A quarterly magazine of the IMF

December 2006, Volume 43, Number 4

Enticing Investors
Calvin McDonald, Volker Treichel, and Hans Weisfeld

To make a serious dent in poverty, Africa must attract more foreign capital

The nearly 750 million people who live in sub-Saharan Africa (SSA) are among the world's poorest. To foster the economic growth required to create jobs, raise living standards, and hasten development, SSA nations need to attract more foreign capital, which, by enhancing imported technology and the transfer of know-how, has proved instrumental in raising productivity in many countries.

Many of these nations have taken steps to lure investors. They have changed fiscal and monetary policies to create a more stable economic climate. They have reformed markets and increased legal protections for investors. Still, to many potential investors, the business environment remains uninviting because of corruption, a poor infrastructure, few skilled workers, and generally lax governance.

Falling behind

Over the past 25 years, foreign direct investment (FDI) in the region has increased substantially, from $11.8 billion in 1980 to $25.6 billion in 1990 and to more than $101 billion in 2004 (see Chart 1, top panel). Moreover, as a percent of GDP, the stock of FDI in SSA increased from 10.2 percent in 1980 to 29.4 percent in 2004. A new source of funding has emerged as well—from a small number of investors who are interested in adding to their portfolios debt securities issued by governments in the region.

But SSA has lagged behind the rest of the developing world in attracting investment. For developing countries, there has been a sharp increase in the flow and the stock of FDI—both increased by a factor of 16 from 1980 to 2004, with Asia's share up significantly and Latin America's by a small margin (see table). But since 1980, SSA's share of total FDI flows has declined. The region currently accounts for just 1 percent of global flows, half the level in 1980 (see Chart 1, bottom panel), and has fallen behind that of other low-income countries—in particular in Asia—that have implemented broad structural reforms. This analysis excludes South Africa, a large middle-income country with different characteristics than the small, poor countries that make up the rest of sub-Saharan Africa.

Moreover, the vast majority of FDI to the region went into the primary sector, particularly the exploitation of mineral and petroleum resources. The 24 countries in SSA classified by the World Bank as oil- and mineral-dependent have, on average, accounted for close to three-fourths of annual FDI flows over the past two decades. With the discovery of new oil fields in Chad and Equatorial Guinea, all of the top 10 SSA recipients of FDI in 2004 have large mineral and petroleum resources. From 1980 to 2004, the stock of FDI in oil-exporting countries in SSA rose from 4.6 to 46 percent of their GDP (see Chart 2).

Manufacturing dominated investments in the secondary sector (which also includes such industries as construction), and services were the chief recipient of investment in the tertiary sector (which also includes tourism). The largest recipient of FDI, measured as a percentage of GDP, is Lesotho, which has attracted significant amounts of inflows into its garment industry. The stock of FDI in the GDP of oil-importing countries increased from about 7.4 percent in 1980 to 24.9 percent in 2004. Historically, SSA has depended on a small number of countries for FDI. Between 1980 and 2000, France, the United Kingdom, and the United States accounted for close to 70 percent of total flows.

A United Nations Industrial Development Organization (2006) survey of 1,200 investors provides evidence that new types of investors with significant employment and export impact have entered SSA since 1990. These investors originate both from developed countries and from South and East Asia. While the Asian investors have focused mainly on labor-intensive manufacturing, especially in the garment sector, those from developed countries have engaged in a range of high-value-added activities, including chemicals, food processing, and financial intermediation. Both groups of investors are export-oriented and expect high growth rates in both sales and exports. Investors have been particularly satisfied and are confident about future prospects in Burkina Faso, Ghana, Madagascar, Mozambique, Tanzania, and Uganda.

Need job-creating investment

What has been the economic impact of SSA's greater FDI flows? So far, it appears that it has strongly helped growth but has had only a limited impact on employment and per capita incomes. Increasing FDI and attracting it to sectors that have a large employment impact will further enhance SSA's growth through at least three channels. First, in addition to providing much-needed capital, FDI can stimulate domestic investment, promote the transfer of technology, and bring market access. Second, given that current flows of official development assistance are insufficient to achieve the Millenium Development Goals, FDI could play an important role in filling the resource gap, especially as income levels and domestic savings in the region are low. And, third, FDI is non-debt-creating.

For these reasons, many countries have implemented reforms that have improved the environment for private sector activity (Pigato, 2001), including the following:

• Greater macroeconomic stability. Prudent monetary and fiscal policies have helped SSA make substantial strides toward macroeconomic stability. Inflation in the region (excluding Zimbabwe) declined from an average of almost 15 percent in 1985 to an average of 8 percent in 2005. Also, the fiscal deficit fell from 5.5 percent of GDP in 1980–85 to 1.3 percent in 2000–05.
• Structural reforms to enhance the supply response. Many SSA countries have been making progress in implementing market-oriented structural reforms, such as privatization and the adoption of a regulatory framework more conducive to investment. Notably, restrictions on external current account transactions have largely been eliminated, and many countries have shifted to market-based exchange rates. Moreover, customs tariffs have been reduced and simplified.
• Increased protection of investors' rights. Most SSA countries have concluded bilateral and multilateral treaties that address issues of particular importance to foreign investors, such as liberalization of restrictions to entry, elimination of discriminatory conditions, and a streamlining and harmonization of investment incentives.

Despite these improvements, FDI flows to SSA continue to be constrained by shortcomings in the business environment—including the poor quality of infrastructure, corruption, lack of a skilled labor force, and weak tax and customs administration. In addition, the World Bank's Doing Business survey underscores the high costs of excessive bureaucratic procedures. While initiatives have been launched in recent years to improve the dialogue between the government and the business community, a strong commitment from the highest levels of government will be essential to ensure effective follow-up on the results of this dialogue, including the mobilization of adequate financial support for priority infrastructure projects and the effective implementation of measures to fight corruption.

A new source of funding

The good news is that some investors are showing more interest in debt instruments issued by SSA governments—especially in Botswana, Cameroon, Ghana, Kenya, Malawi, Nigeria, and Zambia. Why? First, investors have widened their search for yield in a global environment of ample liquidity and historically low interest rate spreads between the government securities of emerging markets and those of industrial countries. Second, risk premiums on government debt have fallen in some SSA countries. Improved macroeconomic performance in many has increased their ability to carry debt, as have debt relief under the Heavily Indebted Poor Countries Initiative and the Multilateral Debt Relief Initiative and debt cancellation by the Paris Club. Several countries, namely, Cameroon, Ghana, Nigeria, and Zambia, have received improved sovereign risk ratings. Third, there may be expectations that the currencies of commodity-exporting countries could appreciate as a result of rising commodity prices.

SSA governments have generally welcomed the inflows of foreign portfolio investment, which they often see as a vote of confidence in their economic management. Foreign investment has helped lower government borrowing costs by exerting downward pressure on domestic interest rates. It has also helped increase market efficiency by increasing the number of bidders for government securities and by adding liquidity. Some governments hope that foreign investment in government debt will, over time, stimulate much-needed FDI by putting these countries "on the map" for other potential investors and positively affecting their reputation.

But there are risks, too. Volatile private capital inflows can complicate the management of exchange rate and monetary policy. The financial markets of SSA countries are small in relation to the large amounts of liquidity available globally. As the experiences of other developing countries and emerging economies show, capital inflows can reverse rapidly, leading to large swings in exchange and interest rates.

Because of these concerns, many countries apply restrictions to foreign portfolio investments—although the effectiveness of such restrictions is highly uncertain. In Nigeria, for example, foreigners can hold only bonds with a maturity of at least one year. In Ghana, investors must have an account in local currency. In Malawi, investors need central bank approval to purchase bonds or repatriate profits from such investments. In Botswana, foreigners cannot hold central bank bills.

In addition, exchange rate appreciation as a result of capital inflows may reduce external competitiveness—known as Dutch disease. In many SSA countries, export industries are already under pressure from currency appreciation arising from commodity price booms, such as those in oil and metals.

Balancing capital inflows and risks

The key challenge for SSA policymakers in managing capital inflows is to take advantage of these inflows while minimizing the associated risks. To meet this challenge, policymakers should focus on the following:

• Strengthening macroeconomic policies. Policies designed to consolidate gains in stability and, in particular, achieve a sustainable fiscal policy will be critical to limiting potential vulnerabilities associated with capital inflows into domestic debt markets.
• Enhancing mechanisms to monitor capital inflows and keep track of repayment schedules. At present, some countries do not have full information on capital inflows. There is an urgent need for these countries to gather better information and formulate comprehensive strategies to manage investment inflows.
• Reinforcing the supervision of the financial sector so that it can withstand swings in exchange and interest rates. The regulatory authorities need to monitor the balance sheets of financial institutions, including their foreign exchange exposure.
• Deepening domestic debt markets. Most government debt in SSA has short maturities because of weak domestic demand for instruments with longer maturities. The greater appetite of foreign investors for government paper of longer maturities provides an opportunity to reduce rollover risks of government debt and increase secondary market trading.
• Making efficient use of borrowed funds. Governments should use the proceeds of foreign investment in priority social and productive sectors. Particular attention needs to be given to infrastructure bottlenecks for the export sector, where competitiveness may be impaired by exchange rate appreciation in the wake of capital inflows.

If SSA countries implement these measures, portfolio investment has the potential to raise market efficiency and deepen financial intermediation while safeguarding financial sector soundness.