Savings, Capital Flight, and African Development, Part 2

Léonce Ndikumana

This is the second of a two-part series on capital flight from Africa by regular Triple Crisis contributor Léonce Ndikumana. (Part 1 is available here.) 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 2: Fighting capital flight

Capital flight may be one of the causes of low domestic saving in African countries for a number of reasons. The first is a direct effect through allocation of private wealth in foreign assets as opposed to holding domestic assets. Capital flight also affects saving indirectly through its effects on domestic investment and growth. By depressing capital accumulation, growth is retarded as capital flight increases.

Fighting capital flight is, therefore, an essential element of the strategy to stimulate domestic saving in Africa. The discussion here is organized around two sets of strategies: incentive-based strategies, and institutions-based strategies for both fighting capital flight and stimulating domestic saving.

Incentive-based strategies

Following the discussion on the motivation and drivers of capital flight, strategies to reduce capital flight as a way of raising domestic savings incorporate two important premises. First, to some extent, capital flight may be induced or influenced by considerations for security of assets with regard to extortion, expropriation, or any other politically motivated risks. Second, capital flight is also motivated by evasion of the law—either taxation evasion or tax avoidance, or evading prosecution of financial crime in the case of stolen money, fraud, money laundering, illicit trafficking and other crimes that generate dirty capital.

Third, capital flight operators “learn by doing” in the practice of smuggling capital abroad. Over time, they acquire skills and establish networks which help them circumvent regulations with impunity. In other words, there is “habit formation” in capital flight (Ndikumana & Boyce, 2003). For these reasons, the unit cost of transferring funds abroad declines as capital flight increases.

From this analysis, it follows that strategies aimed at discouraging capital flight as a means of stimulating domestic saving should take into consideration agents’ incentives regarding the allocation of wealth between domestic and foreign assets. Traditionally, policies have focused on raising the real interest rates and removing market distortions to reduce the difference between the foreign return and the domestic return to investment in favor of the latter. But these policies have not been successful as saving does not respond strongly to market interest rates. It is nevertheless important to pay attention to non-interest rate factors that may encourage saving. In this context expanding the range of saving instruments through the deepening of financial markets and especially the creation of long term instruments such as pension funds and other retirement instruments are an important avenue to explore.

Institutions-based strategies

Capital flight may be reduced, and thus saving increased by raising the cost of smuggling capital out of the country. This is where institutions-based strategies come into play. Capital flight is perpetuated when predicate crimes that generate illicit wealth and illicit international transfer of funds are not properly prosecuted and penalized. Therefore, the first area of focus in an institutions-based strategy aimed at preventing capital flight and raising domestic saving is to put an end to impunity of financial crime. Such strategy involves reforms and strengthening of the regulatory framework and the legal system. This requires reforms that are accompanied by adequate investments in human capacity in regulatory authorities and the legal systems in the areas of financial and economic intelligence, investigation, prosecution, and deterrence of financial crime. In addition to strengthening regulatory and legal systems, it is also important to ensure their political independence to enable them to properly investigate and prosecute financial crime. This is especially important because the perpetrators of capital flight often include government officials as well as politically connected domestic and foreign private actors. Thus there is a high risk of obstruction of financial crime investigation by politically influential actors that have something to hide.

Given that capital flight involves a shared responsibility between agents in African countries and their counterparts in destination territories including safe havens, successfully combating capital flight requires close cooperation between African countries and international community. African countries can also leverage legislations and conventions in developed countries and international institutions that are aimed at combatting financial crime and corporate sector corruption (see Ndikumana (2013)). African countries will also need financial support from their development partners to invest in capital building and acquire the necessary infrastructure to establish strong anti-financial crime institutions. Making progress in preventing capital flight will yield positive benefits in terms of increased domestic saving.

Conclusion

There is no doubt that the landscape of African economies has changed since the turn of the century, especially marked by improved macroeconomic performance in terms of growth and macroeconomic stability. In that sense, Africa is indeed a changed continent from three decades ago. In the context of the analysis of the linkages between saving, capital flight and development, three interesting questions emerge.

The first is whether the growth resurgence in Africa is evidence of saving-led growth and whether it is sustainable. Evidence shows that the rise in saving rates during the growth acceleration is concentrated among oil rich countries. These countries have also grown faster than resource-poor countries. However, while oil-rich countries recorded rising saving rates, their investment rates did not rise proportionately. This raises concerns about the sustainability of the growth momentum in the medium term.

The second question then is what does it take to translate rising domestic savings into rising domestic investment. The issue is not solely a matter of efficiency of financial intermediation. It also has to do with the nature and source of the rise in domestic saving. In the case of resource-rich countries, the rise in domestic savings accrues primarily in the public sector through tax revenue and resource rents. The question is why rising public savings do not systematically translate into rising domestic investment. One possibility is that governments have not used these savings to increase public investment. Another is that these savings have little spillover effects on domestic financial intermediation, in the sense that they do not stimulate domestic bank credit and the development of long-term lending instruments. The question of composition of domestic saving has not received much attention in the literature, which has focused on aggregate savings. Yet, understanding the drivers of private and public domestic saving, and the linkages between the two and domestic investment is essential for designing appropriate policies for stimulating sustainable growth. Research aimed at shedding light on these issues would add much value to the policy debate.

The third question is a paradox: why has growth acceleration coincided with explosion of capital flight over the past decade?. The evidence implies that capital flight from Africa is not, at least not to a significant extent, the result of actions by private asset holders seeking higher returns abroad or protection of their savings against policy-induced risk or political risk. Therefore, standard economic analysis of portfolio decisions needs to be coupled with institutional analysis to uncover deep fundamental factors that drive capital flight from Africa. The evidence has clear implications for strategies aimed at both raising domestic saving and addressing the problem of capital flight.

We propose two sets of strategies. One is an incentives-based strategy aimed at increasing the attractiveness of domestic investment relative to foreign assets. This would address the part of capital flight that may be motivated by portfolio diversification. The second is an institutions-based approach aimed at strengthening the regulatory and legal systems to enable adequate investigation, prosecution, punishment and prevention of financial crime. We argue that African countries should focus mostly on the latter. This will help deter illicit acquisition of wealth, embezzlement of public assets, and illegal transfer of private funds into safe havens. Given that capital flight involves shared responsibility between African actors and agents in the international financial system particularly in safe havens, combating capital flight from Africa requires a global compact between African governments and their counterparts in advanced economies to improve transparency and accountability in the global financial system.

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