Capital Flows and Capital AccountLiberalisation in the Post-Financial-CrisisEra: Challenges, Opportunities andPolicy Responses

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Working Paper No. 99July 2009

Capital Flows and Capital Account Liberalisationin the Post-Financial-Crisis Era: Challenges,

Opportunities and Policy Responses1

(1)This Working Paper is published from a consultancy report prepared by Victor Murinde, presented at a workshopon the Global Financial Crisis hosted by the African Development Bank on 10 April 2009 in Tunis, Tunisia.

This paper invokes a flow-of-funds framework toscope the challenges, opportunities and policyresponses regarding capital flows and capitalaccount liberalisation as Africa emerges fromthe global financial crisis. The framework is usedto highlight the transmission of the financial cri-sis from the foreign sector to the household sec-tor, company sector, banks and capital markets,as well as the government sector. Financialprices, mainly the exchange rate and stockprices, provide the propagation mechanism forcontagion effects of the financial crisis; forexample, collapse of the exchange rate, collapseof stock prices, and a surge in capital outflowsincluding capital flight. While by the end of 2007,remittances and other private capital flows hadovertaken official aid as the main source ofexternal finance for Africa, the financial crisisseems to be distorting the pattern and predicta-bility of capital flows into the continent and posea threat to debt sustainability. Moreover, giventhe intensity of the financial crisis and the bail-

out packages for banks in the USA and UK,among others, it is unlikely that the Gleneaglescommitment of the G-8 heads of state in 2005 todouble aid to Africa by 2010 will be met. But per-haps, “the angel is in the details”: the flexibilityof individual African countries to manoeuvre outof the crisis will very much depend on financialsector reforms, especially relaxation of controlson portfolio investment and FDI, and capitalaccount liberalisation. Hence, the paper high-lights the magnitude and determinants of capitalflows into Africa and the capital account liberali-sation challenges and policy responses. Thepaper concludes with lessons and policy agendafor Africa in the post-crisis period; in particular,it emphasizes that policymakers face particularchallenges and opportunities in maintainingsound macroeconomic management, transparentcapital account policies, debt sustainability andundertaking financial sector reforms in order toattract inflows in a competitive world and tomanage the inflows to target economic recovery.

Abstract

Victor Murinde, University of Birmingham

Keywords: Financial crisis, flow-of-funds, liberalisation JEL classification: G1, G15, G18

1. Introduction2. Flow-of-Funds Framework3. The Global Financial Crisis

3.1 After the Mexican, Asian and Russian financial crises3.2 Implication for banks, companies, investors, governments and capital flows

4. Capital Flows and Capital Account Liberalisation in Africa4.1 The current trends in capital controls and capital account liberalization

in Africa4.2 The magnitude and determinants of capital flows into Africa4.3 Capital account liberalisation challenges and policy responses4.4 Debt sustainability

5. Conclusion: Lessons and Policy Agenda for Africa ReferencesFiguresFigure 1: Remittance inflows to GDP ratio for the SANE economiesTablesTable 1: Flow of Funds Framework (excluding financial prices and policy

instruments) Table 2: Typology of controls on portfolio investment and FDI in African countriesTable 3: Examples of Capital Account Liberalisation ProcessTable 4: FDI flows and stock for selected African and BRIC countriesTable 5: Capital Market Indicators and Capital Flows for a Sample of African and

BRIC Countries Table 6: Official Financial Flows for Selected African and BRIC countriesTable 7: Impact of the crisis on selected African financial markets in an international

contextTable 8: Exchange rates for selected African countries (local currency per US Dollar) Table 9: International Reserves Excluding Gold for African and BRIC CountriesTable 10: Examples of Capital Account Liberalization Challenges and Policy

responses

12669

11

111425262631

18

4121315

1719

212223

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Contents

1. Introduction

There is already a plethora of goodpapers on the possible causes and trenddynamics of the current global financialcrisis. There is also much heated debateamong academics, policy makers and thegeneral public about the size and pos-sible efficacy of the bail-out packagesthat the USA and UK governments,among other OECD governments, haveput in place to abate the velocity and lon-gevity of the crisis. This paper departsfrom the aforementioned stream of workand debate. It seeks to invoke a flow-of-funds approach to analyze the complexityof the financial crisis and its implicationsfor capital flows and capital account libe-ralisation in the post-financial crisis era inAfrica.

It is useful to note that African countries,like most emerging economies, haveenjoyed substantial increases in privatecapital inflows since 2000, as we showlater where individual African countriesare compared to the BRIC economies.Private capital flows to sub-SaharanAfrica reached over US$53 billion in2007, which was about four times largerthan flows in 2000. Most flows weredirected to Nigeria and South Africa, butalso in Ghana, Uganda, and Zambia;portfolio flows have been on the rise, fol-lowing financial sector reforms, improve-

ments in the investment climate and highcountry risk ratings. By the end of 2007,the scenario was that remittances andother private capital flows had overtakenofficial aid as the main source of externalfinance for Africa. Hence, most Africancountries have been basking in the gloryof stable macroeconomic performance,high global demand for commodities,increased capital inflows and debt reliefthanks to the HIPC initiative.

But this scenario simulates “the calmbefore the storm”. Indeed, the outbreak ofthe global financial crisis has changed allthe positive indicators, because one ofthe main channels through which thefinancial crisis is hurting African econo-mies is through financial links, namely areduction or reversal in capital flows tothe region, including FDI. Aid flows arealso under threat. Given the intensity ofthe financial crisis and the bail-out pac-kages for banks in the USA and the UK,among others, it is unlikely that theGleneagles commitment of the G-8heads of state in 2005 to double aid toAfrica by 2010 will be met.

But perhaps, “the angel is in the details”:the flexibility of individual African coun-tries to manoeuvre out of the crisis willvery much depend on a number of fac-tors, including financial sector reforms,especially relaxation of controls on portfo-

1

lio investment and FDI, and capitalaccount liberalisation. It will also dependon whether a country is oil-exporting,resource rich or otherwise. It will alsodepend on the composition of capitalflows. For example, there are some keydifferences between aid flows and privatecapital flows into Africa. The former main-ly goes to the government sector and caneasily and carefully be incorporated inthe government budget; indeed the bud-gets of many African countries are fundedby aid inflows. Private capital inflows arereceived by private sector agents andthey can be quickly reversed in case ofan external shock, as capital outflow orcapital flight.

Hence, this paper invokes a flow-of-fundsframework to scope the challenges,opportunities and policy responses regar-ding capital flows and capital accountliberalisation as Africa and the rest of theworld emerge from the global financialcrisis. The framework is used to highlightthe transmission of the financial crisisfrom the foreign sector (the rest of theworld) to the household sector, companysector, banks and capital markets, as wellas the government sector. The paperexamines the factors which influence thedistribution and composition of recent pri-vate capital flows to African countries;factors such as including macroeconomicperformance, capital account liberalisa-

tion, and financial market development. Italso highlights the policy challengesassociated with the recent increase follo-wed by a sudden decline in capital flowsbefore and during the current crisis. It isnoted that policymakers face particularchallenges and opportunities in maintai-ning sound macroeconomic manage-ment, transparent capital account poli-cies, and undertaking financial sectorreforms in order to attract inflows in acompetitive global environment and tomanage the inflows to target economicrecovery.

The rest of the paper is structured intofour sections. After using the flow-of-funds framework (Section 2) to underpinthe mechanisms for capital flows in rela-tion to the financial crisis (3), the paperfocuses on capital flows and capitalaccount liberalisation in Africa in Section4. It considers the current trends in capi-tal controls and capital account liberalisa-tion in Africa, the magnitude and determi-nants of capital flows into Africa and thecapital account liberalisation challengesand policy responses. In Section 5, thepaper concludes with lessons and policyagenda for Africa in the post-crisis period.

2. Flow-of-Funds Framework

We invoke a flow-of-funds framework inorder to underpin the special role played

2

by capital flows in linking the domesticeconomy with the rest of the world andhow these flows relate to financial tran-sactions by households, companies andthe government(2). We argue that thisspecial role by capital flows can be dis-torted by an exogenously propelled finan-cial crisis, in which case careful remedialpolicies are required to restore the capitalflows to previous levels.

Flows of funds arise from the transac-tions which take place within the econo-my and the rest of the world, mainlyinvolving exchanges of assets and liabili-ties. These transactions generate flows offunds from one agent to another andfrom one sector to another. In Table 1,flow-of-funds accounts show net transac-tions in financial instruments among thekey economic sectors (Green andMurinde, 1998). Each row (i) representsan asset, and each column (j) a sector.Each cell (i,j) in the matrix shows net pur-chases(+) or sales(-) of asset i by sector jduring the unit time period. The row sumsof the matrix are zero as net purchasesof an asset must equal net sales, andeach column (j) sums to the j'th sector'ssurplus or deficit, that is, its NetAcquisition of Financial Assets (NAFA).

When households and companies makeconsumption and investment decisions,changes in the stocks of assets and liabi-lities are tracked through identities whichstate that the current stock is equal to thesum of: the previous period’s stock, netflows into or out of the stock throughtransactions (purchases or sales by anygiven sector), changes in valuation (capi-tal gains or losses), and depreciation ofthe pre-existing stock. Net flows into orout of a stock correspond to entries in theflow of funds account for any given sec-tor. Capital flows are part of the flow offunds of the foreign sector relative to thedomestic economy in Table 1. Flow offunds models are generated by represen-ting the assets and liabilities into identi-ties and then reparameterising someidentities into behavioural equations(which include policy instruments such asinterest rates and exchange rates).Examples include models to explain theportfolio behaviour of the household sec-tor, the company sector or the banks sec-tor, and the role of flow of funds in inter-est rate determination(3). In addition,these models seek to explore why agentsin a particular sector hold specific assetsand why the agents choose to substituteassets within their portfolio; that is, asset

3

(2)As pointed out by Klein (2000, p.ix), “…. the main function of the flow of funds accounts is to reveal the sourcesand uses of funds that are needed for growth”.

(3)See, in particular, Tobin and Brainard (1968), Green (1992), Green and Murinde (1998, 2004, 2005).

demand equations. A specific examplehere is to specify an equation for capitalflows or the demand for assets by theforeign sector. Also, as shown by Moore,Green and Murinde (2006a, 2006b), sto-chastic policy simulations within a flow-of-funds model can shed light on the type offinancial reform policies for influencingoutcomes for households, companies,banks and government(4). As emphasized

by Fleming and Giugale (2000), a keyadvantage of the flow of funds is that itimposes internal consistency on analysesand forecasts, and provides an expositionof the complete financial implications ofpolicy or other changes. The frameworkin Table 1 can be extended so that theentries in the rows and columns reflectasset prices as well as instruments. Theimportant instruments include private

4

(4)The implementation of flow of funds accounts in official statistics follows the UN System of National Accounts(SNA; United Nations, 1968 and 1993).

Table 1: Flow of Funds Framework (excluding financial pricesand policy instruments)

Household Sector

CompanySector

BanksSector

GovernmentSector

ForeignSector

1. Income-expenditure1.1 Income (Y)1.2 Taxes (T)1.3 Consumption (C)1.4 Investment (I)

Net acquisitions (S)

2. Assets and liabilities:Balance-sheet accounts

2.1 Capital (K)2.2 Loans (L)2.3 Domestic money (M)2.4 Foreign money (R)

Net worth (W)

H

YH

TH

CH

IH

SH

KH

LH

MH

WH

P

YP

TP

CP

IP

SP

KP

LP

MP

WP

B

LB

MB

WB

G

TG

CG

IG

SG

KG

LG

MG

RG

WG

F

CF

IF

SF

KF

RF

WF

non-bank lending, corporate debt andequity, foreign direct investment, over-seas development assistance (aid), totalcapital flows, and remittances. The inclu-sion of these instruments reflects not onlythe growth of non-bank institutions andcapital markets in most African econo-mies in recent years, but also the impor-tance of capital inflows in financingAfrica’s growth.

In the context of the financial crisis andcapital flows in Africa, the flow-of-fundsserves at least three main purposes.First, the framework underpins thesources and uses of funds between thehousehold, company and banks sectors,on the one hand, and the foreign sector,on the other. When a financial crisiserupts in the rest of the world (forexample, the USA in the case of the cur-rent crisis), the contagion effects of thecrisis are transmitted via the foreign sec-tor and its link to the rest of the economy.At least two financial prices provide thepropagation mechanism for the contagioneffects: the exchange rate and stockprices; equally, the transmission mayoccur via the differences between thedomestic interest rates and the worldinterest rates – theory predicts a stablerelationship among exchange rates, inter-est rates and stock prices. The bankssector is also important here because it

provides financial intermediation from thehousehold sector to the company sector;financial instruments (such as depositand loan interest rates), financial reforms,and bank regulation influence the size ofintermediation. Two results occur: (a) theexchange rate depreciates rapidly andinvestors panic to convert their local cur-rency holdings into foreign money andtake the lot outside the country, that is,exchange rate collapse and capital out-flows; (b) foreign investors sell theirshares on the local stock exchange andstock prices fall, that is, stock price col-lapse. We argue, therefore, that the flow-of-funds framework is used to highlightthe transmission of the financial crisisfrom the foreign sector (the rest of theworld, or specifically the USA) to the hou-sehold sector, company sector, banksand capital markets, as well as thegovernment sector. Financial prices provi-de the propagation mechanism for conta-gion effects of the financial crisis. For thismatter, the early-warning symptoms forcontagion effects into African economiesare likely to include rapid depreciation ofthe exchange rate, collapse of the stockmarket index, sudden capital outflowsand potential (or actual) bank run.

Second, the flow-of-funds frameworkunderpins the centrality of banks inAfrica’s financial system. Because the

5

current financial crisis is characterised bybank fragility, it may impair (throughexchange rate and stock price effects)the financial intermediation function ofdomestic banks in Africa in three mainways: (a) the immediate effect is a reduc-tion in the supply of intermediary capital;that is, a credit squeeze, popularly knownas a credit crunch; (b) a collapse of theprices of real assets (e.g. residentialhouses) and company real assets, lea-ding to a collateral squeeze; (c) price andother incentives for attracting depositsfrom household sector fall, leading acontraction in the supply of savings; thatis, a savings squeeze.

Third, the role of the government sectorin the flow of funds and the financial cri-sis is important because in most Africancountries, companies require governmentguarantees to access funds from theforeign sector (international banks andcapital markets). In addition, at the earlysigns of contagion effects, the govern-ment sector should react by bailouts tobanks and companies or by funding com-pany redundancies. Also, the governmentis centre stage in other supporting func-tions, including the legal infrastructure.Above all, the government sector isimportant because these mechanisms alldepend on the degree of capital accountliberalisation in force in the domestic eco-

nomy, and as we shall show there aresharp variations across Africa, rangingfrom strict exchange controls to full capi-tal account liberalisation.

3. The Global Financial Crisis

3.1 After the Mexican, Asian andRussian financial crises

In a flow-of-funds context, a financial cri-sis may be transmitted from the foreignsector to the domestic economy, wheninternational financial prices such asexchange rates and stock prices providethe propagation mechanism for the conta-gion effects. In the domestic economy,the role of financial intermediation bybanks is impaired to the extent thatbanks become dysfunctional and the cor-porate and financial sectors experience alarge number of insolvency and bankrupt-cies. To highlight this argument, we brie-fly review the current global financial cri-sis in view of the three main financialcrises in recent history.

The Mexican Peso Crisis broke out on20 December 1994 when the Mexicangovernment suddenly announced thatthe peso was devaluated by 15% (Han,Lee and Suk, 2003). The peso continuedto fall as currency traders and investorspanicked and sold their peso holdings.

6

At the same time, there was a rapidcapital outflow and the Mexican stockmarket (Mexican IPC) fell by 47.94% inone month. The “tequila effect” spreadto neighbouring countries, especiallyBrazil (Sharma, 2001). Hence, the mainsymptoms of the Mexican crisis werethreefold: exchange rate depreciation,fall in stock prices and huge capital out-flows.

The 1997 East Asian Financial Crisis(5)

has been attributed to different factors bydifferent researchers; however, there isconsensus that the main causes includedlarge external deficits, property marketbubbles and stock market bubbles. Themain symptoms were the collapse of theexchange rate and stock prices (see, forexample, Grouzille and Lepetit, 2008)(6).Also, the crisis is attributed to the presen-ce of internal weaknesses in the financialsector, such as traditional banking prac-tices and inadequate bank regulation(7).Inadequate bank regulation and supervi-sion was rampant to the extent that “new

banks and finance companies were allo-wed to operate without supervision oradequate capitalization.” (Radelet et al,1998:35). Some foreign banks tried toimpose some capital adequacy mea-sures; for example, it has been arguedthat “Japanese banks were the criticalactors who triggered the Asian crisiswhen they reduced their credit, first toThailand in early 1997, in order to meetcapital requirement” (Brana and Lahet,2008:98)(8). In addition, the crisis is attri-buted to excessive foreign borrowingmainly by the private sector; “firms borro-wed heavily to fund plant expansion andacquired unsustainable debt/equity ratios”(Jackson, 1999:6). Various East Asiancountries increased a large proportion oftheir net foreign liabilities. When the crisisarose in mid-July 1997, there were largescope of indebtedness of short-term andun-hedged loans exceeding 50 percent ofGDP of Thailand, Indonesia and Philip-pines. Furthermore, not only was theindebtedness of these countries substan-tial, they were also held back by the

7

(5)The crisis first exploded in Thailand in September 1997 and almost immediately spread to Malaysia, thePhilippines, Indonesia and Korea.

(6)The Asian financial crisis has also been described as a currency crisis, defined as a nominal depreciation of the currency of at least 30 percent that is also at least a 10 percent increase in the rate of depreciation com-pared to the year before (Frankel and Rose, 1996).

(7)A sound domestic financial system is important. In the case of the Asian financial crisis, Mullineux, Murindeand Pinijkulviwat (2003) show that the standard regulatory instruments of Central Bank of Thailand wereinadequate to deal with the financial crisis.

(8)Another additional factor is exchange rate overvaluation, which is blamed on governments for maintainingfixed exchange rates and allowing currencies to become overvalued (Jackson, 1999:3).

short-term loans which amounted up to22 percent of their respective GDPs. It isargued by Radelet et al (1998) that manyforeign investors assumed that theywould be bailed out by host governmentsin case of repayment problems by com-panies. Moreover, the literature suggeststhat premature capital account liberaliza-tion was a root cause of the 1997 Asianfinancial crisis (Wang, 2007). The"double-edged sword" of capital accountliberalization was that while the opening-up of domestic capital markets greatlyincreased capital inflows, the sameattracted substantial international hotmoney which was potentially destructive.For example, speculative hot money ledby George Soros’s Quantum Fund wasdestabilizing to fragile local financial mar-kets in the absence of adequate financialregulation. However, an interesting les-son from the Asian financial crisis is thatcountries in the regions were not directlyvulnerable to contagion effects. Accordingto Jackson (1999), countries such asSingapore and Hong Kong escaped thespread of the crisis in the region becausethey had stronger financial systems,including adequate bank regulation. Inthis context, financial reforms whichstrengthen bank regulatory and supervi-sory framework may help to mitigateadverse contagion affects of the financialcrisis.

The Russian Financial Crisis broke out inAugust 1998, approximately one yearafter the break out of the Asian financialCrisis. Russia’s foreign currency reservesfell sharply, the Rouble rapidly deprecia-ted and huge capital outflows followed.The stock market index fell quickly. TheRouble depreciated further by 34% at theend of December 1998, amid speculativepanics that marked the outbreak of theRussian financial crisis. Some analystshave attributed the crisis to economicfundamentals, such as the erosion offederal government revenues and collap-se of fiscal discipline, while forced thegovernment to borrow heavily by issuingbonds. Foreign investors holding govern-ment bonds started to panic when theRouble depreciated rapidly (see Sojli,2007).

The global financial crisis was triggeredby the US subprime mortgage crisis inthe spring of 2006, when the US second-largest subprime mortgage company(New Century Finance) announced it wasfiling for bankruptcy protection (Mizen,2008). This was followed quickly byannouncements of trouble among severalbig names in banking and investments inthe USA. Goodhart (2008) categorizesthe reason of the crisis as the mis-pricingof risk, the new financial structure, thepoor credit rating agencies and insuffi-

8

cient liquidity. Similarly, Mizen (2008)acknowledges the period of exceptionalmacrostability, the global savings glut,and financial innovation in mortgage-bac-ked securities as the precursors to thecrisis. Raynes and Zweig (2009) suggestthat the proper valuation of these securi-ties is seen as being crucial to resolvingthe financial crisis.

Hence, the previous financial crises inAsia, Mexico and Russia have someimportant common element elements.These crises, especially the 1997 AsianFinancial Crisis and the current globalfinancial crisis, can be attributed tomonetary issues or sub-prime mortgageproblems, as well as contagion effects.

3.2 Implication for banks, companies,investors, governments andcapital flows

The current financial crisis has importantimplications for banks, companies, inves-tors and governments. In a flow of fundscontext, the main implication for banks isthe centrality of the financial intermedia-tion role, such that there must be a stablesource of funding for all types of banks,including commercial banks and invest-ment banks. Hence, it is very importantfor banks to maintain capital ratios toavoid liquidity and solvency risks. When

the subprime mortgage crisis broke out in2007, the loss of market confidencemade liquidity extremely difficult.Consequently, Northern Rock could notfinance its business, and it ultimatelyended up with U.K. Government nationa-lization.

The main implication of the crisis forcompanies relates to executive compen-sation and corporate governance alsosometimes labelled “the fat cat problem”or simply “greed”. The point is that com-panies should beware of high incentiveused in management which led to uncon-trollable risks. Research shows that, in2007, the United States executives’ sala-ry level was 275 times that of ordinaryem-ployees. The ratio was only 35 to 1about 30 years ago (Bloomberg, 2008).Therefore, it is learnt that companies inany industry should have a reasonablemargin of incentives, which must notbreach the industry standard and appro-priate balance of the principles of socialequity.

For investors, the main implication of thecrisis is that investors need to rememberis the importance of diversification andgovernment bonds in their portfoliomanagement. Governments, in particular,have important lessons to learn from thecurrent financial crisis. First, all govern-

9

ments must be aware of the extensiverisks associated with rapid financial inno-vations, including the likelihood of cau-sing financial bubbles. The ongoing finan-cial crisis has been triggered and spreadby the U.S. subprime mortgage lossesdue to improper uses of financial deriva-tives, such as securitisation of U.S. mort-gage agencies (Fannie Mae and FreddieMac) into mortgaged-backed securitiesfor sale in the market. Then, investmentbanks used their financial engineeringtechnology to repackage and trade thesecurities. Second, governments shouldbeware of the excessive uncertaintiesand risks resulting from over-speculation.Looking back the history of financialcrises, no matter big and small, almost allof them are connected and caused by theexcessive speculation and ignorance ofrisk control. Moreover, modern invest-ment banking business is heavily enga-ged in financial derivatives, which haveleverage effects, such that investors caneasily enlarge profits (as well as risks) bybearing a small amount of trading margin.High leveraging ratio has made invest-ment banks highly dependent on finan-cing. However, during the credit crunch,investment banks’ balance sheet deterio-rated dramatically, rating agencies (suchas S&P and Moody’s) therefore loweredtheir rating so that the financing costsincreased significantly. The Big Five on

Wall Street at the time (Bear Stearns,Lehman Brothers, Merrill Lynch, GoldmanSachs, Morgan Stanley) exhibited thisproblem (Bloomberg, 2008). Hence, inorder to maintain the stability of financialmarkets as well as the whole financialsystem, it is necessary for all govern-ments to take effective measures to curbexcessive speculation (e.g. setting upthresholds of leverage with strict penal-ties).

Hence, it is noted that in the context ofthe flow of funds framework, all the sec-tors of African economies are inextricablylinked in the crisis and must be percei-ved as part of the problem as well as thesolution. This is simply because mostfinancial crises, including those reviewedabove, are preceded by a credit boomenjoyed by households, companies andbanks, an asset bubble enjoyed mainlyby households and banks, and wideningcurrent account deficits. The financial cri-sis represents the unwinding of unsustai-nable financial exposures in a disruptivemanner. Policy requirement is to stop thebubble before it becomes unsustainable,but this is partly a political economy pro-blem. When the economic boom is rol-ling, no government has an incentive tostep in and stop it, and a regulator whotries to do it would have to be verybrave.

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The foreign sector of the flow of fundsframework is important in linking thefinancial crisis to capital flows and capitalaccount liberalisation in Africa. When thecrises occurred, some key financial indi-cators, such as exchange rates andstock prices deteriorated in some largeAfrican economies (see Tables 7 and 8).Moreover, the Asian financial crisis,Mexican Peso crisis and the Russianfinancial crisis, which occurred in emer-ging economies, were characterised byuncertainty in capital flows. The main rea-son is: “In an emerging market financialcrisis, an economy that has been therecipient of large-scale capital inflowsstops receiving such inflows and insteadfaces sudden demands for the repaymentof outstanding loans. This abrupt reversalof flows leads to financial embarrass-ment, as loans fall into default or at leastare pushed to the brink of default.”(Radelet et al, 1998:4).

4. Capital Flows and CapitalAccount Liberalisation inAfrica

4.1 The current trends in capitalcontrols and capital accountliberalization in Africa

Table 2 shows the typology of controls onportfolio investment and FDI in Africa. It

highlights the regulatory framework forcapital account transactions in mostAfrican countries, based on the IMF’sAnnual Report on Exchange Arrange-ments and exchange Restrictions(AREAER) database, as reported in IMF(2009). It covers both capital account orfinancial openness (the de jure status ofregulations affecting capital account tran-sactions) and financial integration (the defacto degree of openness as measuredby the actual size of capital inflows). Thetable illustrates the fact that the frame-works for regulating capital account tran-sactions in African economies are quicklychanging, although they are still highlycomplex and opaque. Exchange controlshave been lifted in most countries, butthere are still some administrative orbureaucratic procedures in place, whichlimit capital flows. The controls rangefrom: significant restrictions, as inCameroon; to partial opening as in thecase of Nigeria and South Africa; to nocontrols, as in the case of Uganda andZambia. What is interesting is across thetypology, there are no controls on debtoutflows and debt inflows, except inCameroon and South Africa. FDI inflowsare not restricted, except that there aresome administrative procedures (such asregistration), which, if they are cumberso-me, may work as barriers to the domesticmarket.

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Table 2: Typology of controls on portfolio investment and FDIin African countries

Source: Adapted from IMF (2009), Table A3.1, page 69-70.

Controltype/Country

DebtInflows Outflows E&FDI Inflows E&FDI Outflows

No controls

Minimal controls

Uganda

Zambia

Bonds: no controls Bonds: no controls Shares: no controls Shares: no controls

Money marketsecurities: no controls

Money marketsecurities: no controls

FDI: no controls

Shares: no controls

FDI: no controls

Shares: no controls

FDI: no controls

FDI: no controls

Derivatives: no controls Derivatives: no controls

Bonds: no controls Bonds: no controls

Nigeria

South Africa

Camerooncontrols

Shares: no controls Shares: no controlsBonds: no controls Bonds: no controls

Money marketsecurities: no controls

Money marketsecurities: no controls

Money marketsecurities: controls onresident purchasesabroad

FDI: no controls, onlyregistration

FDI: no controls

Money marketsecurities: no controls

Derivatives: no controls Derivatives: no controls

Derivatives: no controls Derivatives: no controls

Bonds: controls onresident sale or issueabroad

Bonds: controls Shares: controls onresident sale or issueabroad

Shares: limits on resi-dent purchasesabroad

Money market securi-ties: controls on resi-dent sale or issueabroad

Money marketsecurities: controls

FDI: no controls FDI: controls

Derivatives: controlson resident sale orissue abroad

Derivatives: controls

Bonds: controls Bonds: controls Shares: controls onissuing, advertising,and sale of foreignsecurities of morethan CFAF 10 million

Shares: no controls

Money marketsecurities:controls

Money marketsecurities:controls

FDI: no controls ifbelow CFAF 100million

FDI: no controls ifbelow CFAF 100million

Derivatives: Notapplicable

Derivatives: Notapplicable

Equity and FDI

13

Table 3: Examples of Capital Account Liberalisation Process

Source: IMF (2009), Table A3.2, p71; see Ndikumana (2003), Table A2, pp 56-59 on the evolution of these figures.

Status/Sequencing

Fully Open Fairly OpenPartially Open

One-stepopening

Sequencedopening

Uganda (1997)Liberalization part of abroad package of mar-ket-oriented reforms, pri-vatization and trade libe-ralization

Zambia (1990-95) 1993-94: liberalization of capi-tal transactions

1995: banks allowed toaccept foreign currencydeposits

Liberalization part ofbroad reforms focusedon economic stabiliza-tion, competitiveness,and debt restructuring,accompanied by financialmarket reforms

Cameroon (2000 to present)2000: Harmonization of nationalforeign exchange regulationsand liberalization of capital flowswithin CEMAC

Prudential limits on banks' netopen foreign positions

Residents' foreign exchangedeposits prohibited

Continued administrative restric-tions remain on most capital out-flows

No immediate plans for furtheropening

Senegal (1999 to present) 1999: elimination of controls oninward FDI and foreign borro-wing by residents

Continuing administrative restric-tions remain on capital outflowsto non-WAEMU countries

Ghana (1995-2006) Mid-1990s: partial liberalization of portfolioand direct investment

2006: Foreign Exchange Act, allowing non-residents to buy government securities withmaturities of three years or longer, minimumholding period of one year

Liberalization following economic stabiliza-tion and debt restructuring: parallel reformsin the primary government debt and stockmarkets; efforts to develop interbank moneyand foreign exchange markets and tostrengthen financial sector supervision andsoundness

Nigeria (1985-2006) Economic reforms initiated in the mid-1980sand subsequently reinvigorated in the mid-1990s, starting with treatment of dividendsand profit repatriation, then later removal ofcontrols in other areas such as derivativesand real estate; some remaining administra-tive restrictions

Foreign exchange market reformed atvarious points from the mid-1980s to whole-sale Dutch auction system initiated in 2006,along with growing importance of interbankmarket, and the effective unification of theparallel and official exchange rates

Tanzania (1990) 1990: start of FDI liberalization

1997: full liberalization of FDI flows

1998: supporting foreign exchange regula-tions

Continuing restrictions on portfolio invest-ments (government securities)

FDI liberalization coinciding with privatiza-tion program, creation of one-stop shop,and investment promotion policy

However, capital account liberalisationmay involve a complex process. Table 3illustrates the fact that the frameworks forregulating capital account transactions inAfrican economies are quickly changing,although they are still highly complex andopaque. Exchange controls have been lif-ted in most countries, but there are stillsome administrative procedures in place,which may limit capital flows.

Tables 2 and 3 explore the differentapproaches of moving from strict controlsto full liberalisation. It appears that inmost African countries, the markets fortransactions for long term capital flows,such as bond transactions, have beenliberalized before the transactions forshort term capital flows such as moneymarket transactions. It is also shown thatthe speed of capital account liberalizationis different across countries; Uganda libe-ralized in ‘big bang’ fashion, while Ghana,Nigeria, and Zambia have adopted a gra-dualist approach. Some countries are stillexploring the way forward with capitalaccount liberalisation. In some countriessuch as Ghana, Nigeria and Zambia,capital account liberalisation has beenimplementation as part of comprehensivefinancial sector reforms. However, somecountries have combined theseapproaches; for example, Uganda imple-mented a ‘big bang’ approach but as partof broad macroeconomic policy reforms.

Taking into account these variations, itseems plausible to sequence capital

account liberalisation such that FDI whichhas growth enhancing effects is liberali-sed first, followed by all short term andlong terms flows. During this phasedapproach, some other institutional reformsshould be implemented; reform of thefinancial legal framework; improvingaccounting and statistics; strengtheningsystemic liquidity arrangements and rela-ted monetary and exchange rate opera-tions; strengthen prudential regulation andsupervision, and risk management; anddevelop capital markets, including pen-sion funds (IMF, 2008a, 2008b).

4.2 The magnitude and determinantsof capital flows into Africa

The recent trend in capital flows to Africaindicates a rapid increase in all forms ofcapital flows since 2000, especially toNigeria and South Africa, but also tocountries which have undertaken financialsector reforms. According to IMF (2008a,2008b), private capital flows to Africancountries have increased almost fivefold,from US$11 billion in 2000 to US$53 bil-lion in 2007.3; portfolio flows increasedfrom 2002 to 2006, while private debtflows and FDI have also gone up sub-stantially since 2000. Non-resource-inten-sive low-income countries in Africa havealso enjoyed the increase in capital flows.However, the capital inflows have beenvolatile, as measured by the ratio of thestandard deviation of capital inflows to

14

their average. According to IMF (2009),total capital inflows to Africa averaged 4.9percent of GDP for 2000–2007. In termsof specific components of the flows, FDIinflows were least volatile whereas debt-creating inflows were most volatile duringthe period 2000-2007.

We highlight the trend in capital flows intoAfrica by looking at three components:FDI stock and flow measures; externallong term debt of all types including bondfinancing and company instruments; aidand associated official financial flows; andremittances. We also highlight the positionof international reserves for selectedAfrican countries. After a stable growth

during 2000-2006, capital flows havedeclined by 2007 in some countries, witha further decline in 2008-2009 due to thefinancial crisis.

Table 4 reports the stock and flow mea-sures of FDI for selected African coun-tries and BRIC during 2000-2007. Thereare at least two interesting observations.First, some African countries registered ahigher percentage change in FDI flowsbetween 2006 and 2007 than the BRICeconomies. Second, some African eco-nomies witnessed a contraction in FDIflows during the same period; forexample, Algeria, Tunisia, South Africaand Nigeria.

15

Table 4: FDI flows and stock for selected African and BRIC countries

Kenya

Mozambique

Uganda

Tanzania

Zambia

Angola

Cameroon

Algeria

FlowStockFlowStockFlowStockFlowStockFlowStockFlowStockFlowStockFlowStock

110.9931.3139.2

1249.2180.81807.1

2162777.8121.7

2332.4878.627977.9158.8

1600.2438

3497.2

5.3026936.61255.4

1504.6151.5962.3388.8

2959.771.7

2404.12145.51012373.2851673.4

11964693.2

27.625964.23347.251851.9184.651146.9387.6

3242.7303.4

2707.51672.111795

601.752275.2

10655758.2

81.7351046336.7

2188.6202.191349.1308.2

4138.6347

3054.53504.711988

3832658.2633.86392

46.0641092244.7

2441.6295.421644.6330.6

4758.5364

3418.51449.313437319.342977.5881.9

7273.9

21.2821113.3107.852630.2379.812024.4567.94390356.9

3775.4-1303.8

12133224.663202.21081.38355.2

50.7271164

153.732788.7400.252424.6521.75342615.8

4391.2-37.769

12171309

3511.21795.410151

728.011892.1427.363216.1367.9

2909.2599.55942983.9

5375.1-1499.9

12207284.333795.51664.611815

1335.1762.54

178.0015.33-8.0819.9914.9111.2359.7822.41

3871.170.30

-7.988.10

-7.2916.40

Year 2000 2001 2002 2003 2004 2005 2006 2007 % change

16

Table 4: FDI flows and stock for selected African and BRIC countries (Cont.)

Egypt

Tunisia

Botswana

Namibia

Sourh Africa

Ghana

Nigeria

Flow

Stock

Flow

Stock

Flow

Stock

Flow

Stock

Flow

Stock

Flow

Stock

Flow

Stock

1235.4

19955

778.8

11545

57.319

1826.6

186.46

1276.3

887.92

43462

165.9

1605.1

1309.7

23786

509.9

20465

486.4

11520

30.84

1388.5

365.19

715.01

6788.7

30568

89.3

1694.4

1277.4

2506.4

646.9

21112

821.3

13861

404.62

854.09

181.39

1822.5

1572.8

30604

58.9

1753.3

2040.2

27104

237.4

21349

583.9

16229

419.5

1167.2

148.74

2951.9

733.67

46868

105.4

1858.7

2171.4

29275

2157.4

23506

638.9

17844

391.55

982.11

225.85

4120.4

799.23

64444

139.27

1997.9

2127.1

31402

5375.6

28882

782.4

16840

281.32

806.28

347.99

2453.4

6643.8

78985

144.97

2142.9

4978.3

36381

10043

38925

3311.8

21853

488.8

805.1

386.57

2785.7

-527.1

87782

636

2778.9

13956

50337

11578

50503

1617.9

26.223

494.9

1300

697.48

3822.5

5692.1

93474

855.4

3634.3

12454

62791

15.29

29.74

-51.15

20.00

1.25

61.47

80.43

37.22

-1179.87

6.48

34.50

30.78

-10.77

24.74

Year 2000 2001 2002 2003 2004 2005 2006 2007 % change

Brazil

China

India

Russia

Flow

Stock

Flow

Stock

Flow

Stock

Flow

Stock

32779

122250

40715

193348

17517

-

2714.2

32204

22457

121948

46878

203142

20326

-

2748.3

52949

16590

100863

52743

216503

25419

-

3461.1

70884

10144

132818

53505

228371

31221

-

7958.1

96729

18146

161259

60630

245467

38183

-

15444

122295

15066

195562

72406

272094

44458

-

12886

180313

18822

236186

72715

292559

52369

-

32387

271590

34585

328455

83521

327087

76226

-

52475

324065

83.75

39.07

14.86

11.80

45.56

-

62.03

19.32

Year 2000 2001 2002 2003 2004 2005 2006 2007 % change

Source: UNCTAD (2008): http://stats.unctad.org/FDI/TableViewer/tableView.aspx?ReportId=1254 [Accessed30/03/2009]

BRIC

17

Table 5: Capital Market Indicators and Capital Flows for a Sample of African and BRIC Countries

Source: Selected and adapted from Beck, Dermiguc-Kunt and Levine (2009).Notes: inslife = Life Insurance Premium Volume to GDP; insnonlife = Non-Life Insurance Premium Volume toGDP; stmktcap = stock market capitalization to GDP; stvaltraded = stock market total value traded to GDP; sttur-nover = stock market turnover ratio; listco = number of listed companies (EMDB); prbond = private bond marketcapitalization / GDP; pubond = public bond market capitalization to GDP; intldebt = international debt issues toGDP; intldebtnet= loans from non-resident banks (net) to GDP; nrbloan = loans from non-resident banks (amtoutstanding) to GDP; offdep = offshore bank deposits to domestic bank deposits; remit = remittance inflows toGDP.

Country Inslife Insnonlife stmktcap stvaltraded stturnover Intldebt intldebtnet nrbloan offdep remitListcoYearAFRICA

Botswana

Egypt

Ghana

Kenya

Morocco

Mauritius

Nigeria

Tunisia

BRIC

Brazil

Russia

India

China

2000

2007

2000

2007

2000

2007

2000

2007

2000

2007

2000

2007

2000

2007

2000

2007

2000

2007

2000

2007

2000

2007

2000

2007

0.001761

0.0040283

0.007137

0.0077605

0.008419

0.0097714

0.02318

0.0007665

0.001349

0.0020845

0.00356

0.0139137

0.0006762

0.016645

0.0402505

0.009705

0.0095919

0.004102

0.004481

0.019069

0.016707

0.020514

0.019611

0.016452

0.0041463

0.015099

0.0177328

0.017312

0.0156

0.0224421

0.005154

0.0061855

0.0082

0.1654462

0.4191545

0.3107006

0.912432

0.1442233

0.1861185

0.1067166

0.4223444

0.3719554

0.8553718

0.3353287

0.7306699

0.0782934

0.3593745

0.1431607

0.1408193

0.3545794

0.7934616

0.2163808

0.9962026

0.3644097

1.127215

0.3810258

1.318386

0.0076604

0.009344

0.1113799

0.4143859

0.0020313

0.0071444

0.0037362

0.0446524

0.03281

0.3585976

0.0168795

0.0579915

0.0057151

0.1012384

0.0321808

0.0186265

0.1571543

0.4451107

0.0782114

0.5844539

1.107817

0.9458412

0.6020443

2.375481

0.0463017

0.0222926

0.3584799

0.4541553

0.0140846

0.0383862

0.0350109

0.1057251

0.0882095

0.4192301

0.0503372

0.0793676

0.0729957

0.2817071

0.2247879

0.1322728

0.4432132

0.5609733

0.3614528

0.5866818

3.040033

0.8390953

1.580062

1.80181

16

1076

22

57

53

40

195

44

459

249

5937

1086

0.001008

0.0431598

0.0505459

0.0308036

0.0123757

0.0126336

0.0171691

0.0769247

0.0448868

0.0015663

0.0804569

0.1054445

0.1300224

0.0883687

0.1115085

0.0870442

0.010101

0.0244795

0.0146502

0.0104359

0.0623133

-0.0335621

0.0430615

-0.0023659

0.0003429

0.0015097

-0.000027

0.0084554

0.0028686

0.0006692

0.0003713

0.0027696

0.0150792

0.0712865

0.1043663

0.241105

0.140232

0.0847231

0.0450542

0.1710646

0.0699022

0.3206492

1.491616

0.0317885

0.0345575

0.1580763

0.1092757

0.098333

0.0613803

0.1419043

0.0908406

0.0423781

0.063276

0.048074

0.0354735

0.2443523

0.2821469

0.3177874

0.428921

0.2514963

0.135099

0.4234449

0.4392721

0.2390833

0.2409376

0.7928312

4.742743

0.2246169

0.3000074

0.2055092

0.3267269

0.1086883

0.0608802

0.1409198

0.2428689

0.076014

0.0489135

0.1335671

0.1140292

0.004209

0.0099178

0.0285661

0.0457862

0.0064289

0.0069037

0.0426768

0.044055

0.0583129

0.0777887

0.0396033

0.0337891

0.0302673

0.0200899

0.0409396

0.0476586

0.0025587

0.0033347

0.0049094

0.0031761

0.0280107

0.0230578

0.00521

0.0078362

18

In addition, Table 5 reports the magnitudeof long-term debt by selected African eco-nomies, compared to BRIC economies asa benchmark for most emerging econo-mies. It is shown that for all debt instru-ments, there was a steady increase indebt flows into African economies during2000-2006. But it is also indicated in thelast column of the table that the change indebt flows during 2005–2006 was negati-ve for most African countries as well assome BRIC economies. Until recently,domestic government securities marketshave been dominated by short-term trea-sury bills that domestic banks purchase forliquidity management purposes.

Development of long-term bond marketshas intensified in the last few years, butsecondary trading is still limited ornonexistent.

The magnitude of aid flows was alsostable during the period 2000-2006, bothin terms of aid strictly defined as well asaid plus other official flows with a grantelement. The change in aid flows during2005–2006 is negative for some Africaneconomies and Brazil, among the BRICeconomies.

As shown in Figure 1, remittances havebeen an important component of private

Figure 1: Remittance inflows to GDP ratio for the SANE economies

Note: RI = Remittance Inflows.

19

Table 6: Official Financial Flows for Selected African and BRIC countries

Source: UNCTAD (2008): http://stats.unctad.org/Handbook/TableViewer/tableView.aspx?ReportId=1926 [Acces-sed 30/03/2009]Note: ODA = Official Development Assistance; OOF = Other Official Flows

Kenya

Uganda

Tanzania

Zambia

Algeria

Egypt

Tunisia

SouthAfrica

Nigeria

Brazil

China

India

420.23461.55-41.32773.62790.35-16.731261.11263.8

-2.75362.45348.713.75

223.79223.56

0.231479.71255.6224.09690.75376.93313.82511.92427.8384.09-329

167.82-496.82767.8228.78

25392862

1473.21388.81395.51701.4-305.9

358.37391.04-32.67678.81709.65-30.841122.41235.9-113.5

594.77639.12-44.35118.51328.41-209.91366.51236.9129.53

432264.71167.29434.87504.57

-69.73229.4294.032935.41673.5202.391471.1-103.41471.3-1575-1065

1440.6-2506

477.09521.45-44.36974.57976.14

-1.571648.31704.4-56.09491.83589.36-97.53-28.82234.44-263.3

1188986.75201.27418.51297.67120.841054.3641.25413.08417.42308.06109.36

-293194.19-487.2-1929

1332.7-3262-1176

899.71-2076

641.24654.42-13.181189.11193.8

-4.711662

1751.2-89.181164.61125.239.37-1262

314.25-1577

1991.71455.6536.14502.07327.61174.46930.2628.2

302734.4

578.16156.24-2489

157.08-2646

2043.71685.1358.59130.39693.9

-563.5

787.24767.0820.16

1175.51177.5

-1.971474.5

1481-6.46

837.81934.96-97.15-1135

371.36-1506

2062.9995.111067.8291.52364.99-73.47721.99679.9542.04

6315.66415.8-100.2132.37195.54-63.172103.21801.9301.34

288017281152

974.73943.431.33

1546.41550.6

-4.221833.11825.3

7.8925.951424.9-498.9-4134

208.52-4342

1183.1872.87310.23103.55

432-328.5705.92717.78-11.86

5339.911434-6094

2043.982.42

1961.52332

1245.51086.53307.61378.91928.7

23.8222.9955.4131.5531.69

114.2124.3223.25

-220.7410.5252.40

413.55264.18-43.85188.25-42.65-12.28-70.95-64.4818.36

347.05-2.235.56

-128.21-15.4578.22

5983.641444.06

-57.85-3205.0

10.88-30.88260.5514.85

-20.2067.43

Total official flows netTotal ODA netTotal OOF netTotal official flows netTotal ODA netTotal OOF netTotal official flows netTotal ODA netTotal OOF netTotal official flows netTotal ODA netTotal OOF netTotal official flows netTotal ODA netTotal OOF netTotal official flows netTotal ODA netTotal OOF netTotal official flows netTotal ODA netTotal OOF netTotal official flows netTotal ODA netTotal OOF netTotal official flows netTotal ODA netTotal OOF netTotal official flows netTotal ODA netTotal OOF netTotal official flows netTotal ODA netTotal OOF netTotal official flows netTotal ODA netTotal OOF net

AFRICA 2001 2002 2003 2004 2005 2006 % change

capital flows and seems to have overta-ken aid flows for some countries.

Overall, although there is a steadyincrease in all components of capitalflows during 2000-2006, there are someunexplained variations in the relativechanges that we see for 2005-2006.Hence, it is useful to highlight the keyfactors that determine the magnitude anddirection of capital flows for African eco-nomies. In conformity with the existingliterature, we distinguish between “push”and “pull” factors in order to determinewhether the factors are permanent ortransitory; however, it is fair to say that inpractice both factors work together. Themain domestic “pull” factors that haveattracted FDI into Africa include a stablepolitical environment (less political risk),sound macroeconomic policies, stableexchange rate, improved governance,capital market infrastructure, and thebusiness environment. Also, most ofthese countries have attained good coun-try risk and credit risk ratings, which hasenabled them to access internationalcapital markets. In addition, however,some factors have prompted private capi-tal inflows to flow to Africa; for example,in the case of China, the motive has beento secure natural resources such as oiland gas, mining, and infrastructure, withsuch ventures recently undertaken inGabon, Congo and Susan. However,

China has also taken investments in ban-king; for example equity investment inStandard Chartered Bank of South Africa.

The data on capital flows reported inTables 4-6 show that Uganda andZambia, which have no capital controls,have received huge portfolio inflows,which suggests that capital account libe-ralisation influences capital inflows.However, some countries which still havesome capital controls are also receivingsubstantial capital inflows. So, even interms of anecdotal evidence, it is notclear cut to associate capital accountliberalisation with an increase in capitalinflows. This observation is consistentwith the empirical findings in IMF (2009)in which the variable for capital accountliberalisation is not significant in a modelof the determinants of capital flows;hence, the evidence does not establishan empirical relationship between capitalcontrols and capital flows in Africa.

As can be seen on Table 4, FDI flows toAfrica countries that have well establi-shed debt and equity markets, such asSouth Africa and Nigeria, have receivedthe lion’s share of portfolio capital. Inaddition to South Africa, some countriessuch as Botswana, Ghana, Kenya,Nigeria, Uganda, and Zambia, whichhave functional capital markets have alsoattracted substantial FDI nflows.

20

The current global financial crisis is likely tochange the magnitude and pattern of thesecapital flows. Indeed the main propagationmechanisms of the contagion effects of thecrisis, namely the exchange rate and stockprices have already shown signs of perver-

se effects. Table 7 and 8 show the impactof the financial crisis on stock prices andthe exchange rate, respectively. First, weexamine the impact of the financial crisison selected African capital markets, name-ly Cote d’Ivoire, Egypt, Kenya, Mauritius,

21

Source: Partly from African Development Bank (2009); updated as follows: UK: http://uk.finance.yahoo.com/q/hp?s=%5EFTSE[Accessed 23/03/2009]; Brazil: http://uk.finance.yahoo.com/q?s=^BVSP [Accessed 23/03/2009]; Russia: http://www.rts.ru/en/index/rtsi/ [Accessed 23/03/2009]; India: http://uk.finance.yahoo.com/q?s=^BSESN [Accessed23/03/2009]; China: http://uk.finance.yahoo.com/q?s=000001.SS [Accessed 23/03/2009.]

Table 7: Impact of the crisis on selected African financial marketsin an international context

Country/Region Index name Index code Benchmark31.07.2008

Benchmark31.07.2008

Losses duringfinancial crisis (%)

BRVMCompositIndexCASE 30IndexKenya StockIndexMauritiusAllSharesCasa All ShareIndexNSE All ShareIndexAll ShareIndexTunis se TnseIndex STK

Bovespa IndexRTS IndexBSE SENSEX 30ShanghaiComposite

FTSE IndexDow JonesIndustrialCAC 40 IndexNikkei 225Index

Côte d’Ivoire

Egypt

Kenya

Mauritius

Morocco

Nigeria

South Africa

Tunisia

BRICBrazilRussiaIndia

China

OECDUK

USA

France

Japan

BRVM CI

CASE 30

KSE

SEMDEX

MASI

NSE

JALSH

TUNINDEX

IBOVESPARTSIBSESNSHANGHAICOMPOSIT

FTSE 100

DJ Index

CAC40

N225

242.54

9251.19

4868.27

1735.77

14134.70

52916.66

27552.65

3036.87

59505.001966.68

14355.75

2775.72

5411.90

11378.02

4392.36

13376.81

169.34

3600.79

2855.87

1005.69

10352.81

23814.46

20650.38

3049.60

41674.00624.21

9634.74

2320.79

4189.60

7850.41

2997.86

7779.40

-30.18

-61.08

-41.34

-42.06

-26.76

-55.00

-25.05

0.42

-29.97-68.26-32.89

-16.39

-22.59

-31.00

-31.75

-41.84

AFRICA

Morocco, Nigeria, South Africa and Tunisiaby calculating the change in the value ofthe respective stock market index betweena benchmark period of 31 July 2008 and acut-off period of 12 February 2009. Wethen compare the loss in the value of theindex within that period for each of thesample African markets, to the BRIC capi-tal markets on the one hand, and sampleOECD markets for the UK, USA, Franceand Japan, on the other.

The results reported in Tables 7 and 8 arestriking! The loss in the index value foreach of the Egyptian market (CASE, -61.08%), the Nigerian market (NSE AllShare Index, -55.0), and the Mauritiusmarket (SEMDEX, -42.06), was higherthan the loss in any the OECD market ofthe UK, USA, Japan and Finance. Also,loss in index in each of the three Africanmarkets exceeded the loss of value in

each of the BRIC, with the exception ofRussia (-68.26%). These results are atvariance with the view that African mar-kets are insulated from the contagioneffects of financial crisis. On the contrary,the results in Table 6 drive home the mes-sage that the main African financial mar-kets, which are relatively liquid comparedto the rest in the continent, have beenperversely affected by the financial crisis.In a flow-of-funds framework, the conta-gion effect may be attributable to theover-valuation of stocks and the outflow ofportfolio investments by the householdsector and the company sector. As notedin ADB (2009), African investors, andEgyptian and Nigerian investors in parti-cular, recorded within six months an ave-rage loss of more than half the wealthinvested at the end of July 2008, which ishigher than the losses recorded on thesample OECD markets in Table 7.

22

Table 8: Exchange rates for selected African countries(local currency per US Dollar)

Source: 1- Botswana: http://www.bankofbotswana.bw/section_Exchangerates.php?sectid=4952- Ghana: http://www.bog.gov.gh/index1.php?linkid=173 3- Nigeria: http://www.cenbank.org/Rates/ExchRateByCurrency.asp 4- South Africa: http://www.reservebank.co.za/ 5- Tanzania: http://www.bot-tz.org/FinancialMarkets/FinancialMarkets.asp#ForeignExchangeMarketsNote: All accessed on 30/03/2009

% change (Dec 2008 - Feb 2009)February 2009December 2009December 2006Country

BotswanaGhanaNigeriaSouth AfricaTanzania

6.030.92353

126.56.9737

113.209

7.521.21

130.759.3035

128.030

7.961.34115145.359.9498

130.246

5.8910.8411.176.951.73

The bond market in some Africa countrieswas also affected by the crisis because ofthe adverse changes in the spreads in thebond markets. For example, althoughTunisia is the only market with positivevalue in Table 6, it felt the brunt of the crisis

in its attempt to issue bonds on the interna-tional financial markets, where it was facedwith debt spreads estimated at between45 and 50 basis points, such that it hadto increase its offer by 25 basis points toattract entice investors (ADB, 2009).

23

Table 9: International Reserves Excluding Gold for African and BRIC Countries

Source: UNCTAD (2008) http://stats.unctad.org/Handbook/TableViewer/tableView.aspx?ReportId=1925 [Accessed 31/03/2009]

BurundiKenyaMalawiMauritiusMozambiqueRwandaUgandaTanzaniaZambiaCameroonAlgeriaEgyptMoroccoTunisiaBotswanaLesothoNamibiaSouth AfricaSwazilandBeninBurkina FasoGambiaGhanaNigeriaSenegalSierra LeoneTogo

BrazilChinaIndia

32.9897.7

243897.4723.2190.6

808974.2244.8

2121202413118

4823.21811

6318.2417.9259.8

6082.8351.8458.1243.6109.4232.1

9910.938449.2

152.3

3243416827737902

17.71064.9202.5835.6713.2212.1983.4

1156.6183.4331.818082129268473.91989.25897.3386.5234.3

6045.3271.8578.1260.5

106298.210457447.351.3

126.4

3556321560545871

58.81068161.5

1227.4802.5243.7

9341528.8535.1629.72323813242101332290.35473.9406.4323.1

5904.2275.8615.7313.4106.9539.7

7331.3637.484.7

205.1

3746229112867668

671481.9

1221577.3937.5214.7

1080.32038.4247.7639.6

331251358913851

2945.45339.8460.3325.2

6495.5277.5717.9752.259.3

1352.87128.41110.9

66.6204.9

4884740815196938

65.81519.3128.1

1605.91131

314.61308.12295.7337.1829.3

432461427316337

3935.75661.4501.5345.1

13141323.6

640669.183.8

1626.716956

1386.4125.1359.7

52462614500126593

100.11798.8158.9

1339.91053.8405.8

1344.22048.8559.8949.4

563032060916188

4436.76309.1519.1312.1

18579243.9656.8438.498.3

1752.928280

1191170.5194.6

53245821514131924

130.52415.8133.8

1269.61155.7439.7

1810.92259.4719.7

1716.277913.824461.520340.76773.27992.4658.4449.6

23056.9372.5912.2554.9120.6

2090.342298.81334.2183.9374.5

85156.11068493170737

30.3734.30

-15.80-5.259.678.35

34.7210.2828.5680.7738.3818.6925.6652.6626.6826.8344.0624.1052.7338.8926.5722.6919.2549.5712.027.86

92.45

59.9330.0629.42

AFRICA % change(last 2 years) 2000 2001 2002 2003 2004 2005 2006

BRIC (except Russia)

24

Table 10: Examples of Capital Account Liberalization Challenges and Policy responsesCountry and

Exchange rateSystem

Impact of inflows/Policy Challenges Policy Responses/Recommendations

CameroonHard Peg

NigeriaManagedfloat Reservemoney targe

UgandaManagedfloat Reservemoney target

ZambiaManagedfloat Reservemoney target

Oil Export receipts dominate private debtinflows Inflows have helped build international reserves,but have little impact on money growth andinflation The REER appreciated in line with the euro With low and stagnant private sector credit andhigh excess liquidity, the challenge is to improvefinancial intermediation

tOil export receipts dominate inflows, thoughFDI and particularly portfolio flows are beco-ming more important The interbank foreign exchange market is dee-per and has become the primary measure ofexchange rate developments. Forward foreignexchange contracts are now offered Interest rates on government paper have beenreduced Bank capital increases prompted inflows The REER has appreciated Capacity to monitor private capital inflows islimited

Surge in inflows since 2004 has been causingappreciation pressures Policy trilemma with constraints on how muchfiscal contraction can be implemented : ifinflows persist, tensions between open capitalaccount, monetary policy independence, and acompetitive exchange rate will be heightened

Inflows have complicated the conduct of mone-tary and exchange rate policy. Their onset coin-cided with a surge in copper prices that led to alarge initial appreciation, in the absence of steri-lization Temporary reversals in inflows, associated firstwith the uncertainty before the 2006 electionsand then with the subprime crisis in August2007 caused by a sharp depreciation Challenges arise from the cost of sterilization,the limited availability of monetary policy instru-ments, and the difficulty of selling foreignexchange when the currency is appreciating In spite of good capital flows data, the authori-ties have difficulty forecasting the government'scash flow

Responsibility for monetary policy rests withregional central bank Recommendations: - maintain fiscal sustainability- strengthen the financial sector - improve the business environment, including thelegal framework and the judicial system

The authorities should maintain a prudent fiscalstance to avoid additional domestic demand pres-sure The Exchange rate has become more flexible,and short-term movements in the naira rateshould ensure that investors perceive two-sidedexchange rate risk The country is in transition to an inflation targe-ting regime Strengthening banking supervision and monito-ring of flows is recommended

Response was a mix of sterilized intervention,increase in base money and nominal appreciation Sterilized intervention was the first line of defen-ce, but was incomplete leading to a large increa-se in base money Some appreciation was allowed, but concernsabout high sterilization costs and export competi-tiveness prompted, for a short period, unsterilizedintervention. This caused a temporary but largeincrease in reserve money

Policy response after large appreciation hasbeen to intensify sterilization operations (tomeet reserve money target), but is costlyMonetary policy helped by - underexecution of the budget in 2007 - transfer of government funds in commercialbanks to the Bank of Zambia - steps to increase monetary policy instruments,though liquidity management remains a problem - an active interbank market to manage liquidityshould be developed

Source: Adapted from IMF (2009) Table A3.3, pages 72-73.

Moreover, according to ADB (2009), thefinancial crisis amplified the increase inthe margin applied to loans in the interna-tional financial markets. For Africa andother emerging economies, sovereigndebt spreads rose by an average of 250basis points, while the spread of theJPMorgan emerging countries equityindex increased by 800 basis points inOctober 2008. At the height of bankrescues in the UK and USA, the spreadsincreased by 100 basis points for Egyptand rapidly increased to above 200 basispoints for Tunisia, subsequently forcingKenya, Uganda and Tanzania to postponeplans for selling bonds on the internatio-nal financial markets.

These perverse effects of the financial cri-sis on Africa’s financial system havegrave implications for FDI and short termcapital flows. For example, in the shortterm, FDI into Africa is expected to fallduring 2009 and early 2010, which willfurther increase Africa’s financial margina-lization and undermine growth in foreigncapital dependent sectors such as naturalresources. In addition, remittances, whichfeed directly into rural credit markets,have fallen since 2007.

Some countries may be able to mitigatethe impact of the crisis because of theirreserve position. Table 9 reports themagnitude of international reserves exclu-

ding gold for selected African and BRICeconomies. The argument is that the glo-bal financial crisis has not induced a sud-den reversal of private capital inflowsimmediately because most African coun-tries have enjoyed strong and stable posi-tion of international reserves since 2000.

4.3 Capital account liberalisationchallenges and policy responses

Table 10 reports some examples of capi-tal account liberalisation in African coun-tries and the policy responses. It is shownthat while the policy challenges associa-ted with private capital inflows have beensimilar across countries, the policy res-ponses have varied depending on the ins-titutional factors as well as the monetaryand exchange rate regime. The tableidentifies the challenges and policy res-ponses associated with four regimes:countries with a hard peg, such asCameroon; countries with a managedfloat and reserve money target, althoughNigeria, Uganda and Zambia may bemoving towards an inflation target.

It is shown that in the first category ofcountries with hard pegs, capital inflowsdid not have a substantial impact on infla-tion or the real exchange rate. Forexample, domestic structural weaknessesin the credit market have been such thatdomestic credit growth has not responded

25

and excess liquidity has increased. Forthe second category, namely managedfloat, the key policy challenge has been tocontain inflation without rapid depreciationof the exchange rate. The policy responsehas been to allow more flexibility in theirmonetary or exchange rate targets. Insome cases, the foreign purchases ofgovernment securities have helped finan-ce the current account deficit; forexample, Ghana.

African countries should redesign theircapital account liberalisation regimes,alongside their institutional and financialsector policies in order to tilt the composi-tion of inflows toward longer-term flows.Good examples are Tanzania, Uganda,and Zambia, which have been able tolengthen the maturities held by foreigninvestors by issuing longer-term instru-ments, facilitated by financial sectorreforms and the ability to maintain a cre-dible, stable macroeconomic and politicalenvironment. It is important to lengthenthe term structure of investments to helpreduce both rollover risks and maturitymismatches in the financial sector, becau-se longer-term bonds better match the lia-bility structure of domestic institutionalinvestors. In addition, the long terms viewof instruments is a better risk manage-ment strategy than short-term instrumentsin the face of a financial crisis because ofthe probability of huge capital outflows in

the case of short term investments. Weconsider the lessons and policy agenda inthe concluding section below.

4.4 Debt sustainability

It is important to note that the globalfinancial crisis may undermine the achie-vements by many African countries in thearea of debt sustainability. However,although the sustainability of debt issue isa potential risk, it all depends on financingsources available to each country. Therisks of a return to unsustainable debtlevels involve collapse in exchange rates,reduction in imported intermediate importsand contraction in economic growth.Further research should explore the issueof debt management more fully. It may beargued that in light of the debt relief initia-tive, some countries may be able to usedebt accumulation to smooth expendi-tures.

5. Conclusion: Lessonsand Policy Agenda for Africa

In the post-crisis era, the trend towardcloser integration of Africa into globalfinancial markets is likely to continue.African governments must prepare theireconomies to compete effectively andenhance capital inflows. This will requirenot only capital account liberalisation butalso institutional and policy reforms. The

26

macroeconomic policy framework and itscredibility are important for managingrisks from rapid capital inflows and pos-sible reversals. Transparent capitalaccount policies, and financial sectorreforms will be needed to ensure that theinflows go to productive uses while avoi-ding macroeconomic instability. Improvingthe capacity to monitor the inflows is criti-cal: the authorities need accurate andtimely data on the size, composition, andmaturity of the inflows to design an appro-priate policy response.

Monetary and exchange rate policy res-ponses should reflect the nature of capitalinflows and the authorities’ policy objec-tives. Large inflows could lead to macroe-conomic instability, higher inflation, anddisruptive exchange rate movements, andtherefore need to be managed carefully.Sterilized interventions could help preser-ve exchange rate and monetary stabilityin the short term while allowing the build-up of official reserves in order to ensureagainst possible sudden reversals.Persistent inflows would thus require theadoption of more flexible monetary andexchange rate policy frameworks. Someof the more mature African countries aretransitioning toward inflation-targeting-likeregimes. Countercyclical fiscal policy canhelp mitigate the real appreciation pres-sures associated with the inflows.Keeping fiscal expenditures steady during

episodes of large capital inflows has alsobeen shown to foster better growth out-comes in the aftermath of these episodes.

In terms of capital account policies, in theshort term, countries should focus onimplementing coherent, transparent, andeven handed capital account policies. Asshown earlier in Tables 2 and 3, capitalaccounts across Africa remain fairly clo-sed (de jure) compared with otherregions, and exchange controls are com-plex and difficult to implement. Thisresults in poor information and createsscope for corruption and mismanagement.Existing capital account regulationsshould be carefully reviewed to enhancetransparency, and inconsistencies andinefficiencies between regulations shouldbe eliminated.

Further on capital account liberalisation,in the medium term, a gradual and well-sequenced liberalization strategy wouldhelp countries reap the benefits of capitalmarket access while limiting the associa-ted risks. In parallel with the progressiveliberalization of capital flows, starting withmore stable and long-term flows, coun-tries need to implement supportive institu-tional and regulatory reforms that willstrengthen their capacity to manage capi-tal inflows and the associated vulnerabili-ties. The timing of the liberalization pro-cess should depend on the extent of

27

financial market development and institu-tions in each country.

Controls on capital inflows may at timesplay a useful role in giving policymakersadditional room for manoeuvre, but thisspace is very limited in practice. The inter-national experience is that such measureshave at best a short-term effect on thecomposition of capital flows (see, forexample, Magud and Reinhart, 2007). Re-imposing capital controls in the face of asurge in inflows is not an appropriatemanagement tool, for these reasons andbecause rapid regulatory changes cancontribute to the disarray that is well-implemented and sequenced.

However, the post-crisis era may also becharacterised by capital flight as agentsshift their funds globally due to politicalrisk, or weak macroeconomic environ-ment; see, for example, Lensink, Hermesand Murinde (2000). Alternatively, wheninvestors perceive that the fears of the cri-sis are over, there is likely to be a suddenincrease in capital flows to emerging eco-nomies including Africa. In response tosudden capital inflow surges, the authori-ties could even consider accelerating thepace of liberalization to better managecapital flows and support other policy res-ponses (e.g. exchange rate and monetarypolicies). If inflows are occurring in spiteof capital controls, removing the controls

can improve monitoring. Selective liberali-zation of capital outflows could also easeinflation and appreciation pressures, pro-vided that foreign reserves are at a com-fortable level. However, the impact of out-flow liberalization in Africa deserves fur-ther study: African policymakers havebeen mostly concerned by capital flight,but in emerging economies there is someevidence that outflows liberalization hasattracted further inflows (IMF, 2008).

In addition, financial sector and otherstructural policies are crucial. Better finan-cial sector supervision and regulation arecritical to efficient intermediation of theinflows and reduced vulnerabilities to sud-den reversals. This is particularly impor-tant for African countries, where institu-tions tend to be weak and financial sec-tors shallow. Strengthened financial sectorsupervision and regulations and improvedrisk management capabilities of bankscould help prevent the buildup of balancesheet vulnerabilities.

In some aspects, a regional strategy isdesirable; for example, regional effortsand co-ordination to strengthen existingcapital markets in order to attract capitalinflows. The idea is to address the lack offunctional capital markets which offer arange of financial instruments for inves-tors For example, only 20 African coun-tries (less than 50%) have established

28

equity markets, and of these, only 9 mar-kets have more than 20 listings. Besidesthe small size of the overall market, thesmall volume of issues in the primarymarkets limits entry. The modest capitali-zation of listed equities also limits theforeign funds that can come in throughequity markets. As for government securi-ties, about 30 African countries issue orhave issued treasury bills and 20 issuebonds. However, bond markets for themost part consist of only a handful ofsmall issues, and there are no Nigeriaattracted substantial inflows into its banksafter the consolidation and meaningfulsecondary markets. Thirteen Africancountries have issues of corporate bonds,often stocks of foreign banks, but thereare no real markets and there is nosecondary trading.

Increased government borrowing in forei-gn and domestic currency associated withprivate capital flows could affect medium-term debt sustainability. The access to pri-vate capital is a welcome sign of successand increases the scope for public invest-ment. But it needs to be carefully monito-red, and the risks associated with thecosts and structure of such instruments(e.g., bullet payments on internationalsovereign bonds) should be fully analysedwithin the framework of medium-term debtmanagement strategies. Moreover,government debt issuance strategies

could support the development of thedomestic yield curve and help broadenthe local investor base. Governmentsshould aim at a progressive lengtheningof maturities on domestic debt instru-ments, at reasonable cost. This wouldattract institutional fund managers, provi-de higher-yielding savings options to theresidents (bank deposits in Africa oftenyield negative interest rates after adjus-ting for inflation), and allow pension fundsand insurance companies to better matchthe maturity of their assets and liabilities.A broad local investor interest would alsolower market volatility and the risk of sud-den reversal of capital inflows. In the longrun, capital inflows can leverage domesticinstitutional improvements. The benefitsthey bring depend on strengthened gover-nance, better infrastructure, and humancapital.

It is important to note that remittanceswork to smooth consumption in mostAfrican economies. But there is a possibi-lity that in some African economies,altruistic motives may have contributed tocounter-cyclical behaviour of migrant-remitters, as has been shown to be thecase in Latin America and Asia. In gene-ral, reforms are necessary to reduce tran-saction costs for remittances which arevery high in most countries. In addition,banks in African countries need also tocreate instruments by which remittances

29

could be channelled into investment pur-poses by using them as collaterals.

To further pursue the ideas in this paper,future research is required to map out amatrix type of study that uses the flow-of-funds framework to identify the financinggap for each African economy in order tomap out the relationship among the com-

ponent of capital flows (FDI, debt, aid andremittances) against each type of econo-my (resource-rich, non-oil exporting,other) and the pull factors that maximisefinancing for the economy. This type ofresearch should be of interest to nationalgovernments, regional bodies and regio-nal development banks (such as theAfrican Development Bank).

30

31

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35

Recent Publications in the Series

N°

98

97

96

95

94

93

92

91

90

89

Year

2009

2009

2009

2008

2008

2007

2007

2007

2007

2007

Author(s)

Research Department

Abdul B. Kamara, AlbertMafusire, Vincent Castel,Marianne Kurzweil, DesireVencatachellum andLaureline Pla

Louis Kasekende, LeonceNdikumana and RajhiTaoufik

Margaret Chitiga,Tonia Kandiero andPhindile Ngwenya

Valérie Bérenger andAudrey Verdier-Chouchane

Research Division; AfDB

John C. Anyanwu andAndrew E. O. Erhijakpor

John C. Anyanwu andAndrew E. O. Erhijakpor

Tonia Kandiero

Maarten van Aalst,Molly Hellmuth andDaniele Ponzi

Title

Africa and the Global Economic Crisis: Strategiesfor Preserving the Foundations of Long-termGrowth

Soaring Food Prices and Africa’s Vulnerability andResponses: An Update

Impact of the Global Financial and EconomicCrisis on Africa

Agricultural Trade Policy Reform in South Africa

Des Inégalités de genre à l’indice de qualité devie des femmes

The Impact of High Oil Prices on AfricanEconomies

Education Expenditures and School Enrolment inAfrica: Illustrations from Nigeria and Other SANECountries

Health Expenditures and Health Outcomes inAfrica

Current Account Situation in South Africa: Issuesto Consider

Come Rain or Shine - Integrating Climate RiskManagement into African Development BankOperations

ISBN - 978 - 9973 - 071 - 23 - 1