The global economy has been rocked by three large shocks between 2008 and 2014 that have measurably impacted the size and composition of capital flows. Yet, this impact is far from homogenous across regions and country groups. Indeed, the evolution of gross capital inflows over the last two decades displays a largely similar pattern in industrial countries and non-Sub-Saharan African (SSA) countries, but a markedly different path in Sub-Saharan African countries. What explains these different trends and why does it matter? These are the questions that lie at the heart of the analysis conducted by Calderón, Chuhan-Pole and Kubota (2019). Our main message is twofold: one, the evolution of capital inflows shows divergent patterns for SSA and the rest of the world and another, drivers of capital flows vary by type of flow and regions.
Evolution of capital inflows: Divergent patterns for SSA and the rest of the world
Gross flows into Sub-Saharan Africa follow a different path to that of global capital flows. Three large external shocks reshaped the composition of capital inflows and the structure of financing in Sub-Saharan Africa: the 2008-09 global financial crisis; the 2011-12 European sovereign debt crisis; and the 2014 plunge in international oil prices. These large external shocks have played a role in affecting the magnitude of financial inflows and shifting the current structure of these flows toward other investment inflows.
The data also shows that the European sovereign debt crisis may have caused a larger decline in flows to Africa than the global financial crisis. Figures 1 and 2 clearly illustrate that flows into industrial countries and the non-SSA developing countries experienced a sharp decline after the global financial crisis. However, in the case of SSA, it was the 2011-12 European debt crisis that hit the region harder. The major components of capital inflows for SSA are Foreign Direct Investment (FDI), foreign aid and remittance inflows. For instance, during the period 2000-17, FDI represented on average 3.4 percent of GDP while foreign aid and remittances amounted to 3.3 and 2.3 percent of GDP.
Drivers of capital flows vary by type of flow and regions
The baseline regression analysis (instrumental variables estimation with panel data) estimates total gross capital inflows, FDI, portfolio investments and other investments on a series of pull and push factors for 136 countries from 1980 to 2017. Overall, domestic factors play a greater role in attracting gross capital inflows than external factors although both factors are important. Investment profile (as a proxy of the quality of institutions) and financial openness have a robust and positive impact on all the different types of gross inflows. For example, a one-point increase in investment profile and financial openness leads to an increase in total gross inflows of 0.0132 points and 0.0202 points respectively. Domestic economic growth has a positive and significant influence on total gross inflows and FDI inflows while it has a positive but non-significant relationship with gross portfolio investment (PI) and other investment (OI) inflows. An illustration of the economic interpretation of our findings, for instance, shows that if economic growth increases by one point in the full sample period, total inflows increase by 0.0106 point and FDI inflows increase by 0.00511. Trade openness and all types of flows (such as total inflows, FDI, PI, and OI) are negatively associated but their impact is not statistically significant. A higher rate of CPI inflation induces more total gross inflows, FDI and PI inflows.
A similar baseline regression is estimated for SSA and we find a smaller number of variables that play a role in driving capital flows into the region. Our findings suggest that domestic factors are more important in driving FDI inflows to SSA while external factors are more important in driving PI and OI inflows. Indeed, the relationship between gross capital inflows and their drivers across Sub-Saharan African countries behave similarly to that of natural resource abundant countries. Therefore, different sets of regressions are estimated for Sub-Saharan African countries, with few drivers (mostly, push factors) having a significant impact.
Why it matters
Analysis of capital inflows and drivers of these flows is important because surges in capital flows have real effects on the economy. Flows of foreign capital may have long-term effects on growth. For example, Aizenman and Sushko (2011) show that surges in portfolio investment inflows have a negative impact on growth in the manufacturing sector. However, surges in FDI inflows have a positive impact on aggregate manufacturing growth. Also, there is an impact on total factor productivity (TFP) growth (rather than investment) through the credit channel.
On the other hand, capital flows may have destabilizing effects on domestic financial markets. For instance, a credit boom that ends up in a financial crisis in the domestic economy is typically preceded by surges in gross inflows (and, more specifically, surges in cross-border banking inflows). Kaminsky and Reinhart (1999) and Gourinchas and Obstfeld (2012) argue that it can also lead to greater volatility and higher incidence of financial crisis. In this case, implementing policies that decouple capital inflows and credit expansions will help manage systemic risks. Massive capital inflows can lead to credit build-up and asset price booms may also end up in a systemic banking crisis —e.g. Tornell et al. (2002) and Calderon and Kubota (2012). Moreover, as Bruno and Shin (2013) and Calderon and Kubota (2012) suggest, credit booms can be typically the outcome of surges in private capital inflows. Finally, Borio and Disdayat (2011) and Gourinchas and Obstfeld (2012) suggest that the rapid increase in banking leverage typically has preceded periods of financial instability and crisis.
Plausible policy recommendations arising from the analysis underscore that the SSA countries need to diversify the economic and export structure, develop deeper domestic financial markets, implement policies to promote a productive business environment and create investment opportunities.
To sum up, capital flow behavior for Sub-Saharan African countries is different from that of industrial countries due to different economic structures which render different transmission processes. External factors are the main drivers of gross capital inflows into Sub-Saharan Africa, while both domestic and external factors are important for industrial countries and non-SSA countries.