Portfolio Reallocation of Private Capital Flows to Africa
Trend and composition: Foreign capital inflows have recovered in post-crisis period, reaching a high of US$72.1 billion in 2010, but still below the pre-crisis peak of US$79.0 billion. Recent trends in capital inflows have principally been driven by foreign portfolio investment (FPI), which peaked at US$22 billion since the crisis (Figure 1). In the meantime, foreign direct investment (FDI) in Africa, which has largely been directed towards extractive sectors, has continued on the downward path.
The shift towards portfolio flows shows the growing prominence of this source of external funding, as institutional investors search for better yields in African equities and bonds. Despite this favorable outturn, FPI represent a very small proportion of financially integrated markets (South Africa: total FPI, 4.3% of GDP in 2010; 3.5% in 2011, estimated), and even much lower for less integrated and smaller economies (Zambia: 0.6% of GDP, 2010; 0.1%, 2011 estimate). Foreign investment flows also come in form of bank lending and derivatives trading although data on these flows are generally marred with problems. Remittances have also increased to an estimate of USD37 billion in net terms. This provides an important source of external financing for some countries, especially in smoothening consumption and supporting domestic investment.
Causes: A number of factors explain Africa’s attraction to private portfolio investors. Aided by strong recovery in commodity prices, macroeconomic stability and investor friendly business climate, Africa has posted robust economic growth in recent years. Treasury yield spreads and equity returns have also remained positive, compared with the low interest rate regime prevailing in mature markets. Yet Africa remains vulnerable to global investor risk aversion in an environment plagued by uncertainty as events in the Euro area and fragility in North Africa threaten to reverse the continent’s capital gains.
Effects of private capital flows: Africa still faces a huge financing gap given the low savings rate which makes foreign capital a welcome phenomenon. However, although policy makers remain receptive to FDI, they are generally wary of more volatile and speculative short-term portfolio capital flows because of the potential to destabilize macroeconomic management and derail growth. The volatility of short-term capital flows arising from worsening global investor confidence on the back of the euro zone debt crisis has seen foreign investors pull back from emerging market assets. Africa has not been spared the loss in investor confidence.
In South Africa, the rand has depreciated by more than 25% since the beginning of 2011. Since the revolution, Egypt has lost US$2.7 billion of foreign portfolio capital as political turmoil has damaged investor confidence. In Tunisia, the effect has been less severe (US$0.3 billion), thanks to a swift resolution of the political impasse. In Morocco, the current account (CA) is projected to widen as a result of a reduction in inflows due to risk of contagion. The picture in Nigeria has not been any different as more foreign equity investors have exited the market since the stock market crash of 2008.
Optimal policy response: The optimal policy response would be to reduce external vulnerability by maintaining low public and external debts whilst building adequate international reserves to wade off risks of currency devaluation induced by portfolio outflows. Furthermore, in order to effectively deal with capital flows, African authorities must continue with policies that engender macroeconomic stability, build resilient financial systems and create disincentives for speculative behavior. In particular, improving financial system supervision and regulation and deepening the financial markets will strengthen Africa’s resilience to the volatility of capital flows, making it better placed to weather a potential wave of capital reversals.