An empirical investigation of capital flight in selected African countries

Background Paper No. 5

ECONOMIC COMMISSION FOR AFRICA Ad-hoc Expert Group Meeting on the Domestic

Mobilization of Financial Resources for

Africa's Development: Retrospect and Prospect Addis Ababa, 24-27 March 1996

AN EMPIRICAL INVESTIGATION OF CAPITAL FLIGHT

IN SELECTED AFRICAN COUNTRIES

by:

Oladeji O. Ojo*

African Development Bank Abidjan, Cote d'lvoire

96-462

* the views and interpretations in this paper are those of the author and do not

nessaniy reflect the view of the UNECA secretariat. The terminology and technical

languages are strictly those of the author.

ABSTRACT

In recent years, developing countries have been experiencing massive capital flows. While capital flows are normal features of

modern international trade transactions, what makes the flows from developing countries problematic is that they are flowing from those countries which need them most. It is in these sense that these flows can be described as abnormal or capital flight/Several attempts have been made to analyze the phenomenon of capital flight form developing countries but only a few of these have been on Africa. The present study using C6te d'lvoire, Morocco and Nigeria

as case studies, is aimed at filling that gap.

The paper found that a sizable amount of capital flight took place in these countries during the sample period. It also found that domestic factors (eg. overvaluation of national currencies, domestic economic instability) and external factors (eg. external

reserves, debt service ratio) largely explain capital flight from these countries.

The existence of a sizeable amount of capital flight is indicative of a policy problem, which calls for appropriate policy

responses. Perhaps the single most important policy response to

capital flight is the restoration of confidence in the domestic

economy. Confidence building includes, among other things, the

pursuit of credible and sustained, growth-oriented macro-economic

policies.

TABLES OF CONTENTS

Page

I. Introduction 1

II- Conceptual and Definitional Issues in Capital

Flight 2

III. Cote d'lvoire, Morocco and Nigeria: Debt and Other

Macro-economic Indicators 6

IV. Estimates of Capital Flight 7

V. Methods of Effecting Capital Flight 9

VI. Determinants of Capital Flight 12

VII. Policy Responses to Capital Flight 17

VIII. Conclusions 21

Tables 23

References 30

AN EMPIRICAL INVESTIGATION OF CAPITAL FLIGHT IN

SELECTED AFRICAN COUNTRIES

'" ' ' '■■ : ' ' '■ ^ ■ ,by

Oladeji O. OJO1

■ I- *-' Introduction^ "" • ' .

In the last few years, developing countries have been experiencing massive capital outflows. The problems posed by these outflows appear however to have been overshadowed by their more serious economic difficulties - slow, and in some cases, declining overall

growth rates and external debt crisis. In recent times, concerns have been expressed about

the magnitude, causes and consequences of these capital outflows. In the light of these, capital flight (as a special case of capital outflow), has received considerable attention as one of the possible causes of the slow growth being experienced by indebted countries and also for the debt crisis itself. Capital flight has also been identified by some foreign Creditors as a justification for not lending to developing countries. Interest in capital flight has additionally been motivated by the paradoxical situation of accumulation of external debt by developing countries and the corresponding acquisition of external:assets by their residents.

Since being identified as a major problem for developing countries, there has been an outpour of literature on capital flight. While some have been devoted to the theoretical aspects of the subject, some have dealt with the issue of measurement and policy measures

to reverse the trend in capital flight. Virtually all these studies have been devoted to countries

of Latin America and some South-East Asian countries like the Phillipines and South Korea.

The aim of this paper is to contribute our knowledge about capital flight in some selected countries of Africa. Specifically, the three highly-indebted, middle-income countries of Coted'Ivoire, Morocco and Nigeria are chosen for an analysis of capital flight in Africa.

These throe countries naturally suggest themselves: they belong to the group of

Research Coordinator, Development Research and Policy Department, African

Development Bank. The,views herein expressed arethose of the author and they do

not, in any way, reflect those of the Bank, its Boards of Directors, or the

governments which they represent. 1 would like to thank Mr. Tope Oshikoya for his comments on successive drafts of this paper.

highly-indebted countries whose debt burden are so severe as to warrant a special programme of debt relief - the so-called Baker/Brady Plan. It is hoped that a study of capital flight in these countries could shed light on the nature and causes of capital flight in Africa and possibly suggest policy responses to the problem.

The rest of the paper is sketched as follows. In Section II, we discuss^ the conceptual and definitional issues in capita! flight. As a preclude to the estimation of capital flight, we discuss the debt and other macroeconomic indicators of our sample countries in section III.

Estimates of capital flight (based on different definitions) are provided for these countries in section IV, while in section V, we provide information about possible channels for effecting capital flight. In section VI, we perform some econometric analysis of the determinants of capital flight in these countries. In section VI, we discuss policy measures to reverse the trend in capita! flight, using partly, the operation of Nigeria's domiciliary account as a case study. Our summary and conclusions are contained in the last section.

II. Conceptual and Definitional issues in Capital Flight

, , Since capital flight was identified more than two centuries ago as a problem in international finance, no suitable definition has been found to unambiguously describe what it means. This difficulty is traceable, in part, to the conceptual problems surrounding the subject itself and in part lo the weakness in the data on which an appropriate definition could

be based. . r

. In an open economy, domestic residents commonly engage in international transactions. In that process, they acquire financial claims against nonresidents which have to be met by capital outflows. A major conceptual problem facing any discussion of capital flight is how to make the distinction between Ihosc flows that can be considered "normal"

and those which fall into the category of capital flight. Any definition of capital flight is therefore likely to involve .some clement of value judgement as to whai constitutes normal and abnormal capital flows. This explains in part, why there arc as many definitions of capital flight as there are commentators on the subject. The other difficulty is the weak statistical base on which any definition could be based because any definition involves

3

classifying data "according to characteristics that are only too loosely related and indirectly related, to the constructs being measured" (Deppler & Williamson, 1987 p.39).

Yet another conceptual difficulty in studying or measuring capital flight derives from the views of some economists that it is highly pejorative to label capital movements from developing countries as capital flight and label similar movements from say the United States or Japan as foreign investment. For such economists, there may be no capital flight after all, since wealthy individuals,, irrespective of nationality, tend to diversify their portfolios in order to protect themselves against the riskiness of any investment. But there is at least one good reason for labelling the flows of capital from developing countries as capital flight.

Conventional economic theory will suggest that capital should flow from developed to capital-scarce developing countries. A flow in the direction of developed countries (other than those required for meeting international obligations) can with justification, be labelled

as abnormal.

: While in general, all capital flows are motivated by individual or corporate desires to maximize returns on capita! for a given level of risk, the motivation for capital flight is more specific; According to the Deepler and Williamson (1987), capital flight is "motivated by a residents's concern that if his wealth were held domestically, it would be subject to substantial loss or impairment"^ 40). Fears of capital loss are likely to arise from the risk of expropriation, debt repudiation, or exchange rate depreciation. Fears of capital impairment on the other hand, arise from the risks of new market distortions like capital controls, taxation and financial repression that could reduce the value of asset compared with its value

if invested abroad.,

Therole of risk of expropriation was recently formalized by Khan and UI Haque

(1985). In the paper under reference, they showed that the fear (or risk) of expropriation

largely accounts for capital night. Using an intertemporal optimization model that allows for

simultaneous borrowing and■■investing, and which incorporates risk of expropriation, they

concluded that without any costs lo investing abroad, the.risk-free return on external

investments dominates the risky but equivalent expected return on domestic investment,

thereby leading individuals to invest their domestic savings overseas. Furthermore, as the risk

4 ■

of expropriation increases, the investment that is exposed to this risk (i.e. domestic investment), can be expected to decrease. Viewed this way, capital flight is not necessarily a problem from the individual's point of view. To the extent that it offers the capital owner the opportunity to protect his wealth from losses, it is welfare-improving. Indeed, it represents rational behaviour on his part. But the avoidance of losses by some individuals may merely shift the burden to others, either individually or in the aggregate. When these costs become unacceptable or burdensome to the authorities, capital flight becomes a problem. The problem with capital flight therefore, is not so much that there is capital outflow, the problem is rather that domestic resources escape those who seek to exercise some degree of control over the management of the macroeconomy in general, and over how funds should be utilized in particular (Deppler and Williamson, 1985, p.41).

The measurement of capital flight is usualiy based on whether or not one wants to make a distinction between normal flows and capital flight. One class of definition for example, does not make this distinction but then attempts to measure the acquisition of net foreign assets by the private sector. On the other hand, another class of definition makes this distinction by measuring the stock of foreign claims that does not generate income that is reported in the balance of payments.

Among the various definitions in the literature, perhaps the broadest is that employed by the Worjd Bank (1985) and Erbe (1985) and Morgan Guaranty (1986). The two measurements are arrived at by subtracting current account deficit and the increase in official reserves from inflows of capital (as measured by increase in external debt and net foreign investment). The difference between the two and the extent to which they are used to finance the current account deficit and an increase in reserves is taken to reflect an increase in net foreign claims by the public sector. Capital flight is then viewed as the increase in net foreign claims. Morgan Guaranty (1986) also views capital flight as a residual. In addition to current account deficit and the increase in official reserves, it subtracts the increase in short-term foreign assets of the banking system from total capital flows. The implication of this definition is that the acquisition of foreign assets by banks is not considered to be capital flight, whereas acquisition by other agents is so considered. In this study, the definition provided by the World Bank, which, is also similar to that of Erbe, is utilized largely because

it gives the broadest coverage.

Another measure is that provided by Cuddington (1986). His definition emphasizes

short-term capita! flows as opposed to private-sector acquisition of external assets. This emphasis led him to define capital flight as the sum of the errors and omissions to selected capital items that are chosen individually for each country under consideration. The rationale

on the part of Cuddington, for focusing on short-term capital is his concern for "hot money"

- the funds .that respond fastest to changes in expected rates of return or to changes,in risk.

Although focussing on short-term capital might appear attractive at least from the point of view of capturing "hot money", the definition has problems. For one thing, errors and

omissions contain more than just unreported short-term capital. For another, short-term

capital need not be the only conduit through which an investor could channel his reactions to unfavourable developments at home. He could acquire short as well as long -term assets and the motivation for doing so as well as the effects on the domestic economy would be the same. There is therefore no particular justification for focussing on short-term capital.

The definitions provided by Dooley (1986) and that by Hahn and U! Haque (1987) are, very similar. These authors define capital flight as those external assets held by the

private-sector that do not generate income recorded in the balance of payments accounts of

a country. The motivation for their definition is to be able to make a distinction between

capital flight and those flows that are considered normal in the sense that they correspond to

ordinary portfolio diversification and business transactions of domestic residents. Focussing

on the gross increase in external assets as the definition of capital flight can be misleading

in that .in many countries that are not considered as experiencing capita! flight, domestic

residents acquire both.foreign assets and liabilities. There are thus two-way capital flows

between countries and it would be misleading to identify one of them as capital flight. The

definition proposed by (he authors is to identify those foreign assets that do not generate

reported income as capital Hight because if the income is not recorded, it must be assumed

that the motive of the investor is to place the funds beyond the control of the monetary

authorities; The presumption here is that only the retention of investment income abroad (or

at least its retention outside the reach of the authorities) is indicative of flight concerns. This

definition has an important appeal from the point of view of a country which is experiencing

capital flight in that it incorporates an estimate of the government's loss of control'over resources - an investment income that is not subject to taxation and the foreign currency earnings that are not made-available to the monetary authorities for reserve-rhariagement purposes. The measure is'■-therefore indicative of the budgetary or reserve-management problems facing the monetary authorities and heiice the extent to which they should view

capital flight as; a problem.. , ' .

1H- Cote d'lvoire. Morocco and Nigeria : Debt and Other Macroeconomic Indicators

It is now common knowledge that the decade of the 1980s was a particularly difficult one. for Africa. Growth rates slumped, so did per capita incomes. The Continent is burdened by an external debt that has soared to over US$40 billion and which costs more than 30 per cent of export earnings to service, it has been estimated that living standards are lower today than they were in the 1960s and that it would require up to about five to six years of continuous economic expansion to recoup the losses of the 1980s. In varying degrees, our sample countries have not been spared the general decline on the Continent.

.Cote d'lvoire experienced one of the best growth performances in Africa in the 1970s largely because of the boom in commodity prices. Between 1970-79, the GDP grew on annual average basis, by about 7.5 percent. But all these changed in the 1980s as commodity prices fell. During 1980-91, GDP declined by about 0.2 per cent annually, with 1990 recording thesingle largest decline of about 2.6 per cent (Table 1). The terms of trade index declined for much of this period, while the growth rate of export volume averaged;a mere 0.23. per cent per annum. These difficulties were compounded by adverse domestic developments. Although the price level remained relatively stable, due in part to the stability iii the exchange rate and in the growth in money supply, the government budget deficit was persistently in deficit.

J These economic difficulties virtually made external borrowing inevitable. External debt which stood at about US$1 billion in 1975, rose to about US$18.8 at the end of 1991.

Aljlhougti the debt service ratio was modest at the beginning of the period, it rose systematically as the debt crisis worsened. The debt service ratio and the interest service

" .. .7

ratio averaged 42 per cent and 20 per cent respectively throughout the period, :■ ;

The performance of the Moroccan economy (Table 2) was relatively better than that of Cote dTvpire. Throughout the period 1975-91, which included the decade of the 1980s (the debt,decade), GDP growth rate was averaged about 4.2 per cent per annum. The rate of inflation averaged about 8 per cent annually while the government budget as a proportion of GDP was about -5 per cent per annum. The terms of trade was also consistently

favourable throughout the period, All these positive domestic developments might have

combined to produce the GDP performance described earlier.

.;■;: In spite of these developments, Morocco experienced a sharp increase in her external debt. External.debt rose from US$1.7 billion in 1975'to US$21.2 billion at the end of 1991.

Debt service ratio and interest payments ratio averaged 30 per cent and 15 per cent respectively: What made the relatively small size of the Moroccan debt very problematic is the high debt service ratio which requires that about 30 per cent of total export earnings be devoted to debt servicing.

:■: .. The Nigerian case is perhaps the most dramatic. An annual average rate of growth of the GDP of about 7.5 per cent during 1970-79, was replaced by a growth rate of 2.7 per cent during 1980-91 (Table 3), The inflation rate averaged about 20 per cent during this period while the government budget as a proportion of GDP averaged -4.2 per cent.

The country's total debt rose from US$1.1 billion in 1975 to US$34.5 billion at the end of 1991. Debt from private sources accounted for almost 75 per cent. Debt service ratio and interest payments ratio averaged 18 per cent and 10 per cent respectively during 1975-91. But in the decade of the 80s when the debt crisis became more problematic, the -ratios were 22 per cent and 12 per cent respectively.

IV. Estimates of Capital Flight -

Asobserved earlier, estimates of capital flight are fraught with uncertainties, formuch

of capital flight is designed to avoid government controls. It is therefore not likely to be

^ 'fr^yrHaaBMiama««a5Bg-r- rM~i ■-,; taffi tMwafmtfnstir, tv-rffiTi'n TyiiiirTiiBii^'ii^^TWr*riHSiW^>iv^~^~'*^'1'iw^

registered, except in incomplete forms, in. recipient countries. Consequently, estimates of

capital flight are at best, indicativeof the magnitude of capital outflows from a country. Even

when one makes all kinds of adjustments to the estimates, (for example taking into account figures on overinvoicing and underinvoicing of exports as suggested by Gulati, :1987), the figures remain essentially rudimentary. But rudimentary as they are, they point in the direction of the existence of a policy problem which calls for policy response. The estimates of capital flight presented here should be viewed in this light. They may not be the actual estimates,,but they are indicative of the probable magnitude of the outflows from these countries. The very existence of-capital flight of some reasonable order of magnitude-is'.all that is required to appreciate that a policy problem, warranting appropriate policy responses, exists. Furthermore, for the practical problem of ameliorating the debt problems of developing countries, what is important is the recognition that some domestic assets are held abroad and how they can be used to either reduce the stock of debt or relieve the liquidity problems posed by debt service. (Pastor, 1990, p.2)

Tables 4, 5 and"6 give estimates of capital flight for Cote d'lvoire, Morocco and Nigeria. They are based on three measures of" capital flight - World Bank, Erbe and Morgan Guaranty - discussed earlier. The measures do not indicate any consistent pattern in outflows. While the World Bank measure and that of Erbe give the same figures (because they are defined in the same way), the estimates according to the Morgan Guaranty methodology differ slightly largely because the underlying definition is narrower.

While the figures'do not indicate any consistent pattern in outflows, they do reflect, when compared with the debt figures, sonic curious relationships. In all the three countries, the rate of growth of the debt was mirrored by the rate iA' growth of capital flight. In other words, capital flight increased more when debt acvunuiiation underwent rapid growth. For example, in the case of Cofc d'lvoire, the rate of «row!h ui" capital flight was highest during 1981/82, 1984/85 and 1986/87. These were ahu the yenrs when debt accumulation increased the most. The same pattern is revealed when u comparison is made,of ihc rate of growth of debt and capital flight in both Morocco and Nigeria.

Table 7 shows the cumulative estimates of capital flight in the three countries. The sample was divided into two - the pre-debt crisis period 1975-81 and the debt crisis period 1982-1991. This division was motivated by a desire to establish, the influence of the debt crisis on capita] flight. In each of the countries, capital flight increased more during 1982- 91, probably because the sample period was longer, or because of the crisis of confidence generated by the debt crisis itself. But as the empirical analysis in Section IV shows, there was no evidence of a debt-fuelled or debt-driven capital flight in these countries. The table is however useful in a certain respect, it shows the cumulative capital flight from each of the countries. It shows for example, that Nigeria experienced relatively more capital flight than any of the other two countries during the period under study. The determinants of capital flight are taken up later, but in the meantime, we provide below possible channels through which, capita! flight takes place and the vehicles for effecting such flight.

V. Methods of Effecting Capital Flight

There are several methods for effecting capital flight.. They range from bank transfers, movement of currencies and other financial assets, to false invoicing of international trade transactions. The choice of any one method would be influenced partly by. the cost and safety of She method, and partly by the extent to which the motive which gives rise to capital flight is criminally inspired.

if there are no exchange or capital controls, capital flight can be effected by mere

bank transfer from a local institution or the"local"affiliate.of a foreign institution to a

designated recipient abroad at the prevailing exchange rate. This method is an easy and a

cost-effective means of transferring funds, particularly for noncriminal funds., It has been

claimed (Khan & Ul Haque, 1987, p.3) that among the highly indebted developing Countries,

the largest amounts of such transfers have been from those with relatively free payment

systems. In such systems, the ease with which residents engage in-capital flight is related

to the availability of foreign exchange. For criminal funds however, this method of capital

flight may not be appropriate as the risk of disclosure is very high.

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Where the conventional method of transfer is not available due to say exchange controls of where the risk of disclosure is high, an attractive form of transferring funds is through monetary instruments, for example, domestic or foreign currency, or travellers cheques^ This is the method 6f capital flight usually employed for money involving criminal activities like money laundering and tax evasion. This method involves on the other hand, physical movement of domestic currency out of the country and exchanging it legally abroad

for other currencies at market prices. This method is particularly attractive where the

domestic currency is internationally convertible as in the case of the CFA countries of Africa. On the other hand, foreign currency and other monetary instruments may be purchased for example from parallel markets for foreign currencies locally, and physically transported abroad. The source of the foreign currency can be tourists and/or business travellers who would like to acquire domestic goods and services at a discount in terms of foreign-exchange cost. The success of this method depends on the severity and efficiency with which the foreign exchange regulations are applied, as well as the currency demand - supply relationship (Walter, 1987,p 111).

The movement of currency or travellers' cheques can also be supplemented by that of bonds1 and securities. What is usually done is to endorse these to the buyer. Because it has a greater risk of disclosure and may not be cost-effective, these channel is not frequently used.

Capital flight may also be effected through the movement of precious metals like gold, silver, etc. This is done by converting local currency into precious metals and the moving these abroad for eventual sale. The advantage of this method is that these metals, as traditional stores of value, tend to maintain (heir values even in the face of changing economic policies. Consequently, they are usually in high demand. The major disadvantage is that since they are known to be close substitutes for currency, governments tend to restrict or prohibit the import or exporl o\~ such melals.

A very prominent method of capital flight under exchange control regime is false invoicing of international trade transactions. On the import side, the foreign supplier can issue an invoice in excess of the agreed price of the product for which the buyer holds a

valid import license. The buyer then applies for foreign exchange cover, not for value of the product, but for the amount of the false invoice. The buyer then remits the false value in foreign exchange to the supplier who deposits it in the account of the buyer and keeps the agreed amount, plus, perhaps, a commission. On the export side, the domestic seller issues an invoice for an amount in foreign currency that is less than the agreed price. The foreign seller: places the difference (less any commission) in an account belonging to the seller and remits the invoice amount. This is then surrendered to the monetary authority in return for local currency at the official rate. (Walter, 1987, p. 112)

■: ' The method of false invoicing is very prevalent in countries with exchange controls.

Under such, a system, it can succeed in moving large amounts of money at favourable

exchange rates. From the point of view of the country however, it creates shadow prices of

traded goods and services'thai can alter kTins of trade much the same way as the depreciation of the currency. It also shills Ihe use ol foreign exchange under the established exchange control regime from high-priority to low-priority uses (Walter, 1987, p. 113).

Because of these obvious consequences on the economy, monetary authorities try to control

false invoicing, but they rarely succeed in doing so. Gulati has tried to use the method of

trade misinvoicing to correct estimates of capital flight. He concluded that the inclusion of trade misinvoicing often reduces the estimates of capital flight (Gulati, 1987, p.68).

In those countries of Africa that belong to the CFA (Compagnie FinanciereAfrique)

zone, the currency (the CFA franc), because of its ready convertibility into the French franc,

provides a vehicle for capital flight. One of the countries under study (Cote d'lvoire) is a

member of that currency zone. Although the extent of capital flight induced through the

mechanism of the CFA currency is difficult to document, there have been reports of massive

movement of that currency across national frontiers.

In those countries which benefit substantially from workers' remittances, a popular

means of effecting capita! flight without moving currencies across national boundaries is for

an individual wanting to effect capital flight lo arrange with a migrant worker whereby he

meets the local currency requirement of the migrant worker, while the migrant worker in

turn credits his foreign account with the foreign exchange equivalent. This arrangement

iW^ffi^^^

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relies for its effectiveness on a liberal system exchange system in the host country where the migrant worker resides.

VI. Determinants of Capital Flight ■

. ...A useful starting-point for modelling capital flight or indeed any asset demand, is a standard portfolio balance or portfolio adjustment model in which an investor holds an array of domestic and foreign assets. Over time, he adds to these holdings as his savings grow.

In such a framework, his asset demand will be governed by the relative rates of return on the assets, i.e. by domestic and foreign interest rates, including the fear that if his assets were held domestically, they could be subject to substantial loss or impairment. While

relative rates of return may be important in general asset composition, the fear of capital loss

or impairment may assume relatively greater importance When dealing with capital flight.

Fears of capital loss are likely to arise from the risk of expropriation, debt repudiation, or exchange depreciation. Fears of capital impairment on the other hand, arise from the risks of new market distortions like capital controls, taxation and financial repression that could reduce the value of asset compared with its value if invested abroad. While normal flows are likely to be determined ;b'y relative rates of return on domestic and foreign assets, capital flight, as,abnormal flows or "hot money" that is fleeing, is likely to be governed more by these fears-of capital loss. Consequently, our specification of the equation of the determinants of capital flight will go beyond portfolio balance considerations to include domestic factors that could serve as the driving force behind capital flight in developing countries.

Perhaps the single most important factor that will induce capital flight from a country is the domestic economic environment. This is the catch-word for government policies, inflation rale, etc. Consider the case of inflation. If inflation is accelerating, rationality on the part of domestic economic agents would dictate that they reduce their holdings of the domestic currency in order to protect themselves against inflation tax. Some of the reduced holdings will likely appear as capita! flight. But the proportion of the freed holdings that will go into domestic assets (financial and real), and into external assets, will depend on several factors. If interest earnings on domestic savings are less than the earnings on foreign assets,

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substantial capital flight could ensure. This is likely to be so in developing countries where the financial markets are both narrow and regulated. The range of financial assets in which

wealth can be held are limited. In many countries also, there is the lack of full or credible deposit insurance on assets that are held in the domestic banking sector. In addition to all these, there are extensive controls on interest rates with the result that the spread between domestic and foreign interest rates are so wide, thus favouring capital flight.

Exchange rate misalignment can also induce capital flight. If the exchange rate is overvalued for example, there could be expectations about an imminent devaluation. Since devaluation is likely to reduce the real value of domestic savings, wealthholders may resort

to capital flight as a way of minimizing the loss that could arise therefrom.

Government budget deficits can also induce capital flight. According to Dornbusch, (1985) capital night is usually accompanied by fiscal deficits. When fiscal deficits is financed by money creation, it leads to inflationary pressures and the chain reaction described

above. When it is financed by bond sales, domestic residents will expect, at a future date,

their tax liabilities to increase in order to service the debt. This could encourage domestic residents to move out their capital to foreign countries in order to avoid tax payments. A

tax reform aimed at eitiier increasing the tax rate or broadening the tax base would encourage

investors-wanting to avoid the payment of tax, to move their capita! into foreign countries.

The profitability of investment in the real sector of the domestic economy is also an

important factor in capital night. If the expected profitability in the domestic economy is lower than profitability in the major developed countries, some capital flight may be

expected. The riskiness of investment in the domestic economy is similarly important. If

an investor considers it too risky to invest in what he perceives as an unstable

macroeconomic and political environment, he may move his capital out even when the domestic rate of return is higher than the foreign counterpart.

Jixtcrnal factors also play a part in capital flight. These factors are in the form of

opportunities available outside the country. They include attractive interest rate, a wide array

of financial instalments in which wealth can be held, the ease with which such assets can be

14

accessed, the opportunity of not paying taxes and the confidentiality which surrounds most

■of the transactions.

Finally, capital flow in the form of disbursement of external borrowing, may induce capital flight. Pastor (1990, p.7) has argded that the presence of government guarantee for external loans and the absence of such a guarantee for domestic assets could be a factor in capital flight. He reasoned that the paradoxical movement of Latin Americans into foreign assets and the acquisition by international bankers of Latin American assets through their extension of new loans can largely be explained by the presence of government guarantees on foreign assets and the absence of such guarantees on local assets. Disbursement, particularly of public sector borrowing, increases the availability of foreign exchange. This may nol only increase ihe potential for corruption on the part of all actors, it would probably explain the observation -made.earlieJr-.ta.the effect thai iii our sample countries, capital flight

increased more when external borrowing also increased.

Hollowing the discussion above, we postulate a functional relationship between capital flight and its major determinants given by equation I.

Kl> f(R, V, gdp, DISB, P, Rus, DSR, rUBOR, RE, BS, RD) (1)

(H-H(-) (+) (+) O H) (4-) (-) "(-) (+)

where Kf — estimated capital flight for country i

R — domestic 6 month deposit rate in country i

V = degree of overvaluation or undervaluation of . national currency of country V

gdp - real rate of growth of "GDP in country i

DISB ~net disbursement -(of external loans) to country i

P -- rale of inflation in country i (measured by the change in. the , consumer price index)

• This is measured as the percentage change in the market rate index (Ajayi; 1992,

P--7.Q.) -

15 ■ Rus - United States 6 month - deposit rate

DSR ^Debt-service ratio of country i,. defined as principal

and interest payments as percentage exports of goods and services. = rLIBOR - real libor rate (defined as 6-month L1BOR rate, on

US deposits minus US rate of inflation).

RE = percentage change in external reserves of country i

BS = budget surplus (deficit) as percentage of GDP in country i RD = interest rate differential, defined as 6 month LIBOR rate on

US deposits minus R

The expected signs are indicated below the variables. ,

Variants of the above model were estimated for each.of the countries for the period 1975-91. The definition-of capital flight used was that of the World Bank and Erbe because they are considered broader and therefore capable of approximating the actual size of capital flight. After correcting for serial correlation, insignificant variables and variables with wrong signs, the model for Cote d'lvoire collapsed to the ■following, (t statistics are in

parenthesis).

KF = (2)

R2 = R2 = DW

n -—

- -0.0949 (-0.2114)

=,0.6865

■ 0.3729 - 2.0113

"17

+ .0.221 DSR (1.3823)

+ 0.

(3-

0462 RD 1136)

From the results, one can infer [hat debt service ratio and interest rate differential are

the important variables determining capital flight in Cote d'Woire. While the coefficient of

the debt service ratio is significant al the 10 per cent confidence level and that of the interest

rate differentia! is significant at the 15 per cent level, the intercept is not significantly

different from zero. Although we corrected for serial correlation, the size of the Durbin-

Watson statisfic.suggests the continued existence of some serial correlation in the residuals.

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The best regression result for Nigeria is the following:

, KF « 1.2063 + 0.598V- 0.4934 RE(-l) (3) (-3.7132) (5.7099) (-2.8110)

R2 = 0.6661 R2 = 0.5178 DW « 1.9247 n - 17

Theresult for Nigeria shows that capital flight is determined largely by the overvaluation of the currency and by the change in reserves lagged one period. In other words, the overvaluation of the national currency and the state of the external reserves of the country largely determine capital flight.

The best regression result for Morocco is given by:

KF-4.8180 +0.1790DSR(-l) + 0.0549 rLIBOR (4) (1.6821) (1.7291) . (1.8334)

■ R2 = 0.2965 ,

,,; . R2 = 0.1046 DW = 1.7918 ri = 17

Equation (3) implies that capital flight in Morocco can be explained by the debt service ratio lagged one period and the real LIBOR rate. All the coefficients are significant but the coefficient of determination is rather low. Efforts to improve this result proved unsuccessful.

Partly because of dissatisfaction with Moroccan result and partly because of our curiosity to gain enhanced insight into the interaction of these variables, the data for the three countries was pooled and estimated by ordinary Icasl squares, the result of which was corrected for heleroskedasticity by White's heteroskedasticity - consistent coraviance matrix method (White, 1980).

17

The best result obtained is reported below:

KF - 0.58 + 0.014V- 0.46RE(-l) + 0.015DSR - 0.061BS (0.9239) (4.191 (-2.374) (1.028) (-1.6749)

+0.92 NIG - 0.59 MOR (5)

(1.293) (1.189)

R2 = 0.3553 " ;

R2 - 0.2654

DW - 2.2138,". ' ' . .

, Hie variables are as defined earlier, while NIG is the country dummy for Nigeria and MOR is the country dummy for Morocco. The results imply that overvaluation pf national currencies, foreign exchange reserves lagged one period, debt service ratio and government budget deficit (surplus) are the niajor determinants of capital flight in the three countries. In other words, capita! flight in these countries is traceable to the interaction of

domestic and external factors. '

In order to determine the relative importance of the variables, standardized (or Beta) coefficients were calculated for equation (5).

Variable Beta Coefficient

RE(-I) BS(-l) DSR , V ■

0.3274

0.1833 i

0.1048 0.09831

The calculations show that external reserves lagged one period is relati* r'v toe most important variable in the equation.

VII PQlkV-Responses to Capital Flight

The existence of canilal flight, of a sizeable oHcr of maeni'.i'^ •■?. ■"■ a host

of policy questions. One of such questions is whether capital flight is necessarily bad. And

if it is bad, what are the appropriate policy responses towards it? The rest, of-this p,,per

addresses these two issues. But before then, it is important to .make the poinl thu capital

flight could inadvertently have a positive effect. The positive eiicct i^uj:, u; (he possibility

■ ■ ■ I8

that a country experiencing capital tlight may benefit from increased income as a result of foreign investment income streams (Vos, 1992, p.528). This positive effect may however

be inadequate to compensate for the adverse effects of capital flight.

Several writers on capital flight have identified some adverse,consequences of capital flight. These range from its growth-reducing effects, the erosion of a country's tax

base, to the reduction of a country's access to the international capital markets which it

provokes. As for the growth-reducing effects, two possible channels of this effect have been

identified. The first is that capital flight denies the domestic economy of the opportunity of

utilizing the resource shipped abroad in directly productive activities, thereby limiting the growth potential of the economy in question. The second channel is the import-compression effect of capital flight on the growth potential of the economy. For most developing Countries, the import structure is dominated by capital goods imports which are very vital to production. And if scarce foreign exchange is shipped abroad, the domestic economy is thus denied the use of such resources for financing much-needed imports. Similarly if the resources had remained within the domestic economy,'they could have been used partly to service the existing external debt and thereby avoid the excessive debt servicing difficulties which now stand in the way of recovery and growih in these countries. Pastor (1990, p.4) had used this kind of reasoning to obtain the potential impact of increased imports on growth.

Regressing the growth rate of output on the growth rate of export and import volume, and using the coefficients for the growth of import volume to calculate the potential increase in domestic growth if one-quarter of (he earnings on accumulated foreign assets were devoted to increasing imports, he found for Mexico, that import-enhancing repatriation might boost

growth from say 2 per cent to nearly 4 per cent. t

To the extent that capital flight removes both the stock of wealth and earnings from a country, the taxable assets and income are reduced, thereby creating difficulties for

the tax authorities who must meet government revenue requirements. These difficulties are

likely to become more severe under economic and debt crisis when governments are under pressure to.cut down on budget deficit and still finance basic services and infrastructure for development. Thus capital flight may indeed be an obstacle in the way of recovery of the economies experiencing ii, and its removal could lead !o the resumption of growth. In this

context, one can again recall Pastor's findings with respect to Argentina and Mexico. Pastor

argued that if all interest earnings on capita! flight were subjected to taxation, the taxable income base would increase by around 5 per cent in both countries. By multiplying this increase by the average tax burden, onewould obtain an improvement in the budget deficit of nearly 1 per cent of GDP in both countries (Pastor, 1990, p.6). This is quite apart from the statement made earlier in this paper that capital flight implies that domestic resources escape those who seek to exercise some degree of control over the management of the macroeconomy in general and over how resources should be utilized in particular.

Another important consequence of capital flight is that it could reduce a country's access to external resources. Already, some international banks are citing the existence of capital flight as a justification for their reduced exposure to the highly-indebted countries. At the official level, James Baker, then U.S. Treasury Secretary was quoted as saying at the World Bank/IMF meeting in Seoul in 1985, that "It is unrealistic to call upon the support of voluntary lending from abroad, whether public or private, when domestic funds are moving in other direction. If a country's own citizens have no confidence in its economic system, how can others?"3 This kind of "sentiment has been expressed by commercial banks who describe themselves as reluctant to provide fresh funds unless debtor countries put a stop to capital flight. For economies in crisis, as most debtor economies are, capital flight is thus limiting their access to external funds at a time when they probably need

them most.

If capital Hight has these adverse consequences (and more), what can be done ■ to reverse it? And reversing it the indebted countries must, if they are to have improved

access to external capital and if growth is to be restored to their economies.

Perhaps {he single most important policy response is the restoration of confidence in the domestic economy. And confidence can be restored only if the government pursues credible and siislamcd macroeconomic policies. Policies which give rise to capital flighi in the first instance, for example, overvaluation of the national currency, inflationary

Treasury News; October. 1988, (Cited by Gulati, 1988).

20

policies, regulation of the financial market, etc. ought to be corrected. In short, a credible set of policy reform programmes must be put in place. Since confidence, once eroded, cannot be restored overnight, it is important that such reform measures be sustained.l There would be political opposition to some of the measures but the restoration of confidence demands that economic agents are not given the chance to form about policy reversals.

Once some element of confidence-building has been achieved, some institutional mechanisms for reversing capital flight can be put in place. A good example of such an institutional mechanism is the Domiciliary Account in Nigeria. The decree which established this facility allows Nigerians and Nigerian businesses to open foreign currency accounts in Nigeria. By the provision of the decree, a depositor is allowed to withdraw his deposit in the foreign currency in which the deposit was originally made. He can sell the foreign currency to his bank or any other foreign exchange dealer which offers the most preferred rate of exchange. He also earns some interest on the balance in the account.

The Domiciliary Account was established in 1986 as part of the government effort to reverse capital flight in Nigeria. But to what extent has the government succeeded in this effort? Between 1987-91, the inflow of foreign exchange into this account amounted to some US$3 billion. The annual inflow varies from a high of US$1.1 billion in 1987 and 1988, to a low of US$0.4 billion in 1990. These reported figures are likely to underestimate actual capital inflows since 1986 when the government embarked on the structural adjustment programme. This is because some inflows particularly those not channelled through the Domiciliary Accounts (and these can be large), are never reported. Neither do the recently established bureaux d<\s change make any official reporting of their transactions.

In addition to the pursuit of appropriate domestic policies and the use of such institutional mechanisms like the domiciliary account, another policy response is the institutionajization of efficiency and accountability in, government operations. Although we did not find evidence of debt-fuelled capital flight, there is the view in some quarters that some of the. external borrowing may have in fact have been used to finance capital flight.

The implication of ihis is that, governments must reduce inefficiency and corruption in its operation. For if this were not done, government officials can use their offices to effect

21

capital flight.

Some people have expressed the fear that even with all these measures in place, the return of capital flight may not be that easy. This is because repatriation could expose investors to penalties for taxes that were unpaid or exchange controls that were violated. The fear of punishment for these crimes implies that some threshold must be overcome in order to induce.the repatriation of funds held abroad by residents. The threshold could include

(Williamson and Lessard, 1987 p.52): -r.

(i> an amnesty with regard to past taxes and sanctions for the violation of

exchange controls;

(ii) favoured exchange rates in purchasing domestic assets; and (iii) special guarantees against particular risks.

Each of these measures has its advantages and ■disadvantages. Individual countries may

therefore have to-weigh'these in deciding which of them to adopt.

VII Conclusions .

■ ' ■ " ■' ' "

We have tried in this paper to shed some light on capital flight in the three countries of Cote d'lvoire, Morocco and Nigeria. We called attention to the fact that by its very nature, capital flight is fraught with measurement problems. Because of this, it is the contcnlion of the paper that what counts'is not so much the correct measurement of capital flight as this is near impossible. Rudimentary or inexact as they may appear, the figures reported here indicate the existence'of a policy problem which calls for appropriai., -oiicy response. Perhaps the most important policy response which the paper called for is the restoration of confidence in the economies experiencing capital flight. And restoration of confidence can he brought about partly by the pursuit of appropriate macroecononr r* nolicies.

While not a .sufficient condition. ^ p-vnuih »">: .lpiM-printe r,u\cn ..■■■.-...: : , :s.is a necessary condition for the rovers:' of r;ipit:>' fligH. IV ■<i>lt!'Of- V!:; - ' n '■ "isms for inducing Ihc reversal' oi capital flight, like the Nigerian Domiciliary Account, could be put in pUuv. Finally, .cnunlrics expi-ricncinj,' capital flight need to curb inefficiency and corrupli'in *"i Ihe divisions nf their j?overnmonls if they are to succeed r> n vnrsi;,^ capital

IliglH.

22

The unsatisfactory nature of Ihe data used and in. particular, (he measurement problems surrounding capital flight both suggest that the results herein contained should be interpreted with caution. Indeed, the study is purely exploratory - it requires further work in the following directions. First, the definition and measurement of capital flight needs to be improved to include, for example, overinvoicing of imports and undervoicing of exports.

Guiati (1988) has shown that their inclusion often produces more accurate estimates of capital flight. Second, the study could be extended to "cover many more countries in Africa in order to be able to make concrete policy recommendations.

23

VTED'IVOIRE : Debt and Other Macro-Economic Indicators

Tabie1 GDPGROWTHRATE(%) iTtONRATE .0MONEY(M2)GROWTHRATE ,DMONEY(M2)AS%OF:G0P"■' NALEXCHANGERATES(Lc/USS.encofpenoa) RTSVALUEGROWTHRATE SOFTRADEESTIMATES iETDEFlCnVSURPLUSAS%GDP .DEBT1/ iUARANTEEDDEBTTOOFFICIALCREDITORS iUARANTEEODEBTTOPRIVATECREDITORS SERVICERATIO{%}2/■ ESTPAYMENTSRATIO{%)3/3.3 GDPGrowthRale:-ADBStatisticsDivision. Money,irritation,andNommaiExchangeRates:IMP,InternationalFinancialStatistics.CD-ROMAugust1993 ExportValueGrowthRateandTermsofTrade.UNCTAD.HandbookofIntermtiona.TradeandDevelopmentStatistics,vanousLues BudgetOef-crtorSurplus:,MF.GovernmentRmnceStatanc.and"Director,delaCOn/onctureetde(aPrevisionAbidan" DebtandDebtrelatedfigures:IBRD,World^DebtTables.1992-1993 lionUSdoflars. :ServiceRatioisdefinedaspnncipalandinterestpaymentsaspercenttgeatexportofgoodsandservices. sstpaymentratioisdefinedaspercentage,ofexportofgoodsandservices.

24 ROCCO:DebtandOtherMacro—EconomicIndicators

Table2 5LES197519761977197919811982198519661987198819891990199111 6.7 7.9 20.1 39.2 4.2 -96 c6.0 -92 1.7 1.1 0.6- 6.4 2.2'

11.0 8.5 18.1 41.1 1.5 -18.0 =7.1' -17.6 2.5 1.2 1.0 11.3 4.7

4.9 12.6 19.7 ■40.6 4.3 3.0 34.2 -15.4 5.0 2.0 21 13.1 7.2

.2.9 9.7 17.7 43.1 3.9 15.5 98,1 -10.5 6.3 2.5 2.8 29.3 ■14.0

4.6 8.3 13.9 43.6 3.7 30,1 69.3 -9.6 8.5 3.8 3.5 34.5 17.0

9.1 9.4 10.8 ■10.4 4.3 27.5 97.1' 6.1 9.7 4.4 39 32.7 17.6

-2.8 12.5 16.4 44.1 5.3 -43 107.8 -2.1 10.6 ■5.3 3.7 37,0 19.7

-9.6 10.5 11.1 d1.7 6.3 -13.6 "101.0 -3.5 12.4 6.0 41 43.2 20.6

-0.6 6.2 17.7 46.0 8.1 -2.7 97.1 -2.J ■13.2 7.0 3.8 S8..9 ;9.5

4.2 12.4 10.2 '44.7 9.6 3.7. -96,1 -2.9 14.0 7.6 39 26.6 18.8

3.5 '7.7 18.2 15.9 9.6 4,1 10C.O -6.1 16.5 9.8 4.1 33.2 16.7

6.3 8.7 15.9 44.5 8.7 13.3 105.8 -7.4 17.9 11.6 4.2 36.4 16.2

-2.6 2.7 9.7 43.2 7.8 15.2 .101.0 -1.6 20.6 14.1 4.6 30.2 13.2

10.4 2.4 14.7 47.7 8.2 ■27.5 107.8 -0.3 21.1 14.6 19 26.1 !d.3

1.5 3.1 11.8 49.9 8.1 -8.2 106.8 -4.7 21.7 15.6 .4.8 33.1 18.6

2.6 6.9 18.2 53.5 8.0 29.0 116.5 -6.5 23.6 17.4 4.9 21.9 11.6

----* 5.1 8.0 17.0. 55.7. 8.1; 4.3: 515.5' -5.5* 21.2; 15.5! tf6i ■27.6i 14.1'

iDPGROWTHRATE(%) IONRATE{%) 'MONEY(M2)GROWTHHATE 'MONEY(M2)AS=-=CFGDP ALEXCHANGERATES(Lc/US5.enac!perioo]! TSVALUEGRCWTHGATE OFTRACEESTIMATES ;TDEFICIT/SURPLUSASfiGDP DEBT1/ JARANTEEDDEBTTCOFFICIALCREDITORS' JARANTEEDDEBT"2=>«!VATeCRE0ITCR5" iERVtCERATIO(%)2/ iSTPAYMENTSRATiC(%)3/ GDPGrowthRate:ADBStatisticsDivision. Money,Inflation,andNominalExchangeRates:IMF.InternationalFtnancafStatistics,CD-ROMAugust1993. ExportValueGrcwtnRateandTermsofTrade:UNCTAD.HandbookofInternationalTradeandDevelopmentStatistics,wariuosissues. BudgetDeficitorSurplus."IMF,GovernmentfinanceStatisticsand"DirectionduTresoretdesFinancesexterieuresduMaroc". DebtandDeblre'aieafigures:IBRD,WorldDebtTables,1992-1993 lionUSdollars..■ ServiceRatioisdefinedasprincipalandinterestpaymeritsasperceniageofexportofgoodsandservices. !stpaymentratioisaefinedaspercentageofexportofgoodsandservices.'..■

SERIA:DebtandMacro-EconomicIndicators

25 Table3 SLES1975 -25 33.9. 55.7v 18.5 0.6 -14.7 59.6 -12.7 1.1-. 0.7 .0.4 3.0 O.S

1976 104 124.3 83.5 27.6 0.6. .34.7 62.8 -10.6 0.9 0.7 0.1 3.7 0.4

1977 75 13.8 0.9 23.4 .0.7 12.0 54.9 -11.2 3.1 .0.8 0.1 1.0 0.4

1978 -63 21.7 -2.0 ,20.8 0.6. -15.8 57.4 -13.S 5.1 0.9 1.4 1.3 0.6

1979 -14 11.7 31.0 22.8 0.6 72.8 70.2 -5.3 6.3 0.9 2.3 2.0 1.3

1980 35 10.0 46.1 28.3 0.5 50.8 106.4 -17.0 8.9 1.0 3.3 A.2 3,3

1981 -23 20.8 5.9 30.0 0.6 ■-31.3 1213 -6.6 12.0 1.1 5.2 S.1 5.9

1982 -06 77 9.5 32.3 0.7 -31.7. 113.8 -5.8 12.9 r1.3 78 16.2 9.7

1983 -49 23.2 14.0 33.3 0.7 t15.0 102:1 2.1 18.6 1.9 10.2 23.8 13.1

1984 -48 39.6 11,6 33.4 0,8 .14.5 101.1 .0.7 18.6 2.0 9.4 33.8 15.8

1985 97 -7.4 9.0 32.0 1.0 ,5.8 100.0 -8.6 19.6 2.2 10.9 33.3 12.8

1980 25 5.7 2.0 32.3 3.3 -58.9 '■54.3 -14.3 23.S 8.6 .10.5' 32.7 12.9

1987 -07 11.3 22.4 26.5 4.1 42.9 59.6 -4.0 30.7 11.5 16.9 14.2 8.3

1988 me 9.9 54.5 32.9 26.4. 5.4 -6.7 47.9'■■ -7.1 31.2 _10.9 18.2 30.4 .20.9.

1989 72 50.5 12.3 19.3 7.7 14.5 56.4 0.4 32.0 14.4 16.6 25.1 18.2

1990 82 7.4 32.7 22.1 9.0 '73.7 67.0 3.9- 34.6 16.7 15.9 22.9 12.7

19911 ■ 1 481 13.0! 37.4i 27.4i 9.9 -2.4; 56.4 -.£-2 34.5: 18.8! 14.5- 25.2 16.8

3DPGROWTHRATE{%) riCNRATEf%) 3MONEY(M2)GROWTHRATE 3MONEY(M2)AS%OFGDP 1ALEXCHANGERATES(Lc/USS.enda!perron) 1TSVALUEGROWTHRATE 5CFTRADEESTIMATES ETDEF1QT/SURPLUSAS%GDP .DEBT1/ UARANTEEDDEBTTOOFFICIALCREDITORS■ UARANTEEODEBTTOPRIVATECREDITORS SERVICERATIO(%)21. ESTPAYMENTSRATIO(%)3/ GDPGrowthRate:ADBStatisticsDivision. Money.Inflation,andNominalExcnangeRates:IMF.internationalFinenaaIStatistics.CD-ROMAugust1993. ExportValueGrowthRateandTermsofTrade:UNCTAD.HandbookofinternationalTradeandDevelopmentStatistics,variousrssues. BudgetDeficitorSurplus:CentralBankcfNigehaandNigeriaFederalGovernmentOfficialGazettes. DebtandDebtrelatedfigures:IBRD.WorldDebtTables,1992-1993. illionUSdollars. 1ServiceRatioisdefined-asprincipalanainterest'paymentsaspercenBgeofexportofgoodsandservices. restpaymentratioisdefinedaspercenageofexportofgoodsandservices.