This is the first of a two-part series on capital flight from Africa by regular Triple Crisis contributor Léonce Ndikumana. The series is drawn from a Political Economy Research Institute (PERI) working paper, available here, forthcoming in Celestin Monga and Justin Y. Lin (eds.), Handbook of Africa and Economics, Oxford University Press.
Part 1: Causes and Consequences of Capital Flight
At the turn of the century the story of Africa has changed, from that of hopelessness to exuberance in the face of yet another African renaissance. Growth surged in the continent, even weathering the storm of the Great Recession of 2008-09, with Africa emerging as the second fastest growing region in the world after Asia. Despite this growth resurgence, however concerns remain. The most fundamental concern is that growth has not been accompanied by commensurate reduction in poverty. Moreover, it has been characterized by high inequality, and generally it has not been broad-based. From a long-term perspective the question is whether this recent growth resurgence is sustainable. In particular, the issue is whether the current saving rates are sufficient to support high and sustained growth and development.
Domestic saving in African countries has remained low, leading to high investment-saving gaps and increased dependence on external capital. A key reason is the inadequate performance in domestic saving mobilization in the public sector and in the private sector. But a factor that has been often overlooked is the leakage of resources through capital flight. The financial hemorrhage of the continent is a both a chronic problem and a looming crisis. The levels of capital flight have exploded over the past decade. Thus, efforts to build a solid base for long-term growth and development in Africa must involve strategies to improve efficiency in public and private domestic resource mobilization as well as policies to curb and prevent further capital flight from the continent.
Magnitude and trends of capital flight
Capital flight is a major development issue facing the majority of African countries. The problem is not new, and it is getting worse over time. Over the past decades since 1970, the continent has lost over one trillion dollars due to capital flight (African Development Bank & Global Financial Integrity, 2013; Boyce & Ndikumana, 2012; Ndikumana & Boyce, 2011a, 2012; Ndikumana et al., 2013). In addition to leakages of resources in the balance of payments, including embezzlement of public external debt, a major channel of capital flight is trade misinvoicing, both underinvoicing of exports and overinvoicing of imports.
Resource-rich countries, especially oil exporters feature prominently on the top of the list in terms of volume of capital flight: Nigeria, Angola, Gabon, Congo, the Democratic Republic of Congo and Sudan. In addition to high resource endowment, these high capital flight countries also happen to have a poor governance record. It therefore appears that capital flight is not driven by resource endowment per se, but by a combination of natural resource wealth and poor governance.
Capital flight from African countries is large in absolute terms as well as in relation to the size of the economies and compared to other financial flows. For the continent as a whole, the accumulated stock of capital flight exceeds the stock of debt, ironically making the continent a ‘net creditor’ to the rest of the world. While the absolute value of capital flight from Africa may be smaller than that from other regions (Henry, 2012), capital flight represents a heavier drain on African economies. African countries exhibit higher ratios of capital flight in relation to GDP, domestic capital accumulation, foreign direct investment and official development. The annual flows of capital flight also represents a large share of the investment gap faced by African countries, suggesting that these countries could partly bridge this gap if they could retain these funds at home.
Causes of capital flight
So what drives capital flight from African countries? Some have argued that capital flight is not different than other financial flows and that it can be explained by the same factors that drive portfolio allocation decisions by economic agents (Collier, Hoeffler, & Pattillo, 2001; Collier, Hoeffler, & Pattillo, 2004). Under this view, capital flight from Africa is motivated by the search for higher risk-adjusted returns to investment. In particular, it is argued that capital flight a matter of domestic capital being pushed out by poor economic conditions, high political instability, and poor governance in African countries r. In that sense, capital flight is just about savvy African wealth holders seeking higher returns to their investments abroad. It is also about African wealth holders voting with their feet to somehow penalize governments for bad governance that threatens their wealth.
The view of capital flight as portfolio choice is questionable on conceptual and empirical grounds. First the argument about the portfolio management motive can only hold for honestly acquired capital. But capital flight includes funds that were illicitly acquired which the owners seek to conceal abroad. In such case asset holders are more interested in the protection of the assets than in the returns to investments. In that perspective, safe havens offer a perfect venue to pack these funds. In these jurisdictions, asset holders often receive negative interest rates on their deposits, ‘a premium for security’ they are happily willing to accept (Australian banker Erhard Fürst quoted in Lessard & Williamson, 1987, p. 83). As Walter (1987, p. 107) pointed out, “If confidentiality has value, then asset holders engaging in capital flight should be willing to pay for it.” Confidentiality is the primary motive for holding stolen assets in secrecy jurisdictions.
Empirical evidence also has little to offer in support of the portfolio theory view of capital flight. Actual risk-adjusted returns to investment tend to be higher in African countries than in the rest of the world. This has been more so in the recent years as the developed world plunged in a recession while African countries weathered the storm surprisingly well. Yet, capital flight has continued to increase during the economic expansion over the past two decades. Moreover, capital flight has not abated during and following financial liberalization. In fact the era of financial liberalization since the mid 1995 has seen an escalation of capital flight. Furthermore, if risk and returns calculations were the main drivers of capital flight from Africa, how then can we explain movement of capital in both directions? If savvy African investors are unwilling to invest in Africa, why would equally savvy foreign investors find it worthy investing in the continent? There must be something that the African wealth holders know that foreign investors don’t. But most likely, the reverse home bias is an indication that African wealth holders have something to hide.
The empirical literature has documented a number of factors that consistently appear to be robust determinants of capital flight. First, capital flight tends to persist and exhibit hysteresis. In other words, countries seem to be caught in a capital flight trap (Ndikumana & Boyce, 2003, 2011b; Ndikumana et al., 2013). The evidence suggests that these countries must undertake robust and systematic measures to ‘shock’ the system out of its proneness to capital flight.
The second key result from empirical analysis is a tight positive relationship between capital flight and external borrowing, suggesting that part of capital flight from Africa is funded by embezzlement of public debt. This implies that some of the external debt is in fact odious in that it did not benefit the African people (Ndikumana & Boyce, 2011a).
Third, as mentioned above, the evidence shows that African countries that are both rich in natural resources and have poor governance exhibit higher levels of capital flight. This suggests that capital flight may be fuelled by embezzlement of the proceeds of resource exports and corrupt management of natural resource exploitation as well as illicit behaviour by multinational corporations operating in the sector.
Impact of capital flight
Capital flight is a serious development problem in Africa for several reasons. First, capital flight has negative effects on the economy by reducing government revenue directly through embezzlement of public resources and indirectly through the reduction of the tax base. These pressures on the government budget erode the government’s capacity to finance social services and public investment. By draining domestic resources, capital flight perpetuates dependence on external aid even as it undermines aid effectiveness.
Second, by draining government resources, capital flight retards progress in poverty reduction. The evidence shows that if African countries had been able to invest flight capital domestically, all of them would have accelerated their progress to reaching the objective of halving poverty by 2015 (MDG goal 1), and the goal would be reached in a good number of countries which otherwise would not have been able to do so (AfDB, OECD, UNECA, & UNDP, 2012; Nkurunziza, 2012, 2013). There are also indirect effects of capital flight arising from the payment of external debt that fuelled it. These effects especially materialize through reduced provision of public services such as health, resulting in increased infant mortality (Ndikumana & Boyce, 2011a) and other negative health effects.
Third, even as capital flight is partly caused by bad governance, there are also important negative effects in the reverse direction. Capital flight weakens governance as the perpetrators of capital flight manipulate the regulatory and judiciary systems to shield their illicit transactions and facilitate further capital flight. Governance breakdown is perpetuated and exacerbated by contagion and habit formation effects of capital flight; this partly explains the persistence of capital flight over time (Ndikumana and Boyce 2003).
Finally, capital flight has important distributional and equity implications. The holders of capital flight who are also guilty of tax evasion incur a relatively smaller tax burden than the poor who do not have the opportunity to conceal their wealth in safe havens. As a result, the middle class and the poor effectively subsidize consumption of public services by the rich. As the rich accumulate wealth that is tax shielded, the middle class and the poor incur the full burden of taxation and at the same time are deprived of public services due to lower tax collection. This increases income inequality. Inequality is also increased through exchange rate effects. This is because capital flight holders are shielded against losses due currency depreciation while the poor and middle class who hold all their wealth domestically bear the full cost of depreciation.
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