Financing Developmetn in Africa

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FINANCING DEVELOPMETN IN AFRICA

Revised Version

September 2000

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(Paper Prepared for Economic Commission for Africa, Addis Ababa, Ethiopia)

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Alemayehu Geda

Institute of Social Studies (the Hague)

and KIPPRA (Nairobi)

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TABLE OF CONTENTS

I. An Overview

II Recent Economic Performance And Future Challenges: The Implication ForFinancing Development

III Official Development Assistance

IV Foreign Direct Investment And Other Private Capital Flows

Foreign Direct Investment (FDI)

Other Private Capital Flows

V Domestic Resource Mobilization
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VI Issues Of Capital Flight

VIIAfricas External Debt

VIII The New Financial Architecture And Its Implication

IX POLICY IMPLICATIONS

APPENDIX I: DATA

APPENDIX 2 TECHNICAL NOTE

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I. An Overview

This study is concerned with issues of financing development in Africa. The analysiscommences by organizing major possible sources of financing development in the continentin to seven sub-sections of the study. First, the paper briefly reviews the recent growthtrend and the daunting task of reducing poverty in the years to come. This is done byexamining both the growth performance of the continent, the challenges of reducingpoverty, as well as how this growth might be financed. The implications for financing (bothfrom internal and external sources), drawn from this analysis, are pursed at length in the

rest of the paper.

The brief overview of issues of poverty, growth and financing requirements sets the scenefor the rest of the paper. That is, once the enormity of the task of reducing poverty and itshuge resources implication is drawn, the next stage of the analysis is executed under twobroad themes:

What is the nature and source of such finance (ODA, FDI and Other Capital flows,Domestic resource mobilization) and,

The financing implication of addressing finance related problems such as issues ofCapital flight, External Debt, and the International Financial Architecture.

1. The rest of the study is organized as follows. Section three examines issue of ODAboth from theoretical and empirical perspective. Section four deals with foreigndirect investment and other capital flows such as portfolio, banks, equity and bonds.Section five examines the role of domestic financing. Section six deals with the issueof capital flight and the implication of its reversal for financing development. In asimilar way, section seven examines the issue of debt and the possible effect ofaddressing it for financing development. The paper concludes by briefly examining
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the implications of the new (international) financial architecture for developingcountries such as those in Africa. Finally, an attempt to draw short to medium termpolicy and research implications is made.

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II Recent Economic Performance And Future Challenges:The Implication For Financing Development

1. In sharp contrast to 1970s and 1980s, the mid-1990s witnessed a growingoptimism about Africas economic future. Real GDP growth of more than 4percent, exceeding the rapid population growth, compared to nearly 1percent growth in the first half of the 1990s, the doubling of the growth ofexports, from around 4 percent in the mid 1990s to nearly 8 percent in thesecond half of the 1990s (See Appendix I), growing emphasis on appropriatepolicy reforms and the new political discourse of the African renaissance,

associated with political reforms, may partly explains this optimism.2. Such optimism was not fully embraced by African policy makers,

governments and the academics at large, however. This is because theenormity of the challenge facing the continent is apparent from the grimsocial data they are confronted with. This is in particular true of poverty inthe continent. By the end of the 1990s even the macro indicators started toslide down. The recovery in the per capita real GDP growth that startedfrom -2.9 percent in 1992 and picked to 2.6 percent in 1996 has decelerated to0.4 percent in 1998 (See Table 1.2 in Appendix I). Exports as the share ofGDP that rose form 27 percent in 1990 to 30 percent in 1995 started to slideto 27 percent in 1998 (See Table 2.2 in Appendix I). This unhealthy trend is

rather vivid when one looks at the social data.3. According to ECAs study, which is based on household surveys of 20

countries that constitute 60 percent of the continents population and 76

percent of its GDP, the continent is characterized by (a) a high degree ofinequality of income (with a Gini coefficient 0.44). The highest inequality isfund in South Africa and Kenya (58 percent) and the lowest in Egypt (32percent); similarly the bottom 20 percent of the population received only 5percent of the income (the top 20 percent getting 50 percent); (b) about 44percent of the population is leaving below the poverty line of $39 per personper month. This incidence being 22 percent and 51 percent in North andSub-Saharan Africa, respectively (the highest incidence is found in Guinea-

Bissau, 70 percent, and the lowest, 15 percent, in Algeria). In gross terms theaverage income of the poor for the continent as a whole is found to be only 83US cents per person per day (this figure being $1.5 for North Africa and 67US cents for Sub-Saharan Africa). In general the average incidence ofpoverty for the 32 sample countries is 46.7 percent; the poverty gap being27.3 percent (ECA 1999).

4. There is noticeable regional variation in the state of poverty. North Africancountries are in a better shape having an average score of 21.4 percent and


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5.5 percent for incidence of poverty and poverty gap, respectively. WestAfrican countries follow this, with a corresponding value of 48.6 percent and18.8 percent, respectively. Eastern Africa countries have registered the thirdrank with incidence of poverty of 50.7 percent and poverty gap of 18.3percent. Although the sample from Central Africa has only two countries, it

has the most severe state of povertya head count ratio of 58 percent with apoverty gap of 29 percent. This is followed by Southern Africa with incidenceof 57.5 percent and a poverty gap of 27 percent.

5. Looking the issue in a broader perspective, the main conclusion that can bedrawn from evaluation of recent economic performance and sustainability inthe continent, based on ECAs African Economic Report (ECA 1999), is thatthere is a clear difference between performance and sustainability. The studynoted only three African countries (constituting about 6 percent of thepopulation) are found to be good enough to sustain growth and development.Twelve countries (having nearly 25 percent of the population) are also foundin the good category. Thus, it is reasonable to conclude that African

countries in general are not in a good shape in terms of overall performanceand, in particular, its sustainability. This underscores the need to conduct anin-depth study of the growth process in the continent so as to understandconstraints to growth as well as the sustainability of growth attained.

6. In fact, the second half of the 1990s witnessed a proliferation of what canloosely be termed as growth literature that focused on Africa. These studies

range from those that attribute the slow growth to geographical and relatedfactors (Bloom and Sachs 1998), as well as prevalence of social tension-cum-external vulnerability (Rodrik 1998, Easterly and Levin 1997) to micro-basedexplanation that are blamed to hinder proper market operation by makingeconomic activities risky and costly (Collier and Gunning 1999). Theproliferation of this literature, as aptly noted by Azam and others (1999),although does not provide hard and fast rule to revitalized growth, suggestsimportant lessons for the future. After reviewing this literature, Azam andothers (1999) stressed the importance of addressing structural problems suchas lack of social capital and deficient political institutions.

7. The discussion above clearly shows the enormity of the challenge facing thecontinent. The relevant question is what would it take to address thesechallenges, and most importantly, what is its resource implication. In orderto answer these questions this paper has followed two approaches. In the firstapproach, the level of investment is compared with the level of domesticsaving to arrive at the trend of the current level of the resource gap(financing requirement) from a macro perspective. In the second part thechallenge of reducing poverty is converted in to its growth rate equivalentand the financing needed thereof. This will be based on the scenario drawnby Amoako and Ali (1998).

8. For Sub-Saharan Africa (SSA) excluding S. Africa, the share of investmentin GDP has increased from 15.8 percent in 1990 to 18.8 and 19.5 percent in1995 and 1998, respectively. This figure is relatively high for the NorthAfrica region that had a ratio of 28.2 percent in 1990, 23.1 percent in 1995


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and 22.7 percent in 1998. Although these figures are higher than the ones forSSA, they do show a declining trend. (See Tables 2.3 in Appendix I fordetails). East, Southern and West African regions broadly followed the SSAtrend. Although the trend in SSA and the actual ratio of North Africa aregood, investment in both regions is way below the level of domestic resources.

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Gross domestic saving in SSA (excluding South Africa) has declined from17.4 percent recorded in 1990 to 13.5 percent in 1995 and picked up again to17.2 percent in 1996 only to decline to 12.6 percent in 1998. Thecorresponding figures for North Africa are 21.9, 18.1 and 18.9 percent in1990, 1995 and 1998, respectively. These figures are far below the 30 pluspercent domestic saving rate observed in newly industrializing countries ofEast Asia. What is worrisome in Africa is not only the low level of theabsolute figures but also their oscillating and, more often, declining trend(See Tables 2.4 in Appendix I for details).

10.A simple computation of resource gap following the above two paragraphshows that the external finance requirement in SSA (excluding S. Africa),

which had been negligible in the early 1990 rose to 5 and 7 percent of GDP in1995 and 1998, respectively. The Corresponding figure for North Africastands at 5 and 4 percent in 1995 and 1998, respectively. Taking the GDP ofthe regions in 1998, the 1998 ratios indicate an annual external resource gapsof around 20 billions of US$ for Africa. Although these figures point to a veryhigh level of dependence on external finance, the needs of Africa are muchhigher when the continents objective of reducing poverty is taken on board

(See Tables 2.3 and 2.4 in Appendix I for details).11.Apart from such simple computation, there had also been various attempts to

estimate the resource requirement of the continent. Almost all such studiesare based on the typical Harrod-Dommar set up and usually come up withreasonable estimates. Recently, Easterly (1997) has noted various pitfalls ofthis approach. However, using some regression results of the Easterly type

for a sample of African countries, Amoako and Ali (1998) argue that stillsensible projections can be made using this approach. In the paragraphbelow we have reported the result of projection that is made by Amoako andAli (1998). We have used this estimate for various reasons. First, they haveattempted to address some of Easterlys concerns in the African context;second, they have set up the average and the best performance by taking theactual experience of African countries (such as efficiency of capital use inUganda). Finally, their projection for the period 20002005 embraces theperiod under analysis.

12.Amoako and Alis (1998) review of the literature on estimates of expectedtransfers to Africa shows that over the period 1986-92 an annual inflow ofUS$ 9 billion over and above the previous level of ODA were expected in thecontext of UN Program ofAction for Africas Economic Recovery andDevelopment (UN-PAIRED). This had failed and a new initiative called UNAgenda for Development of Africa (UN-NADAF) estimated a minimum ofUS$ 30 billion in net ODA in 1992; moreover, this ODA is stipulated to growby 4 percent in real terms. Although specific estimates are not explicitly


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made such requirement is also noted in the context of the CopenhagenDeclaration. Estimates of resource needs are also made by ADB (1995) andECA (1993) (See Amoako and Ali 1998).

13.After reviewing such estimates Amoako and Ali (1998) came up with theirown estimates. For the purpose of estimation they have set the objective of

reducing poverty by half by 2015. Using a general measure of poverty andpopulation growth rate, such an objective can be attained if GDP could growby annual figure of 8 percent (World Bank and others 2000 put this at 7percent). This is combined with an average ICOR (7.8) for the sample ofcountries in their studies. It is further assumed that each country willapproach the most efficient one (Uganda with ICOR of 2.5) at the end of theplanning horizon. They have also assumed an initial domestic savings rate of16.1 (observed in the 1990s and noted above) and that this rate is assumed toincrease to the feasible level of 23.5 percent by the year 2015.

14.On the basis of the above assumptions they have reported estimates ofresource requirement for eight countries in their sample and for SSA

(including and excluding S. Africa and Nigeria). This result is given in theSummary table below. The result shows a trend of graduating from aiddependency. This, however, is the result of the authors assumption of rising

level of savings and efficiency of capital use over the planning horizon. Thisfigure will be much higher if World Bank and others (2000) estimated costof combating HIV/AIDS (estimated to be 1 to 2 percent of GDP) is factoredin. This has the strait foreword implication for policy. One way to minimizeexternal finance requirement and meet the objective of reducing poverty israising domestic saving and efficiency of capital use.

External Resource Requirement (Percentage of GDP, Annual Average)

1998 1999-2000 2001-2005 2006-2010 2011-2015

SSA 52.4 46.8 32.1 10.0 -7.1

SSA1 48.4 40.0 26.1 8.2 -7.1

SSA2 55.3 47.3 30.4 10.1 -6.1

Source: Amoako and Ali(1998).

Note: SSA1=SSA excluding S. Africa, and SSA2=SSA excluding S. Africa and

Nigeria

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III Official Development Assistance


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15.The analysis in section II shows not only the huge external financerequirement of Africa but also the frustration of various initiatives aimed ateffecting such transfers to the continent. This section examines the flow ofODA and their future contributions in financing development in Africa. Thisis done by examining both its current trend as well as its theoretical and

empirical determinants.16.Relative to donor GDP, net disbursement of ODA have dropped almost 30percent percent in real terms (OConnell and Soludo cited in World Bank2000). ODA is also increasingly shifting in composition (towardshumanitarian assistances) and facing competition from Eastern Europe. Ingeneral, net transfer per capita has fallen sharply form $32 in 1990 to $19 in1998 mainly because of Africas less strategic significances and donorfatigues. However, this net transfer itself is largely being offset by the termsof trade loss. Cumulative terms of trade loss for SSA (excluding S. Africa)between 1970-97 represent a staggering level of 120 percent of GDP (WorldBank and others 2000). For Sub-Saharan Africa (excluding South Africa) the

recent trend shows that net ODA as the share of the recipients GDP has been9.4 , 12.1 percent in 1990 and 1995, respectively, and declined to 7 percent in1997. The corresponding figure for the whole of Africa were 5.5, 4.4 and 3.3percent in 1990, 1995 and 1997, respectively (See Table 3.1 in Appendix I).

17.Notwithstanding this recent trend, official capital flows represent animportant component of financial flows to African countries. Both thetheoretical and empirical literature about such flows attempts to answerwhat determines official capital flows to the South? and why such flows?

The search for an answer to these questions leads one to different, sometimesconflicting, theoretical explanations. Thus, one school of thought maintainsthat official capital flows are determined by the economic and geo-politicalinterests of donors. Indeed, this suggestion finds support in a number ofstudies (See, for example, Mikesell, 1968; OECD, 1985; Mosley, 1985;Ruttan, 1992; McGllivary and White, 1993). Another major explanation foraid flows relates tohumanitarian or developmental considerations (studiessupporting this viewpoint include Streeten, 1976, cited in Gasper 1992;Riddell, 1987; and the aid as a public good literature of Mosley, 1985;

Dudley and Montmarquette, 1976; and Frey, 1984). A number of studiesinvestigate one or both of these explanations empirically. Indeed, Beenstock(1989), Mosley (1985), and White and McGllivary (1992, 1993) have gone sofar as to portray these empirically based studies as representing a distinctapproach, devoid of theory. However, we prefer to view these simply asempirical manifestations of the theoretical explanations noted above.

18.In one of the earliest studies, McKinley and Little (1979) develop a recipientneed and donor interest model which sets out to examine the humanitarian

versus national (donor) security explanations for aid flows. According tothis recipient need model, aid should be allocated in proportion to the

economic and welfare needs of the recipient, otherwise, such aid is simplyfulfilling the donors interests, either as a commitment, or as leverage

strategy. After discussing, at length, how these propositions might be


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operationalized, McKinley and Little conclude that the recipient needargument is likely to be a secondary one. However, while this paper focuseson bilateral issues, syndicated efforts are more widely followed, today, byinternational and regional organizations in their effort to realize donorinterests. In this study, we do not examine this phenomenon. However, we

would refer the interested reader to Anyadike-Danes and Anyadike-Danes(1992) review of evidence relating to European Community (EC) aid to theAfrican, Caribbean and Pacific (ACP) region. They conclude that aid to ACPcountries is strongly associated with the Pre-Lome association.

19.Moreover, most econometric studies of recipient need models are not robusteither. Having surveyed such models, White and McGillivray (1993) notethat the separate estimation of recipient need/donor interest models suffersfrom specification error due to the omission of relevant variables, which areusually not orthogonal (i.e., correlated with all included variables). This, theysuggest, leads to OLS estimates with bias. They argue that this problem isinherent in the very methodology of this approach. White and McGillivray

illustrate how different results may be obtained if one allows for correction ofsuch specification errors (White and McGillivray, 1993: 36-41). To this, onemight add the observation that such time series studies might as well sufferfrom spurious (non-sense) regression.

20.In a similar study of what determines total aid volumes, Beenstock (1980)starts from the assumption that political factors affect the geographicaldistribution and not the total volume of aid. He points out that, whatever theobjective of aid, its volume is constrained by GNP (or GNP per capita), thebalance of payment, levels of unemployment and the size of net budgetsurplus of the donor state. At a statistical level, he found all signs as expectedand, with the exception of the budget term, all are significant at a 5 per centsignificance level (Beenstock, 1980:142). Using a time trend, Beenstocksuggested a tendency for ODA to increase over time. Although Beenstocks

analysis focuses on the supply side of the issue, his analysis does not explainthe central reason for aid. Further, it is quite difficult to envisage a situationwhere politics is used solely in allocation, and not also in the determination oftotal supply.

21.A summary of the findings of a recent survey of the literature on allocation ofaid, undertaken by White and McGillivray (1992, 1993) can throw light onthe evidence from the existing body of knowledge. White and McGillivrayadopt two broad classification schemes. Firstly,descriptive measures, whichare evaluative in their nature, while measuring donor performance (Whiteand McGillivray, 1992:1). And, secondly, explanatory studies which tracetheir origin to political-economy theories, and base their explanation onpolitical, strategic, commercial and (albeit often begrudgingly)

humanitarian motives (White and McGillivray, 1993:2). These surveys raisea number of important issues. They conclude that models shouldapproximate the actual practice of aid determination process. Perhaps moreimportantly, these surveys also highlight how aid allocation is the outcome ofa bureaucratic decision making process, economic, political and other


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relations between the donor and the recipient (White and McGillivray,1993:68). We have empirically examined this line of thought in the Africancontext.

22.Although the results of this empirical analysis are not robust and needfurther research, because of the relatively short time series data used,

nevertheless they do provide a useful second best indicator of thedeterminants of official flows to Africa. In any case, the use of resultsobtained in the context of this study, no matter how flawed, is preferable tousing spurious results arising from existing literature. Besides, a regionallybased estimation for Africa is not available. In relation to the actual results ofthese estimations, these may be summed up as follows. Firstly, there exists along-run equilibrium relationship between Africas relative economicperformance and flows of capital to that continent. Secondly, humanitarianand developmental considerations are found to be largely negligible ininfluencing such flows to Africa. This result would tend to lend support tothe apparently obvious notion that capital flows are associated with the level

of development, and particularly involvement in trade. Indeed, this remainstrue even when these flows chiefly comprise aid (See Appendix II, TechnicalAppendix 3.1 for detail).

23.The major short to medium policy implication of this result isstraightforward. Instead of expecting aid from pure humanitarianconsideration, identifying the geo-political and strategic interest of donorsand acting on them is crucial. Moreover, growth oriented polices might gohand in hand with increased flows. On the second point understanding thebureaucratic/budgetary process of donors while handling aid is crucial forinfluencing flows to the continent. This conclusion shouldnt deter countries

from vigorously raising external resources through the customary channelssuch those initiatives outlined at the beginning of this section (See Section IXfor detail).

24.Once such flows are secured the next most important task is to enhance aideffectiveness and design ways of graduating from aid-dependency. The mainculprit, apart form terms of trade loss, behind aid effectiveness in Africa isthe extreme low level of growth which is predominately explained by hugesetback in (investment) productivity. According to the World Bank andothers (2000) the ICOR in Africa is half that in Asia in 1970-97, thisinvestment productivity decelerated from 25 to 5 percent (and GDP growthfrom 5 to 1 percent) from early 1970s to now. It is curious to note that thegrowth recovery since 1994 has relied on productivity gains rather than anincrease in investment as such. Thus this failure in growth/productivitycombined with the oil price shock and terms of trade loss led to sharpincrease in Aid, a cumulative transfer of 178 percent GDP (1970-97). But theincrease after 1970-73 (125 percent of GDP) was a little more than the termsof trade loss. Moreover, by 1997 external debt equals to GDP for mostcountries, see section VI below (World Bank and Others 2000).

25.The sharp increase in aid may also have long run detrimental effectsdepending on the initial institutional set-up of the recipient countries as well


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as the emphasis given to that in the design of foreign aid strategy. Azam andothers (1999) noted such outcome as symptoms of aid dependence. Theyargue that when institutions are already weak aid may lead to the collapse ofsuch institutions. The policy implication of these authors analysis is quitestriking: foreign aid strategies, even for countries with similar per capital

incomes, should be differentiated according to there institutional capacity.In the African context, where institutions are both weak and vary acrosscountries, graduating from aid dependency requires an examination of notonly the short run external financing of resource gap but also the long runpossible negative impact of such flows.

26.Apart from the productivity issue, aid effectiveness is also a major problem.It is estimated that a typical poor country receives 9 percent of its GDP butthe poorest quintile of the population consumes only about 4 percent of theGDP (World Bank and Others 2000). Many factors are given for such failureof aid to address poverty (aid ineffectiveness). This list includes, according toWorld Bank and others (2000): support provided to trusted allies even

when they pursue poor policy, donor preference on aid objective and deliverymechanisms that usually face accountability problems as well as debtoverhang.

27.The way ahead for aid effectiveness and transiting from aid dependency,according to a recent study (See World Bank and others 2000) requires, interalia, recipients ownership of policies and programs, transferringaccountability to Africans and strengthening the institutions to run aid bythemselves, emphasizing capacity building as opposed to technical assistance,emphasizing on sustainability (in particular by working through nationalbudget) and transparency as well as focusing on regional rather than countryprogramsper se are few among many (See Section IX for detail). In general itcan safely be concluded that aid could be important in good policyenvironment but can be even harmful in bad policy environment (See Ali andothers, 1999)

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IV Foreign Direct Investment And Other Private Capital Flows

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28.Africas share of world FDI is extremely low. It was mere US$ 5.5 billion in1996, representing only 1.5 percent of the global investment flows. Thedistribution of this flow is extremely skewed, with the main recipients beingNigeria, Egypt, Morocco, Tunisia, South Africa, Algeria, Angola, Ghana andCote dIvoire who accounted over 67 percent of FDI to Africa in 1996.

Between 1991 and 1996 ten countries (Nigeria, Morocco, Tunisia, Angola,South Africa, Ghana, Tanzania, Namibia, Uganda and Zambia) received


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almost 90 percent of such flows with Nigeria alone absorbing a third of thisflows. The main sources countries being France, UK, Germany and US whilethe favorite sector are oil, gas, metals and other extractive industries (ADB,1998). In general, by the second half of the 1990s, the average share of FDI inGDP was not only very small but also was declining. Whenever it has a

positive trend it is largely related to investment in countries with newresource discovery.29.Recently, however, there is a surge of FDI in some countries (Kasekende

others 1995, Fernandez-Arias and Montiel 1996, Bhinda and others 1999).For all Africa the share of FDI in GDP, which was 0.29 percent (US$ 1.3billion) in 1990 has increased to 0.56 percent (US$2.7 billion) in 1995 andjumped to 1.2 percent (US$ 6.3) in 1998. The comparable figure for SSA,excluding South Africa, during this period has been 0.41 (US$0.76 billion),1.61 (US$ 2.7 billion) and 2.4 percent (US$ 4.8 billion), respectively (SeeTables 4.1 and 4.2 in Appendix I). Similar trend is observed when individualcountry data is used (See Table 4.3 in Appendix I).

30.An exploration of the literature on the determinants of FDI leaves much tobe desired. Although FDI, as discussed above, does not comprise a majorcomponent of external flows to low income countries of Africa, nevertheless,this section will briefly summarize the major canons of the theories of thedeterminants of foreign direct investment, in the hope that this may help toexplain why this type of investment has not been so important in thecontinent and why there is a surge in the recent past.

31.The early neoclassical approach, summarized in the classic article byMacDougal (1960), hypothesized that capital flows across countries aregoverned by differential rates of return. The MacDougal model assumesperfect competition, risk free capital movement, mobility in factors ofproduction and no risk of default. The portfolio approach to FDI, presentedin reaction to The MacDougal model, emphasizes not only return differential,but also risk (Iversen, 1935 and Tobin, 1958, both cited in Agarwal, 1980).This is strengthened by a theory that emphasizes the positive relationshipbetween FDI and output (sales in host country), along the lines ofJorgensons (1963) model (see Agarwal, 1980).

32.A major criticism of these theories relates to the question of perfection inmarkets. Hymer (1960, published in 1976) and Kindleberger (1969) arguethat, if foreign firms were able to compete and succeed in the host country,then they must be in possession of a specific and transferable competitiveadvantage, both over local firms, and other potential entrants into the localmarket. This analysis also focuses on the micro foundations of FDI, bymoving from a simple capital movement/ portfolio theory to a broaderproduction and industrial organizational theory. Indeed, this school ofthought has formed the basis for a whole strand of the literature. Accordingto this line of thinking, some advantages of the competitive foreign firminclude cheaper sources of financing, the use of brand names and patentrights, technological, marketing and managerial skills, economies of scale,and, entry and exit barriers (Kindleberger, 1969; Agarwal 1980). A related


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micro-based theory of FDI has also emerged with the development of theVernons product cycle theory (Vernon, 1966) and its extension in Krugman

(1979).33.A second wave of refinements to the neoclassical capital movement/ portfolio

theory of FDI, building upon Hymers original contribution, came with the

emergence of explanations based on the ideas of international firm andindustrial organization. The fact that decision-making about foreign directinvestment (FDI) takes place within the context of oligopolistic firmstructures, - and that such investment includes a package of other inputs,such as intermediate imports and capital flows, - has led to the developmentof alternative explanations grounded in the theory of industrial organization(see Agarwal, 1980; Helleiner 1989:1452; Dunning, 1993). This approachattempts to understand flows of FDI by multinational firms desire tominimize transaction costs,a la Coase (1937), to tackle risk and uncertainty,increase control and market power, achieve economies of scale, and ensureadvantageous transfer pricing (Hymer, 1976; Buckley and Casson, 1976, Lall

1973).34.The recent works of Dunning (1993), which he terms the eclectic paradigm,represents a culmination of this trend towards a refinement of theories ofFDI. Without departing much from the Heckscher-Ohlin-Samuelson theoryof trade, in explaining spatial distribution of multinational firms, Dunnings

paradigm summarizes this strand of theory under an ownership-specific,location and internalization (OLI) framework (see Dunning, 1993). Helleiner

(1989) notes that this "eclectic" theory of FDI, drawing on firm-specificattributes, location and internalization advantages - is widely accepted(Helleiner, 1989: 1253).

35.In sum, the theory of determinants of FDI covers a range of explanations: thepure capital movement, product cycle, industrial organization, the stagnationthesis as well as other political consideration. In the African context, the purecapital theory does not work since the assumptions simply do not hold.Neither is Krugmans hypothesis workable, since it is more relevant tocountries with a good industrial base and infrastructure such as East Asia.The deterioration in terms of trade, combined with the debt crisis, willgreatly undermine the relevance of this theory, in explaining the Africancontext. The most relevant theoretical explanation seems to be found inindustrial organization and the international firm - eclecticexplanations. More importantly, the concentration of MultinationalCorporations in the mining sector of most African countries and, to a gooddegree, the importance of the colonial history in determining their spatialpattern might be taken as lending support to the importance of the eclectic

approach.36.An empirical assessment of the determinants of FDI in Africa using this

theoretical insight reveals that, in general, relative market size, miningactivity and the historical pattern of FDI together determine the flow of FDIto Africa. (See Technical Appendix 4.1 for econometric results). Theimportance of some of these factors in explaining FDI flows is also shown in


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the descriptive analysis of Bhattacharya and others (1997). Bhattacharya andothers (1997) grouped the African FDI recipients into three categories: (a)countries which are long term recipients (Botswana, Mauritius, Seychelles,Swaziland and Zambia), (b) countries that recorded large increase in the1990s (Angola, Cameroon, Gabon, Ghana, Guinea, Lesotho, Madagascar,

Mozambique, Namibia, Nigerian and Zimbabwe) and finally (c) countriesthat have low and/or declining level of FDI but with encouragingturnaround, the best example being Uganda.

37.The main conclusion that can be drawn from the existing body of knowledge(both theoretical and empirical) is that much of the preconditions forsustained flow of FDI to Africa, in the existing global economic framework,relies on the structural transformation of the African economies which willhave a positive effect on market size, resource discovery and enablingconditions for high level of growth. Thus, influencing FDI flows usingconducive monetary and fiscal polices is important if a surge in flows of FDIin the short run is sought. In the medium to long run, however, bringing

structural change in the economy by growth enhancing and growth enablingpolicies (which could be both market and non-market in nature) as well asjoint-venture based exploitation of resources is an important area that needto be looked at (See Section IX for detail).

38.An in-depth study on sources and destination of FDI using country casestudies from micro perspective, and a cross-country analysis using time-series macro data need also to be taken as an agenda for future research.

.

.

Other Private Capital Flows

39.Apart from FDI, other private capital flows such as portfolio flows, bankflows and bonds are also important in financing development.Notwithstanding an extreme inconsistency of data obtained from variousinternational data source (See Appendix I, Table 4.3), the available datashows that such flows do not constitute important flows to the continent. Thisfairly accords with the popular perception about such flows to the continent.

40.What is interesting in examining such private capital flows to Africa is theirtrend (as opposed to their sheer magnitude). At the end of the 1970s andearly 1980s there was a surge of private capital flows (FDI, private equityflows and private loans, the later in turn comprising bank, bond and otherflows), SSA accounting for 8.9 percent of total private flows to developingcountries. It accounted only for 1.6 percent of such flows in the period 1990-95. This sharp fall is chiefly attributed to the sharp deceleration in privateloans starting from mid 1980s (See Bhattacharya and others 1997).

41.This trend and perception is changing in the recent past, however. A recentstudy by Bhinda and others (1999) came up with the interesting observation


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that international data sets were not tracking the sharp increase in privateflows to Africa. This data and the inconsistency problem are reproduced inAppendix I, Table 4.3. The case study countries for this study include SouthAfrica, Zambia, Tanzania, Uganda and Zimbabwe. South Africa hasreceived higher than all four countries taken together (90 percent of total

SSA since 1992) in absolute terms. However, relative to GDP, the othercountries have levels (10 - 15 percent) as high as the fastest growingSoutheast Asian and Latin America countries, while South Africa receivedonly 4 percent (Bhinda and others 1999).

42.Portfolio equity flows: two important categories of other private flows(excluding FDI) are portfolio equity and bank flows. Portfolio equity flows,though insignificant in magnitudes (except in South Africa), are growing inrecent past. From 1994 to 1997 more than 12 African-oriented funds havebeen setup with a total size of more than US$ 1 billion. The operation of thesefunds is expanding from the initial focus on South Africa to Botswana, CotedIvoire, Ghana, Kenya, Mauritius, Zambia and Zimbabwe (Bhattacharya

and others 1997)43.According to Bhinda and others (1999) study, this surge in portfolio flows toAfrica is highly inaccurate if one follows the international data. This isbecause, first, they fail to reflect data from stock exchange and foreignparticipation in primary and secondary markets such as in Zambia andZimbabwe; second, there is huge underestimation of inflows through equityfunds. Recently, there are three important equity funds with SSA exposure:(a) Pan-African funds with an exposure of US$ 692.9 millions, (b) SouthAfrican dedicated funds with an exposure of US$ 8.057 billion and (c)emerging market global funds with an exposure of US1.5 to 3.5 billion (4 to10 percent of world total is in SSA). Thus, the total SSA portfolio investmentstock ranges from US$ 10.3 to 12.3 billion since 1995. When we look closer atthe Pan African funds around 18 percent of it is invested in North Africa, 70percent in SSA - SSA excluding South Africa having 35.1 percent (SeeBhinda et al1999 for details).

44.Bank flows: again the different international sources do conflict on the size ofsuch flows to Africa (See Appendix I, Table 4.3). All the sources, however,show that the magnitude is not only very small but also erratic. Whencountry data is used for sample of countries, this erratic feature is still there,however, the actual magnitude is in general higher in the latter data set. For1996 (for which there is comparable figure for all sample countries) forinstance, country data shows that such flows in South Africa are 2.2 billions(as opposed to 1.8 billion in BIS, Bank of International Settlement, data); forTanzania 27.9 million (as opposed to 13 million in BIS data); for Uganda21million (as opposed to 30 million in BIS); for Zambia 235.8 million (asopposed to 28 million using BIS data) and for Zimbabwe8 million (asopposed to 35 million in BIS). In general all data show that such flows arenot really picking except in South Africa and to some degree in Tanzania.This is partly attributed to the wish of lenders to change exposure followingeconomic trends, the rapid increase of foreign exchange holding in Africa


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following financial sector liberalization, domestic financials sector problemssuch as debt overhang and domestic payment arrears as well as theperception of high country risk. These factors resulted either in the declineor increasingly very short-term nature of bank flows. Whenever such flowsare increasing this is explained by the dominance of foreign banks in those

African countries where this trend is observed (See Bhinda and others 1999for details).45.Bond flows: in terms of magnitude such flows are also extremely

unimportant in SSA. Such flows in 1996 were 1.2 billion using IMF data and586 billion using World Bank data (see Table 4.3 in Appendix I). This lowand erratic nature is partly attributed to low credit rating of most Africancountries.

46.The important question relevant for policy is to understand the determinantsof such flows. In international finance literature there are a number ofsystemic explanations for bank and portfolio flows. These includestatic/dynamic capital movement theories (MacDougall, 1960; Bardhan,

1967), the portfolio theory of capital movement (See Williamson, 1983: 182-192; Solink, 1974) and theories of credit rationing (See Sachs, 1984; andStiglitz and Weiss, 1981;for an empirical study of credit rationing see Federand Uy, 1985 and Lee, 1993). All of these are essentially microeconomicexplanations, tailored to a neoclassical framework. The first explains howcapital is allocated across countries and generations in order to equate returndifferentials, with the aim of achieving optimal borrowing. The secondapproach adopts a portfolio choice method, owing to the emphasis it placeson the evaluation of risk and uncertainty. However, the portfolio theory isessentially governed by the same motives as the first approach. The creditrationing theory builds on both of the above approaches, but alsoincorporates a constraint based on market imperfection.

47.A common problem in applying these approaches is their implicit belief inthe workings of a competitive market, albeit with some reservations in thecase of the credit rationing theory. A further weakness is the assumption thattheories based on micro behaviour may readily be carried over to the macro/international level. This theoretical underpinning greatly limits the relevanceof these approaches for countries in Africa where risk, uncertainty,instability and market segmentation all represent significant factors, whichneed to be taken into account. Neither is it reasonable to assume that fullydeveloped financial markets are available in all African countries. Indeed,most African countries are sovereign borrowers (with sovereign risk) andsystemic explanation might be derived from such an approach. Theimportant question then is what can we draw from highly limited ability ofthe theory to explain such flows and their erratic trend that we observe formthe data?

48.Having such theoretical explanations it is also insightful to examine thedeterminants of such flows from empirical studies. There are various factorsbehind the recent surge of portfolio (the most important component beingequity flows following by bonds, which in African context is taking a form of


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Treasury bills) flows. These determinant factors can be grouped as (a) globalor push factorsthe trend in OECD to invest in emerging markets andgrowing institutional (usually pension) investors faced with low interest rateand slow down in economic activity at home. For such investors SSA is foundto be attractive because its yields have low correlation with other emerging

markets; (b) perception of SSA by investors, which ranges from a perceptionof the region as the final frontier to negative bias is also an importantfactor. This is largely determined by investors information about Africa; (c)there are also national factors such as political and macroeconomic stability,good governance, economic growth and regional integration, standardizedregional structure of banks and developed stock markets with positiveperformance, as well as the existence of motivated labour force (d) finally, inparticular, with non-equity flows (bonds and treasury bills) liberalization ofthe economies, possibility of holding dollar denominated accounts in banksand hence low risk nature of such flows, good credit rating, high domesticinterest rate and development of capital markets are important factors for

the recent upsurge (See Bhinda and others, 1999: 69-84). A recent empiricalstudy using a dynamic modeling approach on the determinants of such flowsin Asian and Latin American developing countries underscored that bothglobal and country-specific factors have roughly the same level ofsignificance in influencing such flows. However, bond flows are found toreact predominantly to global factors while equity flows to country-specificfactors (Taylor and Sarno, 1997). This finding is consistent with previousstudies of Calvo and others (1993, 1996).

49.The policy implication of this should be apparent. Apart from designingappropriate policies that could positively influence the afro-mentionedfactors, African policy makers need to understand the extreme volatilityassociated with such flows. This requires, capacity building on themanagement of the financial sector. Moreover, policy makers might beconfronted with the policy dilemma of a trade-off between high flows owingto increased regional integration and high volatility. This is in particular truegiven the huge cost of bailing out countries when they are faced withfinancial crisis associated with such flows. As Bhinda and others (1999)rightly noted Africa has no big brother to facilitate a bailout in the first

place, this requires appropriate exchange rate policy, debt management,

proper financial regulation and supervision and transparency (See Bhindaand others 1999 and Section IX below for detail).

.

V Domestic Resource Mobilization

50.The emphasis on domestic resource mobilization to bring development hasbeen the preoccupation of economists drawn from the different strands of theprofession. This ranges form Lewis classic assertion in early 1950s about the

importance of savings (Lewis 1954) to the neoclassical growth models of the


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1950s and 1960 and the recent endogenous growth models (See Romer 1986,Lucas 1988).

51.Main stream theories of saving such as the permanent income hypothesis aswell as the life-cycle hypothesis that are based on the assumption thatconsumption is determined by life time resources that are directed at

consumption smoothing, rather than current income, are increasingly beingquestioned in the context of developing countries. This is chiefly because thecharacteristics of households in developing countries are quite different fromthose in developed countries. These characteristics include poor and largehousehold, the dominance of agriculture and uncertainty of income flows,demographic structure as well as binding liquidity constraints (See Deaton1989). It is argued that savings in developing countries are largely explainedby precautionary motive as well as by the need to finance investment as ownfinance dominates such economies (See Bridsall and others 1999, forinstance).

52.Another important dimension widely cited in the developing countriescontext is the relationship between saving and economic growth. Mostimportantly, the direction of causality between saving and output growth isfar from clear (Schmidt Hebel and others, 1996; Elbadawi and Mwega,1998). In Sub-Saharan Africa, Elbadawi and Mwega (1998) argue thatregardless of the direction of causation, focusing on policies that enhanceprivate saving is important for at least two reasons. First, even if saving is theresult and not the cause of economic growth, empirical evidence suggests thatsustaining a high rate of growth requires a high level of accumulation ofcapital, which requires high level of saving. Second, due to Sub-SaharanAfrican countries limited capacity of mobilizing external resource, raisingnational saving to maintain a high rate of investment and hence growth isessential.

53.Elbadawi and Mwegas (1998) empirical study shows that saving ratesignificantly Granger-causes the investment rate although the relationshipbetween saving rate and economic growth is non-significant. Other studies(Dooleey, Frankel and Mathieson 1987, Summers 1998, cited in Schmidt-Hebble et al1996) find that there is a strong correlation between investmentand saving both in developed and developing countries. However, growthfound to Granger-cause both saving and investment (Elbadawi and Mwega,1998). Similar results are also reported in the study by Carroll and Weil(1994). According to Deatons (1990) survey, the literature on householdsaving in LDCs has almost uniformly found that saving will increase withpermanent income (See Bhall 1979, 1980 for India; Musgrave for Latin

America; Muellbauer 1982 for Sri Lanka; Berancours 1971 for Chile and

Paxson 1989 for Thailand, all cited in Deaton 1990). The implication of thislatter body of knowledge is that in order to raise domestic saving it is notonly growth but also its sustainability that policy makers need to focus on.

54.External sector related factors are also important in determining the level ofdomestic saving. In the context of SSA, Elbadawi and Mwegas (1998) work

shows that the foreign aid ratio significantly Granger-causes a reduction in


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saving rate. Similar results are also reported in Alemayehu (2000). In SSAthe Global Coalition for Africa (1993), claims a negative and significant effectof foreign aid on domestic saving. Commenting on such evidence Schmidt-Hebbel and others (1996) noted that the empirical results do widely varydepending on difference in sample, model specification, estimation method as

well as the extent of fungibility of the foreign resources (See also Mwega,1997: 208). This aid-saving debate has been carried for nearly threedecades and is still an unsettled issue (see White, 1992, for a comprehensivesurvey).

55.Another open-economy based variable widely used in the empirical literatureis the terms of trade. Terms of trade are expected to have a positive effect onprivate saving, especially when it is transitory. This has supporting empiricalevidence (See Ostry and Reinhart 1992, Bevan et al1992, and Azam 1995).The widely cited work of Bevan et al(1992) on Kenya noted that 60 per centof proceeds from the Kenyan coffee boom in the mid-1970s is saved. This islargely related to the fact that such incomes are windfalls that result from

fluctuation in commodity prices (Deaton 1990). In Elbadawi and Mwegas(1998) study a growth in the terms of trade has a positive and significanteffect on saving rate. However, in Masson and others (1995) the terms oftrade are found to be statistically insignificant. An extreme result of negativeterms of trade effect is reported in Mwegas (1997) study.

56.Macro policy issues relevant to enhance domestic resource mobilization arealso examined in some of the African empirical literature on the issue. Thiscan broadly be categorized as fiscal policy (in particular public saving andissue of crowidgn-out/in) and monetary policy. Corbo and Schmidt-Hebbel,1991 cited in Mwega (1997); Mwega (1997) and Elbadawi and Mwega (1998)have used public saving as explanatory variable in their saving equation. Forthe sample of LDCs they found negative and statistically significant effect ofpublic saving on private saving. On the other hand, government consumptionis found to have a positive and significant effect in Mwegas (1997) andElbadawi and Mwegas (1998) studies.

57.One way of augmenting public saving is through taxes. It is argued that thissituation brings about what is called the Ricardian Equivalence. Mostempirical studies for industrial countries reject the Ricardian equivalence.Studies for developing countries also dismiss it in its pure form and agreethat public saving offsets some private saving (Haque and Monties 1989;Corbo and Schmidt-Hebble 1991; Easterly, Rodgigues and Schmidt-Hebble1994; Edwards 1995, all cited in Schmidt-Hebble and others (1996) andMasson and others (1995)). These results show that public saving is aneffective tool to raise national saving (Schmidt-Hebble others 1996: 99).Thus, the evidence is not conclusive.

58.A related fiscal issue is the impact of public investment on private investmentand hence saving, if saving and investment have positive relationship. Servenand Solimano (1993) have examined the impact of public investment onprivate investment in developing countries and reported a positive andsignificant correlation in the panel data of developing counties, as well as in


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separate studies of Latin America and East Asia. Similar stylized fact isfound across many developing countries (See Taylor 1991). What theempirical evidence suggests about the impact of public investment is thatdifferent types of public investment are likely to have different kinds ofeffect. Empirically, such examination shows that infrastructure investment

generally has a positive impact while investment by public enterprise doescompete with private investment (See Easterly and Rebelo (1993) cited inSchmidt-Hebble and others 1996). In general as noted by Azam and others(2000) the evidence is mixed. It is also noted that there are certain categoriesof public investment such as investment in infrastructure, human capital andlaw and order that tend to crowd-in private investment. Moreover, thereappear to be lower (uppers) threshold below (above) which public investmentmay not be effective (See Azam and others 2000).

59.A monetary policy that is important in the empirical literature of domesticsaving is the (real) interest rate. This has got prominent status following theMckinnon and Shaws work on financial repression that informed much of

the design of SAPs in Africa. Thus many in Sub-Saharan Africa entered infinancial liberalization since the 1980s. Despite such reforms however, realdeposit rates have not significantly increased in many African countries (seeAryeetey and Udry 1999). Aryeetey and Udry noted that the real depositrates have risen far slower than lending rates in many countries. However,citing the case of Ghana and Nigeria, they added, when there is some stabilityin macro-economic conditions and deposit rates rise, depositors reactpositively. However, this evidence is not conclusive. For instance, Giovannini(1985), Schmidt-Hebbel and others (1992) found no significant impact of realinterest rate on saving, while Ogaki and others (1995) found positive effectsthat are small and very sensitive to income levels. A related financial variableused in the empirical studies is the degree of financial depth (usuallymeasured by M2 to GDP ratio). In line with the mixed result in many studiesof LDCs, the empirical evidence in Sub-Saharan is not conclusive either. Forinstance in Elabadwi and Mwegas (1998) study this variable is found to be

non-significant for a sample of LDCs. Mwega (1997) also reported similarresult for Sub-Saharan Africa. However, in Elabadwi and Mwegas (1998)recent study, it turned out to have significant positive effect when a fixed-effect model is used.

60.Both fiscal and monetary policies are related to macroeconomic stability.Macroeconomic stability is another area that is usually emphasized tostrengthen domestic resource mobilization. The empirical evidence of theeffect of macro-economic instability on saving rate in developing countries ismixed and inconclusive. In SSA there is evidence that macroeconomicstability leads to a rise in deposit rates and depositors react positively to thisrise as noted earlier (Nissanke and Aryeetey 1998, cited in Aryeetey andUdry, 1999). But Mwegas (1997) result shows that inflation (as one of the

indictors of macro instability) has no significant effect on saving.61.Macroeconomic stability is also related to institutional measures such as

financial liberalization, appropriate credit policy and ensuring low level of


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income inequality as the experience of East Asian countries shows (SeeBirdsall and others 1999 for details). Ikhide (1996, cited in Aryeetey andUdry 1999) argues that institutional and structural constraints to saving arethe major reasons for weak saving mobilization in Africa. This iscompounded, he argues, by low presence of formal institutions. Extension of

commercial bank branches to rural areas in five African countries covered inhis study turned out to have the strongest effect on savings. Nissanke andAryeetey (1998 cited in Aryeetey and Udry 1999) have also suggested that thefragmented nature of financial markets in Africa tend to increase thetransaction cost of moving from one segment to the other and hence could actas a disincentive for saving mobilization in Africa.

62.One predominant institutional feature of saving in Africa is the importanceof informal saving. Deaton (1989) suggested that saving in such set up isintended to smooth consumption. Aryeetey and Udry (1999) though agreewith this notion emphasize that most studies of fund utilization by suchassociation shows that the funds are usually spent on consumer durables and

for providing working capital (Miracle et al, 1980; Aryeetey and Gckel, 1991;Chpeta and Mkandawire, 1991, all cited cited in Aryeetey and Udry 1999).This informal financial sector is important because the available evidenceindicate that the value of formal sector financial assets is less than half of thefinancial assets held by households in Africa, although financial asset ingeneral is relatively a small component of the portfolio asset held byhouseholds (See Aryeetey and Udry, 1999).

63.Another structural/institutional feature noted to be important in the Africancontext is the transport cost. Aryeetey and Gockel (1991), cited in Aryeeteyand Udry (1999) have noted that an average travel time of over an hour isrequired to reach a bank in rural Northern Ghana and the cost to such travelis about the equivalent of the prevailing minimum wage. This suggests thatthe incentive to save could easily be offset by the transport cost as long as thecost exceeds the return on saving. Webster and Fdler (1995, cited in Aryeeteyand Udry 1999) attributed the low scale of a number of micro financearrangements in West Africa in part to the low population density in many ofthe rural areas - indicating the importance of location to access credit.

64.Finally demographic characteristic of the household are also taken asimportant factors that could influence domestic resource mobilization. For asample of developing countries, Elbadawi and Mwega (1998) used twodemographic variables: the young-age dependency ratio and urbanization. Inthe pooled model both variables have negative and statistically significanteffects. This result becomes insignificant, however, when the fixed effectmodel is used. Comparing their estimation for LDCs with that of SSA, theynoted, for SSA the dependency ratio emerged as the most important androbust contributor that differentiate the performance of high performingAsian economies from SSA. The dependency ratio has negative contributionespecially in middle income SSA (Mwega, 1997: 214; Elbadawi and Mwega,1998: 19). Masson and others (1995) also found that demographic factorshave significant negative effect for all but middle income LDCs. Others (See


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Harrigan, 1995, cited in Mwega 1997) noted that empirical evidence isconflicting and has not resolved the issue. Mwega (1997) reported thatadverse effect of high dependency ratio on private saving appears to havelittle support for the sample of LDCs in his study. Deaton (1989) has shownthat for developing countries actual age-composition profiles are not

consistent with the predictions of life-cycle theories, thereby undermining theempirical importance of the mechanism. The weakness of the life-cycle modelin developing countries is also noted by Collins (1991) based on a study thatused a sample of ten developing countries (See Aryeetey and Udry, 1999).

65.The discussion in this section, in particular the exploration of myriad ofsaving determining factors, clearly demonstrates the challenge of domesticresource mobilization in Africa. The identification of different factors thataffect each of the saving determinants, it is hoped, would provide somehandle on designing relevant policies geared to domestic resourcemobilization (See section IX for detail). More important, however, is theinconclusive nature of most empirical studies both in developing countries in

general and in Africa in particular. This points to the need to carry out an in-depth research in these areas.

.

.

VI Issues Of Capital Flight

66.One important area that increasingly attracting the attention of researchersand policy makers is the potential of capital flight reversal in financing

development. In the context of Africa this potential is enormous.Notwithstanding the measurement problem associated with such studies, arecent study using a rather large data set based on 22 countries from Sub-Saharan Africa concluded that the continent has the highest incidence ofcapital flight, exceeding even the Middle East. 39 per cent of privateportfolios were held outside the continent. Were Africa able to attract backthis component of private wealth, the private capital stock would haveincreased by around 64 percent (Collier and others 1999). Similarly, Ajayis

1997 estimate of capital flight from severely indebted low-income countries ofSub-Saharan Africa, which stood at 22 billion, constitutes nearly half of theexternal resource requirement estimated by Amoako and Ali for 1999/2000.

67.Recent African literature on the topic touches a number of issues tounderstand determinants of capital flight. According to Collier and others(1999) capital flight arises from portfolio diversification incentives, returndifferential incentives and relative risk incentives. The risk associated withdomestic capital may range from expropriation to wide range of implicittaxes such as inflation or exchange rate depreciation (Collier and others1999). The empirical analysis of this study revealed that the high level ofcapital flight from Africa, despite the continents capital scarce


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characteristics, is explained by overvalued exchange rate, the fact that it israted as the riskiest continent by international investors, and the level ofindebtedness of the continent (Collier and others 1999). The finding aboutdebt is, however, contradicts to the finding of Ajayi (1997) who argued thatthere is no relationship between debt and capital flight.

68.An earlier study by Hermes and Lensink (1992) on capital flight from Africaused debt-creating flows, exchange rate overvaluation and exchange rateadjusted interest rate differential as explanatory variables. Except the lastitem that is found to be statistically insignificant, they have found positiveand statistically significant coefficients. This basically accords with Collierand others (1999) recent finding. Our experiment with similar equation

using Hermes and Lensink type of specification using 18 African countriescould not result on significant coefficient for the coefficient of the debtcreating flowsthus supporting Ajayis result. Some of these inconclusiveresults indicate the importance of further study on these issues.

69.Notwithstanding the inconclusive findings about capital flight, it is possible toidentify preliminary pointers. The major finding of Ajayis examination ofAfrican capital flight points to the importance of trade-faking (over andunder invoicing of imports and exports), problems of political instability(including the abuse of power), unfavorable macroeconomic environment,and lack of economic growth as important areas that African countries needto work on so as to ensure the reversal of flight capital and maintaining whatis reversed (See Ajayi 1997 for details). The Collier and others (1999)findings also basically accord with this view (See section IX for detail).

.

VII Africas External Debt

.

70.The total external debt of Africa has raised nearly twenty-five folds from arelatively low level of US $14 billion, in 1971, to more than $300 billion now.The major component being outstanding long-term debt. Over period, IMFcredits were increasingly used, with Structural Adjustment and Enhanced

Structural Adjustment facilities comprising an ever-important componentof flows to Africa (See Table 7.1 in Appendix I).

71.Changes in the structure of African debt can be described in terms ofcreditor patterns. From Table 7.1 (See Appendix I), it can be read thatbilateral debt comprises the largest share. This is followed by multilateraldebt, with private inflows declining overtime. Generally, a larger share ofofficial debt is now disbursed on concessional terms. It can also be noted thatthe debt problem is being aggravated by capitalization of interest andprincipal arrears, which constitute nearly a quarter of the external debtburden.


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72.Although the share of African debt as a proportion of the total debt ofdeveloping countries is low, the relative debt burden born by African nationsremains high. The debt to GNP and debt service ratios rose from 21 per centand around 9 per cent, respectively, in 1971, to a high of 68 and 23 per centduring the late 1980s. In 1998, the last year for which we have data, these

ratios stood at 64 per cent and 19 per cent, respectively (See Table 7.2 inAppendix I).73.Africas debt burden may also be assessed by examining net transfers. Thus,

if we exclude from Table 7.2 in Appendix I, grants and net foreign directinvestment inflows, it can be seen that net transfers since 1990 have, in factwere negative (i.e., flowedfrom Africa to the developed nations). Furthermore, the level of such transfers (outflow) has increased, from US$ 3.6 billionin 1985 to nearly US$ 12.5 billion in 1998. Finally, in the 1990s it is worthpointing out that nearly 35 per cent of grants to Africa, in fact, went totechnical experts that usually came from donor countries (See Table 7.2 inAppendix I).

74.In summary, the last three decades have witnessed an unprecedentedincrease in the level of African debt. This debt is generally long-term incharacter; there is a growing importance of debt owed to bilateral andmultilateral creditors, a trend away from concessionality to non-concessionality and an increase in the importance of interest and principalarrears (usually capitalized through the Paris and London clubs) as acomponent of long-term debt. Indicators of the debt burden also reveal thatAfrican debt is extremely heavy compared to the capacity of the Africaneconomies, and, in particular their export sectors. Moreover, most Africancountries have been subjected to net financial outflows (of debt related flows)since the mid 1980s. The performance of these economies, coupled with amounting debt burden, surely indicates that African countries are incapableof simultaneously servicing their debt and attaining a reasonable level ofeconomic growth, let alone addressing issues of poverty alleviation outlinedin this paper.

75.The actual size of indebtedness does not usually represent an economicproblem in itself, since this debt may usually be mitigated by reschedulingand similar short-term arrangements. However, the size of accumulateddebt, relative to capacity, and subsequent impacts on the economy, dorepresent a serious problem for African countries. In this respect, threeinter-related implications of the debt problem deserve mention. First,servicing of the external debt erodes foreign exchange reserves, which mightotherwise be available for purchase of imports. This has led to the import

compression problem in the past, in which shortage of foreign exchange

adversely affected levels of public and private sector investment (See forinstance Ndulu, 1986, 1991 and Ratso 1994). Second, the accumulation of adebt stock results in a debt overhang problem, which tends to undermine

the confidence of private investors, both foreign and domestic. A decline inlevels of private investment as a share of GDP, from the late 1970s onwards,may partly be attributed to this factor (See for instance Elbadawi and others


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1997). Finally, servicing of debt is placing an enormous fiscal pressure onmany African nations. Such pressure has had an adverse effect on publicinvestment and provision of social services; this finding is reflected in thedecline in the share of public investment in GDP from late 1970s onwards aswell as high level of fiscal deficit. Naturally, a reduction in levels of public

investment will tend to have adverse consequences for physical and socialinfrastructure. This effect is significant given the empirical finding thatpublic sector investments, in particular in low income countries of Africadoes crowd-in private investment (See Alemayehu 2000).

76.To sum up, the debt issue is a crucial element of the overall economic crisisfacing Africa. Except the recent gesture shown to Uganda (a 20 percent debtstock reduction), the much-discussed issue of the HIPC initiatives is notrealized yet. This initiative comprises two phases. Phase one requires a three-year record of compliance with an IMF program. This leads to the decisionpoint for acceptance into the HIPC initiative. Acceptance requires havingindicators that show the country is beyond debt sustainability thresholds.

These are defined as a 20 to 25 per cent debt service ratio and present valueof debt to export ratio of between 200 and 250 per cent. If countries findthemselves above these thresholds they are eligible for the Naples terms,under which they are entitled to a two-third reduction in debt stock. Thisreduction is applied to all types of debt, including multilateral. Phase two ofthe new initiative comprises the implementation of another three-year IMFprogram and, if accepted within the HIPC category, an 80 per cent debtstock reduction. Since it is widely believed that few African countries arelikely to reach this phase in the foreseeable feature, one may not expect to getmuch from this second phase (See Oxfam, 1997 for a critical review of thisissue).

77.The Bank and the Fund have also announced a major expansion of the HIPCinitiative in 1999. The new expanded HIPC initiative is believed to providedeeper, broader and faster debt relief by (a) qualifying countries when theirpresent value of debt to export reaches 150 percent (as opposed to 200-250per cent noted above), (b) commencing debt relief from decision point, and(c) basing the length of the interim period on achievements of keydevelopment objectives rather than on pre-specified period. Another newdimension emphasized is the idea of linking the debt reduction to povertyalleviation programs (See World Bank and others 2000). Although this newextended initiative seems promising, it is very difficult to count on itsrealization and hence its financing development prospects as can be readform the recent resolution of the (July 2000) G-7 meeting in Japan.

.

VIII The New Financial Architecture And Its Implication

78.The recent turbulence and crisis in the financial sectors of emergingeconomies and to some degree in developed countries has prompted a


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renewed emphasis on examining the operation of the international financialsystem. There seems to be a consensus that the problem is global andsystemic implying the need to go beyond national boundaries to address thisissue. In particular, the Asian crisis underscored the need to carry structuralpolicy reforms both at the national and international levels to restore

financial stability and to mitigate and if possible avert future crisis (SeeBossone and Promisle, 1999). The major issues that need to be addressed arecategorized under the following themes: (a) enhancing standards andtransparency, (b) financial regulation and supervision, (c) management ofcapital account and exchange rate regimes, (d) surveillance of nationalpolicies, (e) provision of international liquidity and (g) orderly debt workouts(See IMF 1998, Bossone and Promisle 1999, Akyuz 2000).

79.At practical level, following the Asian crisis, Finance Ministers and CentralBank Governors form 22 countries, which are significant players in theinternational financial system, gathered to work on a new internationalfinancial architecture spearheaded by the Bretton Woods institutions. These

Ministers and Governors identified three key areas where immediate actionis needed: (a) enhancing transparency and accountability, (b) strengtheningnational financial systems and (c) managing international financial crisis(IMF 1998).

80.Transparency and Accountability: this relates to the importance of improvingthe coverage, frequency and timeliness with which data on reserves, externaldebt and financial sector soundness are published. In particular informationon the international exposure of investment bank, hedge funds and otherinstitutional investors is required. Adherence to transparency is believed toenhance the performance and accountability of international financialinstitutions too (IMF, 1998). In this proposal the international communitywill set the standards for and improving the timeliness and quality ofinformation on key macroeconomic variables, including transparency ofgovernments fiscal and monetary policy (Akyuz 2000).

81.Strengthening financial systems: this relates to principles and polices thatfoster the development of a stable and efficient financial system in areas ofcorporate governance, risk (including liquidity risk) management and safetynet arrangements. The domestic financial sector is also believed to bestrengthened by cooperation of national and international institutionsengaged in supervision and regulation of financial institutions (IMF, 1998).This may be carried along the standards based on Basle Capital Accord thatneed to be applied by national authorities. This accord has variousrequirements such as provision for risk and, specific standards of supervisionand regulatory framework (Akyuz 2000).

82.Managing International financial crisis: the working group set up to examinethis issue stressed the need to encourage better management of risk byprivate and public sectors. In particular, it wants to see governments

limiting the scope and clarifying the design of guarantees that they offer.Moreover, controlling short term, liquid capital flows through market basedmeasure such as taxes and reserve requirements, exchange rate management


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(such as targeting the real exchange rate), IMF surveillance over the policiesof creditors as well as debtors, provision of liquidity (to pre-empt largecurrency swings) by an international institutions such as IMF, and anorderly debt workout (such as temporary standstill on debt servicing andprovision of seniority status to new debt and similar arrangements) are tools

that can be used in managing financial crisis in the context of the newfinancial architecture (See Akyuz 2000: 5-14). In particular the internationalfinancial architecture need to develop in the direction where the role ofinternational financial institutions such as IMF is to reduce demand forliquidity ex ante (preventing collapse) and increase supply of liquidity ex post(organizing bailout) by designing appropriate strategy to tackle possiblemoral hazard problems. This is in particular important in developingcountries where the welfare consequence of financial instability is extremelyharmful (See FitzGerald 1997a 199b).

83.Implications of this new financial architecture for developing countries ingeneral and Africa in particular are many. This list may include,

Many of the proposal are focused on marginal reforms andincremental changes such as standards, transparency etc instead ofsystemic instability issues raised in the wake of the Asian crisisthefocus is toward self-defense and market based solution. Such solutionis not sustainable (See Akyuz 2000)

Explicit rule based operation is generally resisted by industrializedcountries. This gives industrial countries an excessive discretionarypower since they have leverage on international financial institutions.This in turn has implication for reforming the rules of theinternational financial infrastructure such as the IMF quota system.Moreover, Public disclosure of financial and macro information mayenhance instability, in particular if there are no asymmetricaction/transparency by creditor countries and institutions such asIMF (See Akyuz 2000, Jha and Saggar 2000).

The credibility of institutions, which carry the supervision andregulation of national economies (such as credit rating agencies), maycreate a problem. Even when it is believed, it might have detrimentalimpact on flows to Africa or the interest rate spread of flows destinedto Africa since private investors notoriously lack information aboutindividual African countries. Experience in Asia shows that self-surveillance is much more important (See section IX for detail).

African countries need also to carry an in-depth study of theimplication of internationally based rules and regulation to a regionthat is marginalized and perhaps participating in a segmented capitalmarket. For instance, most of the debt owed to Africa is publiclyguaranteed and in general based on sovereign risk. Thus, the ruledeveloped for market based capital flows could hardly be relevant tosuch segmented market. (See section IX for detail).

A recent study by World Bank noted: (a) care must be taken to designappropriate policies at the initial stage of surge in capital flows as this


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largely determines success in dealing overheating and potentialvulnerability, (b) development of well functioning capital marketreduces potential instability, and (c) developing countries need todevelop shock absorbers such as international reserves that varieswith variation in capital account (as opposed to simple import cover),

fiscal flexibility (in indebtedness), building up of cushions in thebanking system and the like (See World Bank, 1997) Finally, African countries need to develop tools (such as global

models) that could be used to analyze the impact of Northern policesand external shocks on their region. Such tools do also allowexamining policy responses to such shocks (See section IX).

IX POLICY IMPLICATIONS

1. This section attempts to bring together the policy implicationsof issues discussed in this paper. The major conclusions that

emerge from the resource gap analysis is that the continentneeds an estimated external resource that amounts to 46.8percent of its GDP (40 % if S. Africa is excluded), annualaverage of 32 percent (26 % if S. Africa is excluded), and 10percent (8% excluding S. Africa) in the period 1999/2000,2001-2005 and 2006-2010, respectively, to attain 8 percentgrowth in GDP. The latter is believed to reduce poverty by halfby year 2015. This figure, although apparently seems large, isvery small if the implication of HIV/AIDS, estimated to bringabout 1 to 1.5 percent reduction in GDP is factored in.

2. Mobilizing such high level of external resource is a formidabletask. In order to realize this, policy makers need to designpolicies relevant for each category of (possible) source ofexternal finance. The rest of this section will outline such policyguidelines organized by each financing category.

Official Development Assistance (ODA)

3. The fall in percapita ODA and its declining trend needs to be areal concern since it is the main source of financing theresource gap of African countries. Thus, policy makers need todesign ways of reversing this trend by working both

collectively and at specific country level. The observeddeclining trend also strengthen the case for efficient use of theexisting level of ODA more than ever.

4. The theoretical and empirical analysis about determinants ofODA flows shows that donor interest, rather than recipientneeds, is much more important. The geo-political interest ofdonors as well as the actual/bureaucratic process of aiddelivery are specifically singled out as important. Policy


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makers, thus, need to find ways of influencing these variablesto bring about meaningful change in such flows.

5. At specific level, the pre-Lome association of African countrieswith Europe and their economic performance are much moreimportant in influencing aid flows than humanitarian

considerations. Thus, policy makers need to creatively designpolicy instruments that can positively influence these variables.More specifically, policy makers need to identify and examine(a) the geo-politics of their country/regions so as to creativelyuse them, (b) understand the budgetary/bureaucratic processof aid delivery from the supply side; and (b) pursue growth-oriented strategies from the demand side.

6. In the face of the declining trend of ODA, aid effectiveness isalso another policy direction. This requires specific polices andstrategies aimed at (a) raising capital efficiency, (b) transitingfrom aid-dependency in the medium to long run and (c) a

strategy to tackle the terms of trade deterioration which isincreasingly offsetting the aid inflow. This may take the formof export diversification and developing collective bargainingposition at regional and continental level.

7. Aid dependency is also found to have long-term detrimentaleffect on existing institutional capacity of African countriesthat are already weak. Policy making, thus, need to focus oninsulating existing institutions from such effect by designingappropriate strategy. The latter may include capacity buildingboth at country and regional level. Such capacity buildingneeds to go beyond economic management to issues ofgovernance, which is central in aid management.

8. The modality of aid need also be based on partnership andshared vision of donors and recipients, with clear definednation wide program (such as medium term budget orexpenditure framework) with focus on social sectors.

9. Finally, the international community has also its share of thetask such as: ensuring ownership of policies by recipients,capacity building in the formulation and maintaining ofmedium term planning and budgeting approaches such as theMedium Term Expenditure Framework (MTF) which isincreasingly informing macroeconomic management in manyAfrican countries. Moreover, donors need also to give at leastequal significance to regional or continental undertakings,which may help to create long run enabling environment.African governments may need to put collective pressure oninternational donor institutions to realize the afromentionedobjectives.



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10.Critical analysis of the theoretical literature on FDI in Africancontext suggests the importance of understandingMultinational Corporations (MNC) to understand FDI flows toAfrica. Thus, policy makers need to invest in understanding onhow MNC do operate. This is helpful both to positively

influence them and to regulate their operation when suchregulation is invaluable.11.FDI related empirical studies in Africa underscore the

importance of relative market size, mining activity as well asthe historical pattern of FDI flows in attracting FDI. Thesefindings have two policy implications. In the short to mediumterm appropriate macro policy is important. In the long run,however, structural transformation to bring about meaningfulchange in market size, availability of skilled labour force andenabling infrastructure is vital to attract FDI.

12.The recent surge in FDI in extractive sectors of Africaneconomies might be explained by the profitability of suchsectors owing to the existence of fairly secured world marketfor such commodities (such as oil) and the relative (low) cost ofcreating an enabling environment for such industries (such assecurity and site-to-port infrastructure). The policy implicationis that recipients need to offer enabling condition by investingon public goods such as security and infrastructure so as tomake investing in their country less costly. From a long runperspect

Financing Developmetn in Africa

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