapitalmarketsinsearchofquickandhigherreturnsandhavenoclearlinkswithstructuraltransformation.InSSA,onlySouthAfricareceivesameaningfulamountofportfolioflows.Asforremit-tances,theyaremainlyaimedatconsumptionandincomesupporttofamilies.Remit-tancesrepresentastablesourceofflowsandarebetterdistributedacrossandwithincountries.Theycanaffectconsumptionandaggregatedemand,whichboostsgrowththrough multiplier effects. However, there is still little evidence of direct effect ofremittancesoneconomictransformation.

Quantitative evidence on capital flows and economic transformation in Africa

SolidempiricalevidenceonstructuraltransformationinAfricaisscarce.O’Connelland Ndulu (2000) provide the only comprehensive empirical investigation of theprocessandfactorsinfluencingeconomictransformationinAfrica.Tworesultsfromtheir cross-sectional studyareworthemphasizing.First, the studyfinds thatgivenincomeandpopulationthesizeoftheservicessectorismarkedlysmallerinSSAthanin other regions, and that of industry and manufacturing is larger than expected.TheshareofagricultureinGDPisjustslightlyhigherinSSAthaninotherregions,buttheshareofagricultureintotalemploymentinSSAismarkedlylarger.Second,comparedtootherregions,Africa’smovementoutofagricultureandintoindustryhasbeensignificantlymorerapidthanwouldhavebeenpredictedonthebasisofitsgrowthperformance.

There isalsoevidencethatmovementof labouroutofagriculturehasbeenslowerdespitesharpfallsinagriculturaloutputinSSA.Recently,notablediversificationinfavourofindustryandmanufacturinghastakenplace,butthisdiversificationisnotyet robust enough to stimulate significant structural change inAfrica (Berthelemyand Soderling, 2002). The evidence underscores Africa’s excessive dependence onagriculturalemploymentandthatlowagriculturalproductivityandaggregateincomeareimportantconstraintstoeconomictransformation.

ToexaminethelinkbetweencapitalflowsandeconomictransformationinAfrica,weextendedtheO’ConnellandNdulu(2000)modelbyaddingacapital-flowvariable.Explanatoryvariablescomprisedinitialcapitalflows,initialpercapitaincome,initialpopulationsize,andthesquaresofthesevariablesaswellasregionaldummies.Usingdataon42Africancountries3,wecalculatedcorrelationsbetweenindicatorsofeco-nomictransformationandcapitalflows.ForAfricaasawhole,totalcapitalflowswere

3 Thedataareorganizedintosix5-yearpanelsplusone3-yearpanelcoveringtheperiod1970-2003.

Efforts to attract more FDI should be accompanied with strategies to stimulate broad-

based growth and economic diversification


insignificantlybutpositivelycorrelatedwithstructuraltransformation,asmeasuredby the shareof industrialoutput inGDP.Thiscorrelationwas stronger forNorthAfricaandnegativeforSSA(table4.1).ODAdominatescapitalflowstoAfricaandseemstohaveahighpositiveassociationwiththeshareofindustryinNorthAfrica’sGDP,butanegativeassociationforSSA.NorthAfricahasgenerallyreceivedmoreaidthanSSAandinvestedsubstantiallyineconomicandhumaninfrastructurewiththehelpofdonorfunding.

TheshareofmanufacturinginGDPisnegativelycorrelatedwithtotalcapitalflowsandODAandnotrelatedtoFDI(table4.2).ThisisconsistentwiththefactthatmostFDItoAfricagoestoextractiveindustriesandverylittleischannelledtomanufac-turing.BothindustryandmanufacturingsharesinGDPareweaklycorrelatedwithgrowth.Thus,forAfricaasawhole,neitherODAnorprivatecapitalflowshavebeeneffectiveintriggeringeconomictransformation.4

Table �.�Correlation between capital flows, growth and industry’s share in GDP

Region Total capital flows

FDI ODA Portfolio investment

Remittances GDP growth

Africa 0.11 -0.02 0.11 -0.04 0.80 0.16

SSA -0.24 -0.03 -0.24 -0.09 0.55 0.01

North Africa 0.36 0.29 0.90 -0.19 0.71 0.22

Source: Authors’ computations using data from World Bank Africa Database 2005.

Table �.�Correlation between capital flows, growth and manufacturing’s share in GDP

Region Total capital flows

FDI ODA Portfolio investment

Remittances GDP growth

Africa -0.80 0.01 -0.80 0.26 -0.05 0.02

SSA -0.61 0.02 -0.61 0.22 0.37 0.03

North Africa -0.76 0.14 -0.55 -0.03 -0.33 -0.30

Source: Authors’ computations using data from World Bank Africa Database 2005.

4 Paneldataregressionsyieldedpositive,butinsignificanteffectsofcapitalflowsoneconomictransformation.Theresultsarenotreportedhere.

North Africa has invested

substantially in economic and

human infrastructure with the help of

donor funding


4.3 Key constraints to structural transformation in Africa

Low investment rates and low productivity growth hamper economic transformation

Relativelyslowcapitalaccumulation(figure4.7),lowsavingratesandslowproduc-tivity growth are among the major reasons for disappointing growth performanceandlackofstructuralchangeonthecontinent(Hoeffler2000).PhysicalandhumancapitalproductivityarethelowestinSSAcomparedtootherregions(table4.3).Inregionswhereaccumulationofphysicalcapitalhasamoreprominentroleingrowth(SouthAsia,EastAsiaandPacific,theMiddleEastandNorthAfrica,andindustrialcountries), total factorproductivityalsohasagreatercontributiontogrowth.LowproductivitygrowthinAfrica isdueto lowqualityofphysicalandhumancapital,poorpolicyenvironmentandweakgovernance(O’ConnellandNdulu2000).

Africaneedslong-termstrategiesinordertoincreaseproductivity.Whilemacroeco-nomicreformsthatreducewastecanproduceshort-runproductivitygains,sustainedlong-runproductivitygainsrequireabalancedmixofcapitalaccumulation,humancapitaldevelopmentandstructuralchange.Inaddition,reallocationoffactorsofpro-ductiontomoreproductiveusescanpermanentlyraisetotalfactorproductivity.

Figure �.�Gross capital formation (% of GDP)


Reallocation of factors of

production to more productive uses

can permanently raise total factor

productivity


Table �.�Growth accounting decomposition by region, 1960-2000 average

Variable SSA Latin America & Caribbean

South Asia

East Asia & pacific

Middle East & North Africa

Industrial countries

Total

Growth of real GDP

per worker

0.51 0.76 2.18 3.89 2.37 2.23 1.63

Contribution of

growth in physical

capital per worker*

0.36 0.44 1.04 2.20 1.10 0.96 0.83

Contribution of

growth in education

per worker*

0.25 0.33 0.31 0.48 0.44 0.32 0.34

Residual (TPG)* -0.09 0.00 0.82 1.21 0.84 0.96 0.47

Source: Ndulu and O’Connell (2003). Note: * Contribution to overall GDP growth

Human capital: a key to economic transformation in Africa

Africa’s labour force is less competitive compared with other developing regionsbecauseoflackofadequateeducationandrelativelypoorhealth,amongotherrea-sons.Africaalsolosesahigherproportionoftheirskilledlabourforcetothedevel-opedcountriesthroughthe“braindrain”because insufficientopportunitiesonthecontinent.Therefore, improvinghumancapital should featureprominentlyon thedevelopmentagenda(UNECA2004a).

GuidedbytheMDGs,manyAfricancountrieshavemadenotableprogresstowardsachievinguniversalprimaryeducation(seechapter1).However,educationalindica-torsstillremainlowforAfricaasawhole.SSAhasthesecondlowestadultliteracyrate(60.5percent)afterSouthAsiawith58.9percent.InsomeAfricancountries,suchasBurkinaFaso,NigerandMali,adultliteracyisextremelylow,withratesof12.8,14.4and19percent, respectively. Incontrast,Zimbabwe,NamibiaandMauritiushadadultliteracyratesof90,85and84.3percent,respectively,in2003(UNDP2006).TheAfricancountries(e.g.TunisiaandMauritius)withabetterhumancapitalbasehavealsoexperiencedsubstantialeconomictransformationovertime.

Itisworthnotingthatinvestmentineducationhasnotledtoeconomicgrowthorimprovementsintotalfactorproductivitybecauseofthepoorqualityofeducation,poorutilizationofskills,andlowreturnsoneducation.There isoftenamismatchbetween school curricula and the skills that are demanded on the labour market.Furthermore,universitygraduatesaremainlyabsorbed inbloatedbureaucraciesorinefficientStateenterprises,addingtolowproductivityandgrowth(Pritchett1996).

Improving human capital requires not only increasing enrolment rates but alsoimprovingthequalityofschoolingandreturnstoeducation.High-qualitysecondaryandtertiaryeducation,adaptedtotheneedsofadynamiceconomyisimportantfor

There is often a mismatch between

school curricula and the skills that are

demanded on the labour market


promoting innovations,whichcontribute to fasterproductivitygrowthandhigherwages.ThelimitedcapacityofAfricanStatestoenhancespendingoneducationcanbemitigatedthroughjointregionalefforts.Forexample,jointlydesigning,producinganddistributingteachingmaterialsandtextbooksreducescosts.Harmonizationofcurriculafacilitatestransferabilityofhighschooldegrees.

Although limited, some efforts of the regional economic communities (RECs) tojointlydevelophumanresourcesarepromising.TheFrancophonememberStatesoftheWestAfricanEconomicandMonetaryUnion(UEMOA)andtheCentralAfricanEconomicandMonetaryCommunity(CEMAC)arecooperatingatalllevelsofedu-cation,especiallyinhighereducation.IntheEconomicCommunityofWestAfricanStates(ECOWAS),memberStatescooperateindevelopingjointcurricula,examina-tionstandardsanddegreerequirements(UNECA2004b)

In addition to educational efforts, building human capital requires improving thepopulation’shealth status.TheHIV/AIDSpandemic reduces the sizeof theactiveworkforceaswellasproductivity levels.AccordingtoILOprojections, the labourforce inhigh-prevalence countrieswill be10-30per cent smaller by2020 than itwouldhavebeenwithoutHIV/AIDS.Moreover,AIDSandotherinfectiousdiseasesreducelaboursupplyandlabourproductivityintheagriculturalsector,factorswhichundermineeconomicgrowthandincreasepoverty(UNECA2004c).

The role of infrastructure in development and economic transformation

Inadequateinfrastructureisamajorconstrainttoinvestmentandeconomictransfor-mationinAfrica.RelativelyhightransportcostsareamajorobstacletoimprovingAfrica’s competitiveness. For instance, freight cost as a percentage of total importvaluewas13percent forAfrica in2000comparedto8.8percent fordevelopingcountriesand5.2percentforindustrializedcountries(UNCTAD2002).

Land-locked African countries, in particular, suffer from high transport costs andtransportdelaysthroughcustomsandlegalandillegalroadblocks.Regionalintegra-tionisespeciallyimportantforland-lockedcountriessincetheydependontheeffi-ciencyofthetransportandcustomssystemsofthetransitcountry.MoreneedstobedonebyAfricancountriesat thepolitical level inorder toharmonizecross-borderregulations, customs and administration, improve infrastructure and speed up theprocessofregionalintegration.ItisimportanttonoteherethateffortsbyRECs,suchastheCommonMarket forEasternandSouthernAfrica(COMESA),tofacilitatecustomsclearanceandabolishvisarequirementsamongmemberStateswillfacilitateborder-crossingandfostertrade.

Overall,infrastructurehasimprovedinAfricaoverthelastfewdecades,thoughmostoftheseimprovementsareduetoinnovationsinthetelecommunicationsector.Tel-ecommunication coverage has significantly improved in SSA from 6.9 subscribers

The limited capacity of African States to enhance spending

on education can be mitigated through

joint regional efforts


per1000peoplein1975to61.9subscribersin2003.Improvementsinroadinfra-structurearemixed.Between1990and1999,SSA’stotalroadnetworkhasexpandedfrom1.107millionkmto1.488millionkm.However,afewlargecountries(namelyNigeriaandSouthAfrica)accountedforthebulkofthisexpansion,whileinsomecountriessuchasAngolaandZimbabwe,roadinfrastructurehasbeendepleted.Elec-tricityproduction inSSAquadrupledbetween1970and2002,but energy supplystillfellshortofdemandandimprovementshavebeenrelativelysmallcomparedtoimprovementsinothersub-regions(seefigure4.8).

Figure �.�Energy production in Sub-Saharan Africa and other sub-regions, 1971-2002 (million kwh)


Goodenergysupplyiscriticalforeconomictransformation.Inabilitytoprovidereli-ableenergyserviceshasbeenamajorconstraintonexportdiversificationanddevel-opmentof themanufacturing sector inmanyAfricancountries (UNECA2004a).Energyconsumptionvariesbyactivityandsomeactivitiesaremoreenergydepend-entthanothers.ManyoftheAfricancountriesthathavereachedmeaningfullevelsofeconomic transformation(e.g.Lesotho,MauritiusandTunisia) startedwith themanufacturingoftextiles,whichisahighlyenergy-consumingprocess.Energycon-sumptionincreasesfromyarntofabricfinishingandfromsynthetictonaturalfibres(Schmidt1999).

Infrastructure improvements in

Africa over the last few decades are due to innovations in the telecommunication

sector


The role of industrial and trade policy

LackofsoundindustrialandtradepoliciesisamongthemajorreasonswhyAfricahasnotbeenabletoattractthetypeofcapitalflowsthathasmorepotentialtopromoteeconomictransformation.Attractingcapitalflowstosectorssuchasmanufacturingorexportableservicesrequiresdeliberatepolicydecisionsthatchangethe incentivestructureforinvestors.Goodpoliciesandinstitutionscanbeasmuchapull-factorforFDIasnaturalresourceendowment(Asiedu2006).

InEastAsia, substantial capitalflows followedeffective tradeand industrializationstrategies, resulting in improved business environment, policies, institutions andinfrastructure(Aryeeteyetal.2003).Beforetheeconomictake-offofEastAsiaaroundthemid-1980s,AfricareceivedmorecapitalinflowsrelativetoGDPthanEastAsia.5However,capitalflowstoEastAsiamorethandoubledinthe1990scomparedtothe1980s.Successintradeandindustrializationstrategies,togetherwithincreasedcapitalflows,boostedgrowthandeconomictransformationinEastAsia.

Incontrast, tradeand industrialization strategies failed inmanyAfricancountries,accountingpartlyfortheweakgrowthperformanceonthecontinent(Soludoetal2004).6EarlierattemptstopromoteeconomicgrowthandtransformationinAfricathrough import substitution strategies (ISSs) were unsuccessful (box 4.1). Due tosmalldomesticmarketsizeandpoorgovernance,ISSsfailedtopromotecompetitiveindustriesandmostestablishedfirmscouldonlysurviveondirectandindirectgov-ernmentsubsidies.Thecostofthesupporttotheseindustriescontributedtounsus-tainableexternalanddomesticdebtlevelsthatledtoexchange-ratedepreciationandhighinflationratesinmanyAfricancountries.

TheSAPsadoptedbymanyAfricancountriesinthe1980sand1990storesolvetheseimbalanceswerefocusedalmostexclusivelyonmacroeconomicstabilizationandtradeliberalizationwithnoclearindustrialpolicy.AmajordeficiencyintheseSAPswereisthattheyleftaccumulationandgrowthtomarketforceswithoutadequateattentiontoshortcomingsinmarkets,institutionsandphysicalandhumancapital(UNCTAD2000).Consequently,freeingmarketsandprivatizationofpublicenterprisesdidnotgenerateadequateprivateinvestmenttoexpandoutputandemployment.Whilemac-roeconomicstabilityimprovedinmanycountries,Africa’sshareinglobalexportssawasharpfallfrom4.1percentin1980to1.6percentin2000beforerecoveringto2.3percentin2003thankstooilandmineralexports.Likewise,Africa’sshareinworldtradedroppedfrom8percentin1980to1.3percentin2000andthenroseto2.3percentin2003.Moreimportantly,Africa’sshareinmanufacturedexportsremainedclosetozero.

5 TotalcapitalflowstoAfricaamountedto112.7percentofcapitalflowstoEastAsiain1970-1979,97percentin1980-1989,37.6percentin1990-1999and55percentin2000-2003.

6 PercapitaGDPgrowthhasbeenbelow1percentinAfricacomparedtoover5percentinEastAsia.

Attracting capital flows to

manufacturing or exportable services

requires a change in the incentive

structure for investors


Options for industrial and trade policy to foster economic transformation

Industrial and tradepolicy can stimulate economicgrowth and transformationbyassistingnewindustriestoemerge,improvingthecompetitivenessoflocalindustryandattractingforeigninvestmentinindustry.Inparticular,tradeliberalizationcanpromoteeconomic transformation through shifts indomesticdemandandprivateinvestmentinfavourofdomesticindustries–asaresultofrealexchangeratechangesandremovalofimportrestrictionsandnon-tariffbarriers.Also,tradeliberalizationcanencouragemanufacturingandexportsbyreducingthewastestemmingfromrent-seekingbehaviourandreformingthesystemofimportandexportlicensingaswellasthegeneralinstitutionalenvironment(Rodrik2000).Improvedinstitutionalandpolicyenvironmentwouldreducecosts,createcomparativeadvantagesfornewindus-tries,andleadtoreallocationofresourcesinfavourofmorecompetitiveindustries.

As noted above, incoherent industrial and trade policies, compounded by controlregimesandstructuralconstraints,haveledtomeagregainsfromtradeliberalizationandthesloweconomictransformationinAfrica.7Africaneedscoherentstrategiesandmarket-basedreformstoaddressbothdemand-andsupply-sideconstraintstoindus-trializationandeconomictransformation.IndustrialpolicyexperiencesinEastAsia,inparticular,provideaframeworkinwhichmanyAfricancountriesmightbeableto

7 Fosu and O’Connell (2006) argue that avoiding anti-growth syndromes, including control regimes, adverseredistribution,unsustainablepublicspendingandStatefailure,couldhaveboostedAfrica’sgrowthbybetween1and2.5percentagepoints.

Box �.�Import substitution strategies (ISSs) and Africa’s failed transformation

From independence to the early 1980s, most African countries adopted ISSs aiming at produc-

ing consumer goods and moving towards producing intermediate and capital goods. ISSs were

accompanied by restrictive policies, including complex systems of tariff and non-tariff protec-

tion, as well as exchange control and import licensing.

Initially, ISSs boosted manufacturing output relative to GDP and led to increased industrial

employment. During the 1970s, Africa maintained an average annual rate of industrial growth of

5.5 per cent, but the industrial growth rate declined to 2.5 per cent during 1980-1984 and 0.4

per cent in 1985-1987.

Eventually, ISSs failed because of economic mismanagement and policy problems. The

production of final goods relied heavily on imported inputs, adding to the recurrent balance-

of-payments deficits. Small domestic markets did not generate sufficient demand for emerging

industries to grow and take advantage of economies of scale. Instead of increasing the pro-

ductivity of new industries, the strategies generated rent-seeking behaviour by firms that were

insulated from international competition.

Source: UNECA (2004b).

Industrial and trade policy can

improve the competitiveness of local industry

and attract foreign investment


designandimplementsuccessfulindustrialstrategies.However,itwouldbetoosim-plistictoadviseAfricancountriestoreplicatetheseexperiences,giventhedifferencesbetweentheconditionsthatprevailedinEastAsiainthe1970sand1980scomparedtothoseinAfricatoday.

TheprocessofindustrializationinEastAsia,likethatinAfrica,beganwithISSsandgraduallyshiftedtoexportpromotionthroughacombinationofpolicy,institutionalandstructuralreforms.Policychoicesaimedatpromotingastablemacroeconomicenvironment,higheducationlevels,efficientfinancialsystems,andopennesstofor-eigntrade,werecombinedwithselectiveinterventionsthatincludedanexportpush,directedcredit,andselectivepromotionofindustriesinEastAsia.

Thesepoliciesworkedwithinan institutional frameworkthatwascharacterizedbytechnocraticinsulationfromdirectpoliticalpressure,high-qualitycivilservice,andsoundmonitoring.Thisresultedinfastaccumulationandefficientallocationofphys-icalandhumancapital, improvedmobilizationofdomesticandexternalresources,highreturnsoninvestment,andrapidtechnicalprogressthroughimportationandadoptionof technology(Aryeeteyetal2003).Large investments inhumancapitalandnewtechnologiesbroughtabout significantgains inproductivityand interna-tionalcompetitivenessinEastAsia,wheregovernmentsemployedexportpromotionstrategiesthatwereregularlyauditedandreviewedaccordingtowelldefinedtargets.

Inadditiontocreatingasoundmacroeconomicenvironment,improvedinfrastruc-tureandadequateincentivestructure,thesuccessofindustrializationinAfricawillrequiremeasuresthatpromoteentrepreneurshipandaddressmarketfailures.Entre-preneurial skills including accounting and management skills, risk-taking and theabilitytoperceiveandexploitprofitableopportunitiesareessentialforstartingandoperatingasuccessfulfirm(NolandandPack2003).

FirmsurveysinTanzania,UgandaandZimbabweshowthatanentrepreneurialatti-tudeisthekeytosuccessfulbusinesses(Trulsson1999).Mostofsampledfirmswerestartedbecausethebusinessownersawagoodbusinessopportunity.Entrepreneur-shipmaypartlybepromotedthroughcentralizedtechnicalsupport,byincorporatingentrepreneurial skills inhigh school anduniversity curricula and through training(UNECA2005).

Depending on their specific endowments and opportunities, individual countriesneedtoexplorepossibilitiesforindustrialpolicytoaccelerategrowththroughresearchanddevelopment(R&D)oroutput-subsidizationschemesaimedatsupportingnewproductdevelopment,innovationandgrowth.8Theappropriatepolicyresponsecouldvary fromexport subsidies to export tax ifprice competition rather thanquantitycompetitionisassumed.Multiplepolicytoolsmaybeneededforpursuingdomesticandinternationalgoalsatthesametime.Sincepolicyinterventionsinvolvecosts,gov-ernmentshavetocarefullyweighallpossiblealternativesforusingscarceresources.However,thesuccessofindustrialpolicywillcriticallydependonthegovernment’s

8 GrossmanandHelpman(1991)citedbyNolandandPack(2003).

Multiple policy tools may be needed for pursuing domestic

and international goals at the

same time


humanandfinancialresourcecapacitytoimplementandsustainthevariouscompo-nentsoftheindustrializationprogramme(NolandandPack2003:19).

4.4 Experiences of capital flows and economic transformation in AfricaThissectionexaminestheexperiencesofMauritiusandTunisiawiththeaimofhigh-lightingtheroleofcapitalflowsintheirrelativesuccessineconomictransformationcomparedtotherestofAfrica.ItalsoexaminestheexperienceofNigeria,wherelackofcoherentandsustainedstrategiesconstrainedeconomicgrowthandtransformationdespiteitssubstantialendowmentinnaturalresources.Table4.4summarizesindica-torsofeconomicgrowthandtransformationinthethreecountries.

Table �.�Indicators of economic growth and transformation in Tunisia, Mauritius and Nigeria, 1970-2003

Tunisia Mauritius Nigeria

1970-74 2000-03 1970-74 2000-03 1970-74 2000-03

Real GDP per capita (2000 $US) 976 2121 1667* 3974 386 338

Agriculture value added

(% of GDP)

19.3 11.6 20.7 6.4 37.3 29.2

Industry value added (% of GDP) 21.9 28.7 26.0 31.1 22.3 46.2

Manufacturing value added

(% of GDP)

9.2 18.3 15.3 23.1 3.7 4.1

Services value added (% of GDP) 58.8 59.7 53.3 62.5 40.4 24.6

Manufacture exports

(% of merchandise exports)

19.9 80.2 5.0 75.3 0.5 0.2

Total capital flows (% of GDP) 9.8 8.4 3.5* 5.0 2.5 8.4

Source: World Development Indicators 2005. * Figures are for 1975-1989.

Tunisia

Tunisiaundertookmanyinstitutionalandeconomicpolicyreformsinthelastthreedecadeswhichwereaimedatopeninguptheeconomy,encouragingeconomicdiver-sification and enhancing competitiveness (OECD and ADB 2005). Sound macr-oeconomic management, with small external debt inTunisia, resulted in low andstableinflationandinaneffectiveexchangerateregime(ElbadawiandKamar2005).A favourable business environment, strengthening of the financial sector, moderninfrastructure, andhuman resourcedevelopment strategies through education andtrainingunderpinnedmarket-orientedreforms.Currently,Tunisiaranks58thworld-wideand4thinAfricaintermsofeaseofdoingbusiness(WorldBank2006).Trade

In Nigeria, the lack of

coherent and sustained strategies

constrained economic growth

and transformation


liberalizationbenefitedfromTunisia’scentralpositioninNorthAfrica,proximityandaccesstoEUmarketsandindustrialpoliciesthatencouragetechnologytransferandadoption,creativityandinnovation.

Between1970and2003,Tunisia’srealpercapitaincomegrewatanaveragerateofabout3percent(table4.4).Thisgrowthwasassociatedwithasteady,thoughslow,reductionintheshareofagricultureinGDP.Theshareofindustryrosefrom22percentin1970-1974to32percenttenyearslater,butdeclinedtoanaverageof29percentduring2000-2003.AsignificantfeatureofstructuralchangeinTunisiawastheriseinindustrialemploymentfrom34.3percentoftotalemploymentin1962-1969to45percent in1995-2000.Atthesametime,agriculturalemploymentdeclinedfrom45.9percentoftotalemploymentto23percent(Ayadietal2005).Servicesandother sectors, including a booming tourist industry, accounted for the largestshareinTunisia’sGDPin1970-2003.

Manufacturingistheonlysub-sectorthatexperiencedasustainedupwardtrendsince1970,increasingfrom20percentofmerchandiseexportsin1970-1974to80percentin2000-2003.ThisrepresentsaremarkablesuccesscomparedtoAfrica’saverageof22percentduringthesameperiod.Despitesignsofincreasingimportance,indus-tryandmanufacturingdoesnotyetplayadominantroleinTunisia’seconomy.

AsTunisia’s economydeveloped, capital inflowscontinued to rise at ahigh rate.Thecompositionoftheseflowsalsochangedovertimeinfavourofprivatecapital,especiallyFDIseparatefromworkers’remittances(figure4.9).However,portfolioinvestmentflowsremainverysmall,reflectingtheunderdevelopmentofequitymar-ketsinTunisia.ThetrendofoverallprivateflowstoTunisiamirrorstheEastAsianexperience in that substantial increases in capital flows seem to follow improve-ments inpolicies, institutionsandphysicalandhumaninfrastructure inanopenexport-orientedeconomy.


Figure �.�Average capital flows to Tunisia ($US million)


Over2,600 foreignor jointly-ownedfirmsoperated inTunisia in2004,providing243,000jobs.9Thesefirmsoperatepredominantlyinmanufacturingintheareasofelectricalandelectronicproducts,automotivecomponents,plasticandtextileindus-tries,leatherandfootwear,agriculturalandfoodindustry,packaging,ICTandtour-ism.Theyexport85percentoftheiroutput,mostlytoEurope.

Policiestopromoteprivatesectordevelopment,expandmarkets,andharnessresourcesto increase investment rates and productivity were associated with relatively highsavingandinvestmentratesinTunisiacomparedtootherAfricancountries.AlthoughtheseratesarelowerthantheratesthatprevailedinEastAsiaduringthesameperiod,sustainedgrowthreducedpovertyinTunisiatoalevelcomparabletothatinthebestperformingEastAsiancountries:Tunisia’spovertyratedroppedfromover20percentin1980to4percentin2000(Ayadietal2005).

DiversificationstrategiesenabledTunisiatocopewithunfavourablechangesintheexternalenvironment,suchashighoilprices,andconsecutivedroughtsintheearlyyears of the millennium decade.10 However, further structural reforms are neededforTunisiatoimprovethebusinessenvironmentandindustrialcompetitivenessandpromoteresourcemobilizationandinvestment.

9 FDI Magazine at www.fdimagazine.com/news/printpage.php/aid/1349/Taleoftunisiantransformation. [Dateaccessed:02-01-2006].

10 Tunisiaisanoilproducerbutitisstillanetoilimporter.

Further structural reforms are needed for

Tunisia to improve the business environment

and industrial competitiveness


Mauritius

Mauritiushassubstantially transformeditseconomy,movingfromanearlysingle-goodeconomybasedonsugartoamorediversifiedeconomybasedonmanufacturedexportsandservices.Overtime,theshareofagriculture inGDPdecreasedsignifi-cantly, from20.7percent in1970-1974 to6.4percent in2000-2003,while theshareofindustryrosefrom26percentto31percent(table4.4).

TheeconomictransformationofMauritiuswasnotinfluencedbycapitalflows,butcapitalflowsincreasedafterMauritiushaddevelopeditsmanufacturingsector.Invest-mentinexport-processingzones(EPZs)wasatthebeginningdominatedbydomesticcapital.Theboominsugarpricesintheearly1970sledtosubstantialwindfallgains.SugarcompaniesusedunanticipatedprofitstoinvestinjointventureswithforeigninvestorsinEPZs,takingadvantageofpromisingconditionssuchastaxholidaysandduty-freeimports.

Mauritiushadseveralgrowthphases,startingwiththesugar-boomdrivengrowthofthe1970s.Thetake-offphase startedduring thisperiodwith theestablishmentofEPZsandgovernmentprogrammestoimprovehumancapital.Educationwasmadefreeatalllevelsin1976andhealthservicesweresignificantlyimproved(NathandMadhoo2003).Mauritiusstartedtostabilizetheeconomyandexpandedexport-ledindustriesafter1983.Thenewstrategyledtoanaveragepercapitagrowthrateof6.6percentbetween1985and1989(NathandMadhoo2003).After1989,Mauritiusfurther diversified its economic base with tourism becoming another pillar of theeconomictransformationstrategy.

MauritiusreceivedsubstantialFDIstartingfromthemid-1990s(figure4.10).In1989, an offshore centrewas set up, attractingmore than$4billionof offshorefunds.Atthesametime,theStockExchangeofMauritius(SEM)startedtooperate,settingthestage for furthercapitalmobilization(NathandMadhoo2003).FDIincreasedfromanaverageof$2millionbetween1985and1989to$78.4millionin2000-2003.

Mauritius has substantially

transformed its economy, moving

from a nearly single-good economy to a more diversified

economy


Figure �.�0Foreign direct investment in Mauritius (BoP, current million of $US)


As a result of successful reforms, Mauritius was classified as the most competitiveeconomyinAfrica in1998(NathandMadhoo2003).Currently,Mauritius rankstwenty-thirdworldwideandfirstinAfricaintermsofeaseofdoingbusiness(WorldBank2006).TheessenceofMauritius’ssuccesshasbeenagradualandtargetedopen-nessassociatedwithstrongtaxandotherincentivestopromotetrade(SubramanianandRoy2001).

In addition to good policies and democratic culture and practice since independ-ence,withstrongparticipatoryinstitutions,MauritiushasbenefitedfromitsculturaldiversityandgeographicproximitytoChina.ThisproximityhasattractedlargeFDIfromChina(SubramanianandRoy2001).Moreover,manyChinesemanufacturingproducersmovedtoMauritiusinordertocircumventexportquotasimposedonChi-nesefirmsoperatinginChinathroughtradeagreementsbetweenthelatterandothercountriessuchastheUnitedStates.

However,Mauritius’economyhasnowreachedapointwhereithastodiversifyfur-therinordertoremaincompetitive.IncreasingwagesinMauritiusandstiffcompeti-tionfromAsiaarethreateningthetextilesector’scompetitiveness.Theeconomyalsosuffersfromhighunemployment(whichreached11percentin2004-2005)andalargepublicdebt(71.8percentofGDPin2004-2005).TheGovernmentplanstoattractgreaterprivatecapitalflowsthroughprivatizationofparastatalenterprisesinthe sugar and textile sectors. The Government also plans to continue to focus oninvestment ineducationand telecommunication inorder to further transformtheeconomytoa service-orientedeconomy.Thesuccessof theseeffortshingesontheabilityoftheGovernmenttomanageitshighbudgetdeficits.

Mauritius needs to diversify further in order to remain

competitive


Nigeria

Nigeria provides an exampleof a countrywhich,becauseofpolicy failures, failedtoachievesustainablegrowthandeconomictransformationdespitesubstantialFDIinflowscombinedwithasoundhumancapitalbase.Thisfailurestemmedfromtherent-seekingandpredatorybehaviourofpastregimes(Asadurianetal2006;HerbstandSoludo2001).

TheNigerianeconomywasdependentonagricultureuntiltheearly1970swhenoilrevenuesbegantorise.The1970soilboomspurredmassivegovernmentspendingandinvestmentinpublicsectorprojectsandsupportedimportsubstitutionindustri-alizationthatdependedheavilyonimportedinputs.Overvaluationoftheexchangerateandexpansionofexpendituresonnon-tradablegoodsunderminedcompetitive-nessofagriculturalandmanufacturedgoods.

Thecollapseofoilpricesintheearly1980sanddecreasedoilexports,duetoacutin theOPECproductionquota forNigeria, led to a sharpdecline ingovernmentrevenueandasizeablecurrentaccountandfiscaldeficits(HerbstandSoludo2001:657).Theseimbalancescausedadeclineinforeign-exchangereservesandanincreaseinexternaldebtfrom5percentofGDPin1980to23percentin1985.Realpercapita income fell from$386 in1970-1974 to$335 in1980-1985and remainedalmoststagnanteversince(table4.4).

Theshareof industry inGDPmore thandoubledbetween1970-1974and2000-2003withnotablefluctuationsduelargelytochangesinoilpricesandrevenue.Atthesametime,thecontributionofmanufacturingtoGDPfellsharplyfromapeakof9percentin1980-1984to4.1percentin2000-2003.TheshareofagricultureinGDPfluctuatedaround30percent,butthatoftheservicessectordeclinedrapidlyfrom40percentin1970-1974toabout24percentin1990-2003.ContractionoftheservicessectorinNigeriacontrastssharplywiththesituationindevelopingcountriesingen-eralandreflectsthepoorstateofinfrastructure,unfavourablebusinessenvironmentandotherfactorsthathamperedforeignaswelldomesticinvestmentinthissector.

Followinghugemacroeconomicimbalancesin1981-1986,patchyeconomicpolicyinNigeriaconcentratedonstructuraladjustmentthroughout1986-2000,withlimitedscopeforgrowthandtransformation.Ingeneral,thebroadobjectivesofthereformprogrammesweretorestructureanddiversifytheeconomy;promotesustainablenon-inflationarygrowth;reduceunproductivepublicinvestment,improvepublicsector’sefficiency,andenhancethegrowthpotentialoftheprivatesector(HerbstandSoludo2001).Theseobjectivesweretoberealizedthrougharealisticexchangeratepolicycoupledwith liberalizationofexternal tradeandthepaymentssystem,appropriatemarket-basedpricingpolicies,reductioninadministrativecontrols,andrationaliza-tionandrestructuringofpublicexpenditureandcustomstariffs(HerbstandSoludo2001).


The reforms were largely unsuccessful because of poor policy design, inappropri-atesequencing,andlackofpoliticalwill(HerbstandSoludo2001;Asadurianetal.2006).Consequently,theeconomycontinuedtodependonoilandagriculture,whileprivatizationstrategiesfailedtospurprivatesectordevelopment.

With the return to civilian rule in 1999, Nigeria adopted a comprehensive planaimedat achievingmacroeconomic stability, reducingpovertyandcombatingcor-ruption (OECDandADB2005).Since2000,policy reformshavebeen relativelymoresuccessfulinreducingimbalancesandinstabilizingtheeconomy.Recently,highoilpricesandimprovementsinthemacroeconomicenvironmenthaveledtohigherGDP growth rates. Currently Nigeria ranks ninty fourth worldwide and ninth inAfricaintermsofeaseofdoingbusiness(WorldBank2006).

FurtherreformsaswellasmoretimeareneededforrecentpolicyreformstogenerategrowthandtransformationinNigeria.Indeed,whiledemocratizationandliberaliza-tionprocesseshavecreatedamorefavourablebusinessenvironment,severeconstraintscontinuetohamperprivate-sectordevelopment.Theseconstraintsincludeinfrastruc-turedeficiency(especiallyunreliablepowersupply),inadequateaccesstofinancing,insecurity,weakinstitutions,ill-definedpropertyrightsandenforcementofcontractsandtheunstablemacroeconomicenvironment(OECDandADB2005:373).

Theabovecountryexamplesclearlyillustratethegoodpoliciesneededforanecon-omytomovefromcommoditydependencetoawiderbase,dominatedbymanufac-turingandservices.BothMauritiusandTunisiaarerelativelyresource-poorcomparedwithNigeria.Yet, they achieved a state of economic transformation thatwill takeNigeriayearstoachieve.InitialeconomictransformationthroughmanufacturinginMauritiusandTunisiaspurredfurthertransformationthroughservices.Conversely,inabilitytotransformthroughmanufacturinginNigeriawasaccompaniedwithcon-tractioninservices.ManyotherAfricancountries,e.g.AlgeriaandLibya,hadbothgreaterresourcesandsimilarorbettertradeopportunitiesthanMauritiusandTunisia.However,theyfailedtousethemtotriggereconomictransformation,mainlybecauseofthelackofsoundmacroeconomicpoliciesandindustrialstrategies.

4.5 Conclusion and policy recommendations Capitalflowsareneitheranecessarynorasufficientconditiontotriggereconomictransformation.LackofeconomictransformationinAfricaisduetoacombinationofshortcomingsinpolicy,institutionsandphysicalandhumaninfrastructure.Over-comingtheseconstraintsisimportantforeconomictransformation,whichiscriticalfor attaining sustainable growth and reducingAfrica’s vulnerability to shocks.Theanalysis of the links between capital flows and economic transformation in Africaindicatesthat:

Further reforms as well as more

time are needed for recent policy

reforms to generate growth and

transformation in Nigeria


• CapitalflowstoAfricaduringthelastfourdecadeshavenotbeenaccompa-niedbyeconomictransformation.IncountriessuchasMauritiusandTunisia,withrelativelygreaterdegreesofeconomictransformation,structuralchangewasnotduetocapitalflowsbutrathertoacombinationofsoundpoliciesandreformsthatattracteddomesticandforeigninvestmentintosectorsthatweremoreconducivetoexportpromotionandeconomicdiversification;

• Formostofthetime,ODAhasbeenthemostimportantsourceofcapitalinflowstoAfrica.However,ODAflowstoAfricahavebeenlargelychannelledtoprimaryeducationandotherserviceswithverylittleflowtoinfrastructure.ODA, in itscurrentstructure,hashad limited impactoneconomictrans-formation.HigherflexibilityindonorpolicytoensureamorebalancedandproductiveallocationofODAflowsamongvarioussectorswouldenhancetheeffectsofODAoneconomictransformation;

• FDItoSSAismainlydirectedtoextractivesectors,especiallyoilandminer-als.SuchFDIwillnotinduceeconomictransformationunlessrevenuesfromoilandmineralsareadequatelyused todevelop infrastructureand institu-tionsandtospurinvestmentinothersectors;

• Portfolioflows toAfrica areunlikely to affect economic transformationasthey are quite small in volume and go to countries with more diversifiedeconomiesandactivecapitalmarkets;and

• Researchindicatesthatremittanceshavebeenlargelydrivenbythemotivetosupportfamilyconsumptionandhavehadlittleimpactoneconomictrans-formation.

TheabsenceofanotablerelationshipbetweencapitalflowsandstructuralchangeinAfricaisattributabletolackofappropriatepoliciestoinfluencethenatureandalloca-tionoftheseflows.Asthepolicyenvironmentimproves,privatecapitalflowsarelikelyto follow with a greater impact on growth and economic transformation throughproductivityenhancement,technologytransfer,greateraccesstoforeignmarketsandreallocationofresourcesinfavourofmorecompetitivesectors.

Topromotestructuraltransformationandmaximizethecontributionofcapitalflowstothisprocess,Africaneedsto:

• Mainstreameconomictransformationobjectivesinindustrialandtradepoli-ciesaswellasinoveralldevelopmentstrategies,andactivelydesignandimple-mentmeasurestoinitiateandmaintainindustrializationtoensurestructuraltransformation. However, in some special cases, it might be more feasibleforcountriestopursuestructuraltransformationthroughtheservicessectorratherthanindustry;

• Maximize the role of capital flows in economic transformation within aholisticindustrialpolicyframework,whicheffectivelyaddressesproblemsofmarketfailuresandpromotesentrepreneurship.Appropriateinterventionsto

As the policy environment

improves, private capital flows are

likely to follow with a greater

impact on growth and economic transformation


enhancetheimpactofcapitalflowsoneconomictransformationmightbecountry-specific;

• Ensurethattradeliberalizationstrategiesaresupportedbymeasuresthatbuildtradecapacityandraiseproductivityandcompetitivenessthroughtechnol-ogytransferandadoption;

• Develop a sound human capital base to enhance absorptive capacity andspillovereffectsfromFDI;

• Upgrade the physical infrastructure, which presently hampers economictransformation.Withagoodhumancapitalbaseandsufficientinfrastructure,Africacouldattractthetypeofcapitalflows,namelynon-extractiveFDI,thataremorelikelytopromoteeconomictransformation;and

• Enhanceregionalintegration,whichcanbeamajorboosttoindustrializationbyfacilitatingintra-regionalmovementofcapitalandlabourandexpandingmarketsforlocalproducers.


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��

5.1 IntroductionAccording to conventional economicwisdom, capital shouldflow fromdevelopedcountrieswhere ithas lowerreturnsonthemargintoAfricaandotherdevelopingareaswhereithassignificantlyhighermarginalreturns.Unfortunately,thisisnotthecaseascapitalflowstoAfricahavebeenlow,unstableandconcentratedinafewsec-torsandafewcountries.Therearemanyreasonsforthisphenomenon.First,bothintermsofperceptionandrealityneithertheglobalnortheregionalenvironmenthasbeenfriendlytoAfrica.

Furthermore,manyAfricancountrieshaveyettotaketheproactiveactionandestab-lishthepreconditions,policiesandstrategiesneededtoattractmorebeneficialinter-nationalcapital.Indeed,themarkethasfailed,atleastintheconventionalsense,toallocatecapitaltoAfrica.NorhavethemacroeconomicpoliciesadoptedbyAfricancountriesfavouredtheinflowofinternationalcapital.Non-marketinstitutionsandmacroeconomicpolicesshould,therefore,beusedtoaddresstheshortcomingsandimperfectionsoftheinternationalcapitalmarkets.

TheinadequateinflowofcapitaltoAfricancountriesresultsnotjustfrommarketfail-urebutalsofromafundamentalpolicyfailure,institutionalinadequacyandfailure.Aswith soundmacroeconomicpolicies, thenormsgoverninghuman interactions,includingorganizationalentities,proceduraldevices,andregulatoryframeworks1con-stituteanimportantdeterminantofcapitalflows.ForAfricancountriestoincreasecapitalflows significantly, tomake themsustainableandminimizefinancial crises,theymustadoptappropriatemacroeconomicpolicymeasures.

Next, theyneed tounderstandhow to strengthen theprocess, substance andout-comesofmacroeconomicpoliciestocreateamoreattractiveenvironmentforcapitalflows.Theymustalsoestablishstronginstitutionsandimprovethequalityofexist-ingones.Inparticular,Africancountriesneedtodevelopinstitutionsthatenforce

1 Institutionscomeinavarietyofdimensionsandlevels:economic,social,political,andcorporateinstitutions;publicandprivateinstitutions;andnationalandsub-national,subregional,regionalandglobal.Notwithstandingtheirvalue,institutionsarehardtograspandhavebeendefinedinavarietyofwaysbydifferentauthors.Mostnotably,DouglasNorth(1990)definesinstitutionsastheformalandinformalrulesgoverninghumaninteractions(seealsoKasperandStreit,1998;WorldBank,2000;andAlfaroetal.,2003).Unlikeinstitutions,policiesarechoicesmadewithinapoliticalandsocialstructure-withinasetofinstitutions.Institutionsmightalsoexplaindifferentialcapi-tal-labourratiosintermsofdifferencesinculturalcontextandtechnologicalcapacity

Economic Policy, Institutional Environment and Capital Flows�

For African countries to

increase capital flows significantly,

they must adopt appropriate

macroeconomic policy measures


propertyrightsandtheruleoflawsoastominimizeuncertaintyaboutreturnsoninvestment.

ThischapterexaminestheimplicationsofmacroeconomicpolicyregimesforcapitalinflowstoAfrica,andtheproblemsthatsuchinflowshaveposedformacroeconomicpolicymanagementaswellasthedifferentpolicyoptionspursuedbyAfricangovern-mentstodealwithmacroeconomicchallengesofcapitalinflows.Italsoassessesthereformdividend–– that is,whether economic and institutional reformshavebeenaccompaniedbyincreasedcapitalflowstotheregion.Finally,thechapterdiscussesthe importanceofeffective institutionsforattractingcapitalflowsandtheneedtoidentify,buildorstrengthencapital-friendlyinstitutions.

Thechapter isorganizedas follows:Thenext sectiondiscusses theorientationandevolutionofmacroeconomicpoliciesinAfrica.Section5.3examinesthebenefitsofeconomicreforms,includingmacroeconomicpolicyreformsforcapitalflows.Section5.4analyses themacroeconomiceffectsofcapital inflowsand thepolicy responsespursuedtodealwithcapitalinflows.Section5.5highlightsfurthermeasuresneededtoconsolidatemacroeconomicstabilizationwhilesection5.6discussestheimportantroleofeffectiveinstitutionsforattractingcapitalflowsandhowtoachievesuchinsti-tutions.Finally,section5.7concludesthechapter.

5.2 A sound macroeconomic environment is essential for attracting capital flowsFollowingindependenceinthe1960s,mostAfricancountriespursuedpopulistpoli-cieswithanemphasisonexpandingsocialservices,especiallyeducationandhealth.They also undertook massive public investment projects in infrastructure oftenfinancedthroughexpansionarypolicies.Thesepoliciesledtorisinginflation,budgetdeficitsandmountingexternaldebt.Capitalinflowsdiminishedasinvestorsbecamewaryoftheabilityofdevelopingcountriestomeettheirdebt-servicingobligations.ThesepoliciessloweddowneconomicgrowthinAfricaconsiderably.Theoilanddebtcrisesandtheensuingrecessionindevelopedcountriesservedtoaggravatetheeco-nomiccrisisinAfrica(WorldBank1981).Themagnitudeoftheeconomicstagnationwassoprofoundthatthe1980scametobeknownas‘thelostdecade’forSSA.

Theeventsofthe1970sandthefirsthalfofthe1980shavedemonstratedtheneedforsoundmacroeconomicpolicymanagementasanecessaryconditionforresumptionofgrowthandmobilizationofexternalfinance.ItwasagainstthisrealizationthatAfricancountriesimplementedmacroeconomicstabilizationpoliciesinthemid-1980sandearly1990s.Thefocusofmacroeconomicstabilizationwasondemandmanagementthroughexpenditurereductionanddomesticcreditceilings.Theobjectiveofstabili-

African countries need to

develop institutions that enforce

property rights and the rule of law

��Economic Policy, Institutional Environment and Capital Flows

zationprogrammeswastocorrectbalanceofpaymentsdisequilibriaandtocontaininflation.Theyhaveincludedfiscal,monetaryandexchangeratepolicyreforms.

Fiscal policy reform

Fiscalpolicyhasbeenanimportantinstrumentformanagingaggregatedemandandalleviating imbalances in African economies. The objective of fiscal adjustment inAfricainthemid-1980sandearly1990swastobringfiscaldeficitsundercontrolandrationalizepublicinvestment(HusainandFaruqee1996).Totheextentthatpublicinvestment programmes exerted significant pressures on the fiscal balance, fiscalreformsinmanyAfricancountriesalsosoughttoreducethesizeofpublicinvestmentprogrammes.Thiswasalsotobecomplementedbypublicsectorreforms,includingprivatizationandrestructuringofstate-ownedenterprisesandtaxreform.

Apartfromreducingfiscaldeficitsandachievingfiscalstability,anotherexplicitobjec-tiveoffiscalpolicyinrecentyearshasbeentosupportpovertyreduction.ThisisthecaseparticularlyforcountriesthatareimplementingPRSPs.Mozambique,Tanzaniaand Uganda, have increased expenditures to priority social sectors such as health,education, and water provision (ADB 2005). Considerable efforts have also beenexpendedatimprovingrevenuemobilizationandimprovingtaxadministration.Forexample,VATexemptions for thegovernmentand its institutionshavebeenabol-ishedinTanzania.

Africancountrieshavealsoimplementedinstitutionalreformsintendedtoincreasetheefficiencyoftaxcollection,strengthentheindependenceoftaxauthorityandcurbcorruptioninthetaxsystem.Ghana,Kenya,andUgandahaveestablishedautono-moustaxauthoritiesandhave,asaresult,experiencedsubstantialimprovementsintaxcollection(seeNdikumanaandNannyonjo2005forevidenceonUganda).

Monetary policy reform

Thegeneralfocusofmonetarypolicyhasbeentocomplementfiscalpolicyintaminginflationthroughcontrollingdomesticcredit(HusainandFaruqee1996).TheoverallobjectivesofmonetaryreformundertakeninAfricaweretoreduceinflation,improvebalanceofpayments andpromote resourcemobilization through stable real inter-estrates.However,withrespecttomonetarypolicyinstrumentsusedtoachievethedefined objectives, there were some variations across countries, depending on thesourceofmonetarygrowth.InGhana,forexample,thesourceofmonetarygrowthwas excessive lending from the centralbank topublic enterprises (Leechor1996).Therefore,monetarypolicysoughttocontrolbanklending.Thiswassuccessful,asinflationfelltosingledigitsin1991.Theimprovementinfiscalbalancemademon-etarypolicymanageable.

Considerable efforts have also

been expended at improving revenue

mobilization and tax administration


Since1986,monetarypolicyinKenyashiftedfromadirectmonetarypolicycontrolsystemtoindirectmeasuressuchasreserverequirements,variableliquidityratiosandmarket-basedinterestrates.Reformalsosoughttostrengthenthecentralbank’scon-trolovernon-bankfinancialinstitutionsthathavemushroomedinthe1980s.

Inrecentyears,someAfricancountries,notablySouthAfrica,haveadoptedaninfla-tion-targeting monetary policy framework in order to gain credibility2. Under aninflation-targetingregime,theoverridingobjectiveofmonetarypolicyisthemainte-nanceofstableprices(Agénor2001).Thishasbeenadeparturefromtheoldtraditionwheremonetarypolicyreliedonintermediatetargetssuchasmonetaryaggregatesorexchangerates.SouthAfricahasbeenrelativelysuccessfulinstabilizinginflation(seebox5.1).

Whileinflationtargetingcontributestopricestabilitythroughbuildingcredibilityandanchoringinflationexpectationsmorerapidlyanddurably,itinvolvescostlytradeoffsbetweenpricestabilityontheonehandandgrowthandemploymentcreationontheotherhand.Inflation-targetingcountriesarecommittedtohitapre-definedinflationtarget,whichmayunnecessarilyrestraingrowth(SeeBlanchard2003).ThishasbeentheexperiencewithinflationtargetinginSouthAfrica.

2 Theshifttofloatingexchangeratesinmanydevelopingregions,includingAfricahasnecessitatedtheadoptionofanalternativenominalanchorofpricestability(Agénor2001).

Box �.�Experience with inflation targeting in South Africa

South Africa adopted a full fledged, inflation targeting regime in February 2000. The motivation

for this was the growing instability of money supply growth, and inflation following financial

liberalization. The objective of inflation targeting was to instil monetary discipline and enhance

the central bank’s accountability. The inflation target was expressed in terms of headline CPI

excluding mortgage interest costs. Since 2000, the inflation target has been set at 3 - 6 per

cent. The institutional framework gives the Reserve Bank greater instrument independence in

conducting monetary policy.

To enhance transparency in the conduct of monetary policy, the Reserve Bank publishes

the monetary policy statements after each Monetary Policy Committee meeting. Monetary Policy

Forums are also convened by the Reserve Bank twice a year and members of the public and im-

portant interest groups such as trade unions, businesses, and academia are invited to attend.

How has inflation targeting fared? When it was introduced in 2000, the actual inflation

averaged 10 per cent, 4 percentage points above the upper limit of the target range. Thereafter,

inflation declined to 5.4 per cent in September 2003 and then to 4.4 per cent in 2004. Consistent

application of the inflation-targeting framework has strengthened the Reserve Bank’s mandate

to focus on price stability and has contributed to reducing inflation.

Source: Van der Merwe, E. J (2004).

Inflation targetting involves tradeoffs between

price stability and growth and

employment creation


The country faces a serious problem of unemployment partly resulting from slowgrowth.Thepursuitof inflationtargetingtakesawaygovernment’sabilitytoboostgrowththroughdemand-sidemacroeconomicpolicy.Thebenefitsofinflationtarget-ingintermsofcredibilityandpricestabilityshouldbecarefullyweighedagainstthelossesintermsofemploymentcreation.

Exchange rate policy reform

Inadditiontofiscalandmonetarypolicy,exchangeratepolicywasakeyelementinmacroeconomicstabilization(HusainandFaruqee1996).Theobjectiveofexchangeratereformwastoestablishmarket-determinedexchangeratesandtoeliminateparallelmarkets.3AlthoughsomeAfricancountriesoptedforagradualapproachtoexchangeratereforms,mostpursuedan“overnight”approach,whichessentiallyinvolvedashifttoafloatingexchangerateregimethroughtheremovalofforeignexchangecontrols(AgénorandMontiel1996).InGhana,forexample,largeandwidelyspaceddevalu-ationswereimplementedinafour-yearperiod(April1983-September1987)withan“overnight”floatoccurringinthelastphase.InthecaseofNigeria,currencydevalua-tionwasimplementedovernightinSeptember1986.

Many countries have also moved towards greater capital account convertibilitythrough relaxationor eliminationof restrictions on capital-account transactions.Followingitstransitiontodemocracy,theSouthAfricanGovernmentintroducedmeasures to liberalize the capital account. This included the unification of theexchangeratesystem;immediateeliminationofexchangecontrolsonnon-residentswhilethoserelatingtodomesticresidentsweretoberemovedgraduallyandeventu-allyeliminated(Stahl,1995).

5.3 The gains from economic reforms for capital flows have been smallAlthoughperformancehasvariedconsiderablyacrosscountries,thesuccessfulimple-mentationofeconomicreforms,includingmacroeconomicstabilization,hadbroughtpositiveresultsforanumberofcountries.4

Inflationrateshavebeenreduced;twindeficitsnarrowed;exchangerateshavestabi-lized,parallelmarketpremiumshavedeclined,andeconomicgrowth,albeitslowanderratic,hasreturnedtomanycountriesinAfrica.

3 WithrespecttoexchangeratepoliciesinAfrica,therehasbeenamarkedshiftfromsoftpegstowardsindepend-ently-floatingandmanaged-floatingexchangerateregimes.Forexample,outof27Africancountriesthatwereinthesoft-pegcategoryin1991,15wereclassifiedasindependentlyfloatingregimesin1999(Ndikumana2003).

4 Seechapter1ofthisreportforadetaileddiscussionofrecenteconomicperformance.


However,countriesthathaveundertakenthemostambitiousandsustainedreforms,notably Ghana, Mozambique,Tanzania and Uganda, have experienced significantgrowth.InUganda,forexample,GDPgrowthhasaveraged6percentperannumsince theearly1990swhile inflationhasbeenbroughtdown to single-digit levels.However, despite the improvement in growth, formostAfrican countries, growthremainsfarbelowthe7percenttargetconsiderednecessaryformeetingtheMDGs.

Economicreforms,includingmacroeconomicstabilization,wereexpectedtoleadtoincreasedcapitalinflowsbyraisingrisk-adjustedreturnsoninvestment.However,theevidenceshowsthatAfricancountrieshavenotreapedsubstantialbenefitsfromeco-nomicreforms.Forexample,overtheperiod1989-94and1995-1999,FDIinflowsintoAfricagrewbyanaverage72percent.ThisisnotthatremarkableconsideringtheverylowbasefromwhichFDIgrew.Bycomparison,FDIflowstoLatinAmericaandtheCaribbeangrewbynearly200percentandtotheAsia-Pacificregionby150percent(UNCTAD2001,2002and2005).GlobalinwardFDIflowsregisteredanaveragegrowthrateof197percentoverthesameperiod.

ThemarginalizationofAfricainglobalfinancialmarketsismanifestedintheconti-nent’sstagnantshareinglobalFDIflows.Forexample,overtheperiod1989-1994and1995-1999,and2000-2004,SSA’sshareintheworld’sFDIflowsaveraged1percentcomparedto10percentand17percentforLatinAmericaandtheCaribbeanandAsiaandthePacific,respectively.Therefore,thesurgeinprivatecapitalflowstodevelopingcountrieswitnessedintheearly1990sdidnotreachmostoftheAfricancountries(Ndikumana2003).

Anumberof factorsexplainAfrica’s limitedsuccess inreapingthebenefitsofeco-nomicreformsintermsofcapitalinflows.Despitetheimplementationofmacroeco-nomic reforms, the macroeconomic environment remains weak in many Africancountries.This isdue toanumberof factors, including low resource endowment,political conflict, and inappropriatemacroeconomicpolicies thathaveaccentuatedtheadverseeffectsofexternalshocks(Ndikumana2003).Inmanycountries,reformswereincompleteandwerenotunderpinnedbyastronginstitutionalmechanismtosustaintheirimplementation.

Asaresult,policyreversalwascommon,andthismayhaveunderminedthebenefitsof reforms for capital flows. For example, 150 foreign investors operating in EastAfricarankedtheriskofpolicyreversalasthemostimportantriskfactor(WorldBank1994).TheimpactofpolicyreversalisparticularlymoreprofoundforFDIthanforothertypesofcapitalflowsgivenitsirreversibility.Asiedu(2005)foundFDItoAfricatobelessresponsivetotradeliberalizationthaninotherregions.Aplausibleexpla-nationforthis isthatforeigninvestorsperceivereformsastransitoryandthereforesubjecttoreversal.

Furthermore, institutional frameworks for macroeconomic policy management inAfricaareweak.InmostAfricancountries,asinotherdevelopingregions,atrium-virateofinstitutionsisresponsiblefortheformulationandimplementationofmacr-

Macroeconomic environment remains

weak in many African countries


oeconomicpolicy.Theseincludethecentralbank,MinistryofFinanceandnationalplanningbodies.Eachof these institutionshasadistinctmandateandpower,andgoesaboutimplementingtheirmandatesseparately,withlimitedcoordinationintheformulationandimplementationofmacroeconomicpolicies.

Apartfrompolicycoordinationamongthetriumvirateinstitutions,coordinationandpolicyharmonizationbetweenthetriumvirateinstitutionsandsectoralministriesisalsoweak.Thiscomplicatesmacroeconomicpolicymanagement.Thelackofcoor-dinationleadstopolicy inconsistency,whichunderminesefficiencyandinstitutionalcredibility in macroeconomic policy formulation and implementation. Therefore,African countries need to strengthen their institutional framework for macroeco-nomicpolicymanagement.

AnotherfactorcontributingtoAfrica’sinabilitytoattractcapitalflowsrelatestothe“imageproblem”(Asiedu2005).InternationalinvestorshaveanegativeperceptionofAfricathattendstounderminetheeffectsofeconomicreformsoncapitalflows.For example, 56 per cent of firms surveyed in an UNCTAD study reported thattheactualbusinessenvironmentinSSAisbetterthanthecontinent’simagewouldsuggest (UNCTAD 2000). This is also corroborated by empirical evidence whichsuggeststhatcredit-ratingagenciestendtorateAfricancountriesasriskierthanwar-rantedbyfundamentals(Haqueetal.2000).

Asaresult,SSAcountriesreceiveonaveragelessFDIinflowsthancountriesinotherregions, even though the continent offers some of the highest rates of return oninvestmentintheworld5.Arguably,itisunlikelythateconomicreformswouldleadtoincreasedcapitalinflowsaslongastheinvestorsperceivetheregionasrisky.

Furthermore,dueto lackof informationonindividualAfricancountriesandtheirinvestmentopportunities, investmentdecisionsareoftenbasedon inferences fromthe environment of neighbouring countries rather on country-specific conditions(Asiedu2005).Thus,intheeyesofforeigninvestors,Africais‘onebigcountry’ratherthanacontinentmadeupofdifferentcountries.ThiscallsformoreeffortsonthepartofindividualAfricancountries,internationalorganizationsandAfrica’sdevelopmentpartnerstochangetheimageofAfricaandtodevelopamongforeigninvestorsamoredifferentiatedviewofthecontinentanditsopportunities”(UNCTAD1999).

Other factorshavingapositive impactonFDI includegoodphysical infrastructure,aneducatedlabourforce,opennesstoFDI,anefficient legalsystem,lowcorruptionandpoliticalstability.Onthiscount,themajorityofAfricancountriesdonotfarewelleither.PhysicalinfrastructureinmostAfricancountriesisweak,energysupplyisunreli-able,corruptionisrampant,andanumberofcountriessufferfrompoliticalconflicts.

DespitethelimitedbenefitsofeconomicreformsforcapitalflowstoAfrica,capitalflowshavenonethelessposedconsiderablechallengesformacroeconomicpolicyman-agementinanumberofcountries.5 Forexample,theaveragereturnonUSinvestmentinAfricawas30percentovertheperiod1991-1996compared

to21percentand14percentforAsia-PacificandLatinAmerica,respectively(UNCTAD1999).

It is unlikely that economic

reforms would lead to increased capital

inflows as long as the investors

perceive the region as risky


5.4 Capital inflows have posed challenges for macroeconomic policy managementWhileincreasedcapitalflowshavehadpositiveeffectsontheeconomiesofdevelop-ingcountries,includingAfrica,theyhavealsobeenassociatedwithadverseeffects.Ingeneral,policymakershavebeenconfrontedwiththreesetsofproblems:

• Excessiveexpansioninaggregatedemandduetocapitalinflows,leadingtooverheating,thusundermininghard-wongainsinmacroeconomicstability;

• Vulnerability toabrupt reversal incapitalflowsdue tochanges in investorperception,especially forcountries thathaveattractedsizeableamountsofshort-termcapitalflows;and

• Thepremiumthatgreaterfinancialintegrationimposesonmacroeconomicpolicymanagement(WorldBank1997).

Themacroeconomiceffectsofcapitalflowshavevariedacrosscountriesdependingobviouslyon the typeofflows (privateversusofficial, shortversus long-term)andtheirassociatedvolatilities,volumeandmagnitude in relation todomesticabsorp-tionoftherecipientaswellastheusageofinflows.CapitalflowstoAfricahavebeenpredominantlyintheformofODA,withFDIbeingthemajorcomponentofprivatecapitalinflowstoAfrica(seechapter2).Theincreaseincapitalinflowsandtheirasso-ciatedvolatilityhasposedchallengesformacroeconomicmanagement.AccordingtoOseiet al. (2002),privateinflowstoAfricainthe1990sexhibitedahigherdegreeofvolatilitythanthosetoAsianandLatinAmericancountries(seealsochapter2ofthisreportformeasuresofvolatility).

One of the common effects observed in African countries has been an expansionindomesticcreditandliquidityarisingfromfinancingoflargebudgetdeficits.Forexample,followingsuccessfuladjustmentinthemid-1980sinGhana,netaidflowsgrewfromnearly$1millionin1984toover $650millionin1992(Leechor1996).6ThisledtoanincreaseinGhana’sforeignexchangereserves,whichweremainlyusedtofinancegovernmentexpenditures.Althoughforeignaidhasplayedanimportantroleinsupplementingdecliningexportearningsduetoworseningtermsoftradeitalsobecamean important sourceofmonetaryexpansion.Forexample, the rateofgrowthinbroadmoneysupplyrosefrom40percentin1983to52percentin1992.Thankstoanaggressivecreditrestraintpolicy,inflationdeclinedconsiderablyfrom122percentin1983to10percent1992(Leechor1986).

Sinceearly2000,someAfricancountries, forexampleMozambique,TanzaniaandUganda,haveformulatedandimplementedPRSPs.Thesecountrieshavealsoexperi-encedincreasesincapitalflowsrelatedtoPRSPsanddebtreliefundertheHIPCIni-tiative.Thesearemostlylow-incomecountrieswithfledglingfinancialsectorswhichlimitthemenuofpolicychoicesavailabletothemtodealwithmassiveaidinflows.

6 ForeignaidhasbeenconsideredanimportantfactorinGhana’ssuccessfuladjustmentprogramme.


Since thepublic expenditurepriorities embedded incountryPRSPsarebiased infavourofnon-tradablegoodsandservices,PRSP-relatedaidinflowsexertedpressureontherealexchangeratewhilethesimultaneousinflowofprivatecapitalhasledtoan expansionof themonetarybase (Buffie,Adam,O’Connel andPattillo2004).RealEffectiveExchangeRates(REER)aredepictedinfigure5.1.ThatratefortheGhanaian Cedi depreciated from 1990 to 1994 and thereafter appreciated until1999.The same rate for theUgandanShilling showed considerable appreciation,especiallyfrom1992to1997.AccordingtoKasekendeet al.(1997)realexchangeratesappreciatedbymorethan11percentbetween1994and1997.ForTanzania,thecumulativeovervaluationwasestimatedat20percentfortheperiod1994-1996(Leape1999).Realexchangerateappreciationtendstohaveadetrimentalimpactonthetradablesector.

Figure �.� Real Effective Exchange rates for Selected African countries

Source: IMF, 2005

Note: An increase in the rate means appreciation of the national currency.

Capitalflowsexposecountriestoriskofcurrencycrisis,especiallyarisingfromsuddenreversalofcapital.Forexample,themassiveinflowsofcapitaltoSouthAfricasince1994,mostofwhichwereofshort-termmaturity,hasmadetheeconomyvulnerabletosuddenreversalsofcapitalflows.Thishas ledtoaseriesofexchangeratecrises.Thefirst suchwaveoccurred inFebruary1996and lastedtoJuly1996.Themaincontributingfactorwasinvestoruncertaintyaboutthedirectionofeconomicpolicygiventheinherentlyconflictingpolicyobjectivesamongkeystakeholders,especiallybetweenthegovernmentandthelabourmovementrepresentedbytheCongressofSouthAfricanTradeUnions(COSATU).

The massive inflows of capital to South Africa since

1994 has made the economy vulnerable to sudden reversals

of capital flows


ThesecondwaveoccurredinOctober1996andNovember1997,causedlargelybythecontagioneffectsfromtheAsianfinancialcrisis.Thedeclineinthepriceofgoldandothermetalsalsocontributedtotheexchangeratecrisisduringthisperiod.ThethirdcurrencycrisiscameinApril1998asrisingcurrentaccountdeficits,coupledwith poor growth prospects, dampened investor confidence in the South Africaneconomy(AronandElbadawi1999).

Another effectof capital inflows relates to thechallenges that increasedfinancialintegration imposes on macroeconomic policy management. Increased financialintegrationreducesthepolicyspaceforcountriestoconductindependentmonetaryandexchangeratepolicies.Thisisthewell-knownpolicytrilemma,theobservationthatacountrycanattainonlytwoofthethreeobjectivesofexchangeratestability,monetaryindependenceandfinancialintegration.7Whilethesethreeobjectivesareworthpursuing,itisnearlyimpossibleforpolicymakerstopursuethemsimultane-ously.Therefore,ifpolicymakersoptforexchangeratestabilityandcapitalmobility,theyhavetoforegomonetaryindependence.Ifmonetarypolicyindependenceandcapitalmobility are opted for, then the countryhas to choosefloating exchangeratesandgiveuptheobjectiveofexchangeratestability(Taylor2004).8Through-outhistory,policymakershavebeenpreoccupiedwithfindingchoicestoresolvethispolicytrilemma.

InsomeAfricancountries,policymakershaveoptedforexchangeratestabilityandcapitalmobilityattheexpenseofmonetaryindependence.ThisisthecaseforCFAcountriesandthemembercountriesoftheCommonMonetaryArea9(CMA).AgoodnumberofAfricancountrieshaveoptedtopursuetheobjectivesofindepend-entmonetarypolicyandcapitalmobility.Theyhavechosentoforegotheobjectiveofexchangeratestabilitybyfloatingtheirexchangerates.Ethiopia,Ghana,Kenya,Nigeria,SouthAfricaandUgandaaresomeofthecountriesthathavefloatedtheirexchangerates.

With respect to policy responses to address the effects of capital inflows, Africancountrieshavepursuedawiderangeofoptions.Forexample,theGhanaianGovern-mentintroducedanaggressivedomesticcreditpolicyin1989tomitigatethemacr-oeconomiceffectsofforeignaidinflows(Leechor1996).Thepolicyhadanoticeableimpactas itgeneratedfiscalsurpluses,whichwereusedtorepaytheGovernment’sdebtattheCentralBank.

Africancountrieshavealsousedsterilizedinterventionsthroughthesalesofbondstolimittheeffectsofmonetaryexpansiononaggregatedemand.Giventheshallownessofdebtmarkets,thistypeofinterventioniscostly,asrisinginterestratesincreaseddebtservicingcostsforboththeGovernmentandtheprivatesector.Risinginterestratesalsodiscourageprivate sectorborrowingwhile investment inbondsbybankscrowdout lending to theprivate sector.While sterilization is necessary and effec-

7 Foradetailedexpositionofthistheorem,seeforexampleObstfeld,TaylorandShambaugh(2004).8 Taylor,A.M(2004),“GlobalFinance:PastandPresent”,Finance and Development,March2004.9 ThemembersoftheCMAareLesotho,Namibia,SouthAfricaandSwaziland.

Increased financial integration reduces the policy

space for countries to conduct

independent monetary and exchange rate

policies


tiveinoffsettingthepotentialexpansionaryeffectofincreasedcapitalinflowsontheeconomy,thereisalimittoitsapplication.Thefiscalcostcouldbehighduetorisinginterestratesneededtoenticeinvestorstoholdmoreofthenewlyissuedbonds(AronandElbadawi1999).

Inadditiontobondsterilization,centralbanksresorttomoredirectinterventionintheforeignexchangemarkettolimitthepressureonthenominalexchangerate.Thetransferofgovernmentdepositsfromthebankingsystemtothecentralbankisalsousedas ameansof containingexchange rate appreciationdue toaid inflows.ThismethodhasbeenusedinMozambique,SouthAfrica,Uganda,andmanyothers.

5.5 African countries need to further consolidate macroeconomic stabilityAsindicatedintheprecedingsection,theimplementationofmacroeconomicstabili-zationpolicieshascontributedtomacroeconomicstabilityinanumberofcountries.However,themacroeconomicenvironmentremainsweakinmanyAfricancountries.Anumberoffactors,includinglowresourceendowment,politicalconflict,inappro-priatemacroeconomicpoliciesandnarrowexportbasewithvolatiletermsoftrade10combinetounderminemacroeconomicstability.

Giventheirweakinstitutionalframeworkformacroeconomicpolicymanagement(especially the limiteddegreeof coordinationamong the triumvirate institutionsresponsible for macroeconomic policy management) African countries need toenhancetheircapacityformacroeconomicpolicyformulationandimplementation.This should be complemented by granting central banks sufficient autonomy toresistthetemptationofinflationarydeficitfinancing.Whatmakesthisparticularlyimportantistheincreasingtendencyofcountriestomovetowardsinflationcontrolastheprimarygoalofmonetarypolicy.Centralbankautonomymustbecomeanessentialpreconditionforthesuccessfulcontrolofinflation.

Countriesseekingtogainmuchneededcredibilitymayconsideradoptinganinfla-tion-targetingapproachtomonetarypolicy.SomeAfricancountries,includingSouthAfrica, have adopted inflation targeting in recent years and have had relative suc-cessinreducinginflation.Whileinflationtargetingleadstopricestability,itinvolvescostlytrade-offsbetweenpricestability,growthandemploymentcreation.Therefore,inconsideringthechoiceofaninflationtargetingapproachtomonetarypolicy,coun-triesshouldcarefullyweighthebenefitsofinflationtargetingintermsofcredibilityandpricestabilityagainstthecosttooutputandemploymentcreation.

10 Externalshocks,especiallytradeshockscontributesignificantlytomacroeconomicfluctuationsinAfricancoun-tries. Koze and Riezman (1999) estimate trade shocks to account for 44 per cent of variations in aggregateoutput.

African countries need to enhance their capacity for macroeconomic

policy formulation and implementation


Whilemacroeconomic stabilizationpolicies arenecessary for attracting steady andpredictableflowsofexternalfinance,theywillbemoreentrenchedandsustainableifunderpinnedbyasoundinstitutionalenvironment.

5.6 The institutional environment for increasing capital flows to Africa

Institutions are important for attracting capital flows

Theimportanceofinstitutionsandthemechanismthroughwhichinstitutionsaffectcapital flows were not clear until recently. Empirical evidence suggests that insti-tutionaldifferencesareamajorsourceof thedifferences ineconomicperformanceacrosscountries.11Acemoglu,JohnsonandRobinson(2001)foundthatasmuchasthree-fourthsoftheincomegapbetweenthetopandbottomoftheworldincomedistributionmaybeduetodifferencesintheirinstitutions.12Theargumentisthatthestructureofincentivesdetermineseconomicperformanceandinstitutionsprovidetheincentivestructureoftheeconomy(Olson1996).Moreover,institutionsaffecteco-nomicperformancethroughtheireffectoninvestmentdecisions,byprotectingthepropertyrightsofentrepreneursandfavouringtheadoptionofnewtechnologies.

Researchshowsthatinstitutionsplayakeyroleinfacilitatingprivateinvestmentandthat institutionalquality is themost important factorthatexplainswhycapitaldoesnotflowfromdevelopedcountries,whereithasalowerreturn,todevelopingcountrieswhereithasahigherreturn(Olson1996).Institutionscanaffectcapitalflowsdirectlybyprovidingtheenablingenvironment, goodgovernanceandsoundfinancialinstitu-tionsthatencouragetheflowofcapitalandfacilitatelong-terminvestments.Indirectly,institutionsaffectcapitalflows throughtheirimpactonothervariablesthataffectcapitalflows,inparticulartheirimpactoneconomicgrowthandthebusinessenvironment,including thequalityofpublic infrastructure,policy environment,political stability,labourcosts,exchangerates,andpriceandexchangeratestability.

Centraltobothinstitutionalenvironmentandcapitalflowsistheroleofgovernance,thatis,themannerinwhichagovernmentdischargesitsresponsibilitiesinaneffective,transparentandaccountablemannerthatconformswithinternationallyacceptedgoodpractices.Thisdeterminestheamountofcapitalthatflowsintoacountry.Goodgovern-ancehasbeenshownintheliteraturetoaffecteconomicgrowthpositively,implyingthat

11 Seeforexample,KnackandKeefer,1995,orHallandJones,1999.12 Theauthorsarguethatthelegacyofcolonialismandtheinstitutionaldifferencesitcausedpersistedevenafter

colonialismended.Usingtheexogenousvariationininstitutionsacrossformercolonies,duetomortalityratesfacedbyEuropeansatthetimeofcolonization,theyarguethatEuropeansintroducedextractiveinstitutionsincolonieswheretheydidnotsettle,whiledevelopingeffectivepropertyrightsincolonieswheretheysettledinlargenumbers.Thisexplainsthebetterperformanceinthelattergrouprelativetotheformer.

Three-fourths of the income gap

between the top and bottom of

the world income distribution may be due to institutional

differences


governanceindirectlyaffectscapitalinflows.13Thismayoccurasaresultofproductivity-enhancingeffectsexertedbygoodgovernanceoninputsintheproductionprocess.How-ever,animportantchallengeishowtoestablishthemechanismsofgoodgovernance,whichcharacterizethecapableState,includingitsabilitytoenforcecontracts,propertyrightsandtheruleoflaw,allofwhichhavebeenfoundtohavepositiveeffectsongrowth.ThecrucialissueisdeterminingwhatinstitutionalarrangementsarecapableoffosteringacapableStateandhencegoodgovernance.Thistaskisundertakeninthenextsection.

African institutions have not performed well in attracting capital flows

Institutional quality can be measured by the quality of governance, including thedegreeofcorruption,politicalrights,publicsectorefficiencyandregulatoryburdens;theextentoflegalprotectionofprivatepropertyandhowwellsuchlawsareenforced;andthelimitsplacedonpoliticalleaders(Acemoglu,2003).

Figure �.� Corruption, Rule of Law and Regulatory Quality in Africa and Other Regions, 200�

Source: Kaufmann et al., 2005.

13 SeeNduluandO’Connell(1999)forevidenceontheroleofgovernanceineconomicgrowthinAfrica.AlsoseeBarro(1997)andIMF(2003).

The crucial issue is determining

what institutional arrangements are

capable of fostering a capable State

and hence good governance


Figure 5.2 depicts the percentile rank of the various regions with respect to threeindicatorsofinstitutionalquality:controlofcorruption,ruleoflawandregulatoryquality.Highervaluesimplybettergovernanceratings.Regionsarepresentedonthechartrangingfrom‘best’(topofthechart)tothe‘worst’(bottomofthechart)foryear2004.Sub-SaharanAfricascoresworsethanotherregions(onlyhigherthantheformer Soviet Union) in the three selected indicators of institutional quality. ThequalityofthebusinessenvironmentindirectlymeasuresthequalityofAfricaninsti-tutionsforthemarket.TheWorldBank’sEase of Doing Business Index,whichrankseconomiesfrom1to155,showsthatAfricancountriesrankpredominantlyatthebottomofthescale.Twenty-fiveAfricancountriesrankbetweenZimbabwe,whichranked126,andtheDemocraticRepublicofCongo(whichranked155outof155).Itisnotsurprisingthatthecountrieswithgoodinstitutions-theonesthat,amongotherthings,enforcecontractsandpropertyrightsandprotectinvestors-rankhighonthelist,withMauritiusranking23andleadingtheway,followedbySouthAfrica(28),Namibia(33)andBotswana(40).

Corruption is a seriousproblem inmanyAfricancountriesand,as inmanyotherpartsof theworld, is thebaneofgood institutions. Ithasnegativeeffectsnot justoncapitalflowsbutalsoonoveralleconomicdevelopment.Corruptionpreventstheemergenceandsustainabilityofstronginstitutionsanddetersforeigninvestmentincountrieswhereitisrampant.CorruptionalsoconstitutesasignificantchallengetocapitalflowstoAfricaeventhoughcountriessuchasNigeria,whichhassignificantcorruptionproblems,attractcapitalinthenaturalresourceextractionsector.

However, FDI outside the natural resource extraction sector appears much moreresponsive to macroeconomic, political and institutional variables (Nnadozie andOsili 2005).Table 5.1 shows theCorruption Perception Index, with lower rankingindicatinghigherlevelsofcorruptionperception.ThetableshowsthatAfricahasthesecond-lowestrankingafternon-EUSouthandEasternEuropeandCentralAsia.

Table �.�Comparison of Corruption Perception Index across Regions, 2005

Region Index

Non-EU South and Eastern Europe and Central Asia 2.67

Africa 2.86

North and South America 3.86

Global Average 4.11

Asia and Pacific 4.28

Middle East 4.37

EU plus Iceland, Norway and Switzerland 6.67

Source: Transparency International, 2006

Corruption has negative effects on capital flows and

overall economic development


Becausetheinstitutionalenvironment,goodgovernanceandsoundfinancialinstitu-tionsdirectlyplayapositiveroleinencouragingtheflowofcapital,itisimportanttoestablishaninstitutionalenvironmentthatwillenhancetheflowofgood-qualitycapitalandminimizethevolatilityofinflowsthatcancauseseveremacroeconomicimbalances.

InAfrica, thepreponderanceofextractive institutions is the legacyofcolonialism.Indigenousadministrationscouldnotmodifythislegacy,mainlybecauseoncetheyare entrenched, extractive institutions arehard to change. Yet, the keyhindrancetoeffectiveinstitutionsistheentrenchedinterestsoftheelitesorparticulargroupsfavouredbytheexistinginstitutionalarrangements.Hence,theproblemofinstitu-tionalreformandthatofthepersistenceofbadinstitutionslieinthefact“thatanymajorchangecreateswinnersandlosersandthepotentiallosersareoftenpowerfulenoughtoresistchange”(Acemoglu2003:130).Institutionalchangewilloccurwhengroups that favourchangebecomepowerful enough to impose iton thepotentiallosers.Alternatively,societiescanreachanagreementtocompensatepotentiallosersafterthechangetakesplace,orperhapsshieldthemfromtheadverseeffectsofthesechanges(Acemoglu2003).

Becauseinstitutionsdefineandenforcetheeconomicrulesofthegame,theyshapeeconomicperformance,whichmeans that economicdevelopmentdependsheavilyontheestablishmentofstrongandstablepoliticalinstitutions(North,2005).Northarguesthat“Politicalinstitutionswillbestableonlyiftheyaresupportedbyorganiza-tionswithaninterestintheirperpetuation”(North2005:7).TheimplicationisthatAfricancountriesmustencourageandcreatesuchorganizationsasanessentialpartofpoliticalandeconomicinstitutionalreformswithinaparticipatory,consultative,anddemocraticframework.

Effective institutions will enable African countries to increase capital flows

Toincreasecapitalflows,Africancountriesmustacquireanddevelopeffectiveinstitu-tions—those“…thatimprovethemarketsystemsbyimprovinginformation,lower-ing transaction costs and improving resource allocation and distributional equity”(Nnadozie2005).Thecentralchallenge,therefore,ishowtobuildandstrengthenAfrican institutions andmake integration into the global economywork forAfri-cancountriesinachievingdevelopmentgoalsthroughincreasedflowofstablelong-termcapital.Makinginstitutionsplaytheirrightfulrolewillrequireatwo-prongedapproach:identifyingcriticalinstitutionsandbuildingthemorimprovingupontheirefficiencyandeffectiveness.

There is a need to establish

an institutional environment that will enhance the flow of good-quality capital


Identifying institutions that are critical for increasing the flow of beneficial international capital

Havingunderstoodandacceptedtheroleofinstitutions,thelogicalnextstepistoidentifytheinstitutionsthatarecriticalforincreasingcapitalflows.Theinstitutionsthatwill increasecapitalflowsare likely tobe thesameones that increasegrowth,especiallythosethatprotectpropertyrightsandenforcecontracts.Theseareinstitu-tionsthatwillminimizethetransactioncostsassociatedwithinternationalcapitalandalleviateinformationandsovereignrisk,thusimprovingmarketefficiency.Institu-tionsthatwilladdressdomesticmarketimperfectionsareequallycriticalandincludeinstitutionsfordevelopinghumancapitalandimprovinggovernmentpolicies.

First and foremost,African countriesneed institutions thatwill generate the rightincentivesforanincreasedflowofinternationalcapitalbyprovidinggoodinforma-tion to investors, and promoting investment opportunities and political stability.Furthermore, theyneed institutions thatwill ensurebetter economicmanagementandcreateasoundmacroeconomicenvironment. Theyalsoneedinstitutionsthatwillnotonlyprovideanenabledbusinessenvironment,includingprovisionofqual-ityinfrastructure,anddeepeningandimprovingtheefficiencyofthefinancialsectorinordertounleashthepotentialoftheprivatesector.Finally,thesectorneedsinsti-tutions thatenable itsmembers toestablishand implementanational strategy forattractingforeigncapital.

• Institutions for managing conflict and promoting political stability.Because political stability is important for improving sovereign risk, it isnecessarytobuildinstitutionsthatpromotepoliticalstabilityandeffectivelymanageconflicts.Examplesofsuchinstitutionsincludeagoodconstitution,theruleoflaw,anindependentjudiciary,representativepoliticalinstitutions,free elections, independent trade unions, social partnerships, and institu-tionalized representation of minority groups and social insurance (Rodrik2000).

• Regulatory and stabilization institutions. Acapital-friendlyenvironmentrequireseffectiveinstitutionstoattractforeigncapital.Theseincludebanksandstockmarketsandtheinstitutionsthatregulateanti-competitivebehav-iour,includinganti-trustlaws.Thereisneedforefficientprudentialregula-tionandfinancialsupervisionsuchasthecentralbank.Securitiesregulationrequiressecuritiesandexchangecommissions.Likewise,institutionsformac-roeconomicstabilization,especiallyanindependentcentralbank,willhelptoavoidfinancialcriseswhenflowsincrease.

• Legal institutions, the rule of law and property rights enforcement. These are equally important for attracting foreign capital. Property rightsenforcement isan importantdimensionof the ruleof law. Incentivesplayan important role in enterprise formationandgrowthandproperty rightsareattheheartoftheincentivestructure(WorldBank1999).Fortheflow

The financial sector

needs to establish and implement a

national strategy for attracting foreign

capital


of capital to increase, these rights, includingownership andcontrol,mustbeclearlydefinedbylawthroughacombinationoflegislation,privateandpublicenforcement,andcustomandtradition(Rodrik2000). Goodlawsmustbepassed,theymustbeappliedfairlyandtransparentlyandeven-hand-edly to all,by apolitically independent judiciary.Aboveall, theymustbeenforced.Investorsmustbeprotected.

Becauseofweakandsometimescorruptcourtsandregulators,underdevelopedcapitalmarketsandashortageofskilledoperators,lawyersandaccountants,foreigninvestorsoftenhavedifficultyinobtaininginformationoncompaniesandarethereforewaryofinvestinginAfricancountries(WorldBank1996).Thereisaneedforcorporatelawandbettercorporategovernancetoimprovetheinvestmentenvironment,controlcorruptionandincreasetheleveloftrustintheState.Howeverlawsareonlyasgoodastheinstitutionsthatenforcethem.

Building and strengthening capital-friendly institutions

The issue is not just what type of institutions are needed to enable each Africancountrytoincreaseitscapitalinflowsbutalsohowtheycanbebuilt,developedandstrengthened.SignificantlyincreasingcapitalflowstoAfricancountrieswillrequireaheavydoseofstrategicinstitutionaldevelopment.Theoptionspursuedintermsofdesirable institutionalarrangementwillvaryacrossandwithincountriesover timewithin the historical realities (Rodrik 2000). Making institutions work for capitalinflows requires adefinitionofnational capital-flowobjectives, a correctdiagnosisof institutionaldeficiencies inachievingtheseobjectivesandastrategy for increas-ingcapital inflowwithinawell-establishednationalgrowthandpoverty reductionframework.

DiverseinitialconditionsamongAfricancountriesimplythattheirapproachtoinsti-tutional reforms and institution-building will vary from country to country. Thestrategieswillbebasedonanassessmentoftheinstitutionalgapsandcapacities ineach country. In acquiring functional, capital-friendly institutions and improvingupontheir quality,shouldAfricancountriesfocusonbestpracticesandcopyexistingmodelsor should theyengage in local experimentationbasedon local innovation.They must choose between ready-made blueprints or experiments using domestichistorical,social,andpoliticalrealitiesandknowledgeoflocalneedsandcapacity.

Eachchoicehasadvantagesanddisadvantagesandthereforeentailstrade-offs.Thereshouldbeacountry-specificapproach.Forsomecountries,itwillbetheestablish-mentofnewinstitutions.Forothers,itwillbetheharmonizationofexistingones.Thereisalsoneedforlocalexperimentation,inrecognitionthatthisapproachhasitsowndangersandiscostlyintermsoftimeandresources.

Theblueprintapproachmaynotbethewaytogobutuseoflocalknowledgeinadap-tationofimportedmodelshasitsownproblems.Nonetheless,thereisalwayssome-

Increasing capital flows to

African countries will require a heavy

dose of strategic institutional

development


thingtolearnfromtheinstitution-buildingexperienceorinstitutionalarrangementprevailingelsewhereeveniftheyareoften“inappropriateorcannotbetransplanted”(Rodrik 2000: 12). Sometimes, institution-building may require combination oforthodoxandheterodoxstrategiesinaparticipatoryprocess.Thisapproachhasena-bledMauritius,astabledemocracywithregularfreeelections,toattractconsiderableforeigninvestmentandgenerateoneofAfrica’shighestpercapitaincomes(seebox5.2).Besides,democracyhelpsbuildbetterinstitutions,whichmeansthattheeco-nomicstrategyneedstobeunderpinnedwithsocialandpoliticalarrangementsthatencourageparticipation,representativenessandcoalition-building(Rodrik2000).

Certainstepsarerequiredtoadaptpolicyandinstitutionalchangetolocalconditionsand there isneed forbroad-basedparticipation in theprocessof change. AfricancountriescanlearnfromtheexperienceofsomeoftheirAsiancounterpartsandfromthesuccessstoriesinAfrica.BotswanaandMauritiusaretwoAfricancountriesthathaveconsistentlyperformedwelldespitefacingmanyconditionssimilartothoseoftheirAfricanneighbours.14Thedifference,manystudiesconclude,lieingoodgovern-ance,thatis,thequalityofinstitutionsthatencourageparticipationandtransparencyinthesetwocountrieshasbeenmuchhigherthanthoseontherestofthecontinent(Rodrik2000;Acemogluet al.,2001).

Regional dimensions of institution-building

Asidefrommobilizinginternalandexternalresourcestofundinstitutionalchange,there are also regional and global dimensions. African countries need to developandstrengthenregionalorganizationsthatenablethemtoattractandabsorbhighervolumesofprivatecapitalflows.Inparticular,subregionalandcontinent-wideinitia-tivesaimedatimprovingeconomicandpoliticalgovernanceplayanimportantroleinimprovingAfrica’simageintheeyesofinternationalinvestors.

Forinstance,asanintegralpartoftheAU’sNewPartnershipforAfrica’sDevelopment(NEPAD), theAfricanPeerReviewMechanism (APRM)aims to foster the adop-tionofpolicies,standardsandpracticesthatleadtopoliticalstability,higheconomic14 Someofthesecommonconditionsincludelowhumancapital,commoditydependence,tropicalclimateandlack

ofaccesstothesea.

Box �.�The Export Processing Zone in Mauritius

In creating the Export Processing Zone (EPZ), the Government of Mauritius recognized that

there would be winners and losers, especially industrialists who for years had been favoured by

protectionist arrangements. By addressing the needs of the industrialists through negotiation,

the Government earned their support for the reforms. The EPZ generated new trade and employ-

ment opportunities, while protecting existing interest groups. As a result, Mauritius benefited

from high levels of capital flows that boosted trade and investment.

Source: Rodrik 2000.

African countries can learn

from the experience of some of their

Asian counterparts and from the

success stories in Africa


growth,sustainabledevelopmentandacceleratedsubregionalandcontinualeconomicintegration.Thisistobedonethroughsharingofexperiencesandreinforcementofbestpractices,whileidentifyingdeficienciesandassessingtheneedsofcapacitybuild-ing in theareasofgovernanceandsocioeconomicdevelopment. It isbelieved thatas a regionalmechanism, APRMwill encourage the emergence of soundnationalinstitutions andpromote economic development inAfrica by improvingpolitical,economic,andcorporategovernance.

5.7 ConclusionAfrican countries have undertaken a number of economic reforms since the early1980s.Macroeconomicstabilizationpolicieshavefeaturedprominentlyin‘thefirst-generationreforms’agenda.Thesepolicieshavebeencomplementedbytrade,finan-cialandcapitalaccount liberalization.Taxreformswerealso included,generally inthe later stages of stabilization programmes. Implementation of these policies hasbroughtpositive results foranumberofAfricancountries, as evidencedby fallinginflationratesandnarrowingoffiscalandcurrentaccountdeficits.Althoughgrowthhas returned to anumberof countries, it remainsbelow the sevenper cent targetrequiredformeetingtheMDGs.

WhileAfricaasacontinentremainsonthesidelinesoffinancialglobalization,somecountrieshavebeenabletoattractsubstantialvolumesofexternalcapital,includingofficialaidandresource-seekingprivatecapital.Theseflowshaveposedconsiderablechallenges for macroeconomic policy management. The common effects observedacross Africa have been inflationary pressures and real exchange rate appreciation.

Box �.�China’s success in attracting foreign capital

China offers more, incentives to attract FDI than any other country in the world but also offers

more legal restrictions. Adopting a pragmatic strategy that has been adjusted over time, China

was able to attract significant amounts of capital flows with a mix tilted in favour of FDI.

The country adopted an export-oriented approach targeting foreign capital that could help

transmit technical and marketing know-how. It embarked on prudential capital-account liber-

alization, coupled with a mixed policy of simultaneously discouraging foreign debt and foreign

portfolio investment and providing incentives for FDI.

Through the experience of the Asian crisis, China adopted an incentive mechanism and a

step-by-step relaxation of restrictions. It promulgated laws governing capital investment at the

start of the reform programme and used tax benefits for FDI and capital controls to limit other

flows.

Source: Eswar Prasad and Shang-Jin Wei (2005).


In response to capital inflows,African countrieshavepursuedanumberofpolicyoptions. These have ranged from sterilization through bond issues, direct foreignexchangeinterventionandtransferringgovernmentdepositsfromcommercialbankstothecentralbanks.

Notwithstandingthechallengesthatcapitalinflowsposeforeconomicpolicyman-agementingeneralandmacroeconomicpolicyinparticular,theyareimportantforthegrowthanddevelopmentofAfricaneconomies.Properlymanaged,thebenefitsofinternationalcapitalcanoutweighthecosts.Forinstance,theycanhelptoreducethesavingsgapandprovidetheresourcesneededforinfrastructuredevelopmentandforsocialspending,(bothofwhichareessentialforprivatesectorandhumancapitaldevelopment)andpovertyreduction.Toincreasecapitalflowswhileminimizingtheirpotentialnegative effects,African countriesmustdesign strategies and institutionsto reduce transactioncosts and investment risk anddevelophumancapital.Prop-ertyrightsmustbesecuredthroughhonest,competent,andreliableadministrationofjustice.Thiswillpermitgreaterinvestment,whichwhenallocatedefficiently,canimproveeconomicgrowth.EffectiveinstitutionscanhelpAfricancountriestopursuebetterandmoresustainablepolicies,benefitfromincreasedcapitalflowsandmaxi-mizetheirbenefits;competentinstitutions,andthepublic’strustinthem,takealongtimetogrow.

Properly managed, the

benefits of international capital

can outweigh the costs


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��

6.1 IntroductionThislastchapterofthereportexaminesthecapacityofAfricancountriestoabsorbfor-eigncapitalanddiscussespoliciestomanagecapitalflowssoastomaximizethebenefitswhileminimizingtherisksoffinancialfragilityandotheradverseeffects.Acountry’scapacitytoabsorbforeigncapitaldependsonmanyfactors,includingthequalityofthelabourforce,theavailabilityandqualityoftheinfrastructure,thedepthandefficiencyofthefinancialsystem,andtheoverallinstitutionalandpolicyenvironment.

Thediscussionoftheroleoflabourmarketfactorswasundertakeninchapter3whilethatoftheinstitutionalenvironmentwasexaminedinchapter5.Thischapterexam-inestheroleofthedepthandefficiencyofthefinancialsysteminabsorbingcapitalflowsandharnessingtheirdirectandindirecteffectsonthehosteconomy,includingtechnologicaldiffusionandcrowding-ineffectsondomesticinvestment.Itdiscussestheneedforpromotingregionalfinancialintegrationasameansofattractingcapitalflows,andthemechanismsformonitoringandmanagingcapitalflows,includingsug-gestionsforwarningindicatorsoffinancialrisksandcorrespondingpolicyresponses.

6.2 Financial Development and Absorptive CapacityThedepthandefficiencyofthefinancialsysteminfluenceacountry’scapacitytoabsorbcapitalflows,bothprivateandofficial.Theleveloffinancialdevelopmentalsoinfluencestheextenttowhichacountryisabletobenefitfromcapitalflowsintermsofspilloversfromtargetedsectorstotherestoftheeconomy,andtheoverallgrowtheffects.

Efficient financial intermediation enhances absorptive capacity

Foreign direct investment and absorptive capacity

Thefinancialsysteminfluencesboththevolumeofforeigncapitalflowsandtheimpactofforeigncapitaloneconomicgrowth.Long-termforeigncapitalorFDIisnotonly

Absorption Capacity and Management of Capital Flows �


thedominantformofprivateforeigncapitalinAfricancountriesbutisalsotheformofprivatecapitalflowsthatislikelytohaveasubstantialimpactoneconomicgrowth.Threeimportantrelationshipsareworthemphasizing(Lehmanet al.,2004;Feldstein1994;DiGiovanni2005).

First,financialdevelopmentisadeterminantofcapitalinflowsbecausethedeeperthefinancialsystem,thebroadertherangeofinvestmentopportunitiesandthehighertheincentivesforforeigninvestorstoenterthecountry.Second,financialdevelopmentisakeycomponentofthehostcountry’sabsorptioncapacity.Third,asacorollarytothesecondrelationship,financialdevelopmentisakeychannelforthegrowtheffectsofforeigncapital.Thesethreerelationshipsareessentialinunderstandingboththerela-tivelypoorperformanceofAfricainattractingforeignprivatecapitalandthelimitedeffectsofFDIoneconomicgrowthonthecontinent.

Financialdevelopment,ormorespecifically,thedepthandefficiencyofthefinancialsystem,areanimportantconditionforattractingcapitalinflows.Financialdevelop-mentexertsdirecteffectsoncapitalflowsbyofferingmoreopportunitiesforequity-basedinvestmentstoforeigninvestors(DiGiovanni2005).Thedeeperthefinancialsystem,thebroadertherangeofinvestmentopportunitiesandthehighertheincen-tivesforFDIintothecountry.Amoredevelopedfinancialsystemalsoallowsforeigninvestorstoborrowdomesticallytoexpandtheiractivities.

Moreover,borrowingfromlocalfinancialmarketsallowsforeigninvestorstoreducetheirexposuretohost-countrycurrencyrisks(Lehmanet al.,2004;Feldstein1994).Furthermore,financialdevelopmentexertsindirecteffectsonFDIgiventhatamoreefficientfinancialsystemisassociatedwithlowertransactionscostsandbetterinfor-mationsystems,allofwhichfacilitateinvestmentoperations.Throughtheprovisionofsystematicinformationoninvestmentopportunitiesandreturnstocapital,aneffi-cientfinancialsystemalleviatestheproblemsofinformationimperfections,whicharemoreacuteforforeigninvestorsthanfordomesticinvestors.

The importance of the financial system for a country’s capacity to absorb foreigncapitalderivesfromthediversefunctionsthatitplaysintheeconomy.Inadditiontothetraditionalsavings-mobilizationrole,thefinancialsystemalsoperformsotherfunctionsthatarevitaltotheproperfunctioningofamarketeconomy,namely,infor-mationproduction,pricediscovery, risk sharing, liquidityprovision,promotionofcontractual efficiency, promotion of corporate governance, and facilitating globalintegration(seeSenbetandOtchere2006).

Therearetwoimportantreasonswhyfinancialdevelopmentisimportantforthecoun-try’sabsorptioncapacity.First,thedepthofthefinancialsystemallowsthecountrytoattractintermediateforeigncapitalwithminimalstrainonmonetaryandexchangeratepolicy(NkusuandSayek2004;Buffieet al.,2004).Alargeanddeepfinancialsystemminimizestheexchangerateappreciationeffectsofcapitalinflowsandgivesmoredegreesofmanoeuvertothecentralbankinsterilizingtheinflows,inordertominimize the inflationary impact. In many African countries, the bond market is

A more developed financial

system allows foreign investors to

borrow domestically to expand their

activities

��Absorption Capacity and Management Of Capital Flows

eithernonexistentorverythin,whichlimitsthenumberoftoolsbywhichthecentralbankcancontrol the inflationaryandexchange rateappreciationeffectsof foreigncapitalinflows.Forexample,thelargeincreaseindomesticinterestratesinUgandabetween1998and2000(from5percenttoalmost20percent)waspartlyaresultoflargeaidinflowsthatcouldnotbeabsorbed,giventherelativelythinfinancialmar-kets(NkusuandSayek,2004).EvidencefromotherAfricancountriesshowssimilareffects(Buffieet al.,2004).

Second, and most importantly, an efficient financial system allows the country tomaximizethespillovereffectsofforeigncapitalintheeconomy.Sucheffectsmayoccurthroughdemonstrationeffects,competitioneffects,anddownstreamandupstreameffectsondomesticproduction.FDIprovides incentives forexpandingproductionpartlythroughthecreationofFDI-relateddemandforgoodsandservicesandalsobypushingdomesticproducerstoinvestininnovationandskillsacquisitiontokeepupwiththecompetition.

Productionexpansionandtechnologydiffusionneedtobefinanced.Plansforexpan-sionandtechnologyacquisitionmayverywellbefrustratedbylackofappropriatefinanceinanycountrywithanunderdevelopedfinancialsystem.Intheabsenceofadequate finance, FDI sectors may remain economic islands in the country, withminimaleffectsonoveralleconomicactivity.InthemajorityofAfricancountries,lackofaccesstofinancehasbeenidentifiedasanimportantconstrainttobusinessforma-tionandexpansion(seeBigstenet al,.1999;GunningandMengistae2001).Indeed,accordingtoafirmsurveyoftransnationalcorporationsbyUNCTADin1999/2000,28percentofthefirmsidentifiedlackfinance.ItisalwaysoneofthemostimportantconstraintstoFDIinSSA,rankingthirdaftercorruption(49percent)andaccesstoglobalmarkets(38percent)(UNCTAD2000).1

Byfacilitatingabsorptionofforeigncapital,financialintermediationwillenhancethegrowtheffectsofforeignprivatecapital.ThereisgrowingconsensusthatFDIaffectseconomicgrowthlessthroughdirectinvestmenteffectsandmorethroughefficiencyortotalproductivityeffects(ModyandMurshid2005;Durham2004;OmranandBoldol2003).TheproductivityeffectsofFDIongrowthoccurthroughtheincreaseinthemarginalproductivityofcapitalinsectorsthataredirectlyreceivingFDI.These“privateproductivity” effects are compoundedbypositive effectsonmarginalpro-ductivityofcapitalinothersectorsintheeconomy–or“socialproductivity”effects(ModyandMurshid2005;Alfaroet al.,2004).FDIthereforecreatespositivetechno-logicalspillovereffectsandmanagerialexternalitiesinnon-FDIsectorsthatraisetotalproductivityintheeconomy.

However,theseeffectswillmaterializeonlyifthefinancialsystemisabletointermedi-ateresourcesefficientlyandmeetnewdemandsforinvestmentfinance.Theoverallproductivityeffectswilldependontheefficiencyofthefinancialsysteminchanneling

1 AlsoseeAsiedu(2002,2004),AsieduandLien(2004),andMorisset(2000)forfurtherempiricalevidenceonconstraintstoFDIinAfrica.Seechapter5forfurtherdiscussionofconstraintstocapitalflows.

In the absence of adequate finance, FDI

sectors may remain economic islands

in the country, with minimal effects on

overall economic activity


resources to investmentactivitieswiththehighestreturnsoncapital.Thefact thatFDIinAfricatendstobeconcentratedinextractivesectors(seechapter2)contrib-utestolimitingtheseproductivityeffects.InordertomaximizethegrowtheffectsofFDI,AfricancountriesneedtoestablishincentivesfordiversificationofthesectoralallocationofFDI.

Theconclusion from this analysis is that a country’s absorption capacity,which isinfluencedbythedepthofthefinancialsystem,isanimportantdeterminantofthegrowtheffectsofforeigncapital.Incountrieswithunderdevelopedfinancialsystems,FDIwillhavelimitedeffectsongrowth.ThismayexplaintheweaklinkbetweenFDIandeconomicgrowthobservedindevelopingcountries(OmranandBoldol2003).TheevidencesuggeststhatAfricancountriesmustaggressivelypursuestrategiesforimproving the efficiency of their financial systems in order to reap the maximumbenefitsfromforeigncapitalflows.

TheforegoingdiscussionimpliesthattheremaybeavirtuouscirclebetweenFDIandgrowtharisingfromthereciprocalrelationshipbetweenFDIandfinancialdevelop-ment.ForeigncapitalcreatesinvestmentopportunitiesduetoFDI-relatedspillovereffects.This,inturn,inducescreditexpansionleadingtoanoverallincreaseinfinan-cial intermediation.Therefore, to theextent thatcountries areable toestablishanadequate institutional environment forfinancial intermediation, exposure to long-termforeigncapitalmayhavemultipliereffectsinboththerealsectorandthefinan-cialsector,eventuallyboostingtheoveralleconomicgrowth.

Other flows and the role of the financial system: aid and workers’ remittances

Thedepthandefficiencyofthefinancialsystemalsoinfluencesthecountry’sabilitytoabsorbandtakeadvantageofotherformsofcapitalflows,namely,ODA,workers’remittances and short-termportfolioflows.Countrieswithunderdevelopedfinan-cialsystemshavedifficultymitigatingthenegativeeffectsoflargeinflowsofforeignexchange,forseveralreasons.First,thelackofadevelopedbondmarketlimitsthedegreesofmanoeuverforthecentralbanks,insterilizingtheeffectsoftheinflows.ThisraisestheriskforDutch Diseaseeffectswherebytheunsterilizedinflowscauseanappreciationofthelocalcurrency,whichunderminescompetitiveness(seeHellerandGupta2002).

However,attemptstosterilizetheinflowsbyTreasuryBillsalesinashallowdomesticmoneymarketwillleadtohigherandmorevolatileinterestrates,whichhavedetri-mentaleffectsonprivateinvestment.EvidencefromUgandaconfirmstheseadverseeffectsofaidmanagementoninterestrates(NkusuandSayek2004).Aidmayindi-rectlycrowd-outdomesticinvestmentincountrieswithunderdevelopedfinancialsys-tems.Theseadverseeffectsarelikelytobemorepronouncedifaidinflowsarespentondomesticnon-tradablegoods.Incontrast,Dutch Diseaseeffectsaremitigatedwhentheinflowsareusedtoincreaseproductioncapacity(includinginvestmentinpublic

A country’s absorption capacity, which is influenced by the depth of the

financial system, is an important

determinant of the growth effects of

foreign capital


infrastructure), inwhichcase,positivesupplyeffectsoffsetadversedemandeffects,therebyminimizingtheimpactoninflationandexchangerateappreciation.

Second,thelackofadiversifiedpooloffinancialinstrumentstendstodirectprivateforeigncapitalintosuchspeculativeinvestmentsrealestate,whichcausespricedis-tortionsandraisestheriskforcostlyassetpricecrashes.Asthevolumeofworkers’remittancescontinuestoriseinAfricancountries,theserisksofassetpriceinstabilitywillalsocontinuetoincrease.ThechallengeisforAfricanfinancialintermediariestodevelopnewinstrumentstodirectthesefundsawayfromspeculativemarkets.Inthisregard, itmaybehelpful that they initiatediscussionswithnon-residentnationalsandtheDiasporaaboutthebestoptionsforchannelingremittancesintoproductiveinvestments.Whilefinancialinstitutionshavetheknowledgeofthelocalinvestmentmarket,non-residentsmaycontributetothedebatebydrawingontheirexperiencesofthefinancialsystemsintheirhostcountries.

In addition to minimizing the risks of instability associated with official capitalinflows,financialdeepening also enhances the effectivenessof aid.ODAcan con-tributetoeconomicgrowth,althoughtheaid-growthrelationshipappearstodependonarangeofconditioningfactors,includingthequalityofinstitutions.Onestrandoftheliteraturethatisparticularlyrelevantfortheforegoingdiscussionsuggeststhattheeffectivenessofaidisenhancedbythedepthoffinancialmarketsinaid-recipientcountries (seeNkusu andSayek2004). Inparticular, deeperfinancialmarkets areabletointermediateexternalresourceflows,thusmaximizingpositiveindirecteffectsofaidoutsidethesectorsthataredirectlytargetedforaid.Theseindirecteffectswillenhancetheoveralleffectsofaidoneconomicgrowth.

Underdevelopment of African financial systems may explain the weak gains from capital flows

MostmeasuresoffinancialdevelopmentshowthatAfricaingeneral,andSSAinpar-ticular,lagbehindotherregionsindevelopment,bothinthebankingsectorandinthecapitalmarket.Therecordindicatesthattheperformanceofthefinancialsectorhasstagnatedandevendeterioratedinmanycountriessincethe1990s.Ascanbeseeninfigure6.1,thesupplyofcreditbybanksinSSA,excludingSouthAfrica,waslowerinthe1990sandearly2000sthaninthe1980s.Itisclearthatthebankingsectorisnotkeepingpacewiththegrowthofdomesticdemandforcredit.

As the volume of workers’ remittances

continues to rise in African countries,

these risks of asset price instability will

also continue to increase


Figure �.�Bank credit to the private sector (% of GDP) in sub-Saharan Africa


Moreover, despite substantial efforts to reform and liberalize financial systems inAfrica,evidencestillpointstoimportantimpedimentstoefficientmobilizationandallocationofbothdomesticandforeignresources(SenbetandOtchere2006;Nis-sanke and Aryeetey 1998; Ndikumana 2003). Financial systems in most Africancountriesaredominatedbyasmallnumberofbanksthatcommandheavymarketpower,whichunderminestheefficiencyofallocationofresources.

Forexample,inBurundithreeleadingbanksaccountforover70percentofdeposits,loans, and assets (Nzobonimpa, Nkurunziza, and Ndikumana 2006). The marketshareofthetop4banksisashighas75percentinUganda,65percentinGhana,and49percentinTanzania(SenbetandOtchere2005).Theoligopolisticstructureofthebankingsystemcontributestohighcostsoffunds,asillustratedbyhighinter-est-ratespreads.Contrarytoexpectations,reformsinthebankingsystemhavebeenaccompaniedbyariseinthespreadbetweenthelendinginterestrateandthedepositinterest rate andan increase in thegapbetweendomestic interest rates andworldinterestrates.Theinterestratespreadsin1996-2003weretwiceashighasthe1980slevelsinsomecountries(table6.1).Highspreadsdiscouragesavingsmobilizationduetolowremunerationofdepositsanddepressborrowingduetothehighcostsoffunds.ItisclearthatfinancialreformsinmanyAfricancountrieshavebeenaccompaniedbylessandnotmoreefficiencyinfinancialintermediation.

Financial systems in most

African countries are dominated by

a small number of banks that

command heavy market power


Table �.�Average interest rate spread and interest rate differential in African countries

Period Deposit rate (%) Lending rate (%) Spread (%) Differential with the USA (%)

1980-84 8.3 13.5 5.2 -19.3

1985-89 10.7 16.1 5.4 -26.5

1990-94 15.4 23.3 7.9 -8.9

1995-99 12.8 23.4 10.6 -0.9

2000-03 10.6 22.4 11.8 4.9

Source: IMF, 2005

Note: The figures are averages for a sample of 22 African countries with consistent quarterly data over the 1980-2003 period. The interest rate differential for an African country is obtained by subtracting the US real interest rate from the African country’s real interest rate.

FinancialreformshavemovedAfricancountriesfromaninterest-repressionregimetoahighreal-interestregime,bothofwhicharedetrimentaltoresourcemobilizationandinvestment.Moreover,Africanbankingsystemsareexcessivelyliquidasaresultofriskaversionbutalsobecausebanksareabletomaintaincomfortableprofitratesbychargingusuryratestotheirtraditionalborrowers(includingthegovernment)whilehoardingrisk-freegovernmentsecurities.Thus,Africanbankingsystemsareengagedindysfunctional intermediation (SenbetandOtchere2006;Senbet2001) thatbothwastesresourcesandkeepscountriesbelowtheirgrowthpotentials.

FDIinAfricahastraditionallybeenconcentratedinresource-richcountries.Thesecountriesalsohappentohavetheleastdevelopedfinancialsystems(figure6.2),imply-ingveryweakabsorptioncapacity.

ThispartlyexplainsthelimitedeffectsofFDIoneconomicdiversificationandtrans-formation(seechapter4)andoveralleconomicperformance(chapter2).FDIhashadlittleeffectonthemanufacturingsector,whichmayexplainthelowgainsintermsofgrowthandemploymentcreation.Thedatashowthatthere is littlerelationshipbetweenthevolumeofFDIandmanufacturingsectorgrowth(figure6.3).Leadersinmanufacturinggrowth,suchasEgypt,Mozambique,TogoandUgandarankatthebottomintermsofFDIinflows.Thedebateonstrategiestoincreasecapitalinflowsinthecontinentmustthereforeaddressthecriticalquestionofhowtoenhancetheimpactofforeigncapitaloneconomictransformation.

The critical question of how to enhance the

impact of foreign capital on economic transformation must

be addressed


Figure �.�FDI and financial development, 199�-2003

Source: UNCTAD, 2005; IMF, 2005.


Figure �.�FDI and manufacturing sector growth, 199�-2003

Source: UNCTAD, 2005; World Bank, 2005.

Note: Manufacturing sector growth = growth rate of the ratio of the manufacturing sector value added to GDP.

African countries need to promote regional financial integration

Capitalmarketsconstituteavitalcomplementtothebankingsectorintheprocessofdevelopinganefficientfinancialsystem.TheexistingcapitalmarketsinAfricaarestillshallowandhighlyilliquid,withtheexceptionoftheSouthAfricanstockmarket(table6.2).Presently,thereare20activestockexchangesinAfricaandaregionalcapi-talmarket(BRVM)thatcoversalltheeightWestAfricanEconomicandMonetaryUnion (WAEMU)memberStates.Overall,African emergingmarketshave grownsteadily in the last ten years in terms of market capitalization, value traded, andnumberoflistedcompanies.Moreover,thoughilliquid,Africanmarketsare,none-theless,quiteprofitable.In2005,theaverageequityreturnwas34percentforAfrica,excludingSouthAfrica.However,despitenotableprogress,Africancapitalmarketsremainsmallandisolatedandunintegratedinregionalandglobalmarkets.

Given the small size ofnationalmarkets and the cost of the infrastructure that isrequiredtorunavibrantcapitalmarket,itisclearthatnationalcapitalmarketsare

Despite notable progress, African

capital markets remain small

and isolated and unintegrated in

regional and global markets


not viable inmanyAfrican countries.Oneway to increase the viability of capitalmarketsistopromoteregionalequitymarketsbydrawingontheexperienceofexist-ingeconomicregionalintegrationschemes.However,twopointsmustbemadeclearfromtheoutset.First,financialregionalismisnotasubstituteforfinancialreformsandothereffortsatthenationallevelaimedatdevelopingnationalfinancialsystems.Inotherwords,countriescannotoutsourcefinancialdevelopment.Inparticular,thedevelopmentofefficientnationalbankingsystemsisindispensableforthesuccessofregionalfinancialintegration.

Second, thegains fromfinancial integrationare likely tobeunevenacrosscoun-triesduetodifferencesininitialconditions.Relativelymoreadvancedcountriesarelikelytoreapmorebenefitsduetoeconomiesofscaleandscope(Venables1999).However, in the long run, thesedistributional effectswill be outweighedby thegainsfromintegrationandmaybemitigatedthroughappropriateregionalredistri-butionalarrangements.

Table �.�African capital markets: key characteristics

Country Levels 2004 or latest 10-year growth, 1995-2004 (or earliest 9 years)

Listed Cos.

Capitalization (m $)

Turnover Listed Cos.

Capitalization (m $)

Turnover Returns (US $)

2002 Index 2001-02 P/E

Algeria (2002) 3 145 8.8

Botswana 18 2548.3 2.3 4.1 20.4 40.2 41.4 96.1 13.0

Côte d’Ivoire 39 2082.6 2.7 2.3 9.2 2.7 27.4 58 9.9

Egypt 792 38515.9 17.3 0.6 16.9 -2.7 na na 17.1

Ghana 29 2643.6 3.2 4.3 4.8 6.7 33.3 56.9 5.9

Kenya 47 3891.0 8.2 -1.7 7.5 45.4 7.7 3.9 8.7

Malawi (2002) 8 107.0 13.8 na na na na na 4.2

Mauritius 41 2378.8 4.5 3.9 6.0 7.7 30.8 22.5 6.0

Morocco 52 25064.3 9.1 1.7 15.5 -14.9 na na 11.7

Namibia 13 442.3 4.8 2.7 8.9 11.7 -15.8 -44.5 5.4

Nigeria 207 14464.4 13.7 1.4 21.7 32.2 7.6 38 14.3

South Africa 403 455536.2 47.4 -4.5 4.9 22.0 27.9 5.7 11.2

Swaziland (2003) 5 172.0 0.0 2.3 -6.5 na na na 51.2

Tanzania (2002) 5 695.0 2.4 na na na na na 12.4

Tunisia 44 2641.1 9.2 5.4 -3.9 22.7 na na 8.3

Uganda (2002) 3 52.0 na na na na na na 15.2

Zambia (2002) 11 231.0 20.8 na na na 9.9 -17.1 5.8

Zimbabwe 79 1941.4 9.2 2.1 -0.5 2.0 -52.2 -59.9 47.1

Memorandum: comparison

UK 2865200 -14.2 -28.3

USA 16323500 -22.4 -31.6

Emerging markets 5143000 -7.5

Source: World Bank, 2005; UNDP, 2003. IMF, 2006.


Therearealreadysomesignsofinterestinregionalcapitalmarketsasillustratedbycross-listingsinsomemarkets,especiallyinSouthernAfrica.Thisisoftenawayforcompaniestoraisetheirvisibilityincountrieswheretheydobusiness(UNDP2003).Theconsolidationofcapitalmarketsattheregionallevelhasimportantadvantagesfordomesticandforeigninvestors.Financial integrationwillprovidemoreinvestmentopportunities, thus increasing the scope for portfolio diversification. The benefitsfromdiversificationattheregional levelarisefromthefactthatbusinesscyclesarenotperfectlycorrelatedacrossmemberStates.Asaresult,returnsoninvestmentwillexhibit lowervolatilityasdiversificationreducestheeffectsofcountry-specificeco-nomicshocksonoverallreturns.Byincreasingthenumberofplayersinthemarket,regionalizationofcapitalmarketswillalsoincreaseliquidity,whichisacriticalcondi-tionforthegrowthbenefitsfromfinancialintermediation.

Byexpandingthescopeofinvestmentopportunities,regionalcapitalmarketsattractmoreglobalinvestorsinterestedinthehigherreturnsthatAfricanmarketsofferbutwhoarecurrentlydiscouragedbytheilliquidityofnationalcapitalmarketsandtheexposuretosovereignrisk.Beyondportfoliodiversification,theopportunitytomaxi-mizereturnswillbeanattractivefeatureforforeigninvestors(Senbet2001).Indeed,theevidenceintable6.2showsthatAfricanstocksarehighlyprofitableandsubstan-tially undervalued.The returns on equity aremuchhigher inmanyAfrican stockmarketsthaninWesternmarketsandtheprice-earningsratiosaresignificantlybelowthoseobservedinmaturefinancialmarkets(SenbetandOtchere2006;Senbet2001).Thus,Africanmarketsexhibitsubstantialunexploitedprofitopportunities.

TheemergenceandconsolidationofregionalmarketsinAfricaallowfortheestablish-mentofthecruciallyneededsynergybetweencapitalmarketsandnationalbankingsystems.ItisonecomponentofastructuralapproachtoaddressingtheproblemofdysfunctionalintermediationintheAfricanbankingsystemdescribedearlier.DespiteeffortstoliberalizethefinancialsysteminAfricancountries,bankingsystemsarestillplaguedbypervasiveinefficiencies.Thehighinterestspreadsareonlyoneofthevis-iblesignsoflackofcompetition.Anotherformofdysfunctionalintermediationisthetendencyofbankstoaccumulategovernmentsecurities,thuscrowdingoutlendingtotheprivatesector.

Indeed,thelackofcompetitioninthebankingsectorcreatesperverseincentivesonthepartofbankstomaximizeprofitsbyinvestinginrisk-freegovernmentsecurities,chargingusuryratestothefewborrowersthataccesscredit,whilediscouragingsav-ings.Thedevelopmentofalternativenon-banksourcesoffinancethroughregionalfinancialmarketsisameanstoincreasingbothaccesstocapitalforfirmsandawayofpromotingefficiencyinthebankingsector,notablythroughdownwardpressureonlendinginterestrates.

AnotherbenefitfromthedevelopmentofregionalcapitalmarketsinAfricaisthatitwillincreasepressureoncountriestoacceleratethereformsoftheinstitutionalenvi-ronmentthatarecriticalforefficientfinancialintermediation.Regionalintegration

Regionalization of capital markets will also increase

liquidity, which is a critical condition for the growth benefits

from financial intermediation


canserveasa tool to lock innational reformsandenhance thecredibilityof suchreformsintheeyesofinvestors(CollierandGunning2000).Inaddition,financialregionalism accelerates exposure to and sharing of international and regional bestpracticesandstandardsinfinancialintermediation,especiallyinformation-disclosureproceduresandaccountingstandards.Thus,lessadvancedAfricancountrieswillben-efitfromspillovereffectsfrommoreadvancedcountriesintheareaoffinancialinfra-structure,paymentssystemsandregulation.

Regional financial integration contributes to overcoming one of the major con-straintstocapital-marketdevelopmentatthenationallevel.Thisisthelackofcapac-itytomanageoperationsandtoregulatemarkets.Thiscapacityconstraintmustbeaddressedthroughjointeffortsbetweengovernmentsandtheirdevelopmentpartners(seebox6.1).

6.3 Managing capital flowsGiventheincreasingpaceoffinancialglobalizationandtheimpliedhigherrisksoffinancialcrisis,Africancountriesneedtoestablishprudentialregulationmechanismsforminimizingexposuretosuchrisks.Indeed,whileAfricancountriesneedtoattractmoreexternalresources,theyalsoneedtoprotecttheireconomiesfromtheadverseeffectsofunregulatedcapitalflows.

Benefits of capital management for African countries

Box �.�ECA’s contribution to capacity building for capital market development

To alleviate the capacity constraint in capital market development, ECA launched a capital mar-

kets development project in 2002. The main objectives are to:

• Strengthen the capacity of African capital market regulators and operators;

• Strengthen the capacity of African capital markets to achieve regional integration;

• Enhance the capacity of capital market associations to promote regional integration;

and

• Increase awareness of African countries of the role of capital markets in national devel-

opment and poverty reduction.

The main activities are training workshops for market operators and regulators. In addition,

the project organizes expert meetings and conferences that bring researchers, capital-market

practitioners, and policymakers together to assess progress and draw policy recommendations

on the way forward in the area of capital market development at national and regional levels.

African countries need to attract more

external resources and protect their

economies from the adverse effects of

unregulated capital flows


AnumberofreasonscanbeadvancedforactivistprudentialregulationofcapitalflowsandexchangeratesinAfricancountries.First,Africancountriesneedtoadoptstrate-giesthataimattiltingthestructureofcapitalflowsinfavouroflong-termcapital,2asameansofacceleratingeconomicgrowthandstructuraltransformationthroughdiversification of economic activity. They also need to design capital managementstrategies that encourage more green-field investments to promote new activities,especiallyexport-orientedinvestments inthemanufacturingandservicesectors.Inthatsense,capitalmanagementcanserveasa tool forresourceallocation,apolicythatwassuccessfullyusedbyAsiancountries(e.g.,SouthKorea).Atthesametime,byadoptingpreferentialtreatmentforlong-termcapital,Africancountriescanminimizetheriskof instabilityas ithasbeendemonstrated inothercountries suchasChile(Epstein,Grabel,andJomo,2005;LeFortandLehman2003).

ThesecondreasonforadoptingactivecapitalmanagementpoliciesinAfricaisthatAfricancountriesneedtominimizeexchangeratevolatilityarisingfrominstabilityofcapitalinflowsandoutflows.Highvolatilityoftheexchangerateraisesuncertainty,which discourages trade and long-term investment. Capital management policiescanalsopreventexcessiveappreciationordepreciationoftheexchangerate.Exces-sive appreciationof thenational currencyhasdetrimental effectson the economy,includinglossofoutputandexportcompetitiveness.Firmfailuresordrasticdropsincapacityutilizationduetolossofexportmarketscarryhighcostsintermsofemploy-ment.InSouthAfrica,forexample,episodesofappreciationoftherandhavebeenaccompaniedbydownsizingintheexport-orientedsectorssuchasminingandwinery,whichhavecausedsubstantiallossesinemploymentandfirmprofits.Anygainsfromappreciationintermsofcheaperimportsareoftenoutweighedbytheeffectsofthelossofexportcompetitiveness.

The third reason for active management of capital flows and exchange rates is toinsulatethecurrentaccountfromtheeffectsoffinancialmarketvolatility.Oneofthestrategiesforachievingthisobjectiveistoestablishadualexchangeratesystemcon-sistingofdifferentialtreatmentforfinancialandcurrent-accounttransactions.Thisstrategyhasshownsomedegreeofeffectiveness,atleastintheshortrun,inthecaseofSouthAfrica(seebox6.2).Oneadvantageofthistechniqueisthatitallowsfullcontrolforthemonetaryauthorityindeterminingwhenandhowlongtoimplementthemeasure.

Thefourthmotivationisthattheintegrationofcapitalmarketscarriesimportantcon-straintsonmacroeconomicpolicychoicesatthenationallevel.Inparticular,coun-triesarefacedwithaclassicpolicytrilemma.Inthecontextof integratedfinancialmarkets,itisimpossibleforacountrytopursuethefollowingthreemajorgoalsofmonetary policy independently and at the same time (Obstfeld, Shambaugh, andTaylor2005):

2 Evidencesuggeststhatappropriatecapital-controlmeasurescanalterthecompositionofcapitalflowsevenwhentheycannotaffectthevolumeofflows(MontielandReinhart1999;Ahmedetal.,2005).

By adopting preferential

treatment for long-term capital, African

countries can minimize the risk of

instability


• Anautonomousmonetarypolicyaimedatachievingadomesticgoalsuchasaninflationtarget,anemploymenttargetoranyothertarget;

• Maintainingafixedexchangerate;and• Freecapitalmobility.

Policymakersmustchoosetwoofthethreegoals.Ifacountryiscommittedtopricestability,saybyadheringtoaninflationtarget,thenapolicyoffreecapitalmobilitywould require allowing unstrained fluctuation in the exchange rate, which wouldhavecostlyrealeffectsontheeconomy.Capitalmanagementcanallowacountrytomaintainmonetarypolicyautonomy,notablybymaintainingawedgebetweenthedomesticinterestratesandforeigninterestrates.Thus,capitalcontrolsenableAfri-cancountriestopreservetheirabilitytousemonetarypolicyasatoolforpromotinganationalgrowthstrategy,especiallybyboostingdomesticinvestmentinaneraofglobalfinancialintegration.

Thefifth reason for active capitalmanagement is to reduce the likelihoodofdebtcrises.Inparticular,controlsofcapital-accounttransactionsallowAfricancountriestominimizetheriskassociatedwithdomesticprivateactorsborrowinginforeigncur-rency.Moreover,bystabilizingtheexchangerate,capitalmanagementreducestheriskofexcessivedevaluationofthenationalcurrency,whichwouldraisethecostofdebtservicing.Furthermore,Africancountriesneedtominimizetheriskoffinancialcrisisthroughcontrolsofcapitalinflowsaimedespeciallyatlengtheningthedebtmaturity(Calvo2001;FosuandSenbet2001).GiventhehighdebtburdenfacedbyAfricancountries,itisessentialtolimittherelianceonshort-termdebtinstrumentsinordertoensuresolvency.

Finally,capitalmanagementstrategiesareneededtoretainsavingsinAfricancoun-tries,especiallybypreventingcapitalflight.Africancountrieshaveexperiencedheavyfinancialhaemorrhage,whichrobsthecontinentofvaluableresourcesthatcouldbe

Box �.�South African experience with capital and exchange rate management

The South African capital and exchange rate regimes have undergone five major phases since

the 1960s (Aron and others 2000). Until 1978, the rand was pegged alternatively to the dollar and

the pound, and capital account transactions were strictly controlled. In 1979, the Government

adopted a dual exchange rate system, whereby current account transactions were executed at

a controlled float exchange rate, the commercial rand, while equity capital was transacted at a

freely floating exchange rate, the financial rand. The system was abolished under a controlled

float system in 1983 and reintroduced in 1985, lasting until 1995. The exchange rate regime was

unified again in 1995 during a systematic move toward a market-based exchange rate system.

Foreign exchange and capital controls were motivated by the need to retain domestic savings,

prevent the loss of foreign exchange through transfer of assets abroad by residents, and to en-

courage repatriation of capital. The evidence suggests that the dual exchange rate system, to

some extent, insulated current accounts from the volatility of the rand (Farell 2001).

African countries should limit the reliance

on short-term debt instruments


usedfordomesticinvestment.Africaasaregionhasthehighestratioofprivateassetsheldabroad,comparedtootherdevelopingregions(Collieret al.,2001).Sub-SaharanAfricaisanetcreditortotherestoftheworldinthesensethatprivateassetsheldabroadexceedtheregion’sdebtvis-à-vistherestoftheworld(NdikumanaandBoyce2003;BoyceandNdikumana2001).Consequently,theagendaforincreasingfinan-cialresourcesinAfricancountriesmustincludestrategiesforcurbingandreversingcapitalflight.

TheabilityofAfricancountriestotakeadvantageofthesebenefitsofcapitalmanage-mentdependscriticallyontheircapacitytoundertakeeffectivecapitalflowmonitor-ingandcontrols.Thiscapacityiscurrentlylimitedinmanycountries.Therefore,withthe support of development partners, African countries need to invest in capacitybuildingforcapitalmanagement,includingbothskillsacquisitionandimprovementsoftechnologicalcapacity.

Strategies for managing capital flows and monitoring and addressing financial risk

It isdifficult todeterminewhat typesofcontrolsand incentive structuresvis-à-viscapitalflowsshouldbeimplementedinagivencountryatagiventime.Theappro-priateregimemustbedeterminedbasedonacountry’sparticulareconomiccircum-stancesandtheissuesfacedattheparticularmoment.Forexample,emergingmarketeconomiesaremoreexposedtofinancialrisksbecauseoftheirhigheropennesscom-paredtootherdevelopingcountries.TheimplicationisthatAfricancountrieswithmoreopenfinancialsystems,especiallythosewithstockmarkets,haveanurgentneedforcapitalcontrolstopreventfinancialfragility.However,allAfricancountriesneedtodesignstrategiesforcapitalmanagementforthepurposeofinfluencingthetermstructureinfavouroflong-termcapital,toinfluencesectoralallocationofcapital,andtominimizeexchangerateinstability.

Foreach typeof risk, there shouldbeaparticular setof instruments toprevent itandminimizeitseffectsontheeconomy.ThefirsttaskisforeachAfricancountrytoestablishamonitoringmechanismthatidentifiesthevarioustypesofrisksassociatedwithfinancialintegration.Then,eachcountrycanidentifythecorrespondingwarn-ingindicatorsandpossibletoolsthatmaybeusedtoaddresstheserisks.

There are threemain categoriesof risk: currency risk,flight risk, and fragility risk(table6.3).Foreach typeof risk,a seriesofwarning indicators (or trip wires)andappropriatepolicyinterventions(orspeed bumps)willbedesignedtopreventtheriskoffinancialfragility(Grabel2004).Itisimportantforeachcountrytodesignthesepolicytoolstobeflexibleenoughtoallowadaptationtochangesinthecountry’smac-roeconomicandfinancialcircumstances.

Capital management strategies need to be complemented with domestic financialregulationinordertominimizetheriskoffinancialdistress(Senbet2001).Inparticu-


lar,Africancountriesneedtodevelopsoundbankingregulationstoenforceadequatebankcapitalization,promotecompetition,ensurespeedyandtransparentreportingonthehealthofindividualfinancialinstitutions,andpreventcontagionofbankingdistress throughtimelybankrestructuringbycapitalization,merger,or liquidation(KaneandRice2001).BuildingsounddomesticbankingsystemswillenhanceAfri-ca’sabilitytosustainshockstointernationalcapitalflows.

OneimportantconstrainttoeffectivecapitalmanagementandfinancialregulationinAfricancountriesisthelackofefficientmonitoringofcapitalflows.Africancountries,withthesupportoftheirdevelopmentpartners,needtomodernizetheirstatisticalframeworksfortrackingcapitalflows.Thiswillallowthemtoestablishspecificwarn-ingindicatorsandtodesigntheappropriatepolicyinterventionsforminimizingtherisksoffinancialinstability.

Table �.�Financial risks, and examples of warning signs and policy responses

Financial risks Warning signs or “trip wires” Policy responses or “speed bumps”: targeted and gradual changes in policy based on warning signs

Currency risk

Investors flee the national

currency, inducing sudden and

dramatic depreciation.

Ratio of official reserves to short-

term external debt;

Ratio of official reserves to

current account deficit;

- Limit the fluctuations in the

value of the domestic currency

- Restrict currency convertibility

Flight risk

Portfolio investment

Portfolio investors sell off a

country’s assets, causing

reduction in asset prices and

increasing the cost of new

finance.

Ratio of accumulated foreign-

portfolio investment to gross

equity-market capitalization

or gross domestic-capital

formation;

- Controls on inflows

- Controls on outflows

Lenders

Lenders call loans or stop

disbursing new loans.

Ratio of official reserves to

foreign-denominated debt;

- Stop new inflows of foreign

loans (public and private)

- Especially discourage foreign

borrowing by private agents

Fragility risk

Locational mismatch:

Proliferation of debts in foreign

currency.

Ratio of foreign currency

denominated debt to domestic

currency denominated debt;

- Impose ceilings and surcharges

on foreign-currency denominated

financing

Maturity mismatch:

Proliferation of long-term debts

financed with short-term credit.

Ratio of short-term debt to long-

term debt.

Impose ceilings and surcharges

on short-term borrowing and

long-term debt rollovers

Source: Grabel, 2004.

Sound domestic banking

systems will enhance Africa’s ability to sustain

shocks to international capital

flows


6.4 Policy RecommendationsThe debates on capital flows and development financing should focus on policiesandstrategiesaimedatincreasingthevolumeofcapitalflows,enhancingabsorptioncapacity–includingpoliciestoimprovetheefficiencyofthefinancialsystem–,tilt-ingthebalanceinfavouroflong-termcapital,increasingtheimpactofforeigncapitalondiversificationandtransformation,raisingtheemploymenteffectsandtheoverallgrowthimpactofforeigncapital.Thefollowingpoliciesshouldfigureprominentlyonthenationaldevelopmentpolicyagenda:

Improving the institutional and regulatory environment to promote financial deepening

Theability ofAfrican countries to absorb and take full advantageof capital flowsdepends on the depth and efficiency of their financial systems.To increase finan-cialdeepening,thefinancialreformsinitiatedoverthepastthreedecadesneedtobecomplementedbymorevigorousreformsoftheregulatoryandlegalenvironment,toremovedistortionsandincreaseefficiencyinthefinancialsystem.Thesereformsmustfocusonincreasingcompetitioninthebankingsystem,therangeofsavingsinstru-ments and the returnson savings, andonencouragingdevelopmentof alternativetiersofbankinginstitutionsthataremoreequippedtooperateatasmallerscaleintheruralandinformalsectors.Thedevelopmentofaliquidbondmarketisalsoessentialtodeepeningofthefinancialsystem.

Promoting regional financial integration

RegionalfinancialintegrationallowsAfricancountriestoovercomeconstraintsasso-ciatedwith the small size of their domesticmarkets. Integration allows those thatdonothavenationalcapitalmarketstotakeadvantageofregionalmarketstoraisefundsforinvestment.Regionalfinancialintegrationwillalsoenablethecontinentasawholetoattractmoreforeigncapital.Therefore,Africangovernmentsneedtosupportanddemonstrateeffectivecommitment tonewandexisting initiatives for regionalintegrationoftradeandfinance.

Encouraging investment-oriented remittances

Workers’remittancesplayanimportantroleinincreasingaccesstobasicneedsfortherecipienthouseholds.However,giventheobservedincreasingvolumeofremittances,itisnecessarytodesignstrategiestodirectthesefundsintoinvestmenttominimizetheinflationaryeffectsofapotentialremittance-ledconsumptionboom,butalsoandmostimportantlytomaximizetheeffectsoneconomicgrowththroughcapitalaccu-mulation.Financialinstitutionsneedtoplayanimportantroleindesigninginvest-ment instruments to attract remittances. This alleviates information asymmetries


facedbynon-residentinvestors,whichtendtodiscouragelong-terminvestment.Dis-cussionsbetweenbanksandAfricansintheDiasporamaygeneratesuggestionsfornewandcreativemeansofchannelingremittancesintolong-terminvestment.Africangovernmentsalsoneedtodesignschemesthatexplicitlytargetremittances,suchasfacilitatingaccessto landfornon-residents,eitherthroughpurchasesorfixed-termleasingarrangements.

Establishing systematic monitoring of capital flows to minimize instability

Oneoftheobjectivesoffinancialpolicyistopreventfinancialfragilityespeciallybyshieldingthefinancialsystemandtherealsectorfromtheadverseeffectsofvolatilityofcapitalflows.EachAfricancountryneedstodesignmechanismsformonitoringtheriskofinstabilityandtoestablishtheappropriatepolicyresponsestoimpendinginstability.Inotherwords,eachcountrymustidentifyanumberofwarningindica-torstogaugetheriskofinstabilityandestablishtheappropriatemeasurestopreventinstability.Policiesforregulatingcapitalflowsmustbeconceivedasanintegralpartofthenationaleconomicpolicyframeworkaimedatachievingmacroeconomicstabilityandimprovingresourceallocationthroughouttheeconomy.

�0�Absorption Capacity and Management Of Capital Flows

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African countries continue to face perennial shortages of resources to finance public and private investment. This constrains their ability to accelerate growth, seen as key to reducing poverty. Resource shortages limit the ability of governments to undertake public expenditure in infrastructure and social services needed to boost economic demand, encourage private sector activity, and sustain high levels of economic growth.

To fill the financing gaps and accelerate growth, African countries need to mobilize more domestic and external financial resources. The fact is, official development assistance (ODA) to Africa has grown only in nominal terms, and the resources received over the last decade - excluding emergency aid and debt relief - increased only marginally. But while countries on the continent still depend heavily on aid for development, it is encouraging to note that they are attracting more private capital. Indeed, net flows of private capital have risen, as net official flows have declined and turned negative over the past years.

However, private capital flows remain unequally distributed across the continent, with oil-rich countries taking the lion’s share. The concentration of foreign investment in the extractive industries perpetuates Africa’s dependence on primary commodities, and exposes the continent to the adverse effects of fluctuations in international commodity prices. For this reason, African must attract more foreign capital, and establish incentive mechanisms to encourage a more diversified allocation of capital across sectors. It is also urgent to monitor and manage capital flows effectively so as to minimize the risks of financial instability.

Economic Report on Africa (ERA 2006) debates capital flows in development financing and examines how they can help African countries to accelerate growth and reduce poverty. The report’s objective is to shed light on whether and to what extent more and better-managed capital flows will help Africa achieve its development goals.

Economic Commission for Africa

Econom

ic Com

mission for A

frica Econom

ic Rep

ort on Africa 2006

: Cap

ital Flows and

Develop

ment Financing in A

frica

ISBN: 92-1-125103-6Sales Number: E.06.II.K.3

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