2013

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Working Paper 192 - Empirical Analysis of Agricultural Credit in Africa: Any Role for Institutional Factors
24/12/2013 13:40
Working Paper 192 - Empirical Analysis of Agricultural Credit in Africa: Any Role for Institutional Factors
A strong and efficient agricultural sector has the potential to enable a country feed its growing population, generate employment, earn foreign exchange and provide raw materials for industries. It is however ironical that despite the great potentials Africa has in agricultural production; the continent is a net importer of food. Aside from the problem of poor access to land and modern technology, African agricultural is afforded inadequate access to credit and characterized by low investment. It is in the light of the above that this study examined the extent of agricultural credit and the factors responsible for the level of agricultural credit in Africa. The study equally analyzed the factors responsible for the low level of agricultural credit in Africa, with a special consideration given to institutional factors. Greater access to credit facilities has often been identified as the direct solution to increasing investment agriculture in Africa. The paper estimates an agricultural credit model using data covering 1990-2011 and covering ten countries: Mali, Nigeria, Burundi, Rwanda, Chad, Sudan, Egypt, Lesotho, South Africa and Kenya. The study investigates the determinants of access to credit using panel data techniques. Fixed and random effects models were estimated and compared with the Pooled OLS and examines the importance of individual and period effects explaining differences in access to credit across the selected countries. The data used for this paper were obtained from World Development Indicator (WDI) World Bank, the African Development bank Database, FAOSTAT and the Annual Reports of the Central Banks of the selected countries.    The empirical estimates revealed that higher savings rate produce greater agricultural credit on the continent. Although, savings rate are generally low in Africa, the impact of savings on agricultural credit is still large. All four governance variables- Corruption index, Rule of Law index, Regulatory quality index, and Government Effectiveness index- included in the model produces negative impact on agricultural credit in the continent. Interest rates charged by the various financial institutions, especially commercial banks, have been prohibitively high. Limited availability of farm land is another potential factor that determines the magnitude of agricultural credit on the continent. Land available for agriculture has positive significant impact on agricultural credit in Africa. Overall governance issues are crucial to addressing the challenges of low and dwindling agricultural credit in Africa. The results of the study have important policy implications. First, agricultural banks on the continent (in countries where there is one) should ensure a reduction in lending rate to guarantee better access to credit but also to dilute the pool of creditors they face. Formation of Cooperative Societies, Thrift and Credit societies among the farmers in the continents should be encourages in order solve the problem of credit denial by banks on the account of collateral securities. Institutions should be strengthened to enhance reduction in corruption and enforce accountability across the continent. Efforts towards poverty reduction and implementation of the MDG policy should be intensified. Provision of agriculture based infrastructural facilities like good roads, tractors and others will complement and enhance judicious use of agricultural credit in Africa.Read more
Working Paper 190 - Early Warning Systems and Systemic Banking Crises in Low Income Countries: A Multinomial Logit Approach
23/12/2013 16:15
Working Paper 190 - Early Warning Systems and Systemic Banking Crises in Low Income Countries: A Multinomial Logit Approach
The global financial crisis has stimulated new interest in models aimed at providing early warning about the risk of a systemic banking crisis based on early warning systems (EWSs). While most of the focus has been on advanced economies; which have been at the epicenter of the recent turmoil, the relevant empirical literature has devoted inadequate attention to low income countries (LICs). This paper aims at filling this gap by building an early warning system (EWS) for predicting systemic banking crises in LICs. Our contribution to the literature is twofold. The first and more obvious is to build a body of literature on LICs and banking crises in Sub-Saharan Africa (SSA). The second contribution is methodological and refers to the use of the multinomial logit model in EWS, which is shown to improve upon the widely-used binomial model in terms of number of crises correctly called and number of false alarms produced. This paper estimates an EWS for predicting systemic banking crises in a sample of 35 low income countries in Sub-Saharan Africa. Since the average duration of crises in this sample of countries is longer than one year, the predictive performance of standard binomial logit models is likely to be hampered by the ‘crisis duration bias’. The bias arises from the decision to either treat crisis years after the onset of a crisis as non-crisis years or remove them altogether from the model. To overcome this potential drawback, we propose a multinomial logit approach, which is shown to improve the predictive power compared to the binomial logit model. The results of the study show that banking systems in SSA LICs are more likely to collapse when economic growth declines two years prior to the crisis. Undiversified economies contribute to a build-up of banks’ exposures to a few sectors and customers so that credit risk is magnified during an economic downturn. Sectoral concentration of loans ranges from 50-70 percent in SSA LICs, with the majority of loans being provided to just one or two economic sectors. Such undiversified banking systems are more vulnerable to sector-specific shocks, which exert pressure on bank profitability and solvency with a time lag due to the provisioning rules that tend to delay recognition of losses. The paper also shows that banking systems that engage in excessive credit activity relative to the deposit base one year before a crisis are more likely to experience sustained systemic crises. Banks in SSA LICs tend to rely heavily on volatile customer deposits for funding. In particular, checking accounts, which are typically perceived as the most unstable category of deposits, represent the bulk of total deposits in many countries. On the other hand, savings accounts, which are normally a stable source of funding for banks in advanced economies, exhibit a relatively high turnover in SSA LICs due to the low income of most depositors. Liquidity risk in SSA LICs’ banking system is exacerbated by the high degree of dollarization which characterizes these economies. The findings also indicate that banking systems that are characterized by excessive direct FX risk through currency mismatches between the value of their assets and liabilities are more likely to experience a distress; especially one year prior to the crisis. In SSA LICs, rapid fluctuations of the exchange rate, which often reflect thin FX markets, expose commercial banks to potentially sizeable losses, threatening the soundness and the stability of the banking system. Exposure to direct FX risk is intensified by the absence of derivatives markets, which limit hedging opportunities. Both the liquidity position and the currency mismatch of the banking system deteriorate once a crisis occurs due to a generalized loss of confidence and pressures on the exchange rate. Moreover, we find that negative credit growth and high banking system capitalization are associated with the crisis regime relative to tranquil times. Credit growth indicates that a credit crunch increases the likelihood of remaining in a state of crisis; on the other hand, a positive and significant coefficient for leverage is a sign that the recapitalization of banks lowers the probability of remaining in a crisis. The results have important policy implications at a time when financial regulators and central banks in SSA LICs are reassessing their financial regulatory agenda in the context of recent reforms spurred by the global financial crisis. In particular, the findings underscore the importance of implementing an effective macro-prudential framework for monitoring systemic risk arising out of credit concentrations as well as from maturity and currency mismatches. Many LICs in SSA already use a number of tools which are now considered of macro-prudential nature such as reserve requirements, caps on FX positions and limits on loan concentration. With a history of recurrent banking crises arising from specificities of their economies and financial markets, several SSA LICs have adopted financial regulations beyond traditional capital adequacy rules. Nevertheless, most countries do not have a macro-prudential framework in place and often regulators have no explicit objective to prevent the build-up of systemic risk.Read more
Working Paper 191 - Do Firms Learn by Exporting or Learn to Export: Evidence from Senegalese Manufacturers’ Plants
23/12/2013 16:09
Working Paper 191 - Do Firms Learn by Exporting or Learn to Export: Evidence from Senegalese Manufacturers’ Plants
This paper investigates the link between exports / trade openness and firms’ performance in the Senegalese manufacture sector, using a rich and unique firm-level panel data spanning the period 1998-2011. The data has been obtained from the Single Information Collecting Centre (CUCI). The paper started with the assumption that, in the Learning by exporting (LBE) mechanism, firms improve their productivity after entering a foreign market (Clerides et al., 1998). Therefore, exporting results in productivity gains. The study implicitly takes into account the conclusions of a recent growth diagnosis undertaken by the ADB (2012) about the main obstacles to firms’ growth. These main obstacles are access to electricity and poor education. The framework used is a simultaneous functions model based on Bigsten and al. (2002), controlling for other unobserved effects and the properties of the time series. The observation level is the firm. The approach involves jointly estimation of a dynamic productivity function and a dynamic discrete choice model for the decision to export, where it is allowed for causality running both from efficiency to exporting and from exporting to efficiency. This strategy enables to control for unobserved heterogeneity in the form of firm specific effects that are correlated across the two equations. The estimation follows two steps: the TFP calculation and the self-selection and learning-by-exporting test controlling for unobserved effects. The findings suggest that workers’ qualification and access to Patents and Licences have a positive effect on the process of learning. For instance, skills improve productivity by 41 percent in the self-selection case and by 28% in the learning-by-export setting. Also, small firms particularly learn more from exporting. From a policy perspective, this evidence of learning-by-exporting suggests that Senegal has much to gain from promoting its manufacturing sector towards exporting by supporting domestic firms to overcome the barriers to enter into foreign market, particularly by investing on skilled workers and promote access to Patents and Licences as well as disseminating benefits arising from exporting to non exporters. The results also indicate the evidences of both self-selections of the most efficient firms enter into the export market and effect of Learning in the export market. From a policy perspective, the learning-by-exporting finding suggests that Senegal has much to gain from promoting its manufacturing sector towards exporting by increasing the ability of domestic firms to overcome foreign market barriers as well as assimilate further benefits arising from exporting. Given the importance of the skills of workers in the process of acquisition of productivity gains on the external market, special attention should be accorded to the training of the workforce. Hence, the State could help developing curricula into colleagues and senior secondary schools or other training programs enable companies to have the skills they need. Special public strategies to promote firms’ access to Patents and Licences and Innovation must be implemented. Finally, supports favour to small and medium enterprises programs could strengthen their productivity gains on the external market. The initiatives already undertaken favour to the small plants might be continued and reinforced.Read more
Working Paper 189 - An Empirical Investigation of the Taylor Curve in South Africa
23/12/2013 09:42
Working Paper 189 - An Empirical Investigation of the Taylor Curve in South Africa
Heightened uncertainty and slow growth following the financial crisis have raised expectations about the role of monetary policy in stimulating growth. At the same time, South Africa’s economy has been subject to a number of severe supply-side shocks and the output gap remains negative and wide. Inflation has breached the upper limit (6 per cent) of the target band, albeit for short periods, and the forecast remains persistent towards the upper limit of the target range. Inflation expectations remain marginally above the target band at 6.1 per cent until 2015. The Monetary Policy Committee (MPC) has been facing tough choices as it tries to support a tenuous recovery and bring inflation within the target range. In light of these developments, the paper empirically estimates the relationship between output volatility and inflation volatility without the need to assume that the economy is always operating on the Taylor curve. To this end, first it tries to establish whether the Taylor curve has shifted over time. Second, assess the nature of the departures from the Taylor curve, by looking at the structural (demand and supply) shocks to the conditional volatilities of inflation and the output gap. Third, it assesses the optimality of monetary policy by applying the Taylor principle. Thereafter, assuming a constant Taylor curve, it plots the estimated relative degrees of the South African Reserve Bank’s (SARB or the Bank) preferences over time, irrespective of whether the policy settings were optimal or sub-optimal. Estimates of the correlation between inflation and the output gap are estimated as a time-varying process, in contrast to constant correlations. The paper estimates a mean modified multivariate GARCH model capturing the effects of openness through the exchange rate consistent with the characterization of South Africa as a small open economy. The relationship between the two volatilities is mapped using rolling correlations and impulse responses. Using a VAR framework of unconditional variance, it examines how structural shocks derived from the mean equations affect each of the conditional variances. The results show that the Taylor curve has shifted over the sample period. The Taylor curve shifted inwards under the inflation-targeting regime relative to the pre-inflation-targeting period, implying that the volatilities of inflation and the output were minimised. However, relative to the period before the financial crisis (2000Q1 to 2007Q2), the Taylor curve has shifted outwards as both volatilities have increased during the financial crisis (2007Q3 to 2012Q3). Furthermore, the results indicate that economic growth performance is superior in periods in which the Taylor curve relationship holds, that is, when the volatility in both inflation and the output gap is minimal. The results from the VAR framework show that the effects of demand and supply shocks on the volatilities of inflation and the output gap are transitory. Evidence from the assessment of the inflation and output-gap correlations when the Bank’s policy-setting behaviour is characterised by a Taylor rule suggests optimal monetary policy settings or conduct during the inflation-targeting regime relative to earlier regimes. This implies that policymakers have managed to execute the mandate of flexible inflation-targeting The study shows that, the shift to the inflation-targeting regime minimised the inflation volatilities and ensured price stability. Alternatively, the conduct of policy managed to minimise both anticipated and unanticipated deviations in inflation. However, the results of the shifts in the Taylor curve since the onset of the financial crisis suggest that policymakers should aim at reducing the volatility in inflation and growth with the intention of stabilising it around the levels associated with those around the origin. Given that these volatility measures capture both anticipated and unanticipated deviations. The anticipated volatility deviations can be discounted or hedged by economic agents, whereas the unanticipated component affects investment and spending decision-making by economic agents. Therefore, policymakers should try to minimise the unanticipated volatility component as it adversely affects economic growth performance.Read more
Working Paper 188 - Remittances and their Macroeconomic Impact: Evidence from Africa
23/12/2013 09:41
Working Paper 188 - Remittances and their Macroeconomic Impact: Evidence from Africa
Over the past decade, remittances to Africa and developing countries through formal channels grew rapidly, due to increased migration and reduced transaction costs. Currently, remittances are the largest international flow of financial resources to Africa. They are often ‘finance of the last resort’ in low income countries and a source of financial diversification in middle income ones. Official figures do not capture the full volume – unrecorded remittances, sent to Africa informally, and are estimated to amount to up to 75 percent of the recorded flows. The increased financial weight of remittances in external flows to Africa and the positive role that remittances can play in Africa’s development have brought about heightened attention to the topic among policymakers. Still, Africa has received limited attention in the recent literature on remittances, probably because of its relatively small – albeit rising – share in global remittances received. Research on the macroeconomic aspects of remittance inflow has been particularly sparse, creating a gap in the literature. Yet for Africa’s policymakers, understanding determinants and impact of this source of foreign exchange and income is imperative to sustain high and inclusive growth. This paper contributes to closing this knowledge gap and adds to the growing stream of literature on remittances and development by (i) highlighting the recent macroeconomic trends, properties, and determinants of remittance inflows to Africa; (ii) pointing out the role that remittances can play in closing resource gap in Africa; and (iii) analysing the impact of remittances on debt sustainability in a selected African country (Egypt). By focusing on external balance and debt sustainability aspects of remittances, the paper complements the literature on the impact of remittances on income distribution and poverty reduction. Among various international flows of financial resources, remittances are particularly important because of their volume and relative stability. While FDI inflows to Africa have declined after the global financial crisis, remittances rebounded already in 2010. In 2010 - 2012, they exceeded FDI and official development aid, thus being a major source of foreign exchange for Africa. Remittances are less volatile source of foreign exchange than FDI and other private capital flows. This steadiness makes them suitable for longer-term development purposes such as securitization of future flows and financial sector development. When well utilized, they can also positively influence credit ratings. Further, remittances are less pro-cyclical than FDI, even though they can transmit shocks – especially in downturns – from sending to receiving countries. In light of the importance of remittance inflows for African economies, policy makers need to understand domestic factors that drive these inflows so they can create enabling framework conditions for attracting and utilizing them. We examined empirically the key macroeconomic factors driving remittances from the perspective of receiving countries in Africa during 1990 - 2011. We found that inflation and depreciation of nominal exchange rate have negative impact on formal remittances. Stable macroeconomic environment and consistent policies thus seem essential for bringing in not only capital, but also remittance inflows. Given that African countries are mostly small open economies, crucial interactions occur between the domestic economies, the continent, and the rest of the world. International trade plays particularly important part in these interactions. By being an important source of financing for the trade balance, remittances reduce the need for external borrowing. Further, in countries where remittances account for a large and rising share of GDP, they can somewhat reduce the debt burden, thus helping countries reach high and inclusive growth. In summary, in this paper we have documented trends in remittance flows to Africa, their key macroeconomic properties such as relatively low pro-cyclicality and volatility, and some of the determinants in receiving countries, namely stable macroeconomic environment. We have shown the rising role of remittances as a source of trade balance financing and their possible positive impact on public debt sustainability. Our analysis has the following policy implications:
  • Since the level of income seems to be an important determinant of remittances, policy makers should strive to create environment conducive to growth. This will then increase inflows of remittances and other foreign capital, including FDI, reducing the pressures on external balance financing.
  • However, African policymakers need to do more to leverage foreign savings into increased overall saving and higher investment. This is particularly important in light of the persistent evidence on links between the investment rates and growth.
  • Given the low domestic savings in Africa, policy makers and the private sector should strive to incentivize receiving households to either save larger shares of their remittance income in the formal financial sector or invest it in productive capital;
  • The case of Egypt shows that rising remittances can somewhat ease debt sustainability pressures. However, remittances cannot substitute for prudent fiscal policies.
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Working Paper 187 - The Real Exchange Rate and External Competitiveness in Egypt, Morocco and Tunisia
23/12/2013 09:40
Working Paper 187 - The Real Exchange Rate and External Competitiveness in Egypt, Morocco and Tunisia
A real exchange rate that is broadly aligned with its equilibrium value is an important part of a country’s macroeconomic and external competitiveness framework. Persistently misaligned real exchange rates can cause a misallocation of resources between tradable and non-tradable sectors and negatively impact labor market dynamics. Reduced external competitiveness due to over-valued exchange rates hampers exports, aggregate demand, growth and job creation. Besides the longer-term implications, real exchange rate misalignment can lead to inflationary pressures and even trigger speculative attacks. When setting their exchange rate policy, countries also need to balance their goals of reaching competitiveness and macroeconomic stability. In Egypt, Morocco, and Tunisia concerns about real exchange rate misalignments have prevailed for some time given the countries’ high unemployment, stagnating global export shares, and low export diversification. External competitiveness became even more relevant in the aftermath of the global financial crisis and after the 2011upheaval, with inclusive growth and job creation once again topping the countries’ economic policy agenda. By providing accurate signals to producers, the real exchange rate can help generate competitive jobs via exports. It can also help reduce income inequalities by raising the workers’ marginal revenue product. To be effective, the aligned real exchange rate needs to be complemented by other sound macroeconomic policies and enabling business environment. As shown by their low and stagnating shares in global exports, Egypt, Morocco and Tunisia have been facing external competitiveness challenges. Low and constant (or marginally rising, as was the case of Egypt) export shares help explain why the aggregate demand growth in these countries has remained subdued and not generated enough ‘decent’ jobs in export sectors. The three North African economies are less diversified than some other emerging market economies at comparable levels of development. Europe accounts for a disproportionate share of their export destinations, reflecting geographical closeness and long-established business ties. This paper aims to find out whether the real exchange rate misalignment contributed to the weak external competitiveness (e.g., limited export value added and diversification) in the three North African countries. To this goal, it estimates the real equilibrium exchange rate for the past three decades, using the stock-flow approach. This approach differentiates between (i) the medium-term undervaluation caused by the Balassa-Samuelson effect (productivity catch up) that is unlikely to cause abrupt adjustments and (ii) misalignment caused by other factors than productivity differentials. It is particularly suitable for emerging markets that can go through structural and productivity changes impacting the medium-term path of the real exchange rate. The empirical analysis is based on annual data series from 1980 to 2009, obtained from various databases of the African Development Bank and IMF. The estimate results of the real exchange rate models, obtained using the DOLS and ARDL models. For each country, the baseline model linking the real exchange rate to productivity and net foreign assets was estimated first. Subsequently, additional control variables including the government spending ratio, openness, the investment ration and terms of trade were added one by one to the baseline model. Our results indicate that in the long run, decreases in net foreign assets, equivalent to capital inflows, result in an appreciation of the real exchange rate. Regarding the impact of productivity, the coefficient estimates are generally positive in Egypt, indicating that increases in productivity lead to real exchange rate depreciation. In Morocco the impact of productivity on the real equilibrium exchange rate is significant, but negative, indicating that the increase in productivity has the traditional Balassa-Samuelson effect. In Tunisia productivity has an ambiguous impact on the real exchange rate. Further, a greater openness would lead to a depreciation of the real exchange rate in all three countries. Finally, improvements in terms of trade would lead to real exchange rate appreciation in Egypt and Morocco, most likely via inflation differentials. Regarding the misalignment between the actual and real exchange rate and the long run real equilibrium exchange rate, the paper found that: For Tunisia, the low misalignment in recent years can be explained by the abandonment of the real exchange rate targeting and gradual introduction of the exchange rate flexibility. The real exchange rate of Egypt was overvalued from the mid-1990s until mid-2000s and in recent years, following the rising inflation rate and current account and/or fiscal deficits. In Morocco, misalignment has been low in recent years. The county experienced a short overvaluation in mid- 80s entailed by the current account deficit, followed by the devaluation in the late 1980s. Morocco’s equilibrium exchange rate’s seems to have not been affected by the global economic crises, in part due to prudent monetary policy. In summary, utilizing – for the first time for North Africa – the stock-flow approach to estimating the real equilibrium exchange rate, this paper estimated misalignments of real exchange rates in Egypt, Morocco, and Tunisia during the past three decades. While Egypt experienced protracted misalignment in the past and recent years, real exchange rates in Morocco and Tunisia stayed closer to their equilibrium values. However, in all the export growth has been lagging some other emerging market economies. The paper suggests that non-price structural factors such as labor market flexibility, skills, and investment climate are a key for unlocking the export and productive potential of the three North African countries. Intra-regional trade – both with North Africa and the rest of the continent – together with greater orientation to fast growing emerging markets could also raise countries’ external competitiveness.Read more
Working Paper 186 - Balancing Development Returns and Credit Risks: Evidence from the AfDB’s Experience
23/12/2013 09:39
Working Paper 186 - Balancing Development Returns and Credit Risks: Evidence from the AfDB’s Experience
The objective of this paper is to shed light on the workings of project quality-at-entry frameworks used by development finance institutions during their project appraisal to measure the expected developmental returns of investments. In doing so, it looks specifically at that case of the African Development Bank’s “Additionality and Development Outcomes Assessment” (ADOA) framework. Acknowledging that the AfDB has a broad set of tools to help develop the private sector, this paper focuses on one specific instrument, i.e. its portfolio of operations not covered by sovereign guarantees, and on the specific framework put in place to measure its value-added and development outcomes/returns for each operation, i.e. the ADOA framework. The paper’s main contribution is to provide empirical regarding the extent to which key components of the ADOA framework interrelate and how they balance against credit concerns. In doing so, this paper uses a unique data set, comprising of a total of 121 private sector operations which were assessed by the framework over a period spanning from October 2008 to August 2013. The analysis aims to contribute to the process of mainstreaming development results as a key criterion for the selection of new operations, and to inform future portfolio strategic decisions along the lines of inclusive growth and strong development returns. It also aims to explain how the adopted institutional framework has helped align new operations with the organisational mandate of the AfDB and with the concerns of civil society and donors over the developmental returns of private sector operations. Analysis is undertaken through a series of statistical checks to test different relationship hypothesis between criteria used in the ADOA framework. These criteria include measures of additionality and expected development returns done through the ADOA framework and of credit risk conducted through the independent credit risk department of the AfDB. Development outcomes ratings are an aggregate of eight subcategories and is rated on a 6-point scale from “1- highly unsatisfactory” to “6- excellent”, with rating from 4 to 6 representing assessment that exceed the satisfactory threshold. Additionality is based on a combination three sub-categories and is rated on a 4-point scale from “1- none” to “4  strongly positive”, with ratings 3 and 4 indicating a more than satisfactory level of additionality, and ratings 1 and 2 indicating that additionality is less than satisfactory. Credit risk is assessed on a scale from 1 to 10, with 1 representing the lowest level of risk exposure, and high risk ratings equal to or exceeding 5. These variables are quantitative representation of qualitative variables. The first part of the analysis looks at the correlation between development outcomes, additionality and credit risk. The second part of the analysis performs a multivariate analysis of the correlation between project approval and the three ratings, as well as of the relative importance of the subcategories which make up the development outcome and Additionality ratings. All regressions employ linear models as the literature suggests that OLS estimators significance tests statistics perform better than probit when the sample size is around 100 observations. Overall, the paper finds that the introduction of an independent “Additionality and Development Outcome Assessment” to support the approval of all new private sector operations has increased the development focus of portfolio decisions along the lines drawn by institutional mandates. With this in mind, the analysis showed evidence of the importance of additionality in the project selection process. With regards to development outcomes, results highlight the importance of benefits accruing directly to households as a driver of positive externalities, but also as a feature under which projects tend to be more additional. As regards to associations between the framework’s variables, there is only evidence of a relationship between development outcomes and additionality. This suggests that the AfDB’s contribution to higher development outcomes comes to some extent through making otherwise unviable projects feasible. Conversely, the lack of significant relationship between development outcomes and credit risk suggests that it is not given that investing in riskier sectors will induce higher development outcomes. However, these results should be read with caution to as they are based on the relatively small and unbalanced sample. Against this background, more scrutiny must be put on these relationships as we get information on other projects. The paper also finds that both additionality and development outcomes raise the probability of project approval by the board. With regards to the former, financial additionality considerations are the underpinning drivers to the rating. This is partly due to the fact that the political risk mitigations tools at the AfDB’s disposal are not very developed. With regards to the latter, while all categories contribute to the development outcomes overall rating, household benefits, government, gender and social effects and private sector development come out stronger. These also happen to be cross-cutting considerations which are relevant no matter the project type.Read more
Working Paper 185 - Remittances and the Voter Turnout in Sub-Saharan Africa: Evidence from Macro and Micro Level Data
23/12/2013 09:38
Working Paper 185 - Remittances and the Voter Turnout in Sub-Saharan Africa: Evidence from Macro and Micro Level Data
For many developing countries including in Sub-Saharan Africa, international remittance flows represent a large and stable source of external finance. Recent empirical studies using Sub-Saharan African data have demonstrated the positive contribution of remittances to poverty reduction and financial development. However, a recent wave of the remittance literature shows that remittance flows can have a damaging effect as they impede external competitiveness of receiving countries by fueling inflation and appreciating the real exchange rate. They are also related to more corruption, lower labor force participation, and lower supply of public goods in education and health. The present study takes advantage of this recent literature and investigates the effects of remittances on political participation in Sub-Saharan Africa. Recent studies document the role of international migration in the propagation of political values including voting behavior. For example, international migration can shape the voting behavior in the home country through two main channels. (1) The transfer of political norms from the hosting country to the home country. (2) The direct influence through vote guidance during election time. Empirical investigations are carried out using two samples. First, the analysis is performed using cross-country macro data for 27 Sub-Saharan African countries for which it’s possible to mobilize both voter turnout and annual data on remittances. Econometric specifications controlling for key determinants of voter turnout, country fixed-effects, do not reject the hypothesis that remittances inflows are significantly associated with lower voter turnout in Sub-Saharan Africa. Second, a microeconometric approach is employed using AfroBarometer data. To deal with the non-random nature of remittances in the sample, the paper follows the recent contribution of Esquivel and Huerta- Pineda (2007) and Cox-Edwards and Rodriguez-Oreggia (2009) and resort to propensity score matching techniques to identify the effect of remittances on individuals’ propensity to vote. Using both cross-country and individual country level data, the paper demonstrates that remittance inflows significantly lower the propensity to vote during national elections in Sub-Saharan Africa. This effect is robust to empirical specifications aimed at dealing with the endogeneity of remittance inflows at both country and household level data. The findings of this paper provide evidence that one “bad news” related to remittances implies a drop in electoral participation by remittance-receiving individuals. Remittances the accountability of governments and the benefits to be had from democratic systems by reducing the interest of individuals to participate in political systems by exercising voting rights.Read more
Working Paper 184 - Does Oil Wealth Affect Democracy in Africa?
23/12/2013 09:36
Working Paper 184 - Does Oil Wealth Affect Democracy in Africa?
This paper empirically investigates the effects of oil wealth on democracy in Africa. This is because democracy provides a check on governmental power and limits the potential of public officials to amass personal wealth and to carry out unpopular policies. This is why democracy promotion has been at the top of the US and West European foreign policy agenda since the end of the Cold War. Recently rising coups d’états attempts and oil discoveries in some African countries, high energy prices and the North African and Middle East situation characterized by revolutions have made the question of the link between oil wealth and democracy timelier than ever. The study also adds to the literature on the “natural resource curse” phenomenon. One of the natural “resource curse” arguments in the literature is that oil-rich countries tend to adopt less democratic ways of governance. It is also argued that there are three mechanisms that ties oil wealth to authoritarianism: a “rentier effect” (‘taxation effect” and “spending effect”, through which governments use low tax rates and high spending to dampen pressures for democracy; a “repression effect”, by which governments build up their internal security forces; and a “modernization effect”, in which the failure of the population to undergo certain social changes renders them less likely to push for democracy. More recently, others have suggested alternative mechanisms, including corruption, asset specificity, and international factors. Thus, while empirical support for the “oil-hurts-democracy” thesis has been mixed, not much has been done on the specific African case. This study tries to fill that gap and proffer some policy guidance to governments, politicians, development partners and other stakeholders. We present important stylized facts on trend oil wealth and democratic development in African counties. Africa’s oil reserves have maintained an upward trend, rising from 53.4 trillion barrels in 1980 to over 130 trillion barrels in 2012. Also, while most African countries legalized opposition parties and held competitive, multiparty elections, which, though, have often not met the minimal democratic criteria of freeness and fairness: they have therefore been "pseudo-democracies" or “virtual democracies”, with North Africa being mired in the trap of liberalized autocracy. Thus, in a cross-country panel data, covering 52 African countries between 1955 and 2008, we estimate the effects of oil wealth on democracy in Africa. We estimate the relationship both in a pooled cross-sectional and time-series and fixed effect settings, including robustness checks with different data sets. We find that oil wealth is statistically associated with a lower likelihood of democratization when we estimate the relationship in a pooled cross-sectional and time-series setting. In addition, when estimated using fixed effects, the strong negative statistical association continues to hold. Indeed, this result is robust to the source of oil wealth data, the choice and treatment of the variables set, and sample selection. Our results also show other interesting and important results. The cross-country confirms the “Lipset/Aristotle/modernization hypothesis” (that prosperity stimulates democracy) is a strong empirical regularity. Also, the propensity for democracy rises with population size, population density, ethnic fractionalization, having British legal origin or colonial heritage, and having a supportive institutional environment in the form of maintenance of the rule of law. However, apart from oil wealth, democracy tends to fall with linguistic fractionalization and rough (mountainous) terrain. Consistent with the data, North Africa consistently fails to favor democratic development. Three measures to avoid the political resource curse and promote democracy include promoting high levels of transparency, ensuring that the political system has a centralized system of financial authority and control, and the legislation of a ‘fiscal constitution’ that imposes ceilings (and perhaps also floors) on public spending from resource revenues. Other measures are: promoting and maintaining effective rule of law, deepening macroeconomic and structural reforms and increasing investments to raise national income, and implementing greater economic and political inclusion, especially in North Africa.Read more
Working Paper 183 - Global Economic Spillovers to Africa- A GVAR Approach
23/09/2013 16:05
Working Paper 183 - Global Economic Spillovers to Africa- A GVAR Approach
In this paper, we develop a global vector autoregressive (GVAR) model, with 46 African and 30 foreign countries covering 90% of the world GDP, to examine the growth spillovers coming from the Euro zone and BRICs. To our knowledge, this is the first attempt to include almost all African countries (46 out of 54 for which major macroeconomic data is available) in a GVAR framework. The GVAR modeling approach, advanced by Pesaran et al (2004) and Dees et al (2007), has become an important empirical tool to understand growth spillovers. The GVAR model is a multivariate and multi-country framework used to investigate cross-country interdependency. It is also capable of generating forecasts for a set of macroeconomic factors for a set of countries to which they have exposure risks. Africa is increasingly interconnected with the rest of the world through trade and financial linkages. Africa's real export value has quadrupled between 2000 to 2010, with Europe as the main export destination followed by United States, and China. In 2012, 60% of the African countries have export GDP ratio of 30% or more while 80% of them have export GDP ratio of more than 20%. Moreover, Africa's financial linkage through private capital flows, FDI, remittances, and ODA has also increased significantly during the last decade. External financial flows hit a record high in 2012 and expected to surpass the US$ 200 billion mark in 2013. The flow of foreign direct investment (FDI), portfolio investment, official development assistance (ODA) and remittances have quadrupled since 2001. The growing economic linkage raises the important issues of growth spillover. Historically, Africa's growth pattern is highly linked with the global economic growth. The recent financial crisis has demonstrated the strength of the inter-linkage. In 2009, average economic growth was slashed from an average of about 6% in 2006-08 to 2.5% in 2009 with per capita GDP growth coming to a near standstill (AEO, 2010), following the global economic slowdown. Some estimates show that for every percentage point decline in the world real GDP growth, the sub-Saharan African economies would be contracted by 0.4 to 0.5 percentage points. As the world economy is still struggling to recover where the global growth prospects are far from stellar, it is important to revisit the global growth spillover effect on Africa. The results based on the GVAR generalized impulse response functions show that shocks in the Euro zone and BRIC countries could have significant effects on the African economies. In terms of the order of magnitude, the effect of a percentage decline in Euro zone growth is twice of that of an equivalent decline in BRIC's growth. The effects of both the Euro and BRICs shocks vary significantly from country to country depending on the nature of the economies. While oil exporting countries are deeply affected by the Euro zone growth shocks, the BRICs shock affects fragile states more than the rest of the African economies. The investment driven countries (emerging African countries) are, however, affected by a lower magnitude. This underscores the importance of economic diversification in terms of weathering adverse shocks. The adverse global growth spillover has important macroeconomic implications. Our results indicate that the global slowdown could lead to a decline in inflation rate and depreciation of nominal exchange rate following the contraction of the domestic economy and fall in exports earnings, respectively. The decline in inflation rate is however a short-lived one. Inflation rate would rise up as the depreciating exchange rate passes through prices over the medium term. Inflationary effects would be felt in most of the African economies within a period of one year. A policy response to tame inflation may further contract the economies. The paper also looked at the impact of G4 countries' (US, EU, Japan and the United Kingdom) quantitative easing (QE) on African economies. The QE seems to have a mild inflationary effect and could lead to appreciation of nominal exchange rate although the magnitudes are limited. Our results indicate that the investment driven African countries, which are better integrated with the global market, are more exposed to the undesirable effects of the QE program than the rest of the African economies.Read more
Working Paper 179 - Heterogeneity of the Effects of Aid on Economic Growth in Sub-Saharan: Comparative Evidence from Stable and Post-Conflict Countries
22/09/2013 23:00
Working Paper 179 - Heterogeneity of the Effects of Aid on Economic Growth in Sub-Saharan: Comparative Evidence from Stable and Post-Conflict Countries
L’Afrique subsaharienne est la première région du monde bénéficiaire de l’afflux de l’aide extérieure. La communauté internationale a consacré plus de 568 milliards de dollars américains d’aide étrangère au développement de l’Afrique subsaharienne (ASS) depuis 1960, soit environ 15% du PNB du continent, c'est-à-dire en proportion, quatre fois plus que le plan Marshall qui a permis le redécollage des économies européennes après la deuxième guerre mondiale(Commission Economique pour l’Afrique, 2010). Cependant,  la croissance en Afrique Subsaharienne n’a pas suivi la tendance de l’afflux de l’Aide Publique au Développement (APD). Elle est restée faible malgré un regain de l’activité économique au début des années 2000 (soit  en moyenne 2,37%). Ainsi, l’objectif de cette étude est de mettre en évidence les effets de l’APD sur la croissance et de déterminer les canaux de transmission en Afrique subsaharienne.  Par ailleurs l’étude fait une différence entre les pays stables et les pays en situation de post conflit. L’analyse effectuée sur un échantillon de 34 pays d’Afrique sub-saharienne sur la période 1990-2010 donne lieu à trois résultats majeurs. (1) l’aide a un effet positif sur la croissance uniquement lorsque l’estimation est contrôlée du niveau de la gouvernance. (2) La dynamique comparative quant à elle montre que la gouvernance et l’éducation sont les principaux canaux de transmission de l’aide à la croissance en environnement stable. En revanche, en environnement de post conflit, l’aide affecte la croissance via l’investissement en capital public (infrastructure).  (3), l’approche de décomposition d’Oaxaca-Blinder montre que l’écart en termes de montants d’aide reçus n’explique pas les différences de croissance observées entre pays stables et pays en situation de post conflit. Sur la base de ces résultats, une recommandation de politique économique pourrait être d’orienter l’aide allouée respectivement au financement de l’éducation et à l’amélioration de la gouvernance dans les pays stables. Dans les pays en situation de post conflit, il faudrait par contre insister sur le financement des infrastructures.Read more
Working Paper 178 - Holding Excess Foreign Reserves Versus Infrastructure Finance: What should Africa do?
24/07/2013 11:47
Working Paper 178 - Holding Excess Foreign Reserves Versus Infrastructure Finance: What should Africa do?
Financing infrastructure needs in Africa necessitates new thinking on financing mechanisms. Currently, there is a lively debate on the funding and use of foreign exchange (forex) reserves as one of the funding sources for financing infrastructure. The paper provides insight into the objectives of foreign exchange reserves management, their adequacy, the innovative mechanisms to enhance their management, and the optimal required investment for financing infrastructure in Africa. In practice, a realistic foreign exchange reserves level should meet the following requirements: (i) the ratio of import cover; (ii) the ratio of reserves to short-term foreign debt balance (iii) the ratio of foreign exchange reserves to the total foreign debt balance and (iv) the ratio of foreign exchange reserves to Money & Quasi-money (M2). However more and more studies are showing that the liquidity, followed by security and returns motives remain the main objectives for building excess reserves. The paper argues that the two goals, liquidity and return, can be reconciled by dividing the reserves portfolio into a ‘liquidity portfolio’ and an ‘investment portfolio’, and using different investment guidelines for each portfolio. The rational of this proposal is that the liquidity portfolio which would be targeted at regular disbursements and unanticipated liquidity demand and for intervention objectives would be invested mostly in highly liquid and safe assets such as the money markets of the OECD countries. However, the investment portfolio would comprise a wider set of economic investment products and maturities, and would use investment criteria akin to those of big institutions and pension funds managers. The present study shows that dividing the reserves portfolio into a liquidity portfolio and an investment portfolio is applicable to the aggregate forex reserves of African countries and further highlights the social cost of the status quo for reserve management in these countries.  The study extracts data on the foreign exchange reserve, debt and infrastructure needs of African countries from different IMF, World Bank and AfDB databases and estimates the adequacy level of foreign reserves for these countries based on two commonly used methodologies – the traditional metric method of import cover and the Wijnholds and Kapteyn (WK) method. The paper estimates the excess foreign reserve and the social cost of holding this excess based on comparison to other alternative investment opportunities such as investments in African infrastructure. Based on these estimations, the study shows that: first, African countries have held excess reserves in the range of $ 165.5 and $ 193.6 billion on average per year between 2000 and 2011. This is more than the infrastructure financing gap identified at $ 93 billion per year. Second, holding these excess reserves when compared to alternative investments in domestic infrastructure in the continent also implies a social cost of up to 1.65% of GDP, on average. The findings show the total social cost of holding excess reserves is around $300 billion per year in developing countries, which is approximately equal to the amount of resources needed by developing countries to fund basic investments to meet the MDG. Now, central banks can collateralize their resources or use repurchase agreements (Repo’s) to fund liquidity at short notification, without having to pay huge amounts of securities; and central banks may also include currency forwards and options to their list of financial instruments to defend their currency. Additionally, a range of bilateral and multilateral agreements have been put in place such as credit lines or swap lines among central banks to reinforce foreign exchange reserves. As experienced during the recent financial crisis, highly liquid foreign reserves are no longer the core or sole tool for navigating a currency crisis. Thus, holding a high percentage of highly liquid assets is no longer always the most appropriate approach. The study has also shown that social cost of holding excess reserves is considerably high in many African countries between 2000 and 2011 and more so for commodity export dependent economies. The study also shows that based on the two methods of reserve adequacy applied, that African foreign exchanges excess can be managed to meet the infrastructure financing gap of the continent. Therefore, there is room for the use of these excess reserves through novel investment vehicles to complement existing development partners while focusing on the following: i) economic infrastructure projects with a regional impact; ii) innovative mechanisms for cross-border infrastructure investments; iii) encouraging quick handling interventions (more flexible rules, systems and procedures); iv) deal with political risk, credit risk, and refinancing risk. Such envisaged investment vehicles should be driven by performance accountability criteria to manage parts of these excess reserves through investments in less liquid, higher-yielding wealth as compared to the status quo.Read more
Working Paper 177 - A Macroeconometric Model for Rwanda
09/07/2013 09:46
Working Paper 177 - A Macroeconometric Model for Rwanda
This paper presents a macroeconometric model of Rwanda built to analyze both endogenous and exogenous shocks. The model is developed considering the supply-constrained nature of the economy. On the supply side, total output is disaggregated into agricultural sector and non-agricultural sector. On the demand side, the households' aggregate consumption expenditure and private investment expenditure functions are specified. The government investment and consumption are assumed to be exogenous. In addition to the public and private expenditure components, the domestic demand for imports (disaggregated into consumption goods import and intermediate goods import) and export supply functions are specified on the demand side. The monetary sector contains a behavioral money demand equation and money supply identity. The money supply equation is endogenous to the model to capture the monetization of deficit. The price and the real exchange equations are also specified and hence determined endogenously. The model's operation is consistent with the general equilibrium framework in which price serves as equilibrating variable. The value of export, terms of trade and real exchange rate determine the level of imports, which in turn affect the level of private investment. Imports and exports determine trade balance that may spillover to the monetary sector and affects money supply. The fiscal deficit has a feedback effect on prices through its effect on money supply. The level of output also determined the aggregate demand by affecting consumption and investment. The excess demand over the total output is assumed to be financed by foreign financial flows. However, for a given level of foreign financial flows, the disequilibrium between aggregate demand and aggregate supply is assumed to spillover to the domestic price so as to achieve market clearing through price adjustment. The behavioral equations of the model are estimated individually in a cointegration framework using Pesaran et al (2001) autoregressive distributed lag (ARDL) model. The individual equations fit the data quite well. Given that good individual equation fit does not necessarily imply the overall fit of the model once the interactions among all the model variables are allowed, the Theil's inequality coefficient and its decompositions are used to assess the overall fit of the model. The model exhibits the desirable properties of low bias and variance proportions, implying that there is low systematic error in the model. Two sets of simulations are carried out using the model. The two scenarios experimented are scaling up infrastructural spending by 20 to 75 percent, and aid cut to the tune of 10 to 30 percent under different assumptions. The first set of the scenario, higher infrastructural spending, indicates that further scaling up of infrastructure spending by 20 percent may be accommodated with 2.6 to 3.8 percentage points increase in inflation in the medium term. The inflationary impact of the scaling up could be subdued when the productivity effect of the physical infrastructure kicks in. If the infrastructure spending starts paying off by 2014/15, the inflationary impact of the additional spending will be significantly lower (1.4 percentage points vs. 3.8 percentage points). This underscores the importance of institutional effectiveness in timely implementation of infrastructural projects. Nevertheless, excessive expansion of infrastructure spending may destabilize the macroeconomic environment considerably. Our scenario of scaling up spending by 75% provides an alarming picture. Under this scenario, inflation rate would go easily to the lower twenties territory in the medium term. The inflationary effect would be lower when the productivity effect sets in. However, disinflation would be very costly at such high inflation rate as inflationary expectations may be engrained in the economy. Moreover, the significant appreciation of real exchange rate under this scenario may substantially erode export competitiveness. The second set of simulation considers a decline in aid flows by 10 to 30 percent, with and without partial domestic matching of the decline in aid through domestic borrowing. The results indicate that deeper aid cuts (by 20 to 30 percent) would have considerable effect on the economy and it could reverse the growth momentum that Rwanda has enjoyed over the last decade. The model could be further refined through different channels. First, the production side could be disaggregated by product category, such as exportable and non-exportable, and the production function for each exportable item could be linked with the export supply function. This would accentuate the supply constraint nature of the economy. Second, the labor demand functions could be derived from the production technologies specified and the labor market equilibrium could be derived assuming exogenous labor supply. Third, different tax categories could be specified to look at the effects of government policies on different categories. The refinement of the model is, however, determined by the available data.Read more
Working Paper 176 - Medium-Term Sustainability of Fiscal Policy in Lesotho
19/06/2013 11:00
Working Paper 176 - Medium-Term Sustainability of Fiscal Policy in Lesotho
The objective of this paper is to understand whether the current trends in Lesotho’s fiscal policy is sustainable in the short to medium-term and in the event of shocks to key fiscal drivers such as growth, interest rates and concessional financing. The paper analyzes Lesotho’s fiscal sustainability. The results of the analysis lead to the conclusion that Lesotho’s fiscal policy is unsustainable in the short-run. Drastic fiscal adjustment measures are needed to put fiscal policy on a sustainable path in the medium-term and beyond. Sustainability improves with higher growth, donor willingness to provide concessional funds and lower cost of concessional as well as non-concessional funds. In the aftermath of the global financial and economic crisis, fiscal sustainability has increasingly become a topical issue for all countries. Fiscal sustainability is of particular concern to Lesotho in light of the permanent drop in the countries revenue receipts from the Southern African Customs Revenue (SACU), the main source of budgetary resources which finances close to 50 % of the country’s recurrent budget. In an open economy like Lesotho, a vulnerable public sector has potential damaging effect on the external sector. It can lead to a twin deficit problem (government budget and current account balance). Given the country’s fiscal situation and its potential impact, access to concessional and non-concessional resources from the donor community remain critical for fiscal sustainability in the short to medium-term and even beyond. In the baseline scenario of declining concessional financing, Lesotho might need to operate an annual average primary surplus of 0.2 percent for 2011-2016 and 0.1 percent for the period 2017-2031 in order to attain sustainability. This assumes growth rate of 5 percent per annum but higher growth would improve sustainability. This could be the case if investment in the phase II of the Lesotho Highland Water Project and construction of the Metolong dam generates growth of 12 percent per annum. This would allow the country to operate an annual average primary deficit of 0.5 percent (2011-2016) and 0.8 percent (2017-2031). It is noteworthy that fiscal sustainability in the face of declining concessional resources remains a critical challenge to the pursuit of the envisioned development in Lesotho. Inadequate concessional resources might impede the implementation of the new National Development Strategic Plan and the Vision 2020 which would require more financial resources to realize the overarching objective of inclusive growth and poverty reduction. The agreed reform  measures between  the  Government  and  the International Monetary Fund under the Extended Credit Facility have  since 2010 benefited  the government but  a lot  needs  to  be done to  attain  sustainability in the medium-term. In the National Strategic Development Plan, the government was to reduce the fiscal deficits to 3 percent per annum which is still far below the required fiscal effort. The sustainable primary balance path towards the steady state (desired stable position) under various scenarios is well discussed in the paper. While at the initial level of primary deficit (2010, 4.5 percent), a lot of fiscal effort would be required to bring down the fiscal deficit to sustainable levels until it eventually stabilizes at steady state levels of between 0.15 and 0.7 percent of GDP depending on the growth target chosen, this may not rhyme well given Lesotho’s political sensitivities, inequalities and extreme poverty levels. It is, however, possible to gradually move towards the steady state primary balance by improving expenditure efficiency and rationalization as well as eliminating unproductive spending in addition to intensive resource mobilization including widening the tax base. Additionally, the paper underlines the need to take stock of the expected future expenditures, in particular, those related to pension and contingent liabilities which might increase the fiscal sustainability risk if not fully included in the primary balance.Read more
Working Paper 174 - African Development Finance Institutions: Unlocking the Potential
14/06/2013 12:38
Working Paper 174 - African Development Finance Institutions: Unlocking the Potential
Africa escaped the recent global financial crisis relatively unscathed. While the region could not avoid the spill-over effects of the ensuing global economic downturn, its banking sector proved generally resilient. This was mainly due to the structural reforms implemented over the past decade, including strengthening the relevant regulatory and supervisory systems within a sounder and more flexible macroeconomic management framework. In particular, Basel III offers a set of regulatory standards based on higher and better quality capital, mostly common equity, with improved absorption features, complemented by newly introduced liquidity requirements. This paper provides the first analysis into the macroeconomic impact of the new international regulatory standards on developing countries, particularly on African economies. The paper tries to answer the following set of questions: what is the impact of tighter capital ratios on long-term economic performance in Africa?  Is there still room to raise capital holdings from current levels while achieving net aggregate economic gains? In particular, this paper presents an assessment of the long-term economic benefits and costs of higher capital ratios in terms of their impact on output. Additionally, the paper provides an estimate of the optimal level of regulatory capital requirements for African banking systems. Consistently with other studies, the focus is on the macroeconomic impact of representative changes in bank capital adequacy ratios based on definitions and historical data that do not correspond directly to those introduced by Basel III. The paper focuses exclusively on the long run, assessing the shift from one steady state to another, and does not consider the shorter-term costs associated with the transition. The paper estimates the long-term macroeconomic impact of higher capital holdings on output in African economies by following a three-step approach. First, the long-term benefits are estimated by quantifying the gains in African GDP resulting from a reduced probability of future banking crises. This involves calculating the expected yearly output gains associated with a reduction in the frequency of banking crises in the continent. The mapping of tighter capital ratios into reductions in the probability of banking crises is done based on a multivariate logit model for a panel of 19 countries for which data are available over the period 1980-2008.  
Second, the long-run economic costs of higher capital ratios on output are evaluated by estimating the impact on the cost of bank credit. The higher cost of credit lowers investment and consumption, which in turn affects the steady-state level of output. Two panel data for 22 countries over the period 2001-2008 are used to quantify this. Finally, the study combines the results to quantify the net effect of higher capital ratios on aggregate output of African economies. The paper shows that tighter capital ratios have net positive effects on the level of long-run steady-state output for a relatively wide range of capital levels. There are increasing net benefits for capital ratios up to four percentage points higher than the current level. Thereafter, net benefits start decreasing and, for increases in the current capital ratio of more than nine percentage points, the marginal net benefits of higher capitalization turn negative. Given that African banking systems hold on average capital buffers in excess of minimum requirements, African regulators should ensure that banks keep current levels of capitalization at a minimum. One option to influence bank behaviour would be to raise capital requirements so as to provide a regulatory floor under current capital ratios. In this context, Basel III offers an important opportunity to strengthen the resilience of African banking systems.Read more
Working Paper 172 - Political Economy of Service Delivery: Monitoring versus Contestation
14/06/2013 12:31
Working Paper 172 - Political Economy of Service Delivery: Monitoring versus Contestation
The decentralization of public service delivery often creates local government structures and bureaucracies that fail to deliver the required level of services to local populations. These local government structures involve various strata, such as the municipal level, district level, council level and province level. The goals of decentralization are to transfer real power to the districts and improve accountability at the local level; to bring administrative control over services at the local level; to establish a stronger link between payment of taxes by citizens and provision of services; and to enable local governments to plan, finance, and manage the delivery of services to their respective constituencies. These services include primary health care, education, water and road infrastructure, agriculture extension services, and security and law and order.    This paper analyzes this phenomenon in a model of power contestation at the local level which results in low services delivery. The model is set up in such a way that each monitor has, at its disposal, resources that can be allocated to monitoring or political contestation. Monitoring earns a salary proportional to the amount of monitoring. On the other hand, political contestation gives a fraction of power, expressed as rent and determined by the relative amount of political contestation exerted by all monitors. In the model a one-to-one mapping from monitors to public service providers (teacher, doctors) is assumed. Therefore, if a monitor monitors x% of the time, the teacher or doctor being monitored spends x% of the time teaching or delivering medical services. As a result, with 100% monitoring, then teachers/ doctors monitored experience the monitoring regularly and respond by doing their respective public duties 100% of the time. Similarly, with 0% monitoring, teachers and doctors are left to do as they please. This, of course, assumes that the system of monitoring is set-up such that it operates adequately if all monitors carry out their duties to their fullest capacity. Consequently, for immediate degree of monitoring that falls between 0% and 100%, the degree of proportionality maps directly over to the degree of teaching and delivery of medical services. The study finds that a monitor engages in political contestation than other monitors when his unit cost of monitoring is high, his unit cost of political contestation is low, or his proportionality parameter is for his salary form monitoring is low. Moreover, an unresourceful monitor does not monitor. The less–resourceful monitor does not carry out his duties when his interior equilibrium resource expenditure from political contestation exceeds his resource capability. As the monitor becomes resourceful,  he monitors to the extent that his unit cost of monitoring is low. Intuitively, a monitor enagages more in political contestation as the rent obtainable through political contestation becomes more valuable. The paper argues that the intensity of political contestation enhances the ratio between the monitor’s unit costs of monitoring and political contestation and the proportionality parameters for their monitoring salaries. For common benchmark parameter values, where the monitors are equally matched, increased intensity causes higher political contestation. Contrastingly, when the monitors are unequally matched, increased intensity causes lower political contestation due to strength or weakness. Within the modelling framework provided, the study uses data for education and healthcare services in Tanzania and Senegal to show the seriousness of poor service delivery. In both countries teachers spend far less than the designated time teaching students and health professionals spend a marginal amount of time per-day to attend to care seekers. The study acknowledges that political contestation cannot be erradicated. However, knowledge of factors that influence how monitors allocate resources between monitoring and political contestation can help to minimize the extent and impacts of political contestation.Read more
Working Paper 173 - Production and Conflict in Risky Elections
14/06/2013 11:11
Working Paper 173 - Production and Conflict in Risky Elections
Since the 1980s three major events have shaped the global environment characterising transition to a democratic political system. These are the fall of communism in the late 80s and subsequent democratic election of new leaders; various elections in sub-Saharan Africa that have installed democracies in some countries but have caused reversals in others ; and the post 2011 fall or transformation of autocracies in North Africa and Middle East and the unsteady transition to democracy that ensued. However Africa stands out as being the slowest in establishing democratic institutions and has been home to some notable reversals of democratic processes. Elections in most African countries have been challenged as not having been free and fair. Some of these elections have been marred by violence and followed by more violence once election outcomes were made public. Intuitively, an incumbent government facing elections chooses among a set of strategies. Before an election it can ensure that the country becomes productive, it can fight with the challenger (opposition), or it can produce public goods. After the election it can accept the election results, it can form a coalition with the opposition or it can refuse to leave office causing a standoff with the challenger. This paper analyzes the choices made by an incumbent, and more specifically the dynamics of the post election political process, in a game theoretic framework (2-period). To increase the endogenously determined probability of winning the election, the incumbent can fight with the challenger or produce public goods to appease the population. Winning the election is especially important if the period 2 utility is low (if a costly stand-off ensues in period 2). The paper quantifies how an incumbent strikes a balance between fighting, production and producing public goods in period 1 depending on whether the incumbent chooses to accept the election result, chooses a coalition or a standoff. This, correspondingly, impacts whether or not an election is won after period 1.    The paper uses credible specific functional forms for the probability of success in contest while the probability of winning an election is determined endogenously. This allows exact analytical solutions to be computed backed by numerical simulations and compared with econometric analysis. The use of these functional forms makes it possible to determine actual strategies of the incumbent and challenger before and after an election. The econometric results bear out the approach of using these specific functional forms. The paper finds that public goods production is inverse U shaped in the incumbent’s unit fighting cost where the incumbent wins the election and remains in power (or loses and accepts the loss) and concave where the incumbent loses the election and forms a coalition. Low cost makes public goods unnecessary. Additionally, where the incumbent wins the election and remains in power, ‘high cost’ makes public goods unnecessary since the challenger faces the increasing cost. Secondly, an incumbent earning a larger resource in period 1 produces less public goods in the case where the incumbent wins the election and remains in power. Contrastingly, the incumbent earning a large resource in period 1 produces more public goods in the case where the incumbent loses and is forced to form a coalition to avoid the costly standoff. Thirdly, decreasing unit production cost causes decreasing public good provision in the case where the incumbent wins the election and remains in power or loses the election and cedes power. This result follows from the incumbent’s high period 2 utility. Fourthly, public good provision decreases in the incumbent’s unit cost of producing public goods, but more slowly for cases where the incumbent loses the election causing a standoff due to low second period utility. Fifthly, public goods production is inverse U-shaped in the parameter governing the relative importance providing public goods vis-á-vis struggling to ensure winning the election The paper also finds public goods production increases as the incumbent gets a lower share of the resources in the case where the incumbent losses the election and is forced to form a coalition. Public goods production decreases in the challenger’s fraction of unit fighting cost in the case where the incumbent loses the election and is forced to form a coalition, which makes period 2 less acceptable for the incumbent. Moreover, public goods production increases in both players’ unit production costs in the case where the incumbent wins the election and stays in office or loses and cedes power.    The paper empirically tested the model using a discrete-choice logit model in order to analyze what factors determine the election outcomes. The empirical results support the deductions made in the theoretical model. The paper used a database of 653 elections in Africa over the period 1960-2010, of which 299 are presidential and 354 are legislative. Using descriptive analysis and robust multinomial logit, the study shows that the incumbent wins with no contestation 64%, coalition 6% and stand-off 2%. Out of the 653 elections held, 417 were won by the incumbent without contestation. The study find good economic performance measured by a 1% increase in GDP per capita decreases the probability of the incumbent losing by 0.0053. Therefore, doubling the per-capita GDP decreases this probability by 0.53. A 1% increase in the provision of public goods a year prior to elections increases the probability of losing and not accepting defeat by 0.0013. A 1% increase in the ethnic fractionalization index decreases the probability of the incumbent winning by 0.0034. Similarly, a 1% increase in tertiary level enrolment increases the probability of contesting the election when the incumbent has won by 0.015, while a 1% increase in religious fractionalization increases the probability of contesting the incumbent’s victory by 0.0036. The marginal effect of switching from few to abundant resources increases the probability of the incumbent losing and not accepting defeat by 0.23.Read more
Working Paper 169 - Monetary Policy and Exchange Rate Shocks on South African Trade Balance
19/03/2013 15:45
Working Paper 169 - Monetary Policy and Exchange Rate Shocks on South African Trade Balance
This paper investigates the effects of contractionary monetary policy and exchange rate appreciation shocks on the South African trade balance using vector autoregressions. Thereafter, we identify the dominant channel between income and expenditure switching through, which monetary policy impacts the trade balance and whether policy shocks are transmitted through export or import components. Consistent, with South African policy discussion, we focus on the contributions of the trade balance to gross domestic product and assess the long-run neutrality effects of both the exchange rate and monetary policy on the trade balance. This will assist policymakers’ understanding of the trade balance as a potential driver of economic growth and to identify which component of the trade balance is sensitive to these policy shocks. In addition, we identify how much of the deterioration in the trade balance can be attributed to monetary policy directly, relative to the indirect effects of the exchange rate, ceteris paribus. Using recursive and sign restricted vector autoregressions, we find that a one standard deviation exchange rate appreciation shock lowers the trade balance as a percentage of gross domestic product significantly over more quarters compared to contractionary monetary policy shock. The contractionary monetary policy shock significantly reduces the trade balance confirming the existence of the expenditure switching channel rather than the income effect. The evidence of the expenditure-switching channel suggests that, in the short-run, ceteris paribus, monetary policy can change the direction of demand between domestic output and imported goods through the exchange rate adjustment. Both the exchange rate appreciation and monetary policy shocks worsen the trade balance through imports rather than the exports. Monetary policy worsens the trade balance by more than 0.01 percentage points at the peak when allowed to directly affect the exchange rate relative to when the channel is left unrestricted. This means that, when the fundamental determinants of the exchange rate consistent with the sticky price or flexible exchange rate models are weak, changes in monetary policy magnify the decline in the trade balance via the exchange rate. There are two policy implications from this analysis. Firstly, a significant deterioration in net exports due to the exchange rate appreciation shock indicates that the contribution of net exports to the gross domestic product will remain depressed for longer periods. Hence, this finding does not violate the neutrality of exchange rate effects on long-run economic growth. Secondly, evidence of the expenditure-switching channel, ceteris paribus, suggests that, in the short-run, monetary policy can be used to change the direction of demand between domestic output and imported goods through the adjustment in the exchange rate. However, monetary policy does not offer a long lasting solution in triggering growth via the trade balance channels as it tends to have only temporary effects.Read more
Working Paper 168 - Competition and Market Structure in the Zambian Banking Sector
26/02/2013 14:30
Working Paper 168 - Competition and Market Structure in the Zambian Banking Sector
This study evaluates the degree of competition in the Zambian banking sector in the wake of dynamic market shifts induced by entry of new foreign banks and privatisation of the state-owned bank. Using an unbalanced panel of bank level data complemented with market factors from 1998 to 2011, we measure using the Panzar-Rosse H-statistic and the time varying Lerner index, two non-structural measures mostly applied in the banking industry, see for instance. These indices are estimated across two periods with a view to assess whether or not increased foreign bank presence observed since 2008 and privatisation of the state owned bank in 2007 have had a discenible impact on competition in the Zambian banking setcor. We classify these periods as pre-entry/pre-privatisation and post-entry/post privatisation, respectively. Ther results are then compared. Zambia initiated far reaching financial sector reforms in 1992. The reforms brought great anticipation that competition in the banking system would be enhanced, thus leading to improved provision of financial services after many years of financial repression. However, expectations have been broadly at variance with practical observations. The banking system is concentrated and segmented with four largest banks controlling a third of the industry assets and about three quarters of the loans market. Intermediation margins are also wide, even by regional standards, despite marked improvements in macroeconomic conditions. Between 1998 and 2011, the average net interest margin was about 6% while the equivalent measure for return on assets stood at more than 4%. High profits and wide spreads are reminiscent of the high level of concentration in the sector. Nonetheless, commercial banks in Zambia have continued to show resilience after the banking crisis of the mid-1990s which saw closure of more than 6 banks. Currently, a majority of banks hold capital balances above the regulatory threshold, depicting the strength and stability of the Zambian banking sector. Thus, the failure of financial liberalisation to generate a 'critical level' of competitive pressure stems largely from the inherent nature of the Zambia banking system, with incumbent large foreign banks firmly entrenched in all segments of the market. However, concentration ratios distort the picture of competition because they do not offer adequate and conclusive explanations of actual bank behaviour. In view of this, appropriate measures are required to accurately assess banks’ exercise of market power and competitive conduct. Empirical results from the H-statistic show that Zambian banks earned their revenue under conditions of monopolistic competition. This finding is consistent with the estimate of the Lerner index which suggests that the degree of competitiveness may not be as low as previously understood, especially among foreign banks. Encouragingly, domestic banks also experienced intensification of competitive pressures over the sample period. Risk taking, revenue diversity and regulatory intensity are all important determinants of market power. Tight monetary policy is also found to strengthen the banks’ exercise of market power. Macroeconomic instability, denoted by inflaiton, limits banks’ competitive conduct while a large capital buffer is mainly aimed at maintaining banks’ solvency but it imposes a limit on competitive behaviour. The results also show that more geographically diversified banks have a higher propensity to raise revenue than those with a smaller branch network, and therefore useful in stimulating competition. Benchmarking Zambia against regional peers, the results show that Zambia ranked above countries of the EAC, except Kenya, which exhibited the highest degree of contestability in the region. Generally, the findings lend support to previous research suggesting that foreign bank penetration and privatisation can heighten competitive pressures in the banking sector. Thus, for policy purposes, the analysis shows that competitive conditions could be further enhanced by easing regulatory impediments and in the long-run, allowing more foreign bank participation could spur competitive conduct in the industry.Read more
Working Paper 167 - Promoting Economic Reforms in Developing Countries Rethinking Budgetary Aid?
26/02/2013 14:28
Working Paper 167 - Promoting Economic Reforms in Developing Countries Rethinking Budgetary Aid?
This paper aims to contribute to the current debate on budget support by exploring approaches likely to strengthen the linkages between budget support and reforms in the recipient countries. In this regard, the paper introduces the distinction between “Reforms requiring tangible assets creation” and “Reforms requiring intangible assets creation”, and shows that budget support has a comparative advantage in the financing of reforms requiring intangible assets creation, while project aid has a comparative advantage in the financing of reforms requiring tangible assets creation. The paper further argues that in order to lead to lasting changes in economic behavior and, therefore, to have a real impact on the economy, a reform must have a financial effect on at least one category of economic agents. The paper argues for the proper identification of the changes in economic behavior sought by reform, together with a careful evaluation of the associated financial incidence. These have been important missing links in current donors’ practices in the use of budgetary aid to promote economic and structural reforms in developing countries. To remedy the noted decline of the role of budget support as a catalyst for structural reforms in recipient countries this paper proposes a new instrument for donors, namely, Enhanced Budget Support (EBS).  The latter advocates for the following: i) that budget support should be devoted to implementing reforms requiring intangible assets creation; ii) a clearer identification of the changes in economic behaviors and, therefore, the results, targeted by the reforms, and iii) assessing the budgetary cost of the reforms to be implemented as well as calibrating the financing for budget support in light of the estimated budgetary cost, a practice that few donors currently follow. In addition to fostering greater transparency, this approach would enable stakeholders to better guarantee accountability of the authorities responsible for managing economic policy. The challenges often encountered in estimating the budgetary cost of reforms, can also be overcome. At the country level, a number of factors can create an enabling environment for the successful use of EBS. They include the following three: i) a risk-minimizing national fiduciary framework; ii) a stability-oriented macroeconomic framework; and iii) existence of sufficient analytical capacity. Directions for future research on budget support. Future research on budget support should focus on addressing the following issues: i) identification of reform actions requiring intangible asset creation; ii) costing of reform preparation and implementation; iii) relationship between the financial effect of reform measures and economic agents’ behaviours in respect of demand and production; iv) restructuring of recipient countries’ budgets to create financial space for implementing the reforms; v) improving the fiduciary systems of recipient countries; and vi) assessment of the budgetary impact of reforms.Read more
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