Capital flows and current account sustainability in African economies

Workshop

21 - 23 September 2005

Accra, Ghana

Aide-memoire

I. Background and justification

Most African countries still run current account deficits. However, the situation has improved. This is especially true with regard to the gap between imports and exports of goods and services, which has on average been reduced since the beginning of the 1980s. Theoretically, the current account balance serves as a buffer through which consumption can be smoothed over time in response to fluctuations in output and investment.

However, in particular for the Least Developed Countries (LDCs), dependent on commodity exports, export revenues are not sufficient to meet expenditure for much needed imports of capital goods. This leads to shortages of foreign exchange. Although the number of countries with current account deficits of more than 10 per cent of GDP decreased from 16 in 2001 to seven in 2004, the issue remains relevant. The export structure of these countries makes them vulnerable to price fluctuations. Higher deficits occurred in some African countries, partly driven by conflict and exchange rate appreciation.

Countries showing decreases in their current account deficits were mainly oil-producing countries, which benefited from higher international oil prices and robust oil production levels. Short-term current account surpluses cannot be regarded as an indicator of sustainability, due to the volatility of commodities prices. In principle, private and public capital flows and transfers, such as Foreign Direct Investment (FDI), portfolio investment, ODA, and remittances of migrants, offset current account deficits. But most of these flows are highly volatile. The Asian experience has shown that abrupt reversals of capital flows can be very disruptive for exchange rates and current account sustainability.

Remittance inflows are a major source of external finance for African countries, and they have helped to moderate some countries' current account deficits. They became more significant as ODA flows declined over the 1990s. Between 1980 and 2002, remittances into Africa increased from 1.4 per cent of GDP to 2.1 per cent of GDP. Showing less volatility than net FDI flows the volume of remittances was considerably more stable than net ODA.

FDI to Africa remains low at about 1.7 per cent of global FDI inflow in 2002, which basically reflects its low share in world GDP. But contrary to general perceptions, Africa has benefited from the rapid expansion of FDI. In Sub Saharan Africa (SSA) FDI stabilized from 1997 to 2002 at an average of $8.75 billion, compared to an average of $4 billion at the beginning of the decade. Albeit relatively stable, FDI to Africa remains volatile given its concentration in extractive industries, which possess little linkage to the rest of the economy.

After ODA flows to Africa in 2000 fell to $18.8 billion they hit a new peak of $24.1 billion in 2003. This increasing trend is expected to continue, and will contribute to the easing of Balance of Payment problems. Aid inflows are largely beyond the control of African governments, and have also been volatile over the past decades.

External debt remains a problem for many African countries because of high debt servicing obligations, and the restrictions it puts on obtaining new credit. The initiative to reduce the overall external debt burdens of Heavily Indebted Poor Countries (HIPC) to sustainable levels has made significant progress over the past few years. At the end of 2004, 12 out of 23 African HIPC countries have reached completion point, and have benefited from substantial debt relief. Nonetheless, debt servicing ratios remain high for some countries.

In sum, the structure of African economies and the nature of the global economic system are not likely to lead to current account surpluses for the majority of African countries. It is considered that deficits will continue to be financed mainly through private and official capital flows. The question arises whether current accounts are sustainable. If they are not, what can be done to make them sustainable.

II. Objective and scope

The central issue of the workshop is: how to increase the sustainability of current accounts in African countries. Hence, the objective of the workshop is to explore the factors that affect current account sustainability in African countries, and in particular, the role capital flows play in this regard. The workshop will also provide policy options for improving the sustainability of current accounts.

A further goal is to explore determinants of and policy issues associated with capital flows in light of a changing global financial environment. This will help to identify the policy prerequisites that will allow African countries to exploit the gains, and minimize the risks associated with capital flows in terms of their current accounts.

If a current account balance can be sustained under current policies, given government inter-temporal budget constraints are satisfied, the imbalance is considered to be sustainable. The major factors that might determine current account sustainability for African countries are: macroeconomic stability, growth dynamics, economic structure, internal savings, and aid.

The structure and dynamism of the economy plays a crucial role for the persistence of current account deficits. Liberalization of external trade, which has taken place in most African countries over the past 20 years, has led to an increase in both exports and imports. There is empirical evidence that a reduction of trade barriers might increase the current account deficit, because imports might grow more than exports. Furthermore, many African countries have not managed to diversify their exports towards manufactures. This excludes them from benefiting from faster growth in manufactures trade and makes them vulnerable to terms of trade shocks.

The other side of the coin is the surplus in the capital balance. This is driven by low savings, both private and public. Capital inflows are needed in order to finance investment. The ability to sustain current account deficits will be affected by a country's debt burden, as this determines its access to external borrowing. In addition, a large debt-servicing burden can easily exhaust export revenues, and prevent imports of investment goods needed for growth. The sustainability of the debt burden has to be analysed in this context as well.

When a country's real exchange rate is dramatically overvalued, a current account deficit is likely to be unsustainable, as an overvalued exchange rate restricts exports and encourages imports. Furthermore the changes in the amount of international reserves, which are usually expressed in months of imports, are an indicator of current account sustainability.

To balance the current account different types of capital flows are relevant for Africa, mainly FDI, aid, other external borrowing and remittances. While aid is the most important flow for SSA, remittances have become increasingly important to North Africa.

As the volatility and sensitivity to boom-bust cycles of different types of capital flows varies, it matters how current account deficits are balanced. In this respect the currency mismatch and the maturity mismatch of the components of the capital account are of special importance. To reduce the adverse effects of the volatility of capital flows, capital account regulations can be used.

FDI could also balance current account deficits and help to reduce them if it is export oriented. However, it often induces an increase in imports and outflows of profits. Likewise remittances are mainly used to finance consumption of partly imported goods but could also be used to build export capacity. As Africa has had more capital flight relative to its own wealth than any other region, a reversal of this trend would make a major difference to Africa's capacity to finance its development. All of these capital inflows require an improvement in domestic economic conditions.

III. Workshop themes

1. Factors that contribute to (un)sustainable current account deficits in Africa

To set the scene for the workshop an empirical investigation of current accounts and capital flows of African countries will be conducted to determine their sustainability over the past decades. This analysis should also help to determine the factors that are relevant for current account sustainability in Africa. In this context the positive terms of trade shocks of oil-exporting countries should be included in the analysis. The results of the analysis will help to focus the discussions on the relevant countries and topics.

2. Exchange rate regimes and current account sustainability in African countries

Since the beginning of the 1990s a number of African countries have liberalized their exchange rate policies and switched to flexible exchange rates determined by the market. Therefore it is more difficult to use the exchange rate as a policy instrument. In principle real exchange rate depreciation might help to reduce the trade deficit. On the other hand, it will generate capital losses, which might reduce capital inflows. After more than 10 years of experience with flexible exchange rates in many countries an evaluation of its effect on current accounts is due. This will shed light on the conditions under which a positive effect could be achieved.

3. Institutional dimensions of current account sustainability

Vulnerability to crisis depends to a large extent on the structure of trade and external finance. Both the domestic structure of the economy, as well as the external capital structure of a country depend on the quality of institutions, such as the trade regime, the business environment, and the banking system, among others. This presentation will focus on policy recommendations on how to achieve current account sustainability.

4. Financial liberalization and the structure of capital flows

In principle the liberalization of financial markets is expected to increase the availability of finance to balance current accounts and to spur development. However, because of rigidities in capital markets and information asymmetries the portfolio of liabilities of an African country might be very sensitive to exogenous shocks. Capital account regulations can therefore be used to improve private-sector external debt profiles. Innovations in this area in different countries will be reviewed to distil lessons for Africa.

5. The role of external debt in current account sustainability

As many African countries are highly indebted they need to use a substantial share of foreign revenue for debt servicing, which limits their ability to import new equipment, necessary to increase productivity. In addition, high levels of debt reduce the availability or increase the costs of new loans to balance current account deficits. A long-run solution to the debt problem of Africa also needs to address trade and trade related structural problems on the continent.

6. The role of capital flight and remittances in current account sustainability

In principle it's a normal behaviour of investors in any country to invest part of their capital outside the home country to diversify their portfolios and spread risk. However, in many African countries capital flight is an indicator of economic distortion. But it can also be a consequence of illegal acquisition. The decision to move capital out of the country (illegally) might reflect the anticipation of devaluation, inflation, and further restrictions of external transactions that might lead to negative real interest rates and political instability. With respect to remittances the questions are how to increase the share of remittances that comes through official channels, and how to channel more remittances into investment in order to spur growth. To reverse capital flight and increase remittances, general conditions for investment need to improve in order to reduce risk and enable capital owners to get adequate returns for their investment.

VI. Participation and format of the meeting

The workshop will provide participants with a better understanding of the role that capital flows play in enhancing the sustainability of current accounts and provide an opportunity to explore ways of improving current account sustainability. It will serve as a platform for sharing experiences between African countries through country case studies, lessons learned, and best practices.

Extensive consultations with representatives from Central Banks, Ministries of Finance, Ministries of Economic Planning, Ministries of Trade, the African Development Bank, the World Bank, private sector representatives and African universities will provide a framework for the meeting.