The Compact with Africa (CwA) is the first comprehensive initiative between the G20 and Africa. The Compact with Africa’s primary objective is to increase the attractiveness of private investment in Africa through substantial improvements to the macro, business and financing frameworks. It aims to leverage private financing for infrastructure projects via blended finance to mobilise subsequent foreign direct investment (FDI) flows.
Do good governance and good institutions help attract private capital flows? If they do, can we expect these private flows to stimulate sustainable transformation by promoting structural shifts towards higher productivity? A number studies shown that there is no straightforward answer to this question.
Firstly, while global private capital has been shown to be highly cyclical, driven by United States monetary policy and risk aversion and thus by push factors, equity flows, both portfolio equity and Foreign Direct Investment (FDI), have been shown to be pulled in by better governance and institutional scores. Secondly, private flows can be both disruptive and transformative: disruptive, often as a result of excessive and mismatched debt that eventually leads to financial crises; transformative through the removal of infrastructure bottlenecks or, indirectly, through lowering the cost of risk capital.
It is not a country’s framework conditions but rather United States monetary policy that is one of the principal drivers of capital flow cycles to poor countries. This latter point is especially pertinent today, given that we find ourselves at the tail end of a decade of extraordinary monetary stimulus that is gradually being unravelled. Global risk aversion is another factor as it pushes money into Least Industrial Countries when it is low and pulls it out when heightened. In his article published on “Journal of Economic Surveys” in April 2018, Robin Koepke stated that on an aggregate capital level, push factors such as global risk aversion and external interest rates are found to be most important for portfolio debt flows, somewhat less for banking flows and least of all for FDI.
According to empirical studies, by Andres Rodriguez-Pose and Gilles Cols, portfolio inflows are generally significantly affected by governance measures such as the rule of law, property rights and institutional quality. Similarly, with regards to sub-Saharan Africa (SSA), studies tend to find that the rule of law and institutional quality are significant but further report that political stability and government effectiveness are also decisive. However, even with relatively good governance indicators, portfolio flows have been deterred by the regions poor record when it comes to rule of law and political stability. So the CwA’s emphasis on governance and institutions to attract private cross-border capital to relatively well-run African countries was coherent with respect to its initial focus on portfolio flows from large institutional investors such as pension funds.
The 2018 African Economic Outlook report indicates that infrastructure funding is crucial for Africa’s sustainable transformation. Yet, a significant infrastructure financing deficit, estimated at between 68 billion and 108 billion US dollars annually, needs to be bridged. Given the notorious lack of infrastructure in Africa, which acts as a bottleneck to intraregional trade, urban habitat and rural development, and hence also to transformative growth, the main sources of funding for infrastructure in Africa do not suggest that they have been held back by Western-style governance standards.
What about the flow-transformation nexus? The Compact with Africa aims to foster the conditions for long-term private investment, investment in infrastructure and also for economic partnership and employment in African countries with the objective of promoting sustained and inclusive growth. Institutional investments by both pension funds and life insurers as well as FDI can benefit Africa. Institutional investors enjoy long-term liabilities in their balance sheets, unlike commercial banks or hedge funds, which are essential to fund Africa’s infrastructure and a key growth prerequisite for the continent.
FDI, in turn, requires a modern infrastructure, particularly energy and connectivity, to fully utilise its external benefits. FDI can entail spillovers contributing to the modernisation of production capacity, knowledge transfer, integration into global and regional value chains, and also employment for the jobless. Unlike portfolio flows, corporate FDI reflects a long-term commitment and is hard to reverse, thus providing stability. However, in view of analytical and empirical evidence for List Industrial Countries, trust in the role of cross-border private capital flows to low-income Africa is controversial.
Although finance is needed for economic development, excessive or unstable cross-border flows can damage economic growth, impede poverty alleviation and exacerbate income inequality. List Industrial Countries continue to experience strong pro-cyclical swings in external financing in terms of availability, maturity and cost. Yet they lack the financial safety net provided by swap arrangements among central banks in developed countries to manage these cycles.
Debt-creating flows, in the presence of narrow and illiquid domestic financial mar- kets, introduce currency and maturity mismatches into corporate and government balance sheets. These balance sheet mismatches have repeatedly proved to be time bombs. The nature of equity flows, by contrast, is much more development friendly. List Industrial Countries seek to attract FDI to benefit from the associated external benefits via technology, learning, integration into value chains and global market access. Portfolio equity inflows can, but do not necessarily, stimulate long-term growth prospects. They help to develop efficient stock markets and foster economic growth by reducing the hurdle rate for investments and small business development.
FDI is an accounting convention not a net private capital flow, as it may be funded by local debt or by imported machinery. Large one-off merger and acquisition deals and corporate restructuring may inflate FDI numbers, while greenfield investment counts mostly for productivity enhancement in a low-income economy. FDI statistics also reflect other factors, including tax avoidance, which makes it difficult to differentiate between FDI for long-term investments, which serves as a source of growth, and FDI that is purely financial and has little real economic impact as it merely passes through an economy.
This latter type of FDI also obscures the ultimate sources and destinations of FDI. There is emerging evidence that FDI can also be pro- cyclical, and there is mixed evidence on the relationship between FDI and productivity in different sectors. Recent research has identified a negative relationship be- tween FDI and productivity since 2000. It was found that the composition of FDI was concentrated by sector and that those sectors (such as extractives) had a negative impact on total factor productivity and for promoting transformational growth.
In a much-cited paper, Helene Rey provides conclusive analytical and empirical evidence to this effect. She argued that gains to international capital flows have proved elusive whether in calibrated models or in the data. Large gross flows disrupt asset markets and financial intermediation, so the costs may be very large. To deal with the global financial cycle and the dilemma, we have the following four policy options: targeted capital controls; acting on one of the sources of the financial cycle itself, the monetary policy of the Fed and other main central banks; acting on the trans-mission channel cyclically by limiting credit growth and leverage during the upturn of the cycle, using national macro-prudential policies; and acting on the transmission channel structurally by imposing stricter limits on leverage for all financial intermediaries.
Given this background to private capital flows, the Compact with Africa could be described as audacious. The Compact postulates that macroeconomic stability, an investor-friendly business environment and effective financial sector intermediation are necessary conditions to spur private investment. Kappel and Reisen argued in their study on the Compact that such premises are unsuitable for Least Industrial Countries. All 12 African Compact countries produce such a low yearly income per head that they are either classified as Least Industrial Countries or lower-middle-income countries.
The strong negative link between per capita income and the relative importance of private finance in cross-border financial flows may have driven the Compact with Africa, notably via instruments of risk mitigation. Of course the negative link works both ways: It would be impressive if the Compact with Africa managed to meet the challenge of stimulating private flows into African compact partner countries. The same expectation should reasonably also hold ex-ante for African infrastructure funding. Traditionally, the private response to funding African infrastructure has been negligible.