Investment and Risk in Africa 9781349150700, 9781349150687

Table of contents :
Introduction
Pages 1-1
Investment and Risk in Africa
Paul Collier, Catherine Pattillo
Pages 3-30
Risk in Africa: Its Causes and its Effects on Investment
Pages 31-31
Rating Africa: The Economic and Political Content of Risk Indicators
Nadeem Ul Haque, Nelson Mark, Donald J. Mathieson
Pages 33-70
Risk and Private Investment: Africa Compared with Other Developing Areas
Frederick Z. Jaspersen, Anthony H. Aylward, A. David Knox
Pages 71-95
Risk, Financial Constraints and Equipment Investment in Ghana: A Firm-level Analysis
Catherine Pattillo
Pages 96-121
The Risk and Expected Returns of African Equity Investment
Claude B. Erb, Campbell R. Harvey, Tadas E. Viskanta
Pages 122-150
Risk and Portfolio Investment in Africa: A Practitioner’s Approach
Joe Demby
Pages 151-165
Reducing Risk through Domestic Agencies of Restraint
Pages 167-167
The Central Bank as a Restraint: the Experience of Uganda
Louis A. Kasekende, Iftikhar Hussain
Pages 169-184
The Cash-Budget as a Restraint: The Experience of Zambia
Christopher S. Adam, David L. Bevan
Pages 185-218
The Courts as a Restraint: The Experience of Tanzania, Uganda and Botswana
Jennifer A. Widner
Pages 219-245
Investment Codes as a Restraint: The Experience of Southern Africa
David A. Ailola
Pages 246-271
Reducing Risk through External Agencies of Restraint
Pages 273-273
The Franc Zone as a Restraint
David Stasavage
Pages 275-307
Aid and Debt Conditionality as Restraints
Ravi Kanbur
Pages 308-322
Investment Insurance in Africa
Gerald T. West
Pages 323-337
The Potential for Restraint through International Trade Agreements
Paul Collier, Jan Willem Gunning
Pages 338-351
The Potential for Restraint through an International Charter for FDI
Mark A. A. Warner
Pages 352-362
Conclusion
Pages 363-363
So What Have We Learned
Robert H. Bates
Pages 365-372

Citation preview

Studies on the African Economies General Editors: Paul Collier and Jan Willem Gunning Published in association with the Centre for the Study of African Economies, University of Oxford Editorial Board: Paul Collier, Director, Policy Research Group, World Bank, and Professor of Economics, University of Oxford; Jan Willem Gunning, Professor of Economics, University of Oxford, and Free University, Amsterdam, and Director, Centre for the Study of African Economies, University of Oxford; Ibrahim Elbadawi, World Bank; John Hoddinott, Research Fellow, International Food Policy Research Institute, Washington, DC; Chris Udry, Professor of Economics, Yale University This important new series provides authoritative analyses of Africa's economies, their performance and future prospects. The focus will be on applying recent advances in economic theory to African economies to illuminate and analyse the recent processes of economic reform and future challenges facing Africa. The books, published in association with the Centre for the Study of African Economies, will bring together top scholars from universities and international organizations across the world. Titles include: Arne Bigsten and Steve Kayizzi-Mugerwa CRISIS, ADJUSTMENT AND GROWTH IN UGANDA A Study of Adaptation in an African Economy Paul Collier and Catherine Pattillo (editors) INVESTMENT AND RISK IN AFRICA Paul Glewwe THE ECONOMICS OF SCHOOL QUALITY INVESTMENTS IN DEVELOPING COUNTRIES An Empirical Study of Ghana John Knight and Carolyn Jenkins ECONOMIC POLICIES AND OUTCOMES IN ZIMBABWE Lessons for South Africa Jo Ann Paulson (editor) AFRICAN ECONOMIES IN TRANSITION Volume 1: The Changing Role of the State Jo Ann Paulson (editor) AFRICAN ECONOMIES IN TRANSITION Volume 2: The Reform Experience

Investment and Risk in Africa Edited by Paul Collier

Director, Policy Research Group The World Bank Washington, DC

and Catherine Pattillo

Research Department International Monetary Fund Washington, DC

in association with Palgrave Macmillan

First published in Great Britain 2000 by MACMILLAN PRESS LTD Houndmills, Basingstoke, Hampshire RG21 6XS and London Companies and representatives throughout the world A catalogue record for this book is available from the British Library. ISBN 978-1-349-15070-0 ISBN 978-1-349-15068-7 (eBook) DOI 10.1007/978-1-349-15068-7 First published in the United States of America 2000 by ST. MARTIN'S PRESS, INC., Scholarly and Reference Division, 175 Fifth Avenue, New York, N.Y. 10010 ISBN 978-1-349-15070-0 Library of Congress Cataloging-in-Publication Data Investment and risk in Africa / edited by Paul Collier and Catherine Pattillo. p. cm. - (Studies on the African economies) Papers discussed at a conference held at the Harvard Institute for International Development. Includes index. ISBN 978-1-349-15070-0 I. Investments, Foreign-Africa-Congresses. 2. Risk management­ -Africa-Congresses. I. Collier, Paul. II. Pattillo, Catherine A. (Catherine Anne) III. Series. HG5822.157 1999 332.67'3'096-dc21 99-32994 CIP © Centre for the Study of African Economies 2000 Softcover reprint of the hardcover 1st edition 2000 978-0-333-77753-4 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London WIP OLP. Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The authors have asserted their rights to be identified as the authors of this work in accordance with the Copyright, Designs and Patents Act 1988. This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. 10 9 8 7 6 5 4 3 2 1 09 08 07 06 05 04 03 02 01 00

Contents Preface

vii viii

Notes on the Contributors

1

Part I Introduction

1 Investment and Risk in Africa Paul Collier and Catherine Pattillo

3

Part II Risk in Mrica: Its Causes and its Effects on Investment

31

2 Rating Africa: The Economic and Political Content of Risk Indicators Nadeem Ul Haque, Nelson Mark and Donald 1 Mathieson

33

3 Risk and Private Investment: Africa Compared with Other Developing Areas Frederick Z. Jaspersen, Anthony H Aylward and A. David Knox

71

4 Risk, Financial Constraints and Equipment Investment in Ghana: A Firm-level Analysis Catherine Pattillo Discussion: Jan Willem Gunning

96 120

5 The Risk and Expected Returns of African Equity Investment Claude B. Erb, Campbell R. Harvey and Tadas E. Vzskanta Discussion: Lemma W Senbet

122 146

6 Risk and Portfolio Investment in Africa: A Practitioner's Approach Joe Demby

151

Part III Reducing Risk through Domestic Agencies of Restraint

167

7 The Central Bank as a Restraint: the Experience of Uganda Louis A. Kasekende and Iftikhar Hussain Discussion: Stephen A. O'Connell

169 182

V

vi

Contents

8 The Cash-Budget as a Restraint: The Experience of Zambia Christopher S. Adam and David L. Bevan Discussion: Malcolm McPherson

185 21 6

9 The Courts as a Restraint: The Experience of Tanzania, Uganda and Botswana Jennifer A. Widner Discussion: Karen E. Ferree

219 243

10 Investment Codes as a Restraint: The Experience of Southern Africa David A. Ailola

246

Part IV Reducing Risk through External Agencies of Restraint

273

1 1 The Franc Zone a s a Restraint David Stasavage Discussion: Smita Singh

275 305

1 2 Aid and Debt Conditionality as Restraints Ravi Kanbur Discussion: Stephen A. O'Connell

308 319

13 Investment Insurance in Africa Gerald T. West

323

1 4 The Potential for Restraint through International Trade Agreements Paul Collier and Jan Willem Gunning

338

1 5 The Potential for Restraint through an International Charter for FDI Mark A. Warner

352

Part V Conclusion

363

1 6 So What Have We Learned? Robert H Bates

365

Index

373

Preface This book brings together academics in the fields of economics, political science, and law, with business practitioners in the fields of risk assessment and portfolio management. Their contributions are sequenced to tell a story. Africa is perceived as being a highly risky continent. As a result, investment is discouraged. These risks are partly exaggerated. However, to the extent that they reflect genuine problems they are capable of being mitigated by insurance and reduced by political restraints such as central banks, investment charters, and international agreements. The contributors were brought together for a conference at the Harvard Institute for International Development which discussed drafts of the papers in this volume. Comments and criticisms were provided by a group of discussants, some of which are included in this volume. We acknowledge the major financial support of the Social Science Research Council, and the hospitality of the Harvard Institute for International Development. The project was organised by the Centre for the Study of African Economies, Oxford University, at which both the editors were based. Paul Collier Catherine Pattillo Washington, DC

vii

Notes on the Contributors Christopher Adam is a University Lecturer at Oxford University, and a researcher at the Centre for the Study of African Economies. David Ailola is Associate Professor of Commercial Law at the University of the Western Cape, South Africa. Anthony Aylward is an economist with the International Finance Corporation. Robert Bates is the Eaton Professor of the Science of Government at Harvard University. David Bevan is a University Lecturer at Oxford University and a researcher

at the Centre for the Study of African Economies.

Paul Collier is Director of the Policy Research Group at the World Bank,

and on leave from Oxford University where he was Professor of Economics and Director of the Centre for the Study of African Economies. Joe Demby is with Regent Fund Management, London. Claude Erb is with Liberty Mutual. Karen Ferree is a doctoral student at Harvard University. Jan Willem Gunning is Director of the Centre for the Study of African

Economies and Visiting Professor at Oxford University, on leave from the Free University of Amsterdam.

Nadeem UI Haque is an adviser in the IMF Institute of the International Monetary Fund. Campbell Harvey is a professor at Duke University and associate at the NBER. Htikhar Hussain is an economist in the Reseach Department, Bank of

Uganda.

Frederick Jaspersen is an economist with the International Finance Corporation.

viii

Notes on the Contributors

ix

Ravi Kanbur is Lee Professor of Development at Cornell University, and was previously Chief Economist for Africa at the World Bank. Louis Kasekende is the Executive Director of the Research Department,

Bank of Uganda.

David Knox is a former Vice President of the World Bank. Malcolm MacPherson is a Fellow of the Harvard Institute for Interna­

tional Development.

Nelson Mark is Professor of Economics at Ohio State University. Donald Mathieson is Division Chief of the Emerging Markets Division in the Research Department of the International Monetary Fund. Stephen O'Connell is Professor of Economics, Swarthmore College. Catherine Pattillo is in the Research Department of the International Monetary Fund and was previously a Research Officer at the Centre for the Study of African Economies, Oxford University. Lemma Senbet is William E. Meyer Professor of Finance at the University of Maryland. Smita Singh is a doctoral student at Harvard University. David Stasavage is a Research Officer at the Centre for the Study of African Economies, Oxford University, and was previously with the OECD Development Centre, Paris. Tadas Viskanta is with the First Chicago NBD Investment Management Company, Chicago. Mark Warner is a professor and Assistant Director of the Center for

International and Comparative Law at the University of Baltimore School of Law. Gerald West is a Senior Advisor at the Multilateral Investment Guarantee Corporation. Jennifer Widner is Associate Professor of Political Science at the

University of Michigan.

Part I Introduction

1 Investment and Risk in Africa Paul Collier and Catherine Pattillo I. INTRODUCTION Until recently Africa has been an unambiguously capital-hostile environment. During 1960 to 1990 the return on capital in Africa was on average around a third below that elsewhere. 1 Because the returns on capital were low there was little private investment. However, during the 1990s some African governments have reformed policies sufficiently that returns are now probably quite high: there is evidence that the return on FOi is now higher in Africa than in other developing areas. 2 Despite these improved returns, private investment has remained low. Whereas in other developing areas it is currently averaging 18 per cent of GDP, in Africa even by 1994 it was only 10 per cent, little changed from the 1980s. (World Bank, 1996). The first hypothesis tested in this volume is that an important reason for this continuing low level of private investment is risk. Survey evidence of investor opinions points to this explanation. Fear of political instability was chosen as the most important obstacle to investment by 225 foreign investors in Africa (Blakey, 1994) and the risk of policy reversal was chosen most important by 150 foreign investors in East Africa (World Bank, 1994). This is not a reflection of normal investor caution about foreign environments: Africa is rated as the most risky environment in the world by the commercial risk­ rating agencies. Risk is atypically important as a deterrent to investment in Africa because Africa is perceived as being atypically risky. We postulate that this is true for potential domestic investors as well as foreigners. The second hypothesis investigated in the volume is that African governments and international institutions between them have the power to reduce these risks. The major component of investor risk in Africa relates to fears of government action. A combination of clear signalling of government intentions and the construction of agencies of restraint which increase the incentives for key reforms to be maintained can reassure investors. By these means a reforming government can accelerate the pace at which it lives down its past: its risk-rating can be improved more rapidly than that which would occur simply through the maintenance of the reforms. The chapters in this volume analyse various components of these two hypotheses. Part II investigates the causes of Africa's perceived high-risk

3

4

Investment and Risk in Africa

environment and the consequences of this environment for investment. Part III reviews the experience of four agencies that operate at the national level to reduce risk: the central bank, ministry of finance budget rules, the commercial courts, and investment codes. Part IV considers the experience of international agencies with broadly parallel functions to the domestic agencies: a multinational central bank, fiscal conditionality, and the Multi­ lateral Investment Guarantee Agency. It then considers the potential for two restraints that have not so far been used in Africa: international trade agreements and an international charter for FDI. In Part V a distinguished political scientist assesses the evidence.

II.

RISK AND ITS EFFECT ON INVESTMENT

Part II of this volume focuses on the determinants of risk, the impact of risk on investment and the potential for reducing risk through pooling offsetting risks into investment portfolios. In Chapter 2 Haque et al. examine the empirical determinants of country risk ratings using variables that are consistent with political economy theories of creditworthiness. They find that economic fundamentals do explain a large part of the variance in risk ratings. However, the regressions contain a significant 'Africa dummy', possibly indicating that Africa is rated as more risky than warranted by the underlying economic characteristics. Chapters 3 and 4 analyse the impact of risk on investment at the cross-country, macroeconomic level and the micro­ economic, firm-level, respectively. In multivariate regressions of the private investment/GDP ratios for 1990 to 1994 on the 1980 averages for the independent variables, Jaspersen et al. find that high levels of country risk have a significant negative effect on private investment. In a study of investment in Ghanaian manufacturing firms, Pattillo analyses the impact on investment of an risk proxy derived from the firm's expected demand for its products. The results support predictions from the theory of investment under uncertainty (Dixit and Pindyck, 1994): uncertainty has a larger negative impact on firms with more irreversible investment. Chapters 5 and 6 turn to the potential for diversifying risk by including African stocks in an international portfolio. Demby outlines the approach to portfolio construc­ tion undertaken at an emerging markets investment management firm. Optimizing different investor objectives over risk and return characteristics of African stock markets yields a portfolio allocation over the countries in the region. An innovative chapter by Erb et al. proposes a methodology for establishing expected rates of return and volatility for African equity markets, both for currently existing as well as potential markets. The relationship between equity returns and country risk measures for developed and emerging

Investment and Risk in Africa

5

markets is used to impute the risk-return characteristics on African equity investments, using these countries risk ratings. In order to set the stage for Part II, we will consider three issues. (1) How risky is the economic environment in Africa? (2) What does the theory and empirical evidence say about the effect of risk on investment? (3) How does policy reform affect perceived riskiness? We show that Africa is objectively an unusually risky environment. Further, firms have fewer means of coping with risk. Survey evidence indicates that firms currently identify risk, and in particular the risk of policy change, as the single most important obstacle to investment. Because firms attach great importance to risk, there is a market for the specialist services of agencies that measure its various components. We review the risk ratings that the major agencies produce. Haque et al. (this volume) provide some evidence that Africa is rated by these services as being even more risky than is warranted by objective conditions. Thus, those African governments that are attempting to reform policies may be suffering from a 'bad neighbourhood' effect that is retarding the impact of their reforms. Next we explore how these high risks affect investment. Because many investments are irreversible, potential investors have an incentive to wait during periods of temporarily high risks such as the early stages of policy reform, keeping their options open until the risks are resolved. Finally, we discuss how African policy reforms have in practice affected perceived riskiness. In formulating reform strategies, governments need to attend both to the actual reforms themselves and to a meta-strategy which focuses on making the reforms as credible as possible. This is both more important and more difficult for those governments which are starting reform from a history of prolonged poor policies, policy volatility, and confused signals as to the motivation for policy change. How risky is the economic environment in Africa?

Knightian uncertainty is said to exist when individuals are not able to assign probabilities to potential events, possibly because the universe of possible outcomes cannot even be specified. Risk implies that although the future is not known with certainty, individuals can use available information to form subjective probabilities over future events. Most of the discussion below will consider risk, although we will briefly consider whether Knightian uncertainty has even greater negative effects on investment. Volatility of the macroeconomic environment heightens risk for potential investors. High and variable inflation makes it harder for producers to get good information about relative price changes, thereby making profitable opportunities more difficult to predict. Commodity price volatility clearly affects the profitability of firms involved in primary commodity exports, and has wide-ranging impacts on income, savings, investment and growth. Real

6

Investment and Risk in Africa

Table 1.1 Volatility indicators, by region Variance of Inflation Region

Standard Standard Standard Deviation of Deviation of Deviation of Log of RER changes changes in Commodity tax revenue/ Prices GDP

Sub-Saharan Africa Latin America & Caribbean East Asia South Asia OECD Other (Oceania & Middle East)

9

0.22

15.5

3.3

13.9 6 7.5 4.1

0.19 0.19 0.18 0.13

14.9 6.6

2.2 1.7

7.2

0.18

11.2

1.2

Period Source

1960-90 1960-89 King and Mash Levine (1993) (1995)

1966-88 Pritchett (1991)

1974-89 Bleaney et al. (1995)

10.4

1.7

exchange rate instability creates uncertainty about the returns to both tractable and non-tradable production. Volatility of average tax rates adds an additional level of uncertainty to firm's expectation of the after-tax returns to capital. During the period 1960 to 1989, the volatility of most of these indicators was higher in Africa than in any other region. As shown in Table 1.1, only Latin America experienced higher variability of the inflation rate. Mash (1995) calculates variability of commodity prices under different assumptions about their time series properties, and finds higher volatility for Africa for all the indices. Pritchett (1991) finds that the standard deviation of changes in the real exchange rate is highest for Africa compared with the other regions.3 Bleaney et al. (1995) document that the variability of average tax revenues is significantly higher in Africa. Another indicator of the riskiness of the environment is the level of capital flight. A widespread response to risk is the portfolio reallocation from physical capital into liquid assets, and then the movement of those liquid assets abroad where they are out of the reach of government hands. In Table 1.2 we compare the portfolio choices across regions by combining data on capital flight from 1970-90 and the private domestic capital stock to construct an estimate of regionally owned private wealth and its disposition as of 1990. Despite a lower level of wealth per worker than any other region, African asset owners hold 39 per cent of their portfolios outside Africa, a share higher

Investment and Risk in Africa

7

Table 1.2 Portfolio composition and factor proportions by region, 1990

Sub-Saharan Africa Middle East Latin America South Asia East Asia

Capital Flight/Wealth

Private Wealth per Worker (1985 US$)

0.39 0.39 0.10 0.03 0.06

1752 6 030 19 361 2500 10 331

Source: Collier et al. (1999)

than any other region. One implication is that like foreigners, domestic investors are also responsive to the riskiness of the environment. The low level of the capital stock is strongly influenced by risk, and not purely by low savings levels. Risk ratings

Country risk is the exposure to a loss in cross-border lending caused by events that are, at least to some extent, under the control of the government of the borrowing country. Narrowly defined, country risk refers to risk of lending directly to the government of a sovereign nation. This depends importantly on factors determining whether a government is willing and able to service its hard currency debt obligations. It also depends on political risk - the risk that asset values will decline because of wars, political instability or politically motivated changes in economic policies; and exchange risk - the risk that exchange rate changes will alter hard currency repayments for loans denominated in domestic currencies. Clearly many of these factors are also key to the riskiness of lending or investing in the private sector. The four best-known country risk indices are: the Institutional Investor (II), Euromoney, Economist Intelligence Unit (EIU) and International Country Risk Guide (ICRG). The II index uses information provided by 75-100 leading international banks, who grade each country on a scale of 0---100, with 100 representing the least chance of default. The other indices are derived from panels that assess various economic, credit and political indicators using quantitative indicators and a weighting scheme. Figure 1.1 shows that Africa has been rated as the most risky region by II during the 1979-96 period. Are country risk ratings relevant for total investment and international capital flows, including government and private investment, foreign direct investment and other portfolio and debt flows? (see Figure 1.2) As mentioned, much of the environment that affects sovereign creditworthiness

8

Investment and Risk in Africa 'IO . O ------------------------------�

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Figure 1.1 Institutional investor risk ratings, by region Source: Author's calculations �0 1 10 �------------------------------,

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Figure 1.2 Private investment and country risk Source: Author's calculations is also important for private sector investors. In addition, economies with high levels of country risk are predicted to have greater probability of defaulting on or rescheduling international obligations. Defaults invoke the penalties of being shut out from international lending (including trade credit) or, in the worse case, trade embargoes. The costs, which clearly impact the private sector, are greater the more open the economy. Since many economies with high country risk have heavy debt burdens, the prospect that the government

Investment and Risk in Africa

9

may repay debts could be as detrimental for private sector's expected returns to capital as the possibility that it may default, if 'debt overhang' leads to expectations of increases in future marginal tax rates to finance debt. A final reason why high country risk ratings may be negatively correlated with investment rates is that one component of the rating is an assessment of the quality of the institutional environment and its ability to protect property rights. Recent work by Mauro (1995) and Knack and Keefer (1995) has shown that factors such as the quality of the legal and bureaucratic institutions, degree of contract enforceability, and level of corruption in government are all important determinants of cross-country investment rates. Aron (1998) argues that these institutional quality measures are good proxies for the transactions costs dimension of the institutional framework as emphasized in the work of North (1990). Aron's typology also helps to evaluate Knack and Keefer's findings that the institutional quality measures have greater statistical and economic significance for investment than both indices of political instability and Gastil civil liberties index. Both of these factors may be more important in determining the quality of institutions and protection of property rights through political systems rather than having a direct effect on investment. Although the work by Mauro and Knack and Keefer has used the disaggregated indices produced by international investment risk services such as Business Environment Risk Intelligence (BERi) and International Country Risk Guide (ICRG), the overall country risk ratings produced by II, EIU and Euromoney also contain assessment of institutional factors. However, as discussed in Jaspersen et al. (this volume), there may be a significant amount of independent information in the two types of indices. Analysis for African countries shows that there seems to be less independent information in the two types of indices. The BERi and II ratings show greater correlation than for other regions, suggesting that the information in country risk ratings is relevant for the universe of loans and investments, inclusive of private sector investments. Evidence from surveys of foreign investors

Strong evidence on the perceived riskiness of the African business environment comes from a 1994 survey of actual and potential investors in East Africa (World Bank, 1994). It rated impediments to investment on a scale of 1 (no problem) to 5 (very severe problem). The single most important impediment to investment was non-commercial risk (rated at 3.6). The survey decomposed non-commercial risk into its various components. The most important was the fear of policy reversal. The risk of inconvertibility (defined to encompass restrictions in the access to foreign exchange and/or in the remittability of investment proceeds) was the second most important fear. A

Investment and Risk in Africa close third was the fear of civil war or social disturbance. There was little difference in the worry about fears of policy reversal between investors already operating in East Africa and those considering an investment. Thus, in countries where the government is already providing peace and has made some progress toward reforming policies, the biggest factor deterring investment is the fear that this environment will not be maintained. Less firm-level risk management tools While African firms may face greater risks, they also have access to fewer mechanisms to manage risk. Increasing globalization of economic activity has been accompanied by greater volatility in many commodity, financial and foreign exchange markets. While many developing countries have been able to respond by adopting some of the sophisticated new risk management instruments, Africa is largely on the sidelines. African commodity producers have, to some extent, bee11 able to manage price risk on specific transactions though forward and futures markets. Profitability can still be risky because of the different movements in financing costs and commodity prices. New financial instruments have been developed that allow financing costs to be linked to commodity prices. For example, the IFC has participated in commodity-linked financing arrangements in Zambia and Ghana. In a straightforward operation in Zambia in the late 1 980s, a cotton producer financed expansion using a loan with an interest rate linked to the international cotton price. The effect of the arrangement was to link repayment ability with the ability to produce the commodity (Glen, 1993). A Ghanaian gold mining company arranged financing where loan repayment is made in the currency equivalent of a fixed amount of gold. The company effectively borrowed in the currency equivalent of a fixed amount of gold, and will repay with 'gold' from its production, thus lowering its exposure to risk from gold price changes. For many companies in Africa the risk management problems are more basic: the lack of forward markets for foreign exchange in many countries implies that importers and exporters face high levels of foreign exchange risk. And while the movement toward market-determined exchange rates has been largely positive, interbank markets, where they exist, are generally not playing the stabilizing role in the market as in other parts of the world, largely because of the underdeveloped financial systems. Another firm-level approach to risk management is insurance. Although agencies such as MIGA, ECGD and OPIC provide coverage for a range of political risks, they are only available to foreign investors. It is not clear how domestic investors are affected by the presence of insured foreign investors in their countries. It may be that foreign investors are able to get first access to the most profitable opportunities, thereby crowding out domestic investors.

Investment and Risk in Africa

11

Alternatively, because the insurance agencies can act pre-emptively to restrain government actions using the lever of potential penalties, the presence of insured foreign investors may imply better government treatment of all investors. Is Africa rated as more risky than is warranted? Haque et al. (this volume) have analysed the economic determinants of developing country risk ratings. Results indicate that economic fundamentals - the ratio of foreign exchange reserves to imports, current account balance/ GDP, export growth and inflation explain a large part of the variation in the ratings. Two additional points stand out from this work. First, Africa is systematically rated as more risky than warranted by the fundamentals. Second, the ratings are highly persistent, implying that they respond slowly to changing economic conditions. It would be interesting to see whether Africa was still rated as excessively risky when political instability indicators were included in the analysis. Although the authors find that the addition of political instability variables does not provide significant additional explana­ tory power to the model, they do not report whether the 'Africa dummy' is still significant. With the current evidence one cannot distinguish between the explanations of high perceived political risk, or pessimism toward Africa due to the difficulties of living down government reputation for bad policies. How does risk affect investment? An important new development in economics is the theory of investment under uncertainty (Dixit and Pindyck, 1 994). Previous theories of investment under competitive conditions rested on the Marshallian conditions: firms should invest when price rises above long-run average cost, and should suspend operations and exit the market if price falls below average variable costs. In reality, firms use 'hurdle rates' to determine investment, where expected returns are typically three or four times the cost of capital. That is, firms do not invest until price rises quite a bit above long-run average cost. This behaviour can be rationally explained when three key features of the investment decision are taken into consideration. First, investment is partially or completely irreversible - that is, much of the costs are sunk and therefore not retrievable if disinvestment takes place. Second, there is ongoing uncertainty affecting the returns to investment and more information arrives gradually over time. Third, the investment opportunity does not disappear if not taken immediately; that is, there is often some flexibility in the timing of a project. In these circumstances, the orthodox rule: invest whenever the net present value (NPV) is greater than zero leaves out an important opportunity cost of

12

Investment and Risk in Africa

investing. The ability to delay an irreversible investment expenditure provides a firm with a valuable option - the value of waiting for new information to arrive that may affect the desirability or the timing of the investment. When a firm invests, it gives up this option. Thus the NPV rule should be modified to say that a firm should invest when the value of the project exceeds the cost by an amount equal to the value of keeping the investment option alive. The point is that waiting allows a firm to avoid future downside risk, while still being able to benefit from the upside potential. Of course, the value of waiting has to be set against the sacrifice of current profit. Eventually if current conditions become sufficiently favourable, the firm will invest, but the hurdle rate will exceed the Marshallian required return. Recent studies have shown that this opportunity cost of investment (the option value of waiting) can be large, and it is increasing in the degree of uncertainty over the future value of the project. It is clear that all three factors - irreversibility, uncertainty and the option to wait are extremely relevant for potential investors in developing countries undertaking policy reform. For African countries, investment entails largely sunk costs as second-hand markets for capital goods are thin and mechanisms for outright sale are limited. The implementation of an adjustment programme may increase uncertainty in the short run, as private agents started receiving mixed incentive signals, some from the old regime and some from the new reforms. Consider a country that had previously had high and variable inflation, which had been matched by high relative price variability. The approach outlined above suggests that investors will be extremely cautious in reacting to a policy induced change in sectoral prices - quite a bit of time may be required before they regard it as permanent. A very important source of risk or uncertainty stems from the imperfect credibility of policy reforms. Later we will discuss the reasons why the public may fear that reforms may be reversed. The point to stress now is that the possibility of a future policy reversal has been shown to be a key determinant of the investment response. An example is provided by van Wijnbergen (1985) who shows that if the public expects that a trade reform may only be temporary, it can lead to a fall in investment and increase in capital flight, since there is an option value to holding liquid assets. Investors postpone investment in both the traded and non-traded sectors in order to wait for additional information. Rodrik (1991) shows that potential investors will require a large current return to compensate for the possibility of a costly mistake should policy be reversed. Even moderate amounts of policy uncertainty can imply that large increases in the required return on capital are necessary to induce investment in the newly favoured sector. Pattillo (1996) finds that when a firm is faced both with ongoing uncertainty about demand and costs, as well as uncertainty about the timing of a possible reform reversal, the firm is more hesitant to invest. It also is more sensitive to

Investment and Risk in Africa

13

ongoing uncertainty and has a smaller investment response to currently favourable trends. It is important to emphasize that policy reversal is often an endogenous result of the lack of private sector response. One example is a trade reform that initially lowers government revenue. If higher investment in the tradable sector does not materialize, then excessive deficits may later lead to the abandonment of the reform. Uncertainties over domestic economic policies and the option to wait are also relevant to understanding the slow pace of privatizations in Africa (Adam and Bevan, 1 995). Uncertainty over the future profitability of these assets can stem from the absence of realistic asset valuations; uncertain costs of future retrenchment programmes; and the uncertain costs of capital restructuring as formerly protected parastatals are required to compete in liberalized markets. If there is some uncertainty surrounding government financial liberalization policies, potential owners may find it difficult to project the cost and availability of credit. Given these considerations, it is possible that the sale price where the investment would be 'in the money' - where the return today is greater than the option value of waiting - could be zero or even negative. Given the political limits on how low the sale price can actually go, some governments are beginning to focus policy efforts on the factors that can contribute to the high option value of waiting. For example, the development of leasing and other partial sale mechanisms can allow private sector purchasers to limit the irreversibility of their investments. Note that in all of the models above, the firm has been characterized as risk­ neutral. However, Adam and O'Connell (1997) point out that like rural households, many African firms may have limited access to insurance mechanisms and thus are likely to exhibit risk-aversion. Firms may prefer a reduction in profit variability to a small increase in expected profits. Thus, they will choose safe, but lower-yielding investment activities that are easily reversible. 4 Projected returns from investment in wholly new types of manufacturing activities in African countries are difficult for potential investors to evaluate. The information on projected returns may be so vague and conditional on unknown factors that it is impossible to assign any probabilities to the possible distribution of returns. Aizenman (1997) demonstrates that this Knightian uncertainty can inhibit the development of new products and activities, which, as in the endogenous growth literature, can lower growth. Empirical studies of risk and investment Deriving an estimable investment model from the investment under uncertainty theory is a difficult task that has not yet been successfully undertaken. Numerous studies, however, have found that the volatility of

14

Investment and Risk in Africa

inflation, real exchange rates, profitability and aggregate GDP are negatively related to investment in cross section or time series studies. 5 It is worthwhile to mention a few innovative studies that use data from developing countries. Pindyck and Solimano (1993) test the following implication of the model. When investment is irreversible, firms wait to invest until the marginal revenue product of capital (MRPK) reaches a trigger point, where the trigger is increasing in uncertainty. The study uses the highest observed value of the MRPK as a proxy for the investment trigger and the standard deviation as a proxy for uncertainty. Panel regression results demonstrate that the investment/GDP ratio varies positively with the investment trigger proxy and negatively with the uncertainty proxy, as predicted by the theory. Aizenman and Marion (1994) focus on policy uncertainty, proxied by the volatility of government consumption expenditures, budget deficits, and nominal money growth. The authors find evidence of a significant negative correlation between policy uncertainty and private investment in a cross­ section of developing countries using data from the period 1970 to 1993. Ibarra (1995) tests whether lack of credibility of the trade liberalization in Mexico after 1985 deterred investment. He uses a probit model to measure the probability of trade policy reversal given the potential of an impending balance of payments crisis. The results show that the probability of reform reversal slowed the investment response during the first years of the reform. A few recent studies have tested the impact of country risk ratings on cross­ section investment/ GDP ratios. Jaspersen et al. (this volume) find that the ICRG risk index has a significant negative relationship with private investment rates across countries. In Keefer and Knack (1995), the BERi indices of property rights have a strong negative effect on private investment, controlling for other determinants of investment. This result holds when other global measures of political instability and civil liberties are included in the regressions, indicating the distinct role of institutions that protect property rights in creating a favourable environment for private investment. Mauro (1995) uses both the cross-section and time series aspects of the data to examine the impact of the disaggregated political risk indices produced by risk rating agencies. He forms two indices that represent political stability and bureaucratic efficiency. The results are consistent with the following interpretation. Over long time periods, the variation in both political stability and bureaucratic efficiency play a significant role in explaining average total investment rates. However, only year-to-year changes in political instability, not changes in bureaucratic efficiency, are important for explaining move­ ments in annual investment rates. In the cross-section results, a one-standard deviation improvement in the bureaucratic efficiency index is associated with an increase in the investment rate by 4.75 per cent of GDP. These results are found to be robust to changes in the conditioning set of additional variables in the regression, following the Levine and Renelt (1992) procedure.

Investment and Risk in Africa

15

In contrast with aggregate studies, one of the major advantages of using firm-level data to explore the investment-uncertainty relationship is that it allows one to use measures of uncertainty specific to the firm's environment. There are, however, few empirical studies using firm-level data. One example is Leahy and Whited (1996), which uses a panel of US manufacturing firms. A measure of uncertainty is obtained from the variance of the firm's daily stock returns. The authors then construct volatility forecasts, since an ex ante rather than an ex post measure of the volatility of asset returns is required. The results confirm that the uncertainty of expected asset values is negatively related to firm investment in reduced form panel regressions. Pattillo (this volume) analyses the impact of uncertainty on the investment behaviour of Ghanaian manufacturing firms using a panel data set. An uncertainty proxy is derived from the standard deviation (within an industry group) of the one year ahead expectations of demand changes reported by the firms. Greater dispersion of demand expectations across an industry selling similar products is taken to imply greater uncertainty about product demand. A proxy for the irreversibility of investment is derived from indications of which firms bought used capital, leased capital or sold capital, indicating the extent of second-hand markets. The empirical results support the literature's predictions that uncertainty has a larger impact on firms with more irreversible investment. How does policy reform affect perceived risk? We have seen how policy reform, although expected to lower uncertainty in the medium to long term, can give rise to the risks of policy reversal that can create a serious impediment to investment. To enhance the credibility of the reform, the government must develop mechanisms that both lower the potential future incentives to reverse the reform and 'lock-in' the policy so that it is very difficult to change should the temptation still arise. Below we will discuss which types of 'agencies of restraint' could best mitigate fears of policy reversal that stem from different sources. First, however, let us consider which types of reforms may have positive externalities in terms of reducing perceived risks, over and above their standard desired effects. One example relates to the design of a trade policy reform. Rodrik (1989) argues that provided the trade reform is consistent with macroeconomic equilibrium, there is less chance for reversal when the range of reform is narrow, while the magnitude is large. A big push can combat slow adjustment due to sunk costs and capital irreversibilities, as well as assist in building up a constituency for the reform as soon as possible. Financial sector liberalization may have ambiguous effects on risks for the private sector as well as the government. On the one hand, extensive financial repression policies have played a large role in limiting the development of

16

Investment and Risk i n Aftica

financial systems in Africa, and liberalization should free the system to play one of its critical functions: pooling and diversifying risks. Successfully liberalizing should also reduce private sector uncertainty about the future cost and availability of credit for financing investment. However, financial reforms have sometimes led to periods of financial instability, requiring extensive restructuring of both the banking and real sectors, which can impose huge fiscal costs. A possible negative by-product of these reforms is an increase in risk if the increased public cost of funding a system of explicit or implicit deposit insurance causes the reform package to become macro-incompatible. Reforms that remove anti-export bias and encourage investment in the export sector are common components of adjustment programmes. In the presence of country risk, these policies that increase the openness of the economy can generate positive externalities if they raise the costs of defaulting on international obligations. Generally there is a time-consistency problem with the government pre-committing itself to never defaulting or unilaterally rescheduling. Policies that encourage investment in sectors with large exposure to international trade can improve perceived riskiness since they increase the costs of deviating from the commitment and thereby lower the perceived probability of defaults. Another positive externality from policies that favour the export sector is that if the policy attracts the private sector to invest, it can increase their willingness to pay for the policy in the future. Say the private sector responds by investing in outward-oriented industries. These investments are sunk costs, and the value to the firms of the outward-oriented policy is increased by the value of their sunk investments. Exporters have an incentive to exert political pressure on the government to retain the policy. The idea is that the policy is more likely to be retained if it endogenously generates forces that sustain it. The government can support this development by encouraging the develop­ ment of an exporter's lobby. Privatization policies could also contribute to the development of a political economy where the private sector is strong enough to resist current and future government's urges to heavily tax private capital once it is in place. In Persson and Tabellini (1994), society solves the time-consistency problem of capital taxation by electing representatives who have a higher than average share in capital income. Reforms and country risk ratings It is clear that African governments face a large task in rebuilding reputations after long periods of disastrous policies. However, improving reputations with creditors, donors, foreign investors and domestic investors may require specialized strategies. Some may be linked, others not. Although reputation is impossible to measure, risk ratings provide some information on the

17

Investment and Risk in Africa R"l m11ng (higher mtong = lower nsk) 30

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20

10

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Figure 1.3 Institutional Investor risk ratings for Africa by policy environment Source : Author's calculations

perception of the environment for lending to and investing in a country. We have seen that movements in the ratings are correlated with investment rates, as well as net capital flows. Erb et al. (1996) show that country risk measures are also correlated with future equity returns in both developed country and emerging markets. The ratings show substantial persistence, meaning that in the absence of new information they tend to remain at the same level. 6 Have the country risk ratings responded to the new information from African countries' economic reforms in the 1980s and 1990s? Figure 1.3 shows that the ratings do reflect changes in policy, but the response is slow and relatively limited in magnitude. The graph shows the path of the average risk ratings for countries categorized by the World Bank study Adjustment in Africa (1994) as strong reformers, weak reformers and non-reformers. 7 The strong reformers do improve their ratings, but the process is gradual. Further evidence on the limited magnitude of changes in the ratings comes from comparing two very strong reformers which started with a disastrous inheritance, Ghana and Uganda, with a country like Kenya which never experienced such a complete downturn, but has been characterized more by policy oscillation than sustained reform. Over the period 1987-96 Kenya's risk rating oscillated in the range 31.6-22.8. It was not until 1993, ten years after the start of the reform programme, that Ghana reached even the lowest edge of this range, and Uganda is still far below it after seven years of reform. Comparing the economic record of Kenya and Uganda over the past four years there is little doubt that the latter has performed better: faster growth,

18

Investment and Risk in Africa

lower inflation, peaceful elections, yet Uganda is rated over six points below the lowest rating that Kenya received over the entire previous decade. It would also be interesting to assess whether reforms of similar magnitudes in other regions have led to similar or larger improvements in the ratings of those countries. For example, in response to market liberalization in the 1990s, Vietnam's rating doubled from 16.8 in 1992 to 32.8 in 1 996. Comparison of the rating response to policy change across regions is important (but difficult to implement) because often foreign investors are comparing not one African country to another, but say Southern Africa to Asia. To summarize, by many indicators Africa is a risky place for investment. It may, however, be rated as even more risky than warranted by its economic characteristics. Much of the risk is rooted in the opportunistic behaviour of governments. There is strong theoretical and empirical evidence that risk is a serious impediment to investment, particularly in countries undergoing policy reforms. It is true that policy reform is rebuilding the reputation of African countries, but only slowly and marginally. The crucial question is what governments can do to accelerate this process. Before turning to government's role in attempting to reduce risk, it is important to mention another approach: pooling offsetting risks into investment portfolios. African stock markets are only weakly correlated with other equity markets around the world, so that although the underlying stocks are volatile, their addition to a portfolio can be part of efficient diversification strategy. Up until very recently, the tiny scale of African stock markets has made this approach unimportant. However, there has been recent establish­ ment of a number of Africa funds, and if these grow along the pattern of previous emerging markets, this source of risk-reduction could become important in the future. In Chapter 6, Demby presents a practitioner's approach to portfolio investment in African equities. He stresses that the risk characteristics of African stock markets make them a useful part of a diversified global portfolio. However, portfolio allocation is not straightfor­ ward as many of the standard weighting schemes produce unacceptable risk/ return profiles, implying the need for specialized information beyond the risk premia and company valuations. Although the segmented nature of African equity markets creates potential for risk diversification, it also raises a question about the methodology of Chapter 5, in which Erb et al. use the relationship between country risk measures and equity returns across a sample of developed and emerging markets to establish expected rates of return and volatility for mainly potential African equity markets. As pointed out in the discussion by Senbet, using the same slope coefficients of risk on return from the overall sample to impute returns for Africa is assuming that the prices of risk factors are the same for Africa as for other existing markets, which may not be valid when market segmentation produces different prices of risk.

Investment and Risk in Africa

19

III. AGENCIES OF RESTRAINT AS RISK-REDUCTION MECHANISMS The perceived high risk environment is currently reducing investment in Africa and we now turn to what can be done about it. Naturally, if governments simply maintain reformed policies in place investor confidence will gradually increase. Despite this automatic process of reputation recovery there are two reasons for seeking the reinforcement of agencies of restraint. The first is that the recovery of reputation can thereby be accelerated. Whether this is important depends upon the pace at which investor confidence will recover without overt confidence-building measures. In the absence of overt measures the rate of recovery of confidence may be slow. As a group the 'strong African reformers' identified in Figure 1.1 have improved their risk ratings since the start of their reforms in 1987 at only one point per annum. At this rate it will take them over twenty years to reach the ratings currently assigned to Mauritius, Botswana and South Africa, the only African countries at NIC-levels of risk. Potential foreign investors often know little about Africa because it has not been cost-effective for them to invest in information gathering. With little information about the underlying causes of a country's current good performance, in assessing its durability undue weight may be attached to both the country's own past and the current poor performance of its neighbours. The second reason for seeking the reinforcement of agencies of restraint is that there may genuinely be powerful political forces taking policy back to its pre­ reform configuration. The pre-reform policies usually reflected a domestic political equilibrium which has been disturbed partly by the offer of aid-for­ reform, and partly by the experience of economic disaster. As reform succeeds in bringing the economy back from disaster and the aid is reduced, the former political equilibrium may re-assert itself. Agencies of restraint may have the potential both to reassure investors and to change incentives so as to protect the reforms as a new political equilibrium. Government strategies which are aimed at enhancing credibility can be thought of as a meta-policy: the meta-policy consists not of the economic policy reforms themselves, but for a given set of economic policy reforms seeks to make changes in political institutions which make the persistence of the economic policy reforms more credible. Africa is not alone in having needed such a meta-policy. After World War II Western Europe used the Marshall Plan, the GATT, the EEC and EFTA partly as credibility-enhancing mechanisms. Policy reform in Eastern Europe is a further example. However, investor fear of reversion to communist policies is reduced by the political underpinnings of the policy changes. In Eastern Europe communist governments were overthrown in popular revolutions so that the past history of policy was seen as irrelevant in assessing future risks. By contrast, in Africa political change has been evolutionary so that the past is still seen as a

20

Investment and Risk in Africa

relevant guide to the future. A closer analogy to Africa than the post­ revolutionary Eastern European governments is therefore the evolutionary reforms of the Soviet Union under Gorbachev. By 1 990 Gorbachev recognized that the Soviet Union had a credibility problem with potential investors and addressed their inclination to hold back. He announced: 'Those [companies] who are with us now have good prospects of participating in our great country . . . [whereas those who wait] will remain observers for years to come - we will see to it.' (International Herald Tribune, 5 June 1 990; quoted in Williamson, 1 994, p. 187). Gorbachev clearly recognized the tendency for firms to 'wait and see'. His 'solution', however, was to threaten that those firms which delayed would be subjected to unspecified subsequent discrimination. This 'solution' worsened the problem. Consider what were the likely fears of prospective foreign investors to the USSR. Probably the major fear was that the Soviet state had not, and would not, refrain from the exercise of administrative discretion in a way which could arbitrarily damage firms. This is the sort of risk which firms would find difficult to assess and difficult to insure against. Gorbachev unfortunately achieved a perverse signal with respect to meta-policy of credible commitment, namely that as of 1990 the instincts of the Soviet government were still to threaten arbitrary discrimination. Sources of policy risk We now set out five circumstances in which because a government lacks an ability to lock itself in to a policy change, the persistence of the change can reasonably be doubted by shrewd potential investors. All are pertinent to Africa. Faced with these situations a government would gain an advantage from being able to restrict its own future actions so as to preclude those actions the fear of which will deter investment. The first circumstance is the well-understood problem of time consistency. This problem arises if, were investors to trust to the persistence of a policy reform, the government would have an incentive for reversing it. The most obvious African context for such a problem is with respect to the taxation of mineral and beverage exports. Several African governments have taxed these sectors very heavily. Typically, the capital stocks in these sectors depreciate only very slowly: mines and coffee trees last many years. Once high taxation is introduced, firms and farmers presumably regret having made these investments but have to live with them until the capital depreciates. Suppose that by the 1990s this depreciation has proceeded to such an extent that the high taxation is no longer yielding much revenue. The government, perceiving that it has little to lose, removes the tax and invites renewed investment. The shrewd investor will recognize that post-investment the government's decision problem will be identical to that which prevailed when they had previously

Investment and Risk in Africa

21

invested: once investment has been made, the government has an incentive to impose high taxes. Realizing this, potential investors will hold off: the tax removal loses revenue but does not induce investment. In this situation both the government and investors would be better off if the government could somehow commit itself to refrain from heavy taxation. Only then would there be re-investment and only then would the government experience some recovery in revenue, albeit not back to the level it achieved temporarily with high taxation. The second circumstance is the 'rotten descendent' problem. The better the government, the more it looks ahead. The more forward looking is the government, the more it might fear the 'rotten descendent'. We illustrate this problem with reference to the British budget cycle. During 1967-70 a prudent Minister of Finance accumulated both a balance of payments surplus and a fiscal surplus. Despite this, the government lost the election. His successor relaxed fiscal and monetary policies, triggering a boom and huge payments and fiscal deficits which were electorally popular. The prudence of the first government thus constituted a transfer to an imprudent successor. The political lesson drawn from this experience was to avoid bequeathing a sound economic position to a potential successor government. The general structure of this problem is that the inability of a government to restrain its own successor from actions which it itself would abhor, restricts its own scope for prudence. Only if it can lock in its successors from imprudence will the prudent government save. This type of problem has become much more important in Africa with the greater frequency of government change through the political process. The third circumstance in which the government would benefit from a lock­ in mechanism is where a donor is offering temporary aid during reform. The acceptance of aid contaminates the signal which would otherwise be transmitted by undertaking the reform. Even a government which has no intention of maintaining the reforms has an incentive to embark upon them. Once the aid ends, the government reverses the reforms. Without the aid, by hypothesis a government with such preferences would not embark upon reform so that the only governments undertaking reform would be those which genuinely wanted to make the reforms (although they might genuinely want to make the reforms in order to induce investment which they planned subsequently to tax). The existence of the bogus reformers (the governments which only reform in order to receive aid) creates a signalling problem for the genuine reformers. They can transmit an unambiguous signal by refusing aid, but if they accept aid they weaken the credibility of the reform because potential investors can no longer distinguish between them and bogus reformers. The fourth circumstance in which a lock-in mechanism would be useful is if the government has previously operated a policy rule under which, in present

22

Investment and Risk in Africa

circumstances, it would temporarily change policy. In Africa the clearest instance of this is a trade liberalization during a favourable terms of trade shock. For many years most African governments used trade policy as a macroeconomic instrument to manage their balance of payments. Hence, when the terms of trade deteriorated trade restrictions were tightened, and slackened again when the terms of trade improved, a phenomenon sometimes referred to as an endogenous trade policy. Now consider a coffee-exporting African government during the coffee boom of 1994-95. By then many African governments were planning trade liberalizations for reasons wholly unrelated to the coffee boom. However, such governments now face the problem that liberalization may be misinterpreted as simply a response under the original policy rule rather than a change in the rule. If private agents anticipate that the trade liberalization will be reversed then instead of investing in the export sector they will hoard imports, so that the uncertainty over the interpretation of the policy change might be socially costly. The fifth and final circumstance in which lock-in would be useful is the poor reputation problem. Suppose that a government having followed poor policies for some years realizes that it has been mistaken and so wishes to adopt policy reform. However, it has a poor reputation either because of its own past history or because private agents infer its behaviour from that of neighbouring governments which, let us imagine, have already reversed reform attempts. Because of this poor reputation there will be little investment response to policy reform. In turn, because of the limited investment response, the gains from reform will be modest. Let us suppose that the gains will be too small for the government to survive the political costs of policy change. In this case, the government is compelled to live down to its reputation. Either it attempts reform but has to abandon it, or, more shrewdly, does not attempt it in the first place. If the government could lock itself in to reform it could live down its reputation, which, by assumption, in this particular case is unwarranted. In each of these circumstances the government has a problem caused by not being able to pre-commit itself. Potential private investors are frightened off, reducing growth. In turn, the lower growth prevents the government from making desired expenditures. Thus, the fears of private investors constitute a binding constraint upon the government. If it can reduce these fears the government is better off. The fears of investors concern future government behaviour. The government can reduce investor fears if it can reassure investors that future government behaviour will not include the actions the fear of which deters investment. The most paradoxical aspect of this problem is that, if the government can find a way of precluding these future actions, it does not close off actions which it will otherwise choose to take. The government facing a 'time-consistency problem' because investors fear future high cocoa taxes loses nothing if it can close off this policy as an option. Unless it closes the option, farmers will not plant and so even a high tax will

Investment and Risk in Africa

23

yield very little. Similarly, the prudent current government of a country in which investment is low because of fears of a possible improvident future government does not prevent itself from any actions which it wants to do if it prevents future governments from improvident behaviour. Again, the government which genuinely wishes to persist with reforms, but which faces a credibility problem because it is accepting aid, is not prevented from actions which it wishes to take if it locks into the reforms. The government which wishes permanently to remove trade restrictions but finds itself in the middle of a coffee boom loses nothing if it prevents itself from reversing the liberalization. Finally, the government with a poor reputation which decides to have a permanent policy reform loses nothing by preventing itself from reversing the liberalization. In each of these five examples the government is able convincingly to restrict its future behaviour, although this reassures investors, it does not deny to the government any action which it would otherwise do. Yet by restricting itself, the government is better off and so able to do things which were otherwise infeasible. Thus, paradoxically, by introducing a constraint which it finds non-binding (since no action which it would otherwise do is prevented), the government is able to relax a constraint which is binding (the government will now be able to spend more because growth will be faster). The political institutions which governments build in order to restrain themselves, the building of which constitutes a meta-policy of reform, we term agencies of restraint . They can be classified according to whether they are purely domestic or involve external participants and by whether they work by imposing penalties on the government, or by the government shedding authority. Domestic agencies of restraint Domestic authority-shedding depends upon the credibility of the rule of law and the separation of powers between government, legislature and judiciary. As Widner shows in Chapter 9, the judiciary in Africa has only limited independence and this limits the efficacy of any authority-shedding strategy which depends upon it. In the field of macroeconomic policy the classic domestic authority­ shedding institution is an independent central bank. The evidence on national (that is, domestic) central banks in developing countries is that the rule of law and the separation of powers are not sufficiently well established for the legal form of independence actually to achieve independence. Cukierman et al. (1992) find that whereas in developed countries the greater the legal degree of independence of the central bank the lower is the rate of inflation, in developing countries there is no such relationship. While African states are indeed making progress in establishing the rule of law, the point of an agency

24

Investment and Risk in Africa

of restraint is to increase credibility, so that it works only to the extent that it depends upon relationships which are already trusted. Hence, while independent domestic central banks might be longer term aspirations for the conduct of macroeconomic policy in Africa, their creation would not in the short run reduce the credibility problem. In this volume we focus on the example of the Bank of Uganda. As Kasekende and Hussain describe in Chapter 7, Uganda has a history of disastrous macroeconomic policies which have been revoked during the 1990s. The central bank has been given some degree of legal autonomy. Although it is subject to directives by the Finance Minister, such directives must be approved by Cabinet and Parliament. However, they make clear that to date the key enforcement agency in the highly successful Ugandan disinflation has been not the central bank but the Ministry of Finance, implementing a cash budget rule. The cash budget rule is an example of a variant upon shifting authority to another agency. Instead, authority is removed from the system altogether by adopting a policy rule which eliminates discretion. The cash budget rule works not by locating authority for setting the fiscal deficit with another agency, but by removing discretion from the system. Cash budgets have proved remarkably effective in Africa. Adam and Bevan discuss its efficacy and its costs in the remarkable disinflation in Zambia (Chapter 8). The power of the cash budget rule rests on its simplicity and evident 'good housekeeping' nature. It is defended not by the independence of the judiciary and the legislature but by the coordinating properties of 'common sense'. One problem with such rule-based conduct, however, is that although the rule is 'common sense' it is not necessarily economic sense. A cash budget rule imposes budget balance. Economic models of government fiscal policy can show this to be less than ideal: in a growing economy government debt should increase broadly in line with GDP so that the government should run a deficit. Yet it is precisely at the point at which such complex considerations are built into the budget rule that the coordinating power of 'common sense' evaporates. There can be no equivalent agreement on precisely the size of the appropriate deficit: the power of the balanced budget rule is not that it is right but that it can command consensus. A similar example of authority-shedding in the field of macroeconomic policy is a currency board. A currency board is not simply independent of the government, it is subject to a clear and precise rule of conduct which leaves it no discretion: the creation of a currency board sheds authority from the government, not by locating it with another agency, but by removing discretion from the system. To summarize, African governments wishing to adopt domestic authority­ shedding agencies of restraint are likely to find that authority-shifting is ineffective in establishing credibility. Authority-removal through the pro­ mulgation of simple policy rules may be much more effective, but the

Investment and Risk in Africa

25

consequences are unlikely to be optimal. However, against the background of low credibility and a history of poor policy, the best ( optimal policy) may be the enemy of the good (authority-removal). Penalty-based agencies of restraint work not by shifting authority from the government but by creating an agency which punishes the government if it breaches its policy undertaking. For precisely the reason that firms fear the discretionary action of African governments, governments may find it very difficult to build credible domestic penalty-inflicting agencies. Private agents will suspect that in the event the employees of the agency will be too scared of what the government may do to them to inflict any penalties which are legally appropriate. However, an example of a domestic penalty-based agency, would be for the government to encourage the establishment of a lobby of export producers. By lowering the coordination costs of export producers the government would increase the power of the group to defend its interests against the government, and so reduce the risk of export taxation. Further, by lowering the costs of coordination among businesses the government thereby changes the nature of business lobbying from one in which individual firms seek advantages at the expense of other firms to one in which all firms seek to defend themselves against the government. The case for the assistance of lobbies by the government is analogous to why firms may find it advantageous to have unions: by creating a power against themselves they increase the credibility of their promises. In this volume the domestic penalty-inflicting agency of restraint which is considered is an Investment Authority, implementing an Investment Code. Ailola describes the example of the Southern African code in Chapter 10. Ultimately, they are dependent upon the degree of independence of the courts. Ailola makes the important point that foreign firms may infer the true intentions of the government by observing how it behaves to its captive domestic firms rather than placing confidence in the code itself. External agencies of restraint

External agencies are sometimes cooperatives constructed and run by their members and sometimes wholly distinct from the governments which they restrain. Thus, at one extreme NAFTA is entirely a cooperative of its members. There is no supra-national institution which enforces the rules. Enforcement is entirely by the reciprocal threats of its members: if Mexico imposed trade restrictions on America, America would impose trade restrictions on Mexico. NAFTA is thus a purely penalty-inflicting agency of restraint. To a large extent the European Union works in the same way, although it supplements reciprocal threats with the authority-shedding in some areas of policy. Governments cannot impose trade restrictions on each other without breaching the rules of the Commission. The proposed Euro is a

26

Investment and Risk in Africa

further instance of this blend of authority-shedding and penalties. The removal of national currencies will involve the shedding of authority over some areas of policy, notably on interest rates. National governments will simply be unable to influence national interest rates, not because of penalties but because they will forfeit the ability to do so. By contrast, the 'convergence criteria' for budget deficits envisage penalties being inflicted on governments which set deficits above a particular size. In Africa the main example of an external authority-shedding agency of restraint is the Franc Zone. As with the proposed Euro, member governments forfeit certain policies and are subject to penalties in respect of others. Stasavage discusses the efficacy of the rules in Chapter 11. While the Zone has had several weaknesses, it remains noteworthy that almost all of the original members have chosen to remain in the Zone and have adhered to the rules to a sufficient degree to have had much lower inflation than other African governments. Agencies which are wholly distinct from governments tend to work by means of penalties rather than authority-shedding. In Africa the main instance of this has been that African governments have bound themselves to particular policy changes through donor conditionality. Kanbur discusses the limitations of this approach in Chapter 12. Had donor conditionality been successful, reforming African countries would have much higher risk ratings that are actually observed. A second form of penalty-inflicting external agency is MIGA discussed by West in Chapter 13. Although MIGA sells insurance to investing firms, it recovers over 80 per cent of pay-outs from the governments concerned. Further, it averts most attempted government breaches of contract by taking the part of the affected firms in disputes and persuading the government to modify its behaviour. Thus, the main function of MIGA is to inflict penalties upon a government which breaches its agreement with a foreign investor, thereby discouraging breaches. However, a major drawback with such investor insurance schemes is that they are only available to foreign firms. To the extent that African governments rely upon them as important agencies of restraint they are placing domestic firms at a disadvantage. The last two external restraints considered in the volume are potential rather than present agencies of restraint in Africa. Collier and Gunning in Chapter 14 consider using both the Lome V Agreement between the European Union and the predominantly African group of ACP countries, and the World Trade Organization to lock into trade liberalization. Warner, in Chapter 15, considers using the World Trade Organization to lock into a charter for private investment, in effect an internationalization of domestic investment codes. The World Trade Organization is the main international institution for trade policy lock-in. Through the mechanism of tariff 'bindings' governments commit themselves, at the risk of penalties, not to exceed bound tariff levels. This has been used by most countries in the world to lend

Investment and Risk in Africa

27

credibility to their tariff reductions. It is surely striking that Africa, where trade policy has been at the core of the liberalization process, and which has the most severe credibility problem, has scarcely used this agency of restraint. For example, the government of Uganda has bound only 15 per cent of its tariffs on industrial goods and even these are bound at levels far above actual tariff levels, almost inviting the interpretation that tariff increases might be in prospect. The failure to use the WTO must surely rate as the major missed opportunity in African liberalization. The case for using Lome V is partly that it provides an opportunity which is more immanent than waiting on the next world trade round.

IV. CONCLUSION Africa has so far not attracted sufficient private investment, either domestic or foreign. At present probably the major impediment to private investment is the perceived high level of risk. The risks which deter investors, both domestic and foreign, are mostly related to fears about future government behaviour. Hence, only by reassuring investors about their future actions can govern­ ments generate the large increases in investment needed for rapid growth and poverty reduction. Sustained good economic policies will eventually produce a reappraisal of risks, but this process of reputation building following good performance is very slow for African governments. There is therefore good reason to focus policies explicitly on actions which will accelerate the process of reappraisal. This volume suggests that the way to do this is for governments to build three types of agency of restraint, each of which works by restricting the government from actions which it would not in any case wish to perform but the fear of which are currently discouraging investment. The three are, first, simple rules which have wide agreement, such as cash budgets; second, participation in existing international agencies such as the WTO; and third, the cooperative construction of new agencies which would involve reciprocity between African regional groupings and the EU.

Notes 1. 2. 3.

Collier and Gunning (1999). Bhattacharya et al. (1996) report returns on FDI in the ranges of 24-30 per cent in Africa versus 16---18 per cent for other developing regions during the period 1990-94. Pritchett stresses that the distribution of changes in real exchange rates is highly non-normal because of infrequent very large real appreciations and depreci­ ations, implying that a comparison of real exchange rate uncertainty using

28

4.

5. 6. 7.

Investment and Risk in Africa standard deviations can be misleading. However, Africa still had the highest regional variability when Pritchett computed two alternative statistics. In Fafchamps and Pender (1997) limited credit markets and the irreversibility of the investment implies that poor farmers fail to undertake a profitable investment. They find it difficult to accumulate enough wealth to finance a large, non-divisible investment. Irreversible investments require even higher returns because they cannot be turned into liquid assets should the farmer face an external shock that cannot be smoothed with available savings. For Sub-Saharan Africa see Hadjimichael et al. (1995) Oshikoya (1994) and Fielding (1994). Haque et al. (chapter 2) find that the Institutional Investor ratings exhibited the greatest degree of persistence, while the Economist Intelligence Unit and Euromoney were less persistent. Country categorization follows an updated version of the report by Bouton et al. (1994). Countries were assigned a score for overall change in macroeconomic policies, which is an unweighted average of the scores for fiscal, monetary and exchange rate policy. The analysis is based on the change in policy indicators between the period 1981-86 and 1987-92.

REFERENCES Adam, C. and D. Bevan (1995). 'Investment, Uncertainty and the Option to Wait: Implications for Government and Donor Policies in Zambia', Centre for the Study of African Economies. Adam, C. and S. O'Connell (1997). 'Aid, Taxation and Development: Analytical Perspectives on Aid Effectiveness in Sub-Saharan Africa', Centre for the Study of African Economies, Working Paper 97-5. Aizenman, J. and N. Marion (1994). 'Macroeconomic Uncertainty and Private Investment', Economics Letters 41(2): 207-10. Aizenman, J. (1997). 'Investment in New Activities and the Welfare Cost of Uncertainty', Journal of Development Economies, 52(2): 259-74. Aizenman, J. and N. Marion (1993). 'Policy Uncertainty, Persistence and Growth', Review of International Economics 1(2): 145-63. Aron, Janine (1998). 'Political, Economic and Social Institutions: A Review of Growth Evidence (With an Africa Focus)', Centre for the Study of African Economies, Working Paper 98-4. Bhattacharya, A, P. J. Montiel and S. Sharma (1996). 'Private Capital Flows to Sub­ Saharan Africa: an Overview of Trends and Determinants', mimeo, Research Department, International Monetary Fund, Washington DC. Blakey, G. G. (1994). 'Economic Integration in Sub-Saharan Africa: the Implications for Direct Foreign Investment', mimeo, European Commission, Brussels. Bleaney, M., Gemmell, N. and D. Greenaway (1995). 'Tax Revenue Instability, with Particular Reference to Sub-Saharan Africa', Journal of Development Studies 3 1 : 883-902. Bouton, L., C. Jones and M. Kiguel (1994). 'Macroeconomic Reform in and Growth in Africa: Adjustment in Africa Revisited', Policy, Research and External Affairs Working Paper, The World Bank, No. 1394. Collier, P. (1998). 'The Role of the State in Economic Development: Cross Regional Experiences', The Journal of African Economies, Supplement.

Investment and Risk in Africa

29

Collier, P. and J. W. Gunning (1999). 'Explaining African Economic Performance', The Journal of Economic Literature 37(1): 64-1 1 1 . Collier P., A . Hoeffler and C . Pattillo (1999). 'Flight Capital a s a Portfolio Choice', World Bank PRE Working Paper 2066.

Cukierman, A., S. B. Webb and B. Negapti (1992). 'Measuring the Independence of Central Banks and its Effect on Policy Outcomes', World Bank Economic Review, 6, 353-98. Dixit, A. K. and R. Pindyck (1994). Investment Under Uncertainty, Princeton, NJ: Princeton University Press. Economisti Associati (1994). 'East Africa - Survey of Foreign Investors', consultants report prepared for The World Bank. Erb, C. Harvey, C. and T. Viskanta (1996). 'Political Risk, Economic Risk and Financial Risk', Financial Analysts Journal, 52(6): 28-46. Fafchamps, M. and J. Pender (1997). 'Precautionary Saving, Credit Constraints and Irreversible Investment: Theory and Evidence from Semi-Arid India', Journal of Economics and Business Statistics, 15(2): 180-94. Fielding, D. (1994). 'Price Instability and Investment: Evidence from Africa', CREDIT Research Paper No. 94/8. Glen, J. (1993). 'How Firms in Developing Countries Manage Risk', IFC Discussion Paper, No. 17, The World Bank. Hadjimichael, M., D. Ghura, M. Muhleisen, R. Nord, and E. M. Ucer (1995). 'Sub­ Saharan Africa: Growth, Savings, and Investment, 1986-93', International Monetary Fund Occasional Paper, No. 1 18. Ibarra, L. A. (1995). 'Credibility of Trade Policy Reform and Investment: The Mexican Experience', Journal of Development Economics 47(1): 39-60. Jaspersen, F., A. Aylward, and M. Sumlinski (1995). 'Trends in Private Investment in Developing Countries: 1970-94', IFC Discussion Paper, No. 28, The World Bank. King, R. and R. Levine (1993). 'Finance, Entrepreneurship and Growth: Theory and Evidence', Journal of Monetary Economics, 32(3): 513-42. Knack, S. and P. Keefer (1995). 'Institutions and Economic Performance: Cross­ Country Tests Using Alternative Institutional Measures', Economics and Politics 7 (3): 207-27. Leahy, J. and T. Whited (1996). 'The Effect of Uncertainty on Investment: Some Stylized Facts', Journal of Money Credit and Banking, 64-93. Levine, R. and D. Renelt (1992). 'A Sensitivity Analysis of Cross-Country Growth Regressions', American Economic Review 82: 942-63. Mash, R. (1995). 'The Consequences of International Trade Price Volatility for National Income and Welfare: Theory and Evidence', D Phil Thesis, University of Oxford. Mauro, P. (1995). 'Corruption and Growth', Quarterly Journal of Economics, 1 10(3): 681-712. North, D. (1990). Institutions, Institutional Change and Economic Perfonnance, Cambridge University Press Oshikoya, T. (1994). 'Macroeconomic Determinants of Domestic Private Investment in Africa: An Empirical Analysis', Economic Development and Cultural Change, 42: 573-96. Pattillo, C. (1996). 'The Effects of Regime Switching Uncertainty on Irreversible Investment Decisions', Centre for the Study of African Economies Working Paper, No. 96-9. Persson, T. and G. Tabellini (1994). 'Representative Democracy and Capital Taxation', Journal of Public Economics 55:53-70. Pindyck, R. and A. Solimano (1993). 'Economic Instability and Aggregate Investment', NEER Working Paper, No. 4380.

30

Investment and Risk in Africa

Pritchett, L. (1991). 'Measuring Real Exchange Rate Instability in Developing Countries: Empirical Evidence and Implications', Policy, Research and External Affairs Working Paper, The World Bank, No. 791 . Rodrik, D. (1989). 'Credibility o f Trade Reform: A Policy-Maker's Guide', Th e World Economy 12(1): 1-16. Rodrik, D. (1991). 'Policy Uncertainty and Private Investment in Developing Countries', Journal ofDevelopment Economics 36:229-42. van Wijnbergen, S. (1985). 'Trade Reform, Aggregate Investment and Capital Flight: On Credibility and the Value of Information', Economics Letters, 17. Williamson, 0. E. (1994). 'The Institutions and Governance of Economic Develop­ ment and Reform', World Bank Economic Review, Supplement, 171-97. World Bank (1994). Adjustment in Africa: Reforms, Results and the Road Ahead, New York, NY: Oxford University Press. World Bank (1996). World Development Report, Washington, DC: World Bank.

Part II Risk in Africa: Its Causes and its Effects on Investment

2 Rating Africa: The Economic and Political Content of Risk Indicators Nadeem Ul Haque, Nelson Mark and Donald J. Mathieson

INTRODUCTION This chapter presents results from our ongoing project for evaluating the commercially available, developing-country creditworthiness indicators. Commercial creditworthiness ratings have long been used for the measure­ ment of corporate risk. More recently, country credit ratings compiled by commercial sources have attempted to estimate country-specific risks, particularly the probability that a country will default on its debt servicing obligations. This default risk is measured using country-specific information about political and economic developments that have been identified in theoretical analyses as influencing the ability and willingness to service external debt obligation. These indicators, or risk ratings, have played a critical role in determining both the volume and the spread over London Interbank Offered Rate (LIBOR), of syndicated commercial bank loans to developing countries over the last two decades. Although the mechanisms for providing private capital to developing countries have evolved significantly beyond the syndicated loans in recent years, the concept of country risk or creditworthiness remains both valid and important. This is not only so for the resumed voluntary bank lending to developing countries, but also for the other forms of private capital flows, including portfolio equity and bond flows, which have increased dramatically over the past four to five years. Indeed, many institutional investors from industrial countries can often only invest in instruments that meet or exceed a minimum credit rating standard. In general terms, the indicators of developing-country creditworthiness were affected very adversely by the onset of the international debt crisis in August 1982, when Mexico announced that it could no longer service its external debt. 1 While these ratings remained depressed throughout the rest of

33

Investment and Risk in Africa

34

the 1980s, they began to improve in the early 1990s in response both to the announcement of the Brady Plan to 'writedown' external debt in March 1989 and to significant policy reforms in many developing countries, particularly in Latin America and Asia. Nevertheless, on average, the current risk ratings of developing countries still remain below those before the onset of the debt crisis, although there is a significantly greater variation in ratings across countries than a decade or so ago. As indicated in Figures 2.1 and 2.2, the recovery of creditworthiness ratings in the 1990s was associated with a sharp expansion in portfolio investment flows to developing countries in Asia and Latin America. Interestingly, Billions of US Dollars

Per cent 40 35 30 25 20

Africa

'

Capital flows (right seal�),.

Euromoney rating (left scale) / I I \ I \ I \ I \ \

\

, ,,..

/

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11 10

8

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5

1 5 .___.____,__,____,__�__,____,__,____,__.___.____,.___,____, 4

19&) 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993

Per cent Billions of US Dollars 65 ..------------------------, 70 Heavily indebted countries2

60

Capital flows (right scale) / 55

45

50

Institutional Investor rating (left scale) Euromoney ratmg (left scale) t / -.,

I : , ........ .,,.., I :

/

/

t :'

Figure 2.1

30 20

35

25

40

19&! 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993

Capital flows and ratings

Rating Africa Per cent 75

Euromoney rating (left scale)

70 65 I

I

I

I I

I I

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Asia/

' \

\

\ I \I

I

I

I

I

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60

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Capital flows (right scale)

60

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50 40 30 20

55 Institutional Investor rating (left scale) 50

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 Billions of US Dollars

Per cent 65

55

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Capital flows (right scale) _.·

Institutional Investor rating (left scale) / Euromoney rating / (left scale) /' / / : I .: .- -

45

35

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-..__--'-_,___.__-'-__,'-----' 0 25 '----'-----'1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993

Figure 2.2 Capital flows and ratings

although creditworthiness did not improve for Africa, there was a significant increase in capital flows in the 1 990s, albeit from a very small base. While events in Mexico in December 1994 illustrated how quickly market creditworthiness perceptions can change, it is nonetheless evident that achieving sustained access to international capital markets in order to increase the supply of investment funds will be a key policy objective for many developing countries during the rest of the 1990s and beyond. If one of the objectives of an adjustment programme is to help achieve or restore access to international financial markets, then the issue of what policies or economic developments are likely to make the largest contribution to restoring creditworthiness will be important to the design of these programmes. The

36

Investment and Risk in Africa

empirical analysis of the economic determinants of the country's creditworthi­ ness indicators presented in this chapter provides some evidence on this issue. While a number of previous empirical studies have examined the economic determinants of country creditworthiness, this chapter extends the literature in the following five ways: (a) it utilizes three separate measures of country risk ratings, and employs a comprehensive set of explanatory variables to explain these ratings; (b) it pays much more attention to the dynamics and the lag structures of explanatory variables; (c) it uses a much larger sample of countries, and the longest time series, as well as the most recent data, of any study to date; (d) it analyses the degree of persistence or inertia in country credit ratings; (e) it examines the extent to which there are significant differences in the determinants of ratings across groups of countries, using dummies for countries in different geographical regions; and (f) it examines the impact of both political and economic variables on creditworthiness. In examining the empirical determinants of creditworthiness ratings, the key issues are what economic, political and social factors influence credit rating agencies' decisions and to what extent these factors are consistent with the political economy theories of the determinants of creditworthiness that have been developed. These issues are examined in the following five sections. The following section describes the methodology used in the 'Institutional Investor', 'Euromoney', and the 'Economist Intelligence Unit' to compile their creditworthiness indicators. The next section provides an assessment of the degree of co-variation and persistence in these country credit ratings. Next we examine the theoretical approaches to the determinants of country creditworthiness and discuss the methodology and the variables used in this paper. This is followed by a review of the previous empirical investigations of creditworthiness indicators and situates the contribution of this study. The following section discusses our empirical results. A summary of our main conclusions and policy implications is used in the final section. INDICATORS OF COUNTRY CREDITWORTHINESS Our study extends the earlier analyses by examining the behavior of three creditworthiness series over the longest time period used to date - two for more than a decade and a third since its inception in 1987. Our dataset consists of the credit ratings constructed by the Institutional Investor (11), Euromoney (EM), and the Economist Intelligence Unit (EIU). While all three credit ratings are designed to measure a country's ability and willingness to service its financial obligations, they are based on different methodologies and compiled by quite different groups of experts (see the Appendix at the end of this chapter). The II is based on the weighted evaluations of the staffs of about the largest 100 international commercial banks; whereas the EM index reflects

Rating Africa

37

assessments of a country's creditworthiness by panels of political risk specialists and economists. In contrast, the EIU index reflects an evaluation by the EIUs own staff. The three indices are based on the evaluations of a number of macroeconomic, financial, debt-servicing and political factors (Table 2. 1). The macroeconomic and financial variables are designed to measure a Table 2. 1 Rating agencies: Criteria for assessing country risk Rating Agency

Criteria for Ratings

Institutional Investor

Information provided by 75 -100 leading international banks who grade each country on a scale of 0-100, with 100 representing least chance of default. Individual responses are weighted using a formula that gives more importance to responses from banks with greater worldwide exposure. Criteria used by the individual banks are not specified.

Euromoney

Assessment based on three main indicators: Analytical indicators ( 40% ): Political risk (15%) Economic risk (10%) Economic indicators (15% ); ( debt service/export, external debt/GNP, balance of Payments/GNP) Credit indicators (20% ): Payment record (15%) Rescheduling (5% ). Market indicators ( 40% ): Access to bond markets (15%) Selldown on short-term paper (10%) Access to discount available on forfeiting (15% ).

Economist Intelligence Unit

Medium-term lending risk (45% ): Total external debt/GDP, total debt serving ratio, interest payment ratio, current account/GDP, savings/investment ratio, arrears on international bank loans, recourse to IMF credit, and the degree of reliance on a single export. Political and policy risk (40%) Short-term trade risk (15%)

38

Investment and Risk in Africa

country's capacity to service its debt obligations and the scale of its current commitments. These variables include a country's rate of growth, the ratio of savings to investment, the current account balance relative to GDP and the ratios of external debt to GDP, debt service payments to GDP and interest payments to GDP. In addition, a country's vulnerability to external shocks is also gauged by its degree of reliance on a single export good. A country's willingness to service its financial obligations is proxied by both financial variables such as arrears on international bank loans, reschedulings, access to bond markets, and cost of various forms of trade credits, and by political considerations which typically involve a subjective evaluation of the policies toward foreign creditors, the likely policies of opposition parties, the capacity of the government to implement the measures needed to stabilize the economy and meet external payments, and the likelihood and potential effects of any political instability. 2 While the summary description of the criteria for assessing credit risk provided in Table 2.1 suggests a precise relationship between a country's credit rating and the individual political, economic and financial variables, it is evident that judgmental factors play an important role both at the level of evaluating the individual economic and political variables ( eg, judging the degree of political stability) and in determining the weight attached to the individual variables within each group of factors. Given the role of these judgmental considerations, the historical role that individual economic and political factors have played in determining a country's creditworthiness rating can only be identified through an empirical analysis. One of the surprising features of the credit rating systems is the seemingly limited role assigned to external factors in determining a country's credit­ worthiness. The primary external factors that are considered are country specific such as external debt or dependence on a single export. However, the experience of the debt crisis in the 1980s demonstrated that external financial market developments (such as a sharp rise in international interest rates) and crises in neighbouring or economically similar countries can influence a country's access to international financial markets. Although these factors are not discussed explicitly in the description of the rating process, such external considerations may nevertheless indirectly affect the compilers' evaluations. We will, therefore, test to see if external developments can affect credit ratings. THE RATINGS - THEIR TRENDS AND COVARIANCE The different techniques used to compile these creditworthiness indices raise the issue of whether these ratings have evolved in a similar manner over time. To make this comparison, we first consider the behavior of the ratings for the

Rating Africa 80 -------------Economist a. Asia _ 75 .. . - · · \ Intelligence Unit . .. -:: ::: , ,,,, __.:.:· 70 ' .... - - . . . . ·.. , , ·· ... · . 65 ·•,,• . : .Euromoney •.._- -- · · ··

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50

1980 81 82 83 84 85 86 87 88 89 'Xl 91 'J2 93

60 -------------55 50

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c. Middle East

Economist . ,,.; , Intelhgence U111r:'" .. ----"'./, / y ur \ __ / � :���: / . -..:.,;;.__._---.:.,,__ _ L-�-\i Institutional Investor

1980 81 82 83 84 85 86 87 88 89 'Xl 91 'J2 93

60 �------------e. Western Hemisphere Economist 55 Intelligence Uni_t.. �� < Euromo �X,- . . //> -�,:-� 40 � - . __ ·... · ·. 35 / Institutional Investo 30 ',, / 25 1980 81 82 83 84 85 86 87 88 89 'Xl 91 'J2 93

39

-------------- 55 b. Africa 50 \._ Euromoney 45 ... ... _ _ . . - ·'-" "'"•::: __ _ __ 40 · ··· ··· _ _ Economist,_ 35 ' Institutional Investor Intelligence Unit 30 25 1980 81 82 83 84 85 86 87 88 89 'Xl 91 'J2 93 ------- 55 ------d. Europe,. . . . , 50 Euromone L ..-···· · · /· ·\ ' _ 45 ': ·- - - . . . . ,/ Economist \ . ' 4o ·-· Intelligence Unit \-.. . / ''' : 35 1 30 Institutional Investor - 25 1980 81 82 83 84 85 86 87 88 89 'Xl 91 'J2 93

45 Institutional Investor L,,---'--'--�c;::::;:::::i::==:i:,..,=::J 40 1980 81 82 83 84 85 86 87 88 89 'Xl 91 'J2 93

Figure 2.3 Credit ratings over time: regional averages

various country groupings and then examine the correlations of the three series for each country over time. To measure the extent of the co-movement of three ratings, we employ Kendall coefficients of concordance as well as principal component analysis. Creditworthiness of country groupings over time

All three ratings show a considerable variation across countries and over time. Figure 2.3 displays the average of each rating for the developing countries in Asia, Africa, the Middle East, Europe and the Western Hemisphere. For the II and the EM indices, which have been available since 1981 and 1982, respectively, the data suggest the possibility of three distinct regimes: the period of the debt crisis, a period of consolidation, and finally a period of rebuilding creditworthiness. During the debt crisis of the early 1980s, the (11) and (EM) ratings generally declined across all regions. 3 After a period of consolidation, an improvement in the ratings for the Asian, Middle Eastern, and Latin American countries is seen in the late 1980s. The improvement is not uniform across countries or regions as creditworthiness appears to have declined in Africa and Europe. Figure 2.4 displays average ratings for countries grouped according to their principal export orientation, while Figure 2.5 plots the average ratings for countries grouped according to their borrower classifications (panels a to c).

40

Investment and Risk in Africa

65 r==--=----c-----�---,--� Economist a. Fuel 60 .. _ exporters Intelligerce Uni\. . · . 55 ·· · .. . . \.�urom ?··· ···/ ·'c. =>-�� _ : � �

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25

1980 81 82 83 84 85 86 ITT 88 89 SO 91 92 93

----� 50 .----cc------c--c. Exporters of primary products 45 "" .. · Economist Intelligence Uni\, ,...-:::· · . 40 .. .. . Eurom���X.... ./.: . 25 20 Institutional Investor 15 1980 81 82 83 84 85 86 ITT 88 89 SO 91 92 93

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1980 81 82 83 84 85 86 ITT 88 89 SO 91 92 93

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65 .----=---,---,-,--,,-���-� .....4.Countries with divesified exports 60 Economist ··. . Euromoney. · · •.. . Intellig,�ce Unit _ :-::-----..:-:45 . . . . . .. ... . 40 · 35 Institutional Investor 30 1980 81 82 83 84 85 86 ITT 88 89 SO 91 92 93

;g

___

Figure 2. 4 Credit ratings over time: averages for export orientation categories � 65 ,-------------Economist a. Market borrowers ) ntellig�c.: Una 60 ./ . Euromoney .•·· · \.__,/ ···....':.lsla Zm>obwe I"")' Coos, Sou1h Africa Country

Figure 6.1 Market capitalization weights applied to regional African stock markets this leads to a huge proportion (90 per cent) of the portfolio being placed in South Africa which implies an extremely undiversified portfolio. The turnover weighting is not significantly different from market capitalization. The GDP weighting also yields a portfolio skewed largely toward South Africa, so these methods still lack diversification benefits. Using the simple method of equal weighting allocations provides adequate diversification but takes no account of the differential returns available in the various markets. Market capitalization Market capitalization weighting is based upon efficient markets theory which holds that all countries' returns should be integrated. This makes market capitalization weighting optimal since residual risks are minimized. In Africa, however, the assumption of integration is questionable. The risk-return characteristics of this allocation strategy are that the performance will be very dependent upon South African investment performance. There will be little risk of significantly different performance from the South African market and although South Africa has, by African standards, a relatively low volatility we believe that insufficient use is made of the remaining markets. Stock market turnover Trade turnover is another possible allocation method. It favours markets with high levels of turnover on the basis that turnover is related to the investment outlook of a market. This is debatable, however, as low turnover, value markets are precisely the sorts of situation that an investor seeking enhanced performance is trying to identify. In this circumstance, the resultant allocation is still heavily skewed towards South Africa with an 80 per cent allocation.

162

Investment and Risk in Africa

I____.�-

GDP Wolgj11

! !..__ I _____I____,_ _____ _ ----------■------_...._I____ O>la,l,y

Figure 6.2 GDP weights GDP weights

An alternative benchmark formulation involves using GDP weights on the basis that these are a more accurate reflection of a country's economic importance within Africa. This basis reduces the influence of South Africa on the portfolios although it remains dominant. Equal weights

An equal allocation is simple to construct. It suffers from not having any basis on which to seek either higher returns or lower risks. It is a simple allocation method, which achieves good diversification, but if rigorously applied can lead to excessive allocations to very small markets. There are practical solutions involving constraining the allocation using predetermined algorithms. RFM weights

Our preferred method is to generate portfolio allocations by reference to the relative attractiveness of individual markets and the additional risk of each

1

II�.I____,______. 1 l_________1 Bolswana

EO\'PI

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Konye Mlurllul McNooooN.,.,._ Nigorla lw,y Coo$1

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Figure 6.3 RFM weights

Toriolo

-

South Alricll

i

0-....

Risk and Portfolio Investment in Africa

163

market. It is our view that the investor in African portfolios, at this stage of development of the region's stock markets, is seeking a rather ill-defined objective. We believe that investors' true preferences lie somewhere between GDP weights, equal weights and the portfolio of African countries which minimizes absolute risk. Of these three we choose to optimize towards minimum absolute risk. In fact, since we are very active managers we deviate substantially from the minimum risk portfolio which makes the modest differences between minimum risk and equal weight rather insignificant. We use an in-house optimization method combining our systematically determined country valuations with a regularized covariance matrix to arrive at target allocations. This allocation yields a relatively even distribution of the country allo­ cations with a relatively low weight to South Africa since we believe that other markets offer better value.

COMPARISON OF WEIGHTING METHODS An ex ante determination of the expected returns of a given allocation strategy is generally inadvisable but we can look at the risk arising under each allocation scenario. To permit a fair comparison we have made the assumption that markets are uncorrelated, implying that the relative sizes of the volatilities are accurate although the absolute levels are underestimated. This shows that the most evenly diversified portfolio has lowest risk. Table 6. 4 Expected volatility given zero correlation Volatility (%) Market capitalization weights GDP weights Equal weights RFM weights

21 15 11 14

The weights we advocate take on some excess risk in order to increase exposure to those countries which have the most attractive value characteristics. In summary the RFM portfolio allocation system appears to meet investor's views of the 'Africa Investment' concept, achieves low risk through broad diversification, and gives near optimal exposure to markets we feel offer the best opportunities.

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Investment and Risk in Africa

CONCLUSION African equity markets are the newest stock markets to emerge and have all the characteristics of markets at that stage of development. There are corresponding risks which we have argued can be managed in the following manner. First, by taking account of local political and commercial conditions; and second, by the adoption of an allocation process which diversifies exposures so as to limit the level of risk taken on in the quest for enhanced performance. We have seen that there are two principal risk components incorporated in fair investment valuation. One is the sovereign or country risk premium required by investors as reward for investment in foreign countries. The other is the market risk premium required by all investors as reward for uncertainty related to investing in the equity market. Country Risk: The assessment of country risk premia is often unsystematic and excessive. Valuation levels are consequently often relatively low. The Africa excess risk dummy can be observed by the high levels of risk implicit in these low valuation levels compared with a more objective/explicit evaluation of country risk. It is vital that evaluation of country risks in Africa is performed on a basis which is objective and consistent with other countries. Market Risk: African stock markets have very attractive risk characteristics

which make them a useful part of a diversified global portfolio. Within the region, the lack of market integration means that passive market capitaliza­ tion weighted allocations are not necessarily optimal and are inadequately diversified. It is appropriate, therefore, to incorporate expected returns (inversely related to valuation levels) in investment allocations.

A further implication is that any study of characteristics affecting investment in Africa cannot be restricted to measuring risk. It must simultaneously address the anticipated level of investment returns. African investment is inhibited by the perceived levels of risk, but it is also impacted by possible failure to assess the attractive returns available due to the low valuation levels of investments. Investors must recognize the risks, evaluate them objectively, manage them appropriately and above all diversify.

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REFERENCES AND FURTHER READING AIMR (1993). 'Equity Securities Analysis and Evaluation', (mimeo). Economic Intelligence Unit (1996). 'Country Risk Service', (mimeo). Ellis, S. (1996). Africa Now: People, Policies and Institutions, London: J. Currey. Elton, E. J. and Gruber, M. (1987). Modem Portfolio Theory and Investment Analysis, New York: John Wiley and Sons. Francis J. C. (1997). Investments: Analysis and Management, New York: McGraw-Hill. Hartland-Peel, C. (1996). African Equities: A Guide to Markets and Companies, London: Euromoney Publications Pie. International Finance Corporation (1996). Emerging Stock Markets Factbook, Washington, DC: International Finance Corporation. Morgan Stanley Inc. (1996). 'Fixed Income Emerging Market Research', (mimeo). New African Yearbook (1995-96). London: LC. Magazines, Ltd. Supplements to the Mining Journal on Emerging Markets and African Mining (1995). Mining Journal.

Part III

Reducing Risk through Domestic Agencies of Restraint

7 The Central Bank as a Restraint: the Experience of Uganda Louis A. Kasekende and Iftikhar Hussain INTRODUCTION Uganda has made impressive progress over the last ten years, registering East Asian tiger-like growth rates. In part, this growth can be attributed to the 'peace dividend' as the social structure, which had been horrifically disrupted, returned to normal. In recent years the authorities have demonstrated their commitment to maintaining macroeconomic stability and this has undoubt­ edly contributed greatly to Uganda's success. But economic performance was not always this good. Through the late 1980s and early 1990s, although relatively high GDP growth was achieved (see Table 7.1) there were significant slippages in the government's implementation of economic reform. The crunch came in 1992, when there was a full blown fiscal crisis and the 'printing press' was deployed, resulting in very high inflation. 1 Following the crisis, the realization of the need and desire for change came from the highest Table 7. 1 Macroeconomic indicators

Growth in total GDP (% p.a.) Growth in monetary GDP (% p.a.) Money, M2 (as % of GDP) Growth in average level of M2 (p.a.) Average end-period inflation (p.a.) Private investment ( as % of constant price GDP) Government recurrent revenue (as % of GDP) Government total expenditure (as % of GDP) Source: Background to the Budget

169

Average 1986/87-1991/92

Average 1992/93-1994/95

5.2 6.7 6.3 105.5 107.6

8.0 9.5 8.6 35.1 5.7

6.6

9.0

6.2

9.7

14.6

20.3

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levels of government. The President changed the team in charge of the economy with the instruction that fiscal discipline was to be strictly adhered to. To date, the authorities have delivered on their promise of cutting the budget deficit and attaining low inflation. In addition, dependence on external financing ( aid) has decreased in recent years as government has made progress in mobilizing revenue domestically. 2 Today, the central bank in Uganda is at an interesting juncture. The Bank of Uganda (BOU) no longer acts simply as the printing press for government and the parastatals. It has gained a certain degree of autonomy through legislation, and there have been important changes in the financial sector which enable it to exercise some control on the markets. These are the issues which this chapter attempts to address. First we review the literature on central bank independence and explore what type of monetary policy anchor exists in Uganda. Then we describe developments over recent years which give BOU more autonomy vis-a-vis the government and parastatals. There follows an investigation of monetary transmission mechanisms, their relevance to Uganda, and the ability of the BOU to influence conditions in the market place. Finally, we draw some conclusions. CENTRAL BANK INDEPENDENCE: TYING YOUR HANDS AND BUILDING A REPUTATION A rich literature has evolved on the subject of central bank independence. Most studies address the issue of inflationary bias inherent in monetary policy via dynamic (time) consistency, precommitment ('tying ones hands') and reputation. Inflationary bias is thought to arise because a central bank (or more generally, the monetary authority) may promise low inflation, but because this is not perfectly credible the resultant (non-cooperative) equilibrium yields relatively high inflation. Consider, for example, a two period game between the central bank and private agents, where the latter group set prices in the first period which remain fixed in the second period. The central bank promises to deliver low inflation in the second period, which agents could use to guide prices in their contracts. However, if there is an adverse shock to the economy in the second period the bank's incentives will change. In an effort to minimize the impact on real activity, the central bank accommodates the shock, and inflation turns out to be higher than originally promised. Hence, rational agents, recognizing the time inconsistent nature of the bank's promise of low inflation, incorporate high inflation into their wage and price contracts in the first period. The central bank is then forced to live with higher inflation and with reduced ability to generate inflation surprises.

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To extricate itself from this dilemma, two related solutions have been proposed. First, the central bank can try to build a reputation for itself. One possibility is to minimize the influence of the government (politicians) on monetary policy decision making by changing the institutional and legal structure. The argument is that a more autonomous central bank will be less inclined to generate extra inflation in order to boost the economy. This will be so if the central bank is more conservative than the government and, moreover, has a reputation for being so. Private agents will recognize this and lower their expectations of the inflation rate and hence programme in lower inflation into their price contracts. The result will be a reduced inflation bias in the economy. But an inflation-fighting reputation cannot be achieved overnight: there is always the possibility that the central bank could be bullied into loose money even after so-called 'independence'. Barro (1986) and Backus and Driffill (1985) adapt the Kreps and Wilson (1982) reputation model to investigate how private agents and policy makers engage in strategic games in order to establish, over time, the willingness of the authorities in fighting inflation. However, as Rogoff (1985) has pointed out, there is a tradeoff between the reduction in the inflation bias with a more conservative central bank, and the degree of inflexibility the central bank exhibits in the face of shocks. Ultimately, the central bank should not have widely diverging inflation preferences from that of society: 'The need for flexibility makes it undesirable to have a monomaniacal inflation fighter at the central bank'. 3 The second type of proposal for lowering inflation bias is for the central bank to commit itself to a transparent target. The bank is then said to have 'tied its hands' and is less likely to renege on its promises. The UK's membership of the European Exchange Rate Mechanism is a good example of precommitment. When the UK joined the ERM in 1990 it was widely seen as a precommitment since by effectively pegging the pound to the deutsche­ mark the Bank of England did away with discretionary monetary policy, as well as an attempt to gain credibility by association with the Bundesbank. However, the suspension of the pound from the ERM in 1992 following much speculative activity on the foreign exchange markets serves as a reminder of the inherent dangers of maintaining a rigid monetary target. In recent years many central banks have adopted an explicit inflation target as the anchor for monetary policy. Although price stability is usually the goal of the central bank, what is novel in these inflation target regimes is that the inflation target is made explicit and there is usually no intermediate target. The central bank usually considers a range of indicators as a guide to future inflation. Given the time lags between monetary policy action and the ultimate goal of low inflation, inflation targeting may be considered less transparent than, for example, monetary targeting. What is at stake is the reputation and determination of the monetary authority as an inflation fighter

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in light of its success or failure in attaining the stated inflation goal. Inflation targets have been adopted by countries either as a means of reducing inflation after disappointing results from targeting monetary aggregates (New Zealand and Canada) or as an attempt to restore credibility and find a new anchor after being forced to abandon exchange rate pegs (UK, Sweden and Finland). 4 In Uganda the anchor for monetary policy is provided, in part, by the BOU's base money programme. The path for base money, commercial banks' reserves plus currency issued, is determined by projected broad money (M2) growth. This in turn is anchored by the projections for net domestic assets, ie the banking system's credit to the government plus credit to the private sector, and the international reserves component of net foreign assets agreed annually by the BOU, the Ministry of Finance and the IMF as part of Uganda's ESAF Program. To the extent that the authorities are committed to macroeconomic stability and there are other costs such as reductions in donor funds associated with missing targets by a wide margin, the precommitment can be said to be a credible one. Having said this, it should be pointed out that forecasting an accurate path for base money relies on a stable money demand function as well as a stable money multiplier. Given the rapid structural changes the Ugandan economy is undergoing, both of these requirements are somewhat problematic. 5 Nevertheless, given the rather patchy record of adherence to programmes negotiated with the IMF in many counties, precommitment is far from a foregone conclusion. 6 The fact that the Ugandan authorities have been relatively successful in attaining their goals will have led to some degree of reputation building. The results can be felt in the changed expectations in the private sector. Witness, for example, the rapid non-inflationary growth in broad money and the remarkable stability of the shilling, even over the recent election period. Any 'rolling back' on the part of the authorities would likely result in a sudden loss of reputation, as the policy makers are revealed as 'weak' in the Kreps-Wilson paradigm, and a shift in expectations. But who are these 'authorities' engaged in reputation building in Uganda? Given the low level of development of the financial sector the role of the fiscal authority in price stability is crucial. Nevertheless, to the extent that the Bank of Uganda statute lays down strict limits on the allowed level of government borrowing from the central bank, the argument that its balance sheet and hence monetary policy is driven largely by government action has become less true. At present, on a net basis the government is saving with the Bank of Uganda. Roughly speaking, the counterpart to these savings is BOU's NFA (government savings are mostly out of donor financing). This is mostly out of the BOU's control, although BOU's intervention in the foreign exchange

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market does impact on NFA. Where the BOU does influence developments is through the effect of treasury bill issuance on the level of commercial banks' reserves. These developments in tum have an effect on interest rates, credit availability and, ultimately, on growth and prices. In addition, given the hard budget constraints banks are now faced with in terms of meeting reserve requirements, credit to banks is no longer an elastic item in the BOU's balance sheet. It is these questions of central bank control and effectiveness we address in the next two sections. EXERCISING CONTROL (I): GOVERNMENT AND PARASTATALS Honohan and O'Connell (1996) maintain that the most important questions regarding monetary policy in African economies are who has the use of monetary resources and with what cost to inflation. To help answer these two questions they divide African monetary regimes into four categories. Regime 1 is the 'currency board' or rigid rule based system (typified by the CFA countries); regime 2 is the 'printing press', whereby the central bank accommodates all shocks and finances the government's deficits; regime 3 is the rationed case, where price controls limit the degree of market clearing; regime 4 is the preferred one of 'discretionary central banking'. In this last category the central bank makes use of a variety of instruments to inject or take out liquidity from the system, without losing sight of the inflation goal, while institutional arrangements ensure that the government does not have automatic access to money printing. Over the past few years the Bank of Uganda has been trying to move away from a printing press regime to one of more autonomous central banking. This has been aided by the fact that the government has been saving with the banking system, mostly with the BOU. From the early 1970s to the late 1 980s the Bank was able to enforce little restraint on both the government and the parastatals. In fact, the role of the monetary authority was exactly the opposite: bail out government and its various arms every time bankruptcy threatened. Parastatal bodies grew in importance from 1 972 on, following the ejection of the Ugandan Asian community under the Amin government, and the subsequent 'nationalization' of their enterprises. These and other parastatals were expected to provide a developmental and social welfare role in the economy. In turn, the parastatals were favored with credit at below market rates, as well as being given preferential access to foreign exchange from the central bank. Although the foreign exchange was cheap - under the regime of foreign exchange controls all foreign exchange earnings had to be submitted to the BOU at a highly appreciated shilling rate - it was often not paid for. 7

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Of the parastatals, arguably the most important in terms of its impact on the BOU's balance sheet was Uganda Commercial Bank (UCB), the largest, most dominant player in the banking industry. Although the BOU was itself involved in directed lending to parastatals, this role was provided chiefly by UCB. There was usually little risk assessment in its lending activities, mismatching of long-term loans with short-term deposits and a general lack of restraint. Given the subsidized and non-market nature of its lending, which would inevitably generate losses, UCB itself required indirect subsidies. These came in the form of erosion of its capital base and increasing negative net worth. As a result, not only was UCB unable to meet its reserve requirement, but it ran overdrafts on its account with the BOU. The central bank in tum was able to exert little or no influence on UCB's activities. To understand why it is necessary to appreciate the political clout UCB carried at this time. The Managing Director of UCB, like the Governor of the central bank, was appointed by the President, had direct access to the Minister of Finance and UCB was usually represented at high level economic fora. For example, UCB's Managing Director was a member of the Presidential Economic Advisory Committee. It was not uncommon for the Central Bank to be involved only at the implementation stage after important decisions had been taken by the government in consultation with UCB. In its failure to control the excesses of the biggest player in the banking industry, the central bank loses credibility as a regulator of the financial industry. The key role of regulator takes a back seat to government directives. Another interesting case was that of the Coffee Marketing Board. CMB had direct access to loans from both BOU and UCB. The soft loans were made readily available to CMB thanks to its foreign exchange generating capacity. However, in order to attain this goal, domestic stability took a secondary role: government sacrificed control of domestic liquidity in order to maximize foreign exchange revenue. It is clear then that until the recent past, the BOU was hardly in a position to impose checks and balances on fiscal and parastatal excesses. What has changed? Five fundamental shifts can be identified. Perhaps the most important change has come from the government itself. Over the last four years the fiscal authority has shown its determination to live within its means and not resort to money printing. Nevertheless, even a small degree of slippage could roll back the progress that has been made. In the event of fiscal laxity what could the BOU do? Does it have the capacity to refuse to print money on behalf of the government? These questions lead on to the second development, namely the Bank of Uganda statute of 1 993. Among other things, the statute deals with the appointment and term of office of the Governor of the central bank and the powers of the Minister of Finance. Specifically, the Governor is appointed to a five year term by the President on advice from Cabinet, and the Minister of

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Finance can issue directives after seeking approval from the Cabinet, which the Bank must then implement. It would appear that the government could exercise significant control over the BOU. However, this is mitigated by the limits on government advances from the Central Bank. These are limited to 1 8 per cent of the government's recurrent revenue8 and if this is exceeded 'the powers of the Bank to grant additional financing shall cease until the situation is rectified' (Section 35(2)). But is the statute just a 'dead letter'? When push comes to shove, will the Bank, and the law, capitulate to accommodate the government? When Cukierman et al. (1994) look at the empirical evidence for a cross­ section of developing countries they find that their index of legal independence of the central bank is insignificant in explaining inflation. They state that 'the divergence between the letter of the law and actual practice seems substantially higher in developing than in industrial countries' (p. 33). Thus, even if legally the central bank is relatively autonomous, it may not in practice be able to exercise this independence. 9 In Uganda, although the legislation has been written, the relationship between the central bank and the fiscal authority has not been put to any severe tests. The outcome of a possible conflict between the Bank and the fiscal authority will depend on the respect for the rule of law and the 'democratic will', the level of public support, the track record and transparency of the Bank's past actions, the strength and intellectual force of the Bank's arguments as well as the personalities involved. Some of these are within the Bank's control, others are not. The third important development has been the recapitalization of the BOU. The first tranche of the capital injection took the form of a government bond worth Shs60 billion (approximately US $60 million) paying interest of 10 per cent per annum. This was only the initial tranche; an external auditor has recently submitted a proposal regarding a more permanent capital structure. However, even this injection enables the BOU to issue short-term instruments and engage in open market operations in order to carry out monetary policy. 1 0 A once-and-for-all recapitalization will return the BOU to a more sustainable position. In addition, it will be able to lead by example: given that the Bank is instructing commercial banks to achieve minimum capital adequacy requirements, it hardly does the Bank credit that its own balance sheet is in such a precarious state. The fourth point to note is that the parastatals are gradually being privatized and the Bank has disengaged itself from directed lending. 1 1 Given the strength and momentum of the privatization programme, it is unlikely that the clock will be turned back. In fact, the possibility that the Bank will start bailing out parastatals is much more unlikely than Bank action to alleviate fiscal deficits. In this respect, perhaps the most important privatization is of

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Uganda Commercial Bank. Prior to privatization an external audit estimated that non-performing assets of UCB stood at approximately Sh70 billion. These assets were transferred to a trust, which would in turn attempt to recover the loans. UCB, meanwhile, will be compensated by a capital injection and then offered for sale. In addition, the other weaker banks are undergoing restructuring programmes. The fifth development relates to the financial liberalization exercise, started in the early 1990s. The move away from direct controls on interest rates and credit to indirect controls implies that market mechanisms play a much bigger role in determining prices than in the past. Introduction of indirect controls also implies that the government has reduced capacity to use the BOU to impose arbitrary and ad-hoc regulations. In this sense the government can be said to have reduced its influence on the financial system and the BOU with the liberalization programme. This can be viewed as a signaling device: the government has taken a step towards a decontrolled regime, further locking itself into a more liberal regime in the hope of enhancing its own reputation and credibility as well as that of its adjustment programmeme. 1 2 However, the dangers inherent in financial sector liberalization in a developing country context need to be recognized. One important measure which can help ameliorate possible deterioration and excessive expansion of banks' portfolios is strong central bank supervision. The BOU has taken steps to strengthen its regulatory role, and has set strict targets and firm dates for banks to ensure that they are adequately capitalized. EXERCISING CONTROL (II): MARKETS Apart from legal issues, a key determinant of a central bank's ability to restrain fiscal indiscipline is the effectiveness of its instruments. It is often said that monetary instruments in a financially underdeveloped environment have little or no impact. We turn to this question next and then investigate where the monetary transmission mechanism might break down in the case of Uganda. We continue with a discussion of the impact of the recent financial­ sector liberalization and the effectiveness of BOU's instruments. Monetary transmission mechanisms13 In an environment of a liberalized financial system, a policy of indirect monetary control is assumed to provide the signals necessary to direct economic activity. In developed financial markets, when indirect methods of monetary control are used, a link can be discerned between the levels of excess reserves held by commercial banks and short-term interest rates. Lower levels of excess reserves tend to lead to higher interbank lending rates and

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treasury bill interest rates. Higher interbank and treasury bills rates lead, in tum, to higher bank lending and deposits rates which discourage expenditure and investment, hence slowing down growth and dampening inflation. This series of linkages is the traditional interest rate transmission mechanism. The presence of a liquid interbank market in local currency as well as a liquid secondary market in treasury bills is usually essential for sustaining this policy transmission mechanism. Under these circumstances, the central bank can influence short-term interest rates usually via open market operations. Where the secondary market for short-term government securities is not well developed, the central bank may engage in the interbank market. The US, Germany and the UK are examples of the former policy environment and Japan of the latter. In the past, the industrial countries made active use of minimum lending rates. However, these policies have either been discon­ tinued, as in the UK, or have been used infrequently, such as the raising of the Lombard rate above market rates in 1985 by the Bundesbank, thereby making it a penalty rate. 1 4 The traditional monetary transmission mechanism is being challenged by an emerging view which argues that reduced levels of excess reserves following monetary contraction reduces the capacity of banks to lend, resulting in a squeeze on bank-dependent firms. The argument is that the conventional view of the monetary transmission mechanism places too much weight on interest rate increases, which cannot fully account for economic slowdown following monetary contraction. This new 'lending view' turns to the behaviour of bank loan supply for a fuller explanation of the impact of monetary policy shifts (for an overview of this literature see Kashyap and Stein (1994)). The mechanism may be summarized as follows: monetary tightening =} bank reserves ,j, =} loanable funds ,j, =} supply of bank lending ,j, =} economic activity ,j, To establish whether the supply of bank lending decreases following monetary contraction, it is necessary to disentangle demand and supply effects on lending. Kashyap, Stein and Wilcox's (1993) solution to this problem is to examine how substitutes for bank lending such as issuance of commercial paper behave following monetary tightening. They find that commercial paper issuance surges while bank loans decline. This evidence supports the contention that demand for loans remains relatively strong while the supply of bank loans decreases. Those firms able to raise funds on the capital markets will have to adjust their expenditure decisions less than those dependent on banks for their financing needs. It is the decrease in the activities of these bank-dependent firms which dampens economic activity. The important point is that, on the lending view, economic slowdown is achieved not via standard interest rate effects working to depress aggregate demand, but rather through the central bank-induced reduction in loanable funds and the associated

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effects on bank-dependent business. This channel distinguishes the lending view from the traditional monetary mechanism. Application to Uganda: financial liberalization and increased Central Bank effectiveness The problem the Bank of Uganda faces in implementing monetary policy is two­ fold. The first issue relates to the instrnments at the Bank's disposal and degree of control the Bank can exercise on intermediate targets. Sidestepping the operations and instruments issues for the moment, we tum first to the second issue: the relevance of the traditional monetary mechanism in Uganda. Given the high degree of stickiness in commercial banks' lending rates in the past, the monetary transmission mechanism might be considered less relevant for Uganda. The effectiveness of the traditional monetary transmission mechanism depends crucially on the interest elasticity of money demand. 1 5 Empirical investigations of money demand for African economies have found that the interest sensitivity of money demand is either very low or insignificant ( see, for example, Henstridge (1995) for Uganda, and the various case studies in Page (1993)). However, these results may in part be due to the fact that many African economies have only recently liberalized interest rates and so the measured interest elasticity under the previous illiberal regime may not capture the elasticities that currently prevail. In as far as lending rates are sticky, the lending view - with its reduced emphasis on interest rate flexibility and greater reliance on banks' reserves seems more applicable in the context of under-developed financial markets. In such markets, a central bank may have greater control over banks' reserves via reserve requirements or treasury bill issues, which may not translate into changes in market interest rates. However, the reserve changes alone will impact on lending activity: according to the lending view, this particular channel of the transmission mechanism 'does not depend on how much, or whether, market interest rates rise' . 1 6 In addition, the emphasis of the lending view on bank-dependent firms is pertinent in the Ugandan case, given that there are no capital markets and hence little opportunity to tum to substitutes when bank loans are in short supply. It should be noted, however, that this argument is less applicable to the large exporters who are able to raise short-term finance from abroad. However, there are two caveats one should add at this stage. First, to the extent that in Uganda bank lending as a proportion of GDP is still very low, the impact on the economy of monetary contraction via the so-called bank­ dependent firms will be diminished. Second, in the presence of credit constraints and rationing, commercial banks' lending decisions are less likely to be based on liquidity conditions than on perceived creditworthiness of borrowers. This implies that changing liquidity conditions will have a limited

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effect on the supply of lending. However, as a counter to this, it should be noted that in the recent past credit to the private sector has been growing quite rapidly without causing undue pressure on inflation. In 1991/92 credit to the private sector contributed 25 per cent to monetary growth; this share has steadily increased, reaching 60 per cent in 1995/96. At least in part, this positive development in credit has been due to the more liberal financial arrangements in Uganda. From 1992 onwards interest rates were gradually liberalized. Today lending and deposit rates are freely determined, while the treasury bill rate is competitively determined via an auction system. Commercial banks are by far the largest participants. 1 7 Meanwhile, banking legislation and supervision have been strengthened, while weak banks are undergoing restructuring. The main instrument currently in use for monetary policy is the treasury bill. Although officially a fiscal tool, given that the government is saving with the banking system, the treasury bill is used for monetary management. At present the shortest maturity available is three months, the longest is one year. Although the market is expanding rapidly it still represents under 15 per cent of broad money and about 2 per cent of GDP. It is hoped that the market will be deepened further through the issuance of longer-dated paper. In addition, with the recent recapitalization of the BOU, shorter maturity bills, as well as repos, will be issued in the near future. There are many banks which sporadically keep large excess reserves with the BOU, largely because there are only limited opportunities to invest cash on a short-term basis. This represents a captive market for BOU bills: these bills will help banks manage their liquidity as well as giving BOU greater leverage over banks' reserves and hence their lending activity. A wider range of maturities will improve BOU's ability to conduct monetary policy. Ability to issue bills on its own account will also help increase BOU's autonomy. CONCLUSION In an economy such as Uganda's, where effectiveness of indirect monetary policy in attaining a monetary anchor and impacting on macroeconomic conditions is constrained by the level of development of the financial sector, the fact that the government is committed to fiscal discipline is key to price stability. Nevertheless, we have argued that a number of important changes have increased the effectiveness and credibility of the BOU over recent years. Financial liberalization, the move towards instruments of indirect control, privatization of parastatals, legislation limiting the government's access to central bank credit, reform of weak banks, the recapitalization of the BOU and issuance of its own instruments have all contributed to BOU's increased capacity as an agent of restraint.

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Notes 1. 2.

3. 4. 5. 6. 7. 8.

9.

10. 11. 12. 13. 14. 15.

16. 17.

The monthly inflation in April 1992 reached 1 1 per cent (o r 350 per cent when annualized). It is interesting to note that although the overall budget deficits declined, deficits exclusive of grants were allowed to increase after the watershed year of 1992 (increasing from an annual average of 9.6 per cent during 1989-92 to 11.0 per cent during 1992-95). In 1995/6 the deficit exclusive of grants dropped to 6.7 per cent and was projected at 6.5 per cent in 1996/7. Blanchard and Fischer (1989) p. 610 See Leiderman and Svensson (1995) for individual case studies. The programme M2 growth number has often been well below the actual out­ turn. Uganda is undergoing rapid remonetization, which has allowed money to expand very rapidly without causing excessive inflation (see Hussain (1996)). See Killick (1995). It should be noted that the BOU itself benefited from the foreign exchange controls. It was able to make large profits on its dealing operations via high intermediation margins. In 1995/6 recurrent revenue was approximately 13 per cent of GDP. At these levels money printing could close a deficit of 2.3 per cent of GDP. Even if revenue climbs to 20 per cent of GDP over the next few years the deficit which could be financed via money printing would be 3.6 per cent of GDP. Cukierman et al. do however, find a significant negative relationship between the length of the Governor's term in office and inflation. They admit however, that a 'low turnover does not necessarily imply a high level of central bank independence, because a relatively subservient governor may stay in office a long time' (p. 16). It should be noted that the BOU has up till now been using treasury bill issues to manage liquidity in the economy. This has been a purely monetary tool since the Ministry of Finance funds its deficit from external sources. The Development Finance Department o f the Bank does engage i n refinance activities (usually funded by external funds) geared towards term lending. The implications of liberalization on the effectiveness of BOU instruments are discussed further in the next section. This section draws on Abdulla et al. (1996). For an overview of monetary instruments and operating procedures in the industrial countries see Batten et al. (1990). In the simplest IS-LM framework (narrow) money demand, Md , is determined by real income (y) and the nominal interest rate (i) Md = a.y - b.i. The impact of a monetary boost (a rightward shift in the LM curve) depends, inter alia, on the interest elasticity, b: the closer this is to zero, the larger is the required monetary injection for a given output response. Morgan (1992, p. 34). See Kasekende and Ating-Ego (1996) for further details.

REFERENCES AND FURTHER READING Abdulla, Y., C. Abuka and I. Hussain (1996). 'Indirect Monetary Policy and the Term Structure of Lending Rates in Uganda', mimeo, presented at African Economic Research Consortium meeting.

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Backus, D. and J. Driffill (1985). 'Inflation and Reputation', American Economic Review, June, 530-8. Barro, R. (1986). 'Reputation in a Model of Monetary Policy with Incomplete Information', Journal of Monetary Economics, January, 3-20. Batten, D., M. Blackwell, I. Iskim, S. Nocera and Y. Oseki (1990). 'The Conduct of Monetary Policy in the Major Industrial Countries', IMF Occasional Paper, 70. Blanchard, 0. and S. Fischer (1989). Lectures on Macroeconomics, MIT Press. Cukierman, A., S. Webb and B. Neyapti (1994). Measuring Central Bank Independence and Its Effect on Policy Outcomes, ICP Press. Henstridge, M. (1995). 'The Demand for Money', Chapter 4, PhD thesis, University of Oxford. Honohan, P. and S. O'Connell (1996). 'Contrasting Monetary Regimes in Africa', April, presented at the AERC. Hussain, I (1996). 'Estimating an Inflation Equation for Uganda', mimeo. Kasekende, L, and M. Ating-Ego ( 1996). 'Financial Liberalisation and Its Implications for the Domestic Financial System: The case of Uganda' (May). Final report submitted to the AERC. Kashyap, A, and J. Stein (1994). 'Monetary Policy and Bank Lending', in G. Mankiw (ed.), Monetary Policy, University of Chicago Press. Kashyap, A, J. Stein and D. Wilcox (1993). 'Monetary Policy and Credit Conditions' American Economic Review, Mar, 78--98. Killick, T. (1995). IMF Programmemes in Developing Countries, ODI/Routledge. Kreps, D. and R. Wilson ( 1982). 'Reputation and Imperfect Competition', Journal of Economic Theory, August, 253-79. Leiderman, L. and L. Svensson (1995). Inflation Targets, CEPR. Page, S. (ed.) (1993). Monetary Policy in Developing Countries, Routledge. Morgan, D. (1992). 'Are Bank Loans a Force in Monetary Policy?', Federal Reserve Bank of Kansas City Economic Review, Quarter 2, pp. 43. Rogoff, K. (1985). 'The Optimal Degree of Commitment to an Intermediate Target', Quarterly Journal of Economics, November, 1 169-90.

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DISCUSSION Stephen A. O'Connell on 'The Central Bank as a Restraint: The Experience of Uganda' by Louis A. Kasekende and lftikhar Hussain Central banks are on the short list of potential domestic 'agencies of restraint'. This excellent chapter by Kasekende and Hussain examines the evolving role of the Bank of Uganda (BOU) and suggests that recent developments are laying the groundwork for a much greater independence. I enjoyed the chapter and learned from it. My comments will focus on what it tells us about the restraining role in of central banks in African economies. I begin with a brief observation. The authors draw insightfully on the literature on central bank independence, which focuses primarily on the relationship between inflation and short-run macroeconomic goals like revenue, output stabilization, or the balance of payments. The theme of that literature has been the design of institutions that deliver low inflation rates. This volume, in contrast, focuses on enhancing investment and long-run growth by reducing risk. The links are worth making explicit, and I see at least two. The first operates through the effect of inflation on uncertainty. High inflation rates tend empirically to be uncertain inflation rates. Moreover, inflation has contributed to uncertainty about real variables in African countries by precipitating regime changes and other abrupt macroeconomic transitions (eg, maxi-devaluations). Restraint of inflation may therefore be a useful shorthand for restraint of policy­ induced macroeconomic uncertainty. The second link operates through the discouraging effect of fiscal pressure on domestic financial institutions. The literature on central bank independence recognizes fiscal pressures as one of the primary sources of high inflation. Within Africa, however, excessive fiscal demands have been associated not only (or even primarily) with inflation but also with financial repression. The associated weakening of the banking system and slowing of financial development is widely thought to have reduced growth, primarily by reducing the quality of investment. From the perspective of this volume, what is happening is the undercutting of precisely those institutions designed (in part) to handle risk. In the comments below I will focus on the restraint of inflation, but this discussion suggests that central banks concerned with improving the environment for investment and growth have an equal responsibility to restrain the over-taxation of domestic financial institutions by the fiscal authorities. Proceeding now to the chapter itself, I want to note first that by focusing on the relationship between the BOU and the fiscal authorities, the authors have produced a chapter that is immediately relevant for many other African countries. In particular, the subordinate position of the BOU (relative to the fiscal authorities and the Presidency) was typical of African experience up to the early 1990s, even in the CFA Zone (as we learn in David Stasavage's paper (this volume)) where inflation remained low. And although Uganda is certainly in the vanguard of institutional change, that process is also meaningfully continent-wide in the mid-1990s. No country's experience is wholly typical, however, and it is important to keep in mind (as the authors do) the very high inflation that preceded the reforms analysed in the chapter. There are relatively few such episodes in African experience, and among those that have occurred (eg, in Zaire and Sierra Leone), Uganda's stabilization programme has been unusually successful, achieving persistently low inflation rates at low ( or no) apparent cost in terms of growth. With these observations in mind, I ask two central questions. First, what restraining role, if any, can be attributed to the Bank of Uganda in the recent successful

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stabilization? Second, what prospective restraining role can BOU play in 'locking in' recent macroeconomic policy gains? The authors make clear that until recently, the Bank of Uganda had little scope for resisting fiscal demands, even when they were clearly inconsistent with long-run monetary stability. The message here is that if African central banks are to develop meaningful restraining roles, these will involve restraining the fiscal authorities. What pattern of fiscal restraint, then, is behind the remarkable reduction in inflation expectations in Uganda? High initial inflation makes it difficult to answer this question, because adjustments in the 'fiscal fundamentals' may easily be swamped by expectational effects that shift the economy from the 'bad' side to the 'good' side of the inflation-tax Laffer curve. A dramatic reduction in short-term inflation expectations has certainly occurred, facilitated by the leadership of President Museveni, the cash budget and domestic credit ceilings associated with IMF ESAFs, and the very large conditional aid inflows that have accompanied economic reforms. With regard to the fiscal fundamentals, however, the picture is less clear. The dominant change in the fiscal position appears to be a large increase in spending financed by an even larger increase in foreign aid. Domestic tax revenue has increased sharply, but from a very low base, and this may in part reflect a reverse ( and again reversible) Olivera-Tanzi effect associated with the reduction in inflation. What can be said is that fiscal policy is now clearly consistent with low inflation, given available external financing; and this is no small achievement. But external financing has been generous enough to make this possible without obviously restraining overall spending. What we see, therefore, is very successful application of personal leadership and primarily external restraints and supports in coordinating private sector expectations around low inflation. The success has even allowed the IMF to show flexibility in responding to above-target growth rates in money supply, presumably to avoid a deflationary non-accommodation of increases in real money demand (whether associated with the reduction in inflation expectations, with real growth, or with high coffee prices). It is more difficult to claim a major role for the fiscal fundamentals, or more specifically, for domestic institutions like the BOU itself, the fiscal authorities, or the Ugandan 'polity' in restraining fiscal demands. Uganda's experience looks more clearly favourable in direct comparison with a similarly situated country like Zambia (analysed in the Adam-Bevan paper (this volume)), where post-stabilization slippage has been much more of a problem. The Zambian case demonstrates that even the combination of a cash budget, an IMF programme, and a recent high-inflation experience is not enough to cement low inflation following stabilization. That these external props cannot themselves carry the day suggests that domestic institutions may well have been important in Uganda. But one would have to control for other external shocks and for the role of executive leadership in the two countries before drawing this conclusion. Although the role of domestic institutions in the Ugandan stabilization remains unclear, it is unavoidable that such institutions will ultimately have to substitute for individual personalities and external restraints in securing responsible fiscal policy. This brings us to the second question: to what degree has that process already begun, and how can the BOU enhance it? The authors' discussion is very illuminating. They point to five developments that suggest greater effective independence for the Bank of Uganda. The logic here is readily transferable to other African countries where similar developments are in process. I want to highlight the indirect suggestion here that it is not a single formula but rather the joint effect of many 'small' institutional developments, none of which does the job alone, that may ultimately support meaningful independence for the BOU. This is surely correct, and it is a nice commentary on the analytical literature,

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which for methodological reasons tends to assess institutions one at a time. To the authors' list I would add Uganda's hyperinflation experience (and to their implicit commentary, the point that 'history matters'). This experience clarified the priorities of both internal and external actors, and may have strengthened the resolve of President Museveni by increasing private support for monetary stability. Unlike most of the other developments, of course, this one is not transferrable to countries with less dramatic inflation histories. The authors devote a section to the monetary transmission mechanism and the transition from direct to indirect monetary control. I will end by seconding their claim that successful conduct of day-to-day monetary policy may have an important offshoot in enhancing the credibility of the BOU. This is not only with respect to the weight accorded by the public to the BOU's pronouncements regarding its own intentions (eg, with respect to financing fiscal deficits). A second potentially important contribution is the formation of domestic constituencies in favour of market-oriented macroeconomic reforms. One of the main roles of interest rate controls, domestic price controls and exchange controls was to cover up the macroeconomic implications of fiscal deficits. The move to market-determined interest rates and exchange rates has therefore not only enhanced microeconomic efficiency but also shortened the 'leash' on fiscal policy, in the sense of imposing more immediate and transparent penalties on fiscal impropriety. To the degree that the liberalized system allows the private market to impose fiscal discipline (an important research issue in its own right), the monetary authority acquires an interest in enhancing the market's stake in that system and therefore making a reversal of reforms more politically costly. Ensuring the smooth operation of the system is one way of accomplishing this.

8 The Cash-Budget as a Restraint: The Experience of Zambia Christopher S. Adam and David L. Bevan 1.

INTRODUCTION

Problems of fiscal control, or the lack of it, have been a central feature of African economic experience over the last two decades. Budgetary deficits in excess of 10 per cent of GDP have been common, with inflation rates in a number of countries reaching near hyperinflation levels. The proximate sources of these difficulties have been varied. Sometimes they have originated in revenue collapses following a breakdown of legitimacy due to civil war or predatory behaviour by the state. Sometimes they have been precipitated by external shocks that destabilized the fiscal authorities. Sometimes they resulted from a slow but protracted divergence between revenues and expenditures. Whatever their specific history, these excessive deficits have common consequences. They are widely perceived to be unsustainable, so that they signal the inevitability of radical change in the macroeconomic environment, and very possibly complementary changes in the microeconomic 'rules of the game' as well. The last decade has seen numerous programmes designed to achieve progressive reductions in the fiscal deficit. Apart from those countries which had previously suffered a revenue collapse, the emphasis has typically been on expenditure reduction rather than revenue enhancement (there has often been a related programme of tax reform, but this has usually been designed to be revenue neutral). Variations in the domestic budget deficit are largely monetized for want of alternative flexible financing instruments and this leads directly to pressure on the price level and the exchange rate. Gaining control over the money supply to reduce inflation then requires that the government first establish control over its own deficit. In many cases, orthodox programmes based on expenditure reduction were unsuccessful: sometimes they failed to achieve their initial objective, sometimes this was achieved but only briefly. Even when some lasting reduction in the imbalance was achieved, it was often the case that this was at the expense of a deterioration in the composition of government spending, and hence in the supply of public services. Against this

185

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background of deteriorating fiscal control and accelerating inflation, it is natural that attention should have turned to more draconian means of establishing fiscal discipline. The Zambian 'cash-budget' is a prime example of a switch from a discretionary to a rule-based approach to fiscal control. Following an extended period of unsuccessful orthodox stabilization efforts, the 1993 Budget Speech saw the Minister for Finance commit the government not only to a balanced budget for the year but to one on an ongoing month-to­ month basis. In essence, public expenditure was to be restricted to what could be financed from cash in hand (positive balances held in accounts with the central bank) with no recourse to domestic deficit financing. The cash-budget therefore removed all discretion over the aggregate fiscal stance and simultaneously severely curtailed the scope for discretion over the composi­ tion of expenditure. 1 The Zambian cash-budget was remarkably successful in meeting its primary objective. Inflation was brought to a shuddering halt and has remained at moderate levels ever since. Neither the extent of the previous inflationary potential, nor the scale of this achievement should be underestimated, and it is difficult to believe that this outcome could have been achieved without some variant of a cash-budget. However, in general it is not optimal to adopt too tight a fiscal or monetary stabilization rule because of the costs of lost discretion. Typically rules represent a 'third-best' response to the time­ inconsistency of discretionary fiscal policy in circumstances where less costly institutions of restraint are absent. 2 By having a rule that places an infinite weight on stabilization, society is able to bring inflation down to a very low (possibly zero) level, but at the cost of reduced fiscal responsiveness and - in the Zambian case - reduced quality of service delivery. Our aim in this chapter is to examine the role of the cash-budget in Zambia in achieving price stability and the consequences of this rule-based approach for the conduct of fiscal and monetary policy. We start in Section 2 by examining the rationale for adopting the cash-budget as an instrument of fiscal control, while Section 3 discusses two of the principal limitations attaching to the use of cash-budgets in general, namely the loss of fiscal flexibility and the possibility of limited compatibility with the full range of stabilization objectives. For the remainder of the chapter we focus on the specifics of the Zambian cash-budget. Section 4 describes the background to and the specific structure of the Zambian cash-budget, addressing a number of the technical issues that flow from adopting this form of fiscal management, and stressing its initial success in meeting the disinflation objective. This section also highlights the potentially problematic relationship between the cash-budget and the level of balance of payments support. Section 5 considers the consequences. Here we return to the issues raised in general terms in Section 3: the first relates to the direct fiscal costs of the cash-budget, the second involves the implications for medium-term macroeconomic policy

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compatibility. We also examine the extent to which the potential problems associated with external debt have materialized in practice. In Section 6 we focus on the future, reviewing options for reforming the operation of the cash­ budget in circumstances where there are continued net aid inflows into Zambia, and considering the possible consequences for the cash-budget of a withdrawal of support. Section 7 concludes. To anticipate our conclusions, we suggest that there was probably no alternative to the cash-budget as a means for addressing the immediate inflationary crisis confronting the Zambian authorities in the early 1990s, but the high costs of maintaining the extremely tight and inflexible fiscal stance argue for relaxation of the strict interpretation of the cash-budget. The way in which this may be achieved, however, depends crucially on what view is taken about the government's commitment to sound fiscal policy. Equally crucial is the role of the donors and their commitment, in the case of Zambia, to insulating the domestic budget from the requirements of external debt service. 2. FISCAL CORRECTION AND THE CASH-BUDGET Why should a cash-budget be effective when orthodox forms of fiscal control are not? There are at least three possibilities. The first is that its conceptual and mechanical simplicity resolves technical problems in the management of fiscal policy. The second is that the cash-budget offers the government a more precise way to signal its commitment to fiscal reform, distinguishing itself from less committed governments. The third is that the cash-budget serves to codify the conditionality deemed necessary to permit aid resources to flow, with the aid flow rendering the fiscal stance compatible. These three interpretations, though not wholly exclusive, do imply very different consequences for the future management of fiscal policy. We examine each in turn. Resolving technical issues

Consider first the case where the government (and the donors) are agreed on, and committed to, the pursuit of a conservative fiscal stance. If the government has the will to improve domestic fiscal management, but is unsophisticated in economic matters, then the cash-budget has the advantage of (partly apparent, but to a significant degree real) conceptual simplicity. It is a policy that is not only easy to explain, but it is one that is appealing to the private sector and is relatively easy to monitor. Moreover, if the problem has been one of technical competence in managing a complex fiscal process, with neither politicians nor the senior civil service actively attempting to sabotage the prudent conduct of fiscal affairs, then the mechanical simplicity of the

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cash-budget may be its main attraction, permitting a weak administration to fulfil the intentions of government. There is a further gain from the technical simplicity of the cash-budget. It may be the case that the central authorities are committed to fiscal rectitude while line ministries are not. In these circumstances, the clarity of the cash­ budget and its operational requirements can help to strengthen the hand of central agencies against the spending ministries. The appeal to a non­ negotiable and externally supported decision rule can allow the central authorities to consolidate their authority. Signalling commitment Suppose instead the government is unable credibly to commit to a conservative fiscal stance. This may arise for three reasons. First, such a stance may be perceived to be inconsistent with the government's underlying preferences. We shall deal with this below. Second, the cash-budget may serve as a method for the government to signal its true type. Thus by committing itself to (and observing) a fiscal stance which, it hopes, would never be pursued by a government not wholly committed to reform, the government is able to show its true colours. The third reason - common to many African countries - is that because of a past history of fiscal indiscipline, the government's fiscal policy announcements are perceived to be time­ inconsistent. In such circumstances, the cash-budget provides the government with a mechanism to resolve the time consistency problem, because it is readily monitorable and the private sector can (relatively) easily determine whether it has been breached or not. By making explicit commitments to observe the cash-budget rule, the government thus seeks to associate its credibility with a high-profile indicator. The lack of ambiguity in the cash­ budget allows no room for obfuscation, and raises the cost to acting in a discretionary manner, thereby tying the government's hands to a prudent policy. Under this interpretation, the government would genuinely like to commit to sound fiscal policy but without the cash-budget would not have the 'technology' to limit its own incentives to renege. This argument faces a number of difficulties, the most serious being that if the government is strong enough to tie its own hands, why does it need to do so, and in particular why would it choose to commit to such an inefficient mechanism? Rodrik and Zeckhauser (1988) discuss the role of 'constitutional' instruments and forms of delegated authority over policy making as commitment mechanisms which, though inefficient ex post, allow governments to commit themselves to ex ante policies. The difficulty is that if the prior problem was that the political will was lacking to run a prudent fiscal policy - in other words the time­ inconsistency emerged directly from the preferences of the government - it is not clear how the cash-budget can substitute for it. 3

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Reflecting donor conditionality The third view of the cash-budget is that it provides a codification of the donor conditionality required to allow aid resources to flow. The cash-budget defines the conditions required to bind an otherwise fiscally lax government to a conservative fiscal stance. The simplicity of the cash-budget and the fact that deviations from it are easily measurable by donor agencies, means that conditions of the aid contract are easily specified and their implementation readily verified. This latter is particularly important in circumstances where systems of budgetary control are weak, and where, in the past, governments routinely 'hid' expenditures off-budget. Since the cash-budget is essentially a constraint on financing - and is monitored through the central bank - as opposed to a constraint on expenditure, it serves to define the total resource envelope given the structure of government revenue. It eliminates the need for the aid contract to specify any further expenditure conditions ( although this may still be done) and delegates responsibility for expenditure composition. Summary There are thus a variety of circumstances in which a cash-budget may constitute an attractive option in the attempt to regain fiscal control. However, none of these arguments relies on any notion that a balanced budget is optimal: it is rather a matter of installing a device which combines a simple budgeting mechanism with a tight, clear and observable target, and for this a 'zero borrowing' target embodies greater precision and clarity than a 'low borrowing' target. In short, the loss of flexibility and discretion is justified on several alternative grounds: that they could not efficiently be used because of technical problems; that they be abused, in the conditionality interpreta­ tion; or that they would be misinterpreted in the signalling case. In all cases, while the cash-budget may be a useful form of shock therapy, it leaves the longer-run problem of regaining mature fiscal control unresolved - indeed, it may make the solution more difficult. It is to this we now turn. 3. LIMITATIONS OF THE CASH-BUDGET AS A POLICY INSTRUMENT Problems with the concept of the cash-budget There are two very obvious problems with the notion of a cash-budget, which are central to the fact that budgets are not normally organized in this way, whether the budgeting organization is a government, a firm or a household.

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Both problems relate to time: one reflects the long horizons appropriate to government operations, the other the existence of short term fluctuations in the flows of revenue and expenditure. The inter-temporal budget

While it is true (when grants are booked as revenue and high-powered money is ignored) that a government's budget must balance in some sense over an appropriate horizon, it is rarely true that it is efficient to enforce balance over a short interval. More generally, the appropriate notion of balance is present value balance (ie, that the present value of revenues equal the present value of expenditures) and this rarely implies actual budget balance, even on average. Only in the case of a fully stationary economy is there any automatic presumption in favour of average budget balance. In a growing economy, the debt-income ratio is either at or below its target level, which implies a continuing overall deficit, or it is not: in the latter case, where debt retirement is desired, there is no reason to limit this to the rate permitted by a balanced budget, as opposed to some faster or indeed slower rate. Further, the concurrent average budget balance implied by a given present value restriction differs depending on the structure (as opposed to the level) of revenue. For example, it is unlikely that a present value, revenue-neutral switch between income and expenditure taxation would be concurrently revenue-neutral. The case against any presumption of the automatic desirability of a balanced budget is strengthened when allowance is made for money. To illustrate the point, consider an economy experiencing real growth at stable prices with no interest-bearing public debt. Then growth in demand for real balances requires an injection of high-powered money generated by a government deficit, or it will induce an inappropriate balance of payments surplus. If the economy is undergoing financial deepening, either of the secular variety or in response to successful liberalization or disinflation, this point is reinforced. Budget definitions

So far, we have discussed the budget balance as if the definition was unambiguous. In practice, of course, there is a plethora of alternative definitions, and it is far from clear which of these it is thought appropriate to balance. Sometimes, it is the primary balance that has been targeted, ie the balance struck excluding interest payments. This may be profoundly destabilizing, particularly if financial liberalization raises the interest cost of public debt. However, making the definition inclusive of all nominal interest payments and targeting the overall balance is also destabilizing, and is strictly

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inappropriate in the presence of high inflation. At least these two definitions are easily calculable and transparent; the operational definition, including real interest payments only, and designed to steer between the worst excesses of the others, is hard to operate and opaque. In the usual fiscal situation, this variety of candidate definitions need pose no special problem: the authorities need to keep close watch on several dimensions of fiscal activity, responding to changes not only in 'the deficit', but to discrepant shifts in the various component pieces. With the cash-budget being by design less flexible, this type of pluralism is forfeit, and it becomes necessary to choose a particular definition to target. Short-term fluctuations

The importance of short-term credit facilities in modem economies is a reflection of the fact that financial intermediation is not only required to transfer resources between long-term deficit and surplus sectors, but also to smooth out short-term disparities in the flow of receipts and expenditure requirements. The difficulty is that under normal budgeting arrangements there is no direct control over the deficit; it emerges as the gap between revenues and expenditures. Nominal revenues are endogenously determined by the interaction between the tax structure - which the government chooses and macroeconomic events, which it does not. Depending on the country's circumstances, this means that the short-run path of revenue is more or less uncontrollable, volatile and unpredictable. African governments are particu­ larly afflicted by revenue instability, and so are in greater need of smoothing finance than most (Bleaney et al. , 1995). This instability is partly a reflection of their relatively high revenue-dependence on trade taxes coupled with very volatile conditions of trade: it partly reflects dependence on aid flows whose timing is often very uneven and unpredictable. These problems are apparent over periods of several years taken together, but they are particularly acute within the calendar year. As a consequence, a monthly cash-budget is an even more severe restriction on good budgetary management in Africa than it would be elsewhere. Even if all components of expenditure were equally compressible in the short term, and the budgetary rationing system were even­ handed, the vagaries of revenue fluctuations would impose severe costs on the efficient delivery of public services. In fact, neither of these assumptions is valid: wages are particularly hard to cut in the short run, so capital programmes and operations and maintenance spending are relatively more vulnerable; also, different ministries have very different bargaining power, reflecting either realpolitik (defence spending) or the accident of the connections of their current Minister. In any event, the intersection of inter-temporally random budget cuts with a rationing process which is neither

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even-handed nor sensitive to the technical consequences of delay is likely to be very costly to achieving the underlying objectives of government. If revenues are stable and well predicted, the outturn deficit is close to that which was budgeted. If they are not, the government is faced with two other problems, one of inference and the other of response. The problem of inference is to decide how to interpret an unanticipated movement in revenue. Suppose there is a shortfall. Is this merely a matter of rephasing of receipts (for example, where certain tax collections have not yet materialized but are known to be in the pipeline); a temporary fall which will not be made good but where normal collections are likely to be resumed shortly (for example, when cesses fall in a year of poor harvest); or a permanent change for the worse, with no anticipated reversal (for example, the exhaustion of a mineral reserve and its associated royalties)? Ultimately, these uncertainties will resolve themselves, but prudence suggests that adjustment to long-run changes should not be delayed. This involves the second problem, that of choosing an appropriate pattern and scale of response. Too slow a response to long-run revenue change will magnify both the financial impact of the change and the extent of the total adjustment that has to be made. Too rapid a response to any change may make the adjustment inefficient, and, in the case of temporary changes, may induce unnecessary adjustments and policy reversals. Problems with the cash-budget as a stabilization anchor The objective of stabilization is to ensure the stability of domestic prices and the balance of payments: in principle, the tools at the disposal of the authorities are transactions in foreign assets and transactions in domestic assets. The selection of an anchor for the domestic price system determines the relationship between these tools, with the two obvious choices of anchor being the exchange rate and the money supply. In general, in small open economies - where the non-tradable sector is relatively small - the relationship between the exchange rate and the price level is stronger than the relationship between the money supply and the price level, which argues in favour of an exchange rate anchor. In such circumstances, since transactions in foreign reserves are subjugated to the stabilization of the exchange rate, transactions in domestic assets must be conducted in a manner consistent with the exchange-rate objectives. In the circumstances prevailing in much of Africa, where the scope for active monetary policy is limited, this requirement translates directly to fiscal policy as well: exchange rate targeting thus requires a flexible, discretionary, fiscal stance which is the antithesis of the cash-budget. In practice a cash-budget (in an economy with limited scope for active monetary policy) is only consistent with a money-supply anchor. In this case, transactions in domestic assets influence the money supply through

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changes in the claims on the central government and central bank. If there is a well-defined demand for money, the equilibrium between the demand and supply of money will be achieved through movements in the price level. Given this determination of the domestic price level, the nominal exchange rate adjusts to maintain external balance. This approach to stabilization is faced with two types of problem. First, for economies undergoing financial liberalization, the demand for money function is unlikely to be stable so that it is extremely difficult to establish the short-run relationship between the money supply and prices with any degree of precision. Money-supply based rules may therefore provide an imperfect anchor for the domestic price level. Second, in environments where balance of payments shocks are large and frequent, the nominal exchange rate may be excessively volatile in the short­ run. Thus, in African economies undergoing liberalization, the maintenance of a cash-budget may lead to excess (nominal and thus real) exchange rate volatility without providing a secure anchor for domestic prices in the medium term. Summary The cash-budget's strength lies in its simplicity and its capacity to function as an institution of restraint. However this is traded off against the loss of flexibility with the consequence that the economy may be more volatile than under more discretionary methods of fiscal control. The value of the cash­ budget (in the short- and medium-term) therefore depends on specific circumstances and the calculus of this tradeoff. The case we examine in this chapter is one where the initial conditions were so bad that the loss of fiscal flexibility associated with the cash-budget was at best a second-order problem compared to primary loss of fiscal control. In the short run, the Zambian cash­ budget seemed to make sense; over the medium-term the case for continuance is much less clear. The remainder of this chapter will, therefore, be concerned solely with Zambia. 4. THE CASH-BUDGET IN ZAMBIA Background In 1 991 the newly elected MMD government in Zambia inherited a money supply grossly over-expanded by its predecessor's efforts to stay in power. While this would have been sufficient on its own to trigger a serious inflationary crisis, it was exacerbated by the fiscal costs of the drought later that year. The new government immediately implemented a squeeze on fiscal expenditure to reduce the budget deficit. During its first 18 months in power,

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1 986 1 987 1 988 1 989 1990 1 991 1 992 1 993 Cote d'Ivoire

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Figure 11.6 French non-project aid to UMOA governments (million French francs) Sources : Estimate from Ministry of Cooperation: aide budgetaire, bonifications prets d'ajustement structurels, dons en faveur d'ajustement structure!; Caisse Frarn;aise: subventions d'ajustement structurel, prets d'ajustement structurel, sources: Bilan Statistique des Operations d 'Aide Publique au Developpement du Ministere de la Cooperation, La Zone Franc, annual reports, Caisse Francaise de Developpement, annual reports.

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Investment and Risk in Africa 3000

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Figure 11. 7 French non-project aid to BEAC governments (million French francs) Sources : Estimate from Ministry of Cooperation: aide budgetaire, bonifications prets d'ajustement structurels, dons en faveur d'ajustement structure!; Caisse Frarn,aise: subventions d'ajustement structure!, prets d'ajustement structure!, sources : Bi/an Statistique des Operations d 'Aide Publique au Developpement du Ministere de la Cooperation, La Zone Franc , annual reports, Caisse Francaise de Developpement, annual reports. domestic arrears probably says more about the weakness of the rule of law in the CFA states than about poor performance of the central banks. The two central banks did, however, have a direct responsibility in outcomes involving direct lending to governments and indirect lending via commercial and development banks, where they failed to effectively apply the two basic monetary rules and followed an imprudent refinancing policy. For France, indication of a failure to act as an agency of restraint comes above all from the increase in non-project aid to states which had demonstrated little intention of undertaking fiscal adjustment and which had been disproportionately responsible for banking sector failures. 4. THE FAILURE OF FRANC ZONE RESTRAINTS Explaining France's failure to act as an agency of restraint The absence of statutory provisions for conditionality or sanctions It seems curious that as part of the 1 972-73 monetary reforms, France agreed to relinquish control of the two supranational central banks without restricting its convertibility guarantee, without making operations account finance subject to specific conditionalities, and without establishing pre-determined

The Franc Zone as a Restraint

285

sanctions for states that broke the monetary rules. When interviewed, French officials who took part in the reform negotiations suggested that this concession was motivated by a general fear in the early 1970s that the African states might leave the Franc Zone if too rigid a system was maintained. Madagascar and Mauritania did actually leave the union in the early 1 970s, and several other African leaders made public statements criticizing what they saw as an overly conservative monetary arrangement in which they had little decision-making power. Newspaper reports also corroborate the claim that there was a widespread sentiment that the relationship between France and the CFA states might not last much longer. 1 6 French Treasury oversight Even without statutory provisions, French Treasury officials might have had considerable leverage to implement discretionary sanctions, but they failed to do so.17 Instead, in the early 1980s Treasury officials paid little attention to the rapidly degrading situation of the banking sector in UMOA, and when they did attempt to do something they were subject to political interference. After 1986 members of the Treasury waged numerous protests that nothing was being done to formulate a serious programme to adjust to a severe terms of trade shock in BEAC. One official apparently protested vociferously at several consecutive governing board meetings during 1987-88, but he was eventually told by political authorities that he would be assigned elsewhere if he did not adopt a more docile attitude. Beginning in 1989, the Treasury placed increased pressure on BCEAO and BEAC to restrict the growth of refinancing credit, but despite efforts to convince French politicians of the need for adjustment, it was unable to establish firm conditionalities for non­ project aid. Three principal reasons, suggested by Treasury officials themselves, can be offered for the ineffectiveness of Treasury oversight. First, because Treasury officials rarely stay more than a few years in the same position, they have an incentive to push for short-term solutions that will avoid disaster on their watch. 1 8 Second, while the cost for France of supporting the CFA arrangements has not been insignificant, it has always been an extremely small portion of total French public expenditure. 1 9 Third, and most important, political interference undermined the Treasury's efforts. The importance of French political interests For the developed-country partner in an external agency of restraint, objectives may be both economic and non-economic. For example, recent reciprocal agreements between the European Union and Eastern Europe were motivated by a desire to control immigration as well as by the hope of extending trade and investment opportunities.(Fine and Yeo, 1994). It has not

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been considered how these non-economic goals might weaken a developed country's ability to serve as an external agency of restraint, particularly if it is perceived that adjustment in the developing country poses a potential threat to these non-economic goals. If the developing country government needs to undertake fiscal stabilization to restore growth, but this risks unseating the regime in power, its developed-country partner might favour the short-term solution of providing funding to preserve the status quo. This scenario would be all the more likely if the costs for the developed country of financing the developing country are small in relative terms, and if the costs to the developed country are spread widely (among its taxpayers) while the advantages of not obliging the developing country to adjust are concentrated on a small lobby. It could be argued that the single most important factor behind the interventions of French politicians in Franc Zone affairs has been the personal interest of a number of French politicians and administrators in assuring short-term political stability for Francophone African regimes even when this meant providing finance simply to postpone fiscal stabilization. 20 A small number of these individuals and their political associates have had direct economic interests in Francophone Africa that depend upon maintaining cordial relations with Francophone African heads of state. 2 1 There have also been bureaucratic interests. A number of jobs within the French administra­ tion depend on cooperation with Francophone Africa (not the developing countries as a whole). Top political positions in the Ministry of Cooperation are an example here, as is the special bureau for African affairs at the French presidency (no such bureau exists for Asia, Latin America, or North America) (Bayart, 1984; Wilson 1993). For some, ties to Francophone Africa have also played a role in the internal manoeuvrings of French political parties. Finally, many members of this lobby may have no immediate economic or political interest in Africa policy, but because their claim to expertise often derives less from professional training as diplomats or economists than from personal experience in Francophone Africa and personal contacts with its leaders, they have an interest in maintaining the 'privileged' status of the Francophone regimes. The attitude of French officials towards the application of either firm aid conditionalities or sanctions for non-compliance with the CFA zone's rules has been greatly influenced by the fact that their interests in Francophone Africa depend on maintaining cordial relations with a set of regimes. French officials with a vested interest in the Francophone regimes voiced support for adjustment, but during periods of crisis they preferred continued financing to assure short-term stability, because adjustment measures inevitably bore a risk of popular reactions which would unseat governments. Regime changes might then lead to a wholesale restructuring of Franco-African relations, and the disappearance of the benefits of the current system. Finally, control of French

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aid policy by the above interests has been facilitated by the broad consensus which exists in support of foreign aid in France, combined with incomplete knowledge about where aid often goes in practice. Evidence for the influence of political interests In the early and mid-1980s political interests in France helped undermine any chance for early pressure on the two Franc Zone central banks to reduce credits that were serving directly and indirectly to relieve fiscal pressures. With a set of African connections dating back to his tenure as Minister of Overseas France in 1950, President Mitterrand indicated his own preference for political stability over reform by preserving the traditional institutions of Franco-African diplomacy. Mitterrand maintained the special bureau for Africa at the French Presidency, the Elysee . He nominated a close friend to direct it, someone who had no professional experience as a diplomat but numerous contacts with African heads of state. This official made clear in a number of meetings that his job was to act as the advocate for the African heads of state within the French government, a task which included opposing heavy pressure on either African governments or the two central banks. 22 The Elysee bureau itself would continue to serve as the natural ally of the Franc Zone states, because its very existence depended on the 'privileged' nature of the Franco-African relationship. The result was that a parallel system of Franco-African diplomacy was preserved where African governments could effectively bypass the French Treasury (Bayart, 1984). Political interests would continue to intervene to undermine fiscal discipline after the Treasury succeeded in getting the two central banks to restrict credit, beginning in 1989. While the Treasury hoped that tight credit would put pressure on Cameroon and Cote d'Ivoire in particular to redress their budgetary situation, the heads of state of these two countries were able to call on French political allies to achieve a different outcome. President Felix Houphouet-Boigny of Cote d'Ivoire benefited from relationships maintained since his membership in the French government during the 1950s. President Paul Biya of Cameroon made similar use of contacts, including with the French Ambassador to Cameroon, who after his retirement in 1993 would be hired by Biya as a special counsellor. The end result was that a number of French officials worked at cross-purposes with their own Treasury. 23 While increased pressure from the Bretton Woods institutions was undoubtedly critical in changing the course of events in the CFA Zone, several transformations within France itself also helped lead to a dramatic change in policy towards the CFA states in 1993 as for the first time senior French politicians made clear that they intended to make further budgetary aid to CFA governments subject to IMF conditionality (ie, a devaluation of the CFA franc). 24 These transformations also help explain why France

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maintained a policy after the devaluation of making its non-project aid conditional on governments having an IMF accord. For one, there is clear evidence of generational change in France as those leaders who have had direct professional and educational experience with the African leadership move out of power. 25 A second and more readily identifiable change in 1993-94 involved a 'normalization' of the institutions of Franco-African diplomacy, as officials whose professional experience is based exclusively on Africa were replaced by those with more general qualifications, most notably in the special bureau for Africa at the Elysee. A third change involved the composition of the Balladur government, which had fewer Africa connections than its predecessors. 26 Explaining the failure of the central banks to act as restraints In deciding how much credit to extend to banks and to national treasuries, BCEAO and BEAC were armed with monetary policy rules that provided little in the way of automatic sanctions or restraints. Evidence on the relations between the two banks and member governments shows that they also lacked the independence that might have allowed them to impose discretionary restrictions on credit. This lack of independence is attributable in part to formal institutional features involving the setup of their governing boards. It may also be attributable to the presence of a particular pattern of political interests during reform discussions in 1972-73, and to the absence of a financial sector lobby which, in other developing countries, has been observed to increase de facto central bank independence even when formal institutional criteria for independence are absent. Evidence on the relationship between B CEAO, BEAC and governments In the BEAC zone, affairs in the common central bank were poisoned by enmity among virtually all the national representatives, and the Cameroonian government in particular often chose to ignore or simply refuse demands made by the monetary authorities. On one occasion, a Cameroonian minister reportedly threatened a BEAC representative that he would tell his civil servants to burn the central bank headquarters down if an advance to pay salaries was not forthcoming. The Gabonese governors of BEAC have been hampered by difficult relations with Cameroon since the Africanization of the bank in the mid-1970s, and for a period during 1994-95, the Cameroonian president was unwilling even to meet with the governor. 27 In UMOA, central bank authorities had a less antagonistic relationship with member governments, but this did not result in greater restraint on credit. The governor of BCEAO from 1975 to 1988, Abdoulaye Fadiga, apparently attached considerable importance to trying to keep governments from violating the fiscal borrowing rule directly, but he made no such attempt to

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curtail indirect government borrowing via the banking system and via public enterprises. The BCEAO administration also showed itself particularly desirous of maintaining cordial relations with the Ivoirian government at the expense of other states and the income position of the institution. This included creation of special rescheduling terms for interest owed by Cote d'Ivoire on its operations accounts deficits. 28 Fonnal sources of central bank independence Independence for a central bank on paper does not always add up to independence in practice, particularly for developing countries, but it still seems useful to consider how the formal institutions of BCEAO and BEAC may have affected their ability to act as restraints on governments. Several recent studies focusing on national central banks argue that they will be more independent when: 29 1. there is a statutory commitment to monetary stability; 2. limits exist on central bank credit to governments; 3. tenure of the governor and board members is lengthy (5+ years), and the governor cannot be reappointed; 4. there is no mandatory government participation in or approval of monetary policy; 5. the governor and board members are not appointed exclusively by the executive branch, nor are they members of the government. BCEAO and BEAC do place limits on central bank credit to governments, tenure for governors is fairly long (6 and 5 years respectively), and the two banks have a commitment to defend the French peg (and thus to monetary stability). 30 There are two major problem areas where they fail to meet the above conditions. For one, unlike a number of federal central banking systems (Germany, European Central Bank, US Federal Reserve Board), BCEAO and BEAC do not split membership on key policy making bodies between national representatives and representatives independent of any single political authority. The 1973 Reforms turned the banks over to African control, but rather than making an attempt to staff them with private bankers or with international civil servants, the decision was made to turn the governing boards into ministerial councils. 3 1 A second problem involves the process for choosing the governor of each central bank. 32 In BCEAO the governor, by convention, is always an lvoirian. A deal between lvoirian and Senegalese officials negotiating the reforms of 1973 specified that the BCEAO's headquarters would be moved from Paris to Dakar and that governing board seats would be distributed equally, in

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exchange for allowing Cote d'Ivoire to choose the governor. (Julienne, 1988). Giving the BCEAO governorship to the largest state has had negative consequences for independence, because governors have regularly been close political associates of the President of Cote d'Ivoire. In BEAC, Cameroon in 1972 made the exact opposite choice from Cote d'Ivoire, as it preferred to have the BEAC headquarters in its territory, along with 4 seats on the governing board, in exchange for leaving the choice of the governorship to Gabon. The BEAC statutes actually specify that the governor is nominated by Gabon, then voted on by the rest of the board. Cameroon's four seats allow it to block most adjustment measures single-handedly. 33 As a result, it cannot control the central bank, but it can seriously hinder attempts for the central bank to restrain the government of Cameroon. In the end, while the central banks have lacked formal independence, this does not explain why their statutes were set up in this way in the first place, nor does it offer an explanation for the absence of informal pressures supporting independence. Financial-sector support for central bank independence

For both developing and OECD countries it has been observed that the private financial sector can provide a major bulwark for the independence of a central bank, even when formal attributes of independence are absent (Mas, 1994; Maxfield, 1994, Posen, 1993). Private bankers have a strong interest in the price stability that an independent central bank can provide, because the maturity mismatch of their assets and liabilities gives them much to lose in case of unanticipated inflation. In the Franc Zone, inflation was not a major problem but an absence of central bank independence did certainly have other costs for private bankers as a group, since both BCEAO and BEAC made no attempt to protest when governments pushed commercial banks into making a series of politically motivated loans which eventually led to a financial sector collapse. Missing in the CFA states was a group of private African bankers that would have had a strong interest in independence for the monetary authorities. 34 Instead, the banking system has been comprised almost exclusively of state owned development banks created after the 1973 reforms, and of joint ventures with participation divided between major French banks and African governments. In the development banks, state-ownership politicized their functioning, giving their managers as much of an incentive to curry favour with government authorities as to maximize the profits of their institution. Managers of the major French banks with operations in the zone were probably aware of the French government's political objectives, especially since two were under state control for the entire period in question (Honohan and Vittas, 1995).

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Incentives for African politicians to create agencies of restraint Analyses of central bank independence generally assume that politicians favour monetary stability as a principle but will resort to monetary expansion in a pinch. This ignores the question why some politicians do actually delegate increased authority to central banks. Previous experience can dramatically affect this calculation. If macroeconomic instability has proved to be a serious political liability in the recent past, politicians may be more likely to turn over monetary policy to an independent authority (Haggard et al., 1994). Taiwan, Germany and New Zealand are cited as examples of this phenomenon. If instead, unemployment or slow growth has been the perceived political liability, politicians may benefit in the short term by weakening independence of the monetary authorities and by exploiting this institutional change in order to follow a more expansionary policy, even if they themselves realize that the long term result will be undesirable. 35 The decision to put central banks under direct political control in the Franc Zone took place during the 1972-73 reforms. The principal motivation of the African politicians that pushed for the reform was often referred to in terms such as making 'money an engine of development'. 36 Instead of constructing their union as a response to past failures, African governments had inherited the institutions from a colonial power. The growth experience of the 1960s was deemed unsatisfactory for most countries in the Franc Zone. For politicians under pressure to do something, the independence of the monetary authorities and the supposedly overly restrictive monetary policy they followed became a prime target for criticism. Undoubtedly, there was also a strong non-economic reason for turning the central banks over to African control, but this did not necessitate a bank controlled by politicians. Direct political control was necessitated by the fact that 'money as an engine of development' was interpreted as financing increased government spending and other development projects through central-bank subsidized credit. As a result, in addition to changes in decision-making, rules on direct lending to governments were relaxed, state-owned development banks were created, special facilities for central bank subsidized financing of government infrastructural projects were added, and crop credits were subsidized. Summary In moving from a Franc Zone arrangement that from 1960 to 1972 was essentially a colonial holdover where France controlled the two central banks, France and the CFA states failed to define sanctions or conditionalities that could be applied by the French government to ensure that its providing guaranteed convertibility for the CFA and non-project aid did not undermine fiscal discipline. They were also unwilling to consider how the two

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supranational central banks might be turned over to African control, but not necessarily to direct political control. These failures of institutional design themselves resulted from the interest of a group of French politicians and administrators in preserving the Franc Zone at all costs and from the interest of African politicians in finding a short-term solution to a problem of slow growth. During a period of crisis in the 1980s and early 1990s political interests intervened again to weaken French Treasury oversight and the operations of the two central banks. 5. CURRENT AND FUTURE POSSIBILITIES FOR INSTITUTIONAL REFORM IN THE FRANC ZONE Since 1989 the Franc Zone has undergone a new period of institutional reform. Current and proposed reforms include efforts to close loopholes in the existing rules and a move towards use of indirect instruments of monetary policy. They also include an attempt to broaden the current system by establishing multilateral surveillance of fiscal policies. Reforming the central banks Recent monetary refonns

Under pressure from the French Treasury and the Bretton Woods institutions, beginning in 1989 both Franc Zone central banks undertook a number of monetary policy reforms. A loophole in the fiscal borrowing rule was closed which previously allowed government marketing boards to borrow money from the central banks without it counting as government borrowing under the fiscal borrowing rule. Concessional interest rates for refinancing credit were abolished, and both central banks aligned the rate for advances to national treasuries with market rates. Efforts also began to move towards use of indirect instruments of monetary policy, based on reserve requirements and central bank interventions on a regional money market, but the BCEAO in particular seems unwilling to fully accept this aspect of reform. Finally, commissions for banking regulation were established in UMOA in 1990 and in BEAC in 1993. A need to refonn decision-making structures

While efforts to modernize management of Franc Zone monetary policy were long overdue, past experience suggests that there should also be major alterations in the governance structures of the two central banks to increase chances that they will actually have the independence necessary to act as restraints on governments.

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For one, the central bank governing boards should be turned over to individuals who will stand more of a chance of being independent from national fiscal authorities. This will inevitably be a difficult task in the CPA states, where there is neither a strong financial sector, nor an independent bureaucracy, nor a large group of university economists from which such individuals could be drawn. Even so, transferring board membership to representatives who do not at the same time serve as top finance ministry officials of member governments would be an important initial step towards increasing independence. Consideration could also be given to increasing the size of each governing board by including members that are not nominated by a single government. Finally, Cameroon's possession of four seats on the governing board in BEAC has weakened independence of the monetary authorities in the past, and the BEAC states might do well to reconsider this issue. The process for choosing the governor of each central bank should also be altered. Experience with current arrangements in BCEAO suggests that giving Cote d'Ivoire control of the governorship has reduced the central bank's ability to resist demands by the lvoirian government to exceed its ceiling on direct borrowing and to obtain further refinancing credit. The alternative option in BEAC of giving the largest state no influence over the choice of governor has proven at least as unsuccessful, as Cameroon has used tactics of intimidation to contest the basic legitimacy of BEAC and its governor. A better process for choosing the governor in both UMOA and BEAC might be to have the largest state nominate candidates for the governorship, followed with a vote among member states. This might allow the largest state to nominate an individual with whom it will cooperate, while smaller states could veto candidates whom they suspect will be particularly subject to political influence. Terms for governors should be made non-renewable, in order to reduce incentives to curry favour with politicians. Performance-based contracts might also be considered.37 In addition to revamping their governance structures, both central banks need to make their operations more transparent so at to improve their credibility in the eyes of the private sector, officials in France, and representatives of other donors. BCEAO in particular suffers from a tradition of excessive secrecy in many of its operations including: processing of transfers of CFA francs into French francs, an opaque process for monetary programming, and its own grossly inflated administrative costs.38 Establishing multilateral surveillance of fiscal policies Both Franc Zone unions signed treaties in 1994 to expand the scope of their cooperation to include a system of multilateral surveillance of fiscal policies. The states of the new UEMOA (formerly UMOA) have agreed to a detailed

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programme for surveillance, while progress in the CEMAC states (formerly BEAC) has been delayed by disputes between Cameroon and Gabon over voting weights on the union's council of ministers and other related issues. Several authors have seen these accords as an important step towards promoting overall macroeconomic stability by correcting for the past error of failure to establish rules for or coordinate fiscal policy (Fine and Yeo, 1 994; Ghymers, 1 994; Elbadawi, 1996) The UEMOA process of multilateral surveillance The UEMOA treaty states that the newly established Commission of UEMOA will propose general macroeconomic objectives for the union, which will be voted on by the Council of Ministers. The UEMOA Commission will draft a bi­ annual report on respect of convergence criteria for which non-binding quantitative norms have been established. 39 In the case where a state is determined to be non-compliant with the general macroeconomic objectives of the union, the Commission will propose a directive of adjustment measures that the Council of Ministers can then adopt by a majority. If the directive is not adopted, the Commission has the right to make public its findings anyway. If the directive is adopted by the Council, an adjustment programme is agreed upon with the member state, which can receive assistance if it cooperates and sanctions if it does not, again based on a majority of the Council. Several different sanctions can be applied, ranging in severity from publication of a communique to suspension of the state's access to union resources.

i

i

Potential weaknesses of the multilateral surveillance procedure There are at least three reasons to doubt the effectiveness of the system of sanctions and enforcement described above. First, there is a problem of disparities in size between member economies, stemming from the fact that Cote d'Ivoire and Cameroon each make up approximately half of the GDP of their respective unions. In situations where one of the smaller member states of UEMOA has experienced a negative external shock and has been unwilling to undertake fiscal adjustment, the natural leadership position held by Cote d'Ivoire might increase the chance of sanctions actually being applied. In contrast, in the event that Cote d'Ivoire experiences a negative external shock and fails to adjust, it will, in all likelihood, be more difficult for the remaining member states to organize effectively to threaten sanctions, even if voting weights on the Council of Ministers are nominally equal. The conclusion to draw is that multilateral surveillance between different CFA states will have little effect unless Cote d'Ivoire and Cameroon set a policy standard for fiscal discipline in their respective unions. This is particularly problematic in that previous to the devaluation of January 1 994, these two states instead set standards for fiscal indiscipline. Since January 1994, Cote d'Ivoire has

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improved its fiscal policy stance considerably while Cameroon has been much less successful in doing so. A second problem with the UEMOA surveillance process as it now stands is that sanctions which are drawn directly from the Maastricht Treaty provisions for monitoring public deficits will be less successful in the much different context of UEMOA. In particular, for European governments which seek their financing on domestic and international bond markets, fear of the financial market reaction that a negative communique could provoke would be a powerful incentive to cooperate with a supranational authority. While the severity of financial market reaction under this system is likely to be uncertain, leaving part of the administration of sanctions to financial markets can help make the mechanism more credible. Because the CFA governments currently depend exclusively on bilateral and multilateral aid for finance, and not on financial markets, a negative communique will be likely to have less effect. The other major sanction that could be applied is to suspend the flow of union resources to the recalcitrant state, but under the current system if a state is in severe financial distress it is likely to have already reached its statutory limit on advances from the central bank. These weaknesses in the sanctions mechanism as it now stands may mean that effective sanctions will need to be tied to external aid. Given the potential problems with current arrangements for sanctions between the members of either UEMOA or CEMAC, a third weakness of the current arrangements is that there is no formal role for an external partner. While an informal arrangement is not ruled out, this failure to establish pre­ determined sanctions or specific conditionalities which France might apply as an external partner to UEMOA will undoubtedly weaken the position of those in the French government with an interest in promoting fiscal discipline. Of the three weaknesses in the multilateral surveillance mechanism listed above, the problem of disparities in size and the difficulty of applying sanctions when governments are not borrowing on financial markets are beyond the range of policymakers to immediately address. The lack of specification regarding an external partner could be rectified, but the actions France ultimately takes will be dependent on the evolution of political interests within the French government. Possible contributions of the multilateral surveillance procedure For the reasons outlined above, threats of sanctions for CFA states that run excessive fiscal deficits seem likely, in many cases, to lack credibility. But even if this attempt to impose restraint through the mechanism of sanctions fails, multilateral surveillance might still make a significant contribution to fiscal discipline by improving transparency of budgets and by changing the process through which budgets are actually formulated.

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The growing literature on budgetary institutions provides empirical support for the proposition that countries with more transparent budget processes tend to run smaller deficits, because there is less of a possibility for deceiving the public ( or donors) about the actual costs of current government operations. 40 Alesina and Perotti (1996) distinguish two general problems involving a lack of transparency in budgets: 1) 'hidden' spending; 2) overoptimistic macroeconomic and revenue projections. Within this literature, several analysts also suggest making a division between budget processes that are collegial (where each minister proposes a budget for his or her ministry) and those that are hierarchical (where a President, Prime Minister, or Finance Minister determines the overall size of the budget first). For countries with a history of fiscal indiscipline, establishing more hierarchical institutions may be a useful reform measure. If it is sustained, the UEMOA multilateral surveillance process can make a major contribution to the transparency of budgetary processes in CFA states, and it can do so in a manner that is more participatory than if these issues remained a subject of discussion only between donors and individual countries. In order to reduce the risk of hidden public expenditures, the UEMOA governments have adopted a standardized Table on Government Financial Operations (TOFE, for its French acronym) which presents a unified picture of public spending in member states. They have also begun to harmonize national budgetary laws and to establish procedures for the regular distribution of statistics on individual countries to all member states. During the 1980s, the absence of any document presenting a complete overview of public spending and liabilities made it difficult to assess the magnitude of fiscal pressures on the banking sector. The fact that the TOFEs will be standardized across UEMOA and discussed with the UEMOA Commission and other UEMOA governments should help provide a further check against the emergence of 'creative, budgetary processes in individual states. For the TOFEs to have their full effect, it will also be important to make them public and in a regular manner. One could suggest that restraint might come not just from accountability to supranational authorities and donors, but also through making CFA governments more accountable to the public in member states. 41 Overall, existence of the TOFEs will not prevent governments that are determined to do so from running large deficits, but it might be expected to reduce that likelihood and to influence decisions on individual items of spending. To guard against the danger of overoptimistic macroeconomic and revenue projections, the CFA states already have an important restraint in this area in the form of IMF programmes. This external restraint could be made more participatory if union authorities in UEMOA themselves undertook independent assessments of whether projections formulated by individual governments are realistic. Participation of supranational authorities in

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macroeconomic projections could also be taken a step further in an effort to make the budgetary decision process more hierarchical. Instead of simply having an independent authority verify government revenue projections, individual governments might prepare a full macroeconomic programme in coordination with either the UEMOA Commission or, more likely, the BCEAO. Hausmann and Stein (1996) cite examples of Latin American countries where the government prepares a macroeconomic programme with an independent central bank, suggesting that this process 'is equivalent to demanding that the budget prepared by the government be consistent with the spending and deficit targets identified in the macro programme'. 42 This would be similar to the UEMOA Commission's current task of establishing general macroeconomic objectives for the union, but it would differ crucially in involving a programming exercise for individual states. The problem with this option is that BCEAO would need to improve its capacity to conduct monetary programming before undertaking a broader exercise. It would also need to address its problems of a lack of credibility and insufficient independence.

6. CONCLUSION AND IMPLICATIONS FOR OTHER AFRICAN STATES The failure of the Franc Zone arrangements to promote fiscal discipline in member states during the 1980s and early 1990s is attributable to a number of potentially rectifiable flaws in institutional design. For an arrangement that was intended to be rule-based, far too many issues were left to the discretion of authorities in France and in the two central banks, and the two banks also lacked the formal attributes of independence which might have allowed them to take discretionary actions to restrain member governments. Any similar arrangements constructed elsewhere will need to avoid these potential pitfalls. A number of reforms of Franc Zone institutions have taken place since 1989, but the key issue of central bank independence has not been addressed. Multilateral surveillance of national fiscal policies might make a significant contribution to fiscal discipline in UEMOA and CEMAC, but there a number of reasons to believe that this contribution would come less from the threat of sanctions than from increased transparency and reformed decision-making processes. Questions of institutional design aside, it is also evident that a particular pattern of political interests in France and in the CFA states influenced both the design of the Franc Zone's institutions during a period of reform in 1972-73 and the application of rules and discretionary mechanisms during a time of crisis. The broader issue here is that any external partner to the CFA

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states will be likely to have both political and economic objectives with regard to the arrangement. This prompts the question, will any other reciprocal monetary or trade arrangement between a group of African countries and the European Union be undermined by the same pattern of political interests as in the Franc Zone? For the African countries, Gyimah-Boadi and van de Walle (1996) argue that 'strong agencies of restraint will not emerge in Africa until non­ governmental domestic actors can impose them on recalcitrant rulers'. Domestic political support in Africa to construct an effective agency of restraint in the monetary domain might come from a strong financial sector lobby, as has happened in Thailand (Maxfield, 1994), but such support has been absent in the Franc Zone, and the situation would probably be similar in other African states where financial sectors today are just emerging from a lengthy period of public ownership. Another possibility for political support for restraint may come if leaders in a group of African countries outside the CFA Zone are convinced that heavy monetary financing of fiscal deficits and the high and variable inflation that it produced has been a major political liability for governments in the past. 43 For the developed-country partner in a reciprocal monetary arrangement, the experience of the Franc Zone suggests that the key question is will there be individuals in the government who have goals that conflict with the objective of enforcing restraint? The risk is that what is intended to be an agency of restraint would actually become a source of indiscipline. It seems unlikely that this problem would repeat itself in an arrangement involving other European Union countries, because France's political interest in Africa has long been observed to be something of an exception among European states. Instead of a problem of conflicting goals, for other European countries there is more likely to be a basic problem of a fundamental lack of interest in creating this type of arrangement. Collier and Gunning (1995) suggest that fear of the consequences of continued economic failure in Africa, a desire to improve trade opportunities with Africa in the long-term, and a desire to replace current aid conditionality with a more effective instrument could all serve as potential motivations. Aside from the aid community, however, there may be no identifiable group with a sufficient interest in either of these three goals to lobby for the creation of a reciprocal monetary arrangement. The situation with reciprocal trade arrangement might be different. Collier and Gunning (1995) argue that a reciprocal trade arrangement might be supported politically by export sector lobbies who realize that maintaining their own trading opportunities in the partner country will depend upon their own country not breaking the rules. If one of the African states broke the rules of the arrangement by raising tariffs, European firms that export to the country might lobby for retaliation. This would be most likely to take place if South Africa were part of such an arrangement, given the interest European

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firms have expressed in that market. Similarly, African exporting firms could benefit from the opportunity to gain greater access to EU markets. The flipside of this lobbying for free trade is that once a trade arrangement was created, both European and African firms that compete against imports would still be likely to lobby their governments to break the rules by applying new protectionist measures, and they could do so with the knowledge that any sanctions would fall not on them, but on the export sector of their own economy and on consumers. Because European countries also happen to be donors interested in supporting export sectors in the African countries they aid, there may be a reluctance to penalize exporting firms in an African country whose import-competing firms have succeeded in getting a govern­ ment to break the rules of the arrangement. To the extent that this reaction is anticipated, the arrangement will be ineffective. One way in which this problem might be avoided is to have European countries instead administer sanctions by suspending aid. The problem with this solution is that it would remove the incentive for African exporting firms to lobby their own governments to adhere to the rules, because they would no longer bear the brunt of any sanctions. In sum, a reciprocal trade arrangement between the EU and a group of African countries stands a better chance of enjoying interest group support than would a monetary arrangement, but in trade arrangements the question of how to apply sanctions poses potential difficulties.

Notes

1. 2.

This chapter reflects only the views of its author and not those of the OECD Development Centre. I wish to thank Charles Humphreys, Smita Singh, and conference participants for useful comments. I also thank Patrick Honohan, Serge Michailof, Roland Tenconi, and Charles Wyplosz for reading an earlier draft. All errors are my own. Collier, 1995, 1991; Collier and Gunning, 1995. Similar arguments about the Franc Zone have been made by Devarajan and Walton, 1994; Guillaumont and Guillaumont, 1993, and Medhora, 1993. The Union Monetaire Ouest-Africaine (UMOA), includes Cote d'Ivoire, Senegal, Benin, Togo, Burkina Faso, Mali, and Niger. Since the signature of a new treaty in January 1994 it has become the Union Economique et Monetaire Ouest-Africaine, or UEMOA. Its central bank is the Banque Centrale des Etats de l'Afrique de l'Ouest (BCEAO). The Franc Zone's other union is referred to by the acronym of its central bank the BEAC, or Banque des Etats de l'Afrique Centrale. Its members include Cameroon, Gabon, Chad, the Central African Republic, Congo, and Equatorial Guinea. In 1994 the BEAC states signed a new treaty, the CEMAC, creating a union similar to UEMOA. Before January 1994, the currency of both unions, the CFA franc, was pegged to the French franc at a rate of 50: 1. In January 1 994 the CFA franc's parity was adjusted to 100: 1 .

300 3. 4. 5. 6. 7.

8. 9. 10.

11. 12. 13.

14. 15. 16.

17.

Investment and Risk in Africa Because the discussion here is of the Franc Zone as an external agency of restraint, I take the existence of fiscal pressures within individual CFA states as given. While not the direct subject of this chapter, it could also be argued that resistance to a devaluation of the CFA franc occurred for similar reasons. (Stasavage, 1995) For a more complete description of the Franc Zone's institutions see Guillaumont and Guillaumont, 1984. Collier (1991). This is an argument which, of course, has also been made for Europe. In calculating the total stock of advances BCEAO includes: 1. Direct advances extended by BCEAO to public treasuries, including the balance of BCEAO's postal account held at each government treasury. 2. Public papers issued or guaranteed by government that are discounted or rediscounted by the central bank. 3. BCEAO rediscounted bonds of less than ten years maturity to run issued by government or public entities to finance infrastructure or development. The ceiling is adjusted upward for any positive balance of public treasuries on their current accounts at BCEAO. The ceiling is adjusted downward for the sum of deposits at public treasuries or public banks made by commercial banks that have used the refinancing facility of BCEAO. When determining the total stock of credit issued to governments BEAC includes: 1. Direct advances extended by BEAC to public treasuries. 2. Public papers issued or guaranteed by government that are held by BEAC or held by commercial banks and which are eligible for rediscount by BEAC. I thank Charles Wyplosz and Phi Anh Plesch for providing this information. The French term engagements a vue is most frequently translated as 'sight liabilities' and includes notes and coins, sight deposits of banks, financial institutions and the Treasury, and foreign currency liabilities. The BEAC treaty does state that if the operations account is in deficit for three consecutive months, rediscount ceilings should be reduced by 20 per cent in states with overdrafts on their individual accounts. It is important to note that these figures for government deficits do not fully reflect the extent of fiscal indiscipline in some states because many governments chose to push commercial and development banks under state control into making politically motivated loans to public enterprises and other entities. This had the effect of indirectly relieving budgetary pressures, but, as will seen below, the result was a collapse of the financial sector in several states. World Bank data BCEAO data BCEAO data show that the overall stock of refinancing credit to banks in UMOA exceeded the sum of individual country ceilings in each year between 1986 and 1990. In 1990 the sum of individual country refinancing ceilings was 594bn CFA and actual lending was 834bn CFA. La Zone Franc, annual reports. French non-project aid between 1986 and 1993 totalled 17 per cent of GDP for Cote d'Ivoire and 8 per cent of GDP for Cameroon. Interviews with former BCEAO and BEAC officials and former ministers in Paris, July 1993 and November 1994; 'An End to Intimacy', Financial Times, 10 November 1973; Financial Times, 4 March 1969; Le Monde, 23-25 November 1972. On the Mauritanian departure, 'La Mauritanie va creer sa monnaie nationale', Le Monde, 30 November 1972. Providing evidence for the actions taken by the Treasury is made difficult by the secrecy that surrounds the institution. Nonetheless, several broad trends can be

The Franc Zone as a Restraint

18. 19.

20.

21. 22. 23. 24.

25. 26.

27. 28.

29. 30. 31.

32.

301

suggested, based on intetviews with [then] current and former Treasury and other officials in Paris: October 1992; June-July 1993. There were eight different directors of the Treasury's Franc Zone bureau between 1978 and 1992 tabulated from the Bottin Administratif French bilateral non-project aid to the CFA states even in the peak year of 1993 amounted to less than one-half of one per cent of total French government expenditure. French total government expenditure from IMF, Government Financial Statistics Yearbook. The argument I make here is related to that of Kahler (1992), who argues that conditionality has often been rendered ineffective by the fact that donor governments have multiple, and sometimes, conflicting goals with respect to debtors. Where I differ from Kahler is in focusing on the fact that different individuals within donor governments will have different, and sometimes conflicting interests with regard to how strictly conditionalities should be enforced. For an earlier version of this argument which presents more detail on France's Africa policy, and which also investigates a number alternative hypotheses for France's support for the Franc Zone see Stasavage (1995). The best known example here involves the activities of President Mitterrand's long-time Africa counselor (and also his son), Jean-Christophe Mitterrand. For a discussion of these issues by two journalists, see Smith and Glaser (1992). interview with former Ministry of Cooperation official in Paris, December 1992. Intetviews with (then) current and former Elysee and Treasury officials in Paris June 1992, October 1992, and June 1993. For a journalist's account of relations with Cote d'Ivoire see Jean-Louis Gombeaud et al., La Guerre du Cacao, 1988. This was signaled by a letter from the then French Prime Minister, Edouard Balladur, (published in Le Monde, 23 September 1993) stating that further French structural adjustment loans would be made conditional on countries first having signed an agreement with the IMF. For an attempt to measure this phenomenon see Stasavage (1995) Intetviewees in Paris in January 1994 were quick to comment that the absence of Africa ties in Balladur's government and on the part of the Prime Minister himself, had been instrumental in the change in orientation that led to devaluation. For a newspaper ovetview of this period, see Marie Pierre Subtil in Le Monde, 20 January 1994. Intetviews in Paris with former BCEAO and BEAC officials, November 1994. Intetviews with former BCEAO and BEAC officials in Paris, September­ October 1992 and November 1994. For Cote d'Ivoire and Senegal it was decided, contrary to statutory provisions, that both countries could pay interest on operations accounts deficits over a twelve-year period, with a three-year grace period. This simplified list is drawn principally from Cukierman (1992) and Grilli et al. (1991 ). Although BCEAO's statutes also call for financing economic activity and development, which could be a conflicting goal. BCEAO actually has two governing bodies with a conseil d'administration made up of ministry of finance officials and two French representatives, and the UMOA conseil des ministres with two ministers from each member country but no French participation. BEAC has a single conseil d'administration with ministers as representatives, and it also has unequal voting. Cameroon has four representa­ tives, France has three, Gabon has two, and the remaining states have one each. In addition, the governor of each Franc Zone central bank is elected for a renewable term, making them more susceptible to political influence.

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302 33. 34. 35. 36. 37.

38. 39.

40.

41. 42.

43.

If the French administrators do not take a formal position (as was often the case), with four out of the remaining 10 votes, Cameroon can block decisions on the fixing of refinancing limits (which require a 3/4 majority). The CFA states were hardly exceptions among African states in this regard. For evidence of the absence of a financial sector lobby with an interest in central bank independence elsewhere in Africa see Kasekende and Hussain(1999). The political economy literature suggests that this sort of myopic policymaking is more likely to occur in states with high political instability and/or fragmented societies (Alesina and Drazen, 1991; Haggard and Kaufman, 1990). For a discussion of this period, see Julienne (1988); interviews with former BCEAO and BEAC officials in Paris September-October 1992, November 1994. BCEAO officials already earn salaries that reportedly are, on average, four times higher than similar positions in national governments in the CFA zone (Jeune Afrique, 26 October 1988). For the governor of the central bank, it might bring better results to make pay related to performance. For a discussion of these issues see Walsh (1995). BCEAO has for several years refused to accept demands by French Treasury officials for an audit of its administrative expenses. Criteria state that the wage bill should not exceed 50 per cent of fiscal revenue, the primary surplus should remain greater than 15 per cent of revenue, public investment financed by domestic resources should remain above 20 per cent of fiscal revenue, and there should be no accumulation of either domestic or external arrears. Hausmann and Stein (1996); Alesina and Perotti (1996); Campos and Pradhan (1996). One problem, as Poterba (1996) points out, is that none of the empirical studies in this group of papers address the question of whether budgetary institutions that promote fiscal discipline are simply the product of distributional interests that favour fiscal discipline. I thank Charles Humphreys for pointing this out. Such exercises take place in Chile and Colombia, with the programmes including targets for the inflation rate, the external balance and the growth rate, and targets for policy instruments including fiscal spending, monetary expansion, and exchange rate policy. The government of Thailand also apparently operates under a similar set of arrangements. Kasekende and Hussain (1999) suggest that public support for the central bank will be a key element in deciding whether Uganda's reformed central bank would be able to resist pressures from fiscal authorities in the future.

REFERENCES Traite de ['Union Economique et Monertaire Ouest-Africaine (UEMOA), January, 1994. Convention de Cooperation Monetaire entre la Republique du Tchad, la Republique unie du Cameroun, La Republique Centrafricaine, La Republique Populaire du Congo et la Republique Gabonaise., November, (1972). Statuts de la Banque des Etats de l'Afrique Centrale (1972). Convention de Cooperation Monetarie entre !es Etats membres de la BEAC et la Republique Frani;aise, November, (1972). Convention de Compte d'Operations (BEAC), March, (1973). Statutes de la Banque Centrale des Etats de l'Afrique de l 'Ouest (1973). Traite Constituant !'Union Monetaire Ouest-Africaine, November, (1973).

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Accord de Cooperation entre la Republique Franr;;aise et les Republiques membres de [Union Monetaire Ouest-Africaine, December, (1973). Convention de Compte d'Operations (UMOA), December, (1973). La Zone Franc, Secretariat du Comite Monetaire de la Zone Franc, various years. Alesina, Alberto and Allan Drazen (1991). 'Why are Stabilizations Delayed?', American Economic Review, 81; 5, 1 170-88. Alesina, Alberto and Vittorio Grilli (1991). 'The European Central Bank: Reshaping Monetary Politics in Europe', NBER Working Paper, no. 3860. Alesina, Alberto and Roberto Perotti (1966). 'Budget Deficits and Budget Institutions', NBER Working Paper no. 5556. Bayart, Jean-Franc;ois (1984). La Politique Africaine de Franr;;ois Mitterrand, Karthala, Paris. Collier, Paul (1995). 'The Role of the African State in Building Agencies of Restraint', mineo, Centre for the Study of African Economies, University of Oxford. Collier, Paul (1991). 'Africa's External Relations: 1960-1990', African A.ffairs, 360: 90. 339-53. Collier, Paul and Jan Gunning (1995). 'Trade Policy and Regional Integration: Implications for the Relations between Europe and Africa, The World Economy, 18, 3 387-410, (May). Campos, Ed and Sanjay Pradhan (1996). 'The Impact of Budgetary Institutions on Expenditure Outcomes', World Bank PRE Paper No. 1646. Cukierman, Alex, Bilin Neyapti and Steven Webb (1992). 'Measuring the Indepen­ dence of Central Banks and its Effect on Policy Outcomes', World Bank Economic Review, 6; 3. 397-423. Devarajan, Shantayanan and Michael Walton (1994). 'Preserver la Zone CFA apres la Devaluation', Revue d'Economie du Developpement, 2; 3. 5-30. Elbadawi, Ibrahim (1996). 'Consolidating Macroeconomic Stabilization and Restoring Growth in Africa', in Benno Ndulu and Nicolas van de Walle (eds.), Africa 's Economic Renewal: from Consensus to Strategy, Overseas Development Council. Fine, Jeffrey and Stephen Yeo (1994). 'Regional Integration in Sub-Saharan Africa: Dead End or a Fresh Start', paper prepared for the AERC research programme on Regional Integration and Trade Liberalization in Sub-Saharan Africa, October. Gerardin, Hubert (1994). La Zone Franc, Paris, Harmattan. Ghymers, Christian (1994). 'Integration Economique et Union Monetaire en Afrique de l'Ouest', De Pecunia - Revue du CEPIME, 6; 2. Gombeaud, Jean-Louis, Stephen Smith and Corinne Moutot (1998). La Guerre de Cacao, Calmann-Levy, Paris. Goreux, Louis (1995). 'La Devaluation du Franc CFA: un Premier Bilan en Decembre 1995', World Bank. Grilli, Vittorio, Donato Masciandaro and Guido Tabellini (1991). 'Political and Monetary Institutions and Public Financial Policies in the Industrial Countries', Economic Policy, 6(2): 641-92 Guillaumont, Patrick and Sylviane Guillaumont (1984). Zone Franc et Developpement Africain, Paris, Economica. Guillaumont, Patrick and Sylviane Guillaumont (1993). 'L'Integration Economique: un Nouvel Enjeu pour la Zone Franc', Revue d'Economie du Developpement, 1; 2. 83--112. Gyimah-Boadi and Nicolas van de Walle (1996). 'The Politics of Economic Renewal in Africa', in Benno Ndulu and Nicolas van de Walle (eds.), Africa 's Economic Renewal: from Consensus to Strategy, Overseas Development Council. Haggard, Stephan and Robert Kaufman (1990). 'The Political Economy of Inflation and Stabilization in Middle-Income Countries', World Bank Policy Research Working Papers, no. 444.

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Haggard, Stephan, Chung H. Lee, and Sylvia Maxfield (1994 ). The Politics ofFinance in Developing Countries, Ithaca, Cornell University Press. Hausmann, Ricardo and Ernesto Stein (1996). 'Searching for the Right Budgetary Institutions for a Volatile Region', in Ricardo Hausmann and Helmut Rezisen (eds.), Securing Stability and Growth in Latin America: Policy Issues for Shock-Prone Economies, Paris, OECD Development Centre. Honohan, Patrick (1993). 'Financial Sector Failures in Western Africa', Journal of Modem African Studies, 31, 1. Honohan, Patrick and Dimitri Vittas (1995). 'Ownership and Control in Banking: Policy Issues for Developing and Transition Economies', mineo, World Bank. Julienne, Robert (1988). Vingt ans d'Institutions Monetaires Ouest-Africaines, Paris, Harmattan. Kahler, Miles (1992). 'External Influences, Conditionality, and the Politics of Adjustment', in Stephan Haggard and Robert Kaufman (eds.), The Politics of Economic Adjustment: International Constraints, Distributive Politics, and the State, Princeton University Press. Kasekende, Louis A. and Iftikhar Hussain (1999). 'The Central Bank as a Restraint: the Experience of Uganda', this volume. Mas, Ignacio (1994). 'Central Bank Independence: a Critical View from a Developing Country Perspective', World Bank Policy Research Working Paper, no. 1356. Maxfield, Sylvia (1994). 'Financial Incentives and Central Bank Authority in Industrializing Nations', World Politics, 46; 4. 556-69 Medhora, Rohinton (1993). 'Monetary Integration in West Africa: Lessons from the UMOA', , IDRC, Ottawa. Melo, Jaime de, Arvind Panagariya and Dani Rodrik (1992). 'The New Regionalism: a Country Per�pective' in J. de Melo and A Panagariya (eds.), New Dimensions in Regional Integration, Cambridge University Press. Michailof, Serge (ed.) (1993). La France et l'Afrique: Vade Mecum pour un Nouveau Voyage, Paris, Karthala. Posen, Adam (1993). 'Why Central Bank Independence does not Cause Low Inflation', Finance and the International Economy, vol. 7, Oxford University Press. Poterba, James (1996). 'Do Budget Rules Work', NEER Working Paper, no. 5550. Rodrik, Dani (1996). Understanding Economic Policy Reform', Journal of Economic Literature, 34, March. 9-41 Smith, Stephen and Antoine Glaser (1992). Ces Messieurs Afrique: le Paris-Village du Continent Noir, Paris, Calmann-Levy. Stasavage, David (1995). 'The Political Economy of Monetary Union: Evolution of the African Franc Zone 1945-1994', unpublished dissertation, Harvard University. Tornell, Aaron and Andres Velasco (1995). 'Fixed versus Flexible Exchange Rates: Which Provides more Fiscal Discipline?', NEER Working Paper, no. 5 108. van de Walle, Nicolas (1991). 'The Decline of the Franc Zone: Monetary Politics in Francophone Africa', African Affair, 90; 360. 383-412 Walsh, Carl E. (1995). 'Optimal Contracts for Central Bankers', American Economic Review, 85; 1. 150--67 Wilson, Ernest (1993). 'French Support for Structural Adjustment Programs in Africa.' World Development.

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DISCUSSION Smita Singh on 'The Franc Zone as a Restraint' by David Stasavage Rather than specifically critiquing David Stasavage's excellent paper on the CFA Franc Zone as an agency of restraint, I will extract the strategic games underlying the politics described in the chapter in order to push our discussion toward an agenda for future research and inquiry. This chapter correctly identifies some of the reasons why the Franc Zone has been ineffective as a restraint on member governments in imposing fiscal discipline: 1) a lack of enforceable sanctions from both France as the external partner and the union banks; and 2) a lack of independence, resulting in a lack of credibility in general. In my remarks, I will explore the nature of the strategic problems encountered in setting up an effective agency of restraint. Much of what I will say comes from the literature on time-consistency problems. Although, as Steven O'Connell pointed out earlier, the problem facing the CFA countries is not a time­ consistency problem in a strictly economic sense, I do think it is such a problem in a political sense: credibility problems can be brought about by political as well as strictly economic mechanisms. The crucial point that underlies the story in David Stasavage's chapter, and the basis of my comments on restraint, is that politicians find ways to do what they want to do. This is illustrated beautifully by the evidence in this chapter. Politicians can tie their hands, limit their discretion, or delegate authority over areas of policy to supranational banks, currency boards, and technocrats, but their commitments to such limits or restraints only extend as far as it pays for them to make such commitments. David's chapter shows how formal institutions alone can guarantee little in the way of a prudent check on governments. I am not suggesting that formal institutions do nothing, but rather that their effectiveness as restraints must be based on their ability to structure incentives such that politicians see it in their interests to abide by the rules of the institution. Susanne Lohmann states the point well in a recent paper on central banks: To the extent that countries have different political processes and institutions, we would expect to see different monetary institutions or other types of agencies of restraint not as an optimal response to different economic environments but also as a result of different kinds of political distortions created by different political processes and institutions. 1 So, the question remains about what is strategically required for a commitment mechanism to work? I will posit that at least two conditions should hold in the abstract: first, there needs to exist an actor who restrains, or more specifically, an audience that watches for defections on the part of leaders, bureaucrats and politicians and then, punishes those defections. Second, the punishments that are inflicted by this audience or actor must be significant enough to effectively change the incentives of the actors who are punished for deviations. The cost exacted by an effective punishment will depend upon the political discount factor - how highly the actors value the future, which is in common political parlance another way of saying, how long they expect to remain in office or in power. Because the interactions involved in fiscal policy-making can be characterized as a repeated game, cooperation or compliance on the part of politicians is secured by a trigger strategy, a punishment or a sanction that is inflicted for a period of time ( over iterations of the game) by an interested audience. This trigger strategy will work - ie, secure the Pareto-improving equilibrium - when the politician values the future

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enough. We must open the black box of politics to understand when and how restraint mechanisms become feasible. Specifically, what are the social, political and economic configurations that structure incentives such that politicians find it in their interests to abide by restraints? Or even more to the point, what are the relevant constituencies or audiences within Africa that need to be mobilized to inflict sanctions? And how to mobilize them? How do we build up domestic audiences? We've already had a discussion about the role of donor conditionality in driving restraint, but what can we do in the absence of such international restraints? What mechanisms can be put in place to solve coordination problems between economic actors who could be potential sanctioners? This emphasis on a sanctioning audience magnifies the importance of the timing and sequencing of reforms - eg, liberalization of the financial sector to build domestic constituencies for further reforms. Configuring these political interactions as a repeated play over an infinite time horizon suggests that we should focus research efforts on understanding the determinants of the time discount factors of politicians, and on how to implement mechanisms to induce longer time horizons in decision­ makers. So far, what I've described as the strategic game of restraint says nothing about institutions: reputational solutions suffice. So what is it that institutions do to alter the structure of the game? Let me propose that institutions can structure the game such that restraint can be supported as an equilibrium outcome under a wider, or rather for a lower range of political discount factors. 2 Institutions can do this in four ways: 1) Institutions can coordinate players' expectations about trigger strategies (effective punishments) or what constitutes defection, allowing them to select a Pareto-preferred equilibrium out of a multiplicity of equilibria; 2) An institution can improve the monitoring ability of an audience whose equilibrium strategy is to punish defections; 3) An institution can allow for a more optimal trade-off between credibility and flexibility in a world of uncertainty; and 4) Institutions can create player and issue linkages. In other words, they can serve to connect the objectives of different players allowing one to punish defection against another, or institutions can link issues ( eg, for the EMS, it has been argued, failure to maintain exchange rate parities influences progress on various dimensions of European integration, therefore broadening the arena in which sanctions can be applied). I mention these functions of institutions in altering the strategic environment because I think it helps us identify how to design effective institutions This leads to my final query: How does the Franc Zone specifically, and reciprocal arrangements more generally, build issue and player linkages? The hope, for example, would be that reciprocal arrangements would allow for an expanded set of sanctioners. David Stasavage details several recent reforms that it is hoped will enhance the fiscal disciplining capabilities of the Franc Zone institutions, including multilateral surveillance of fiscal policies. Certainly, looking at my list of how institutions can function to enhance the possibilities for restraint, we can conjecture that this reform could improve the monitoring capabilities of players in the game. But who are these potential sanctioners? And can further institutional reforms allow for the inclusion of new sanctioners or strengthen the hand of any that already exist? If we think in these terms then the question implied by David Stasavage's correct assessment that multilateral surveillance will have little effect unless Cote d'Ivoire and the Cameroon set a policy standard for fiscal discipline in their respective unions, is not can these countries set a standard for fiscal discipline, but rather, who can sanction them in such a way as to make it in their interests to do so? In looking within the political black box, we admit that institutions can only work as restraints when they make restraint a self­ enforcing outcome in the strategic situation.

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Notes 1. 2.

Susanne Lohmann, 'Why D o Central Banking Institutions Matter?', paper prepared for the Annual Meeting of the American Political Science Association, 1 996. My comments draw on the work of Susanne Lohmann ( 1996) 'Optimal Commitment in Monetary Policy: Credibility versus Flexibility', American Economic Review, 82, 273-86; Shepsle, Kenneth, 'Discretion, Institutions, and the Problem of Government Commitment', in Bourdieu and Coleman (eds.), Social Theory for a Changing Society (Westview 1991), pp. 245--63; Milgrom, Paul, Douglass North and Barry Weingast 'The Role of Institutions in the Revival of Trade', Economics and Politics, 2, 1 990, 1-25; Kotlikoff et al. , 'Social Contracts as Assets: A Possible Solution to the Time Consistency Problem', American Economic Review, 78, 1 988, 662-77; Soskice, David, Robert Bates and David Epstein 'Ambition and Constraint: The Stabilizing Role of Institutions', Journal of Law, Economics, and Organization, 8, 1992, 547-61 ; and Weingast, Barry, 'The Economic Role of Political Institutions: Market-Preserving Federalism and Economic Development', The Journal of Law, Economics, & Organization, 1 1 , 1-3 1 .

12 Aid and Debt Conditionality as Restraints Ravi Kanbur THE PROBLEMATIC In his insightful paper 'The Marginalisation of Africa', Paul Collier (1995) puts foiward four explanations for the exclusion of Africa from global trade and investment - 'insufficient reform', 'insufficient scale and low level traps', 'the high risk environment' and 'weak restraints'. While recognizing that the explanations are all interrelated, and that the evidence lends some support to all four explanations, he nevertheless concludes that 'the foremost explana­ tion would appear to be the high risk environment, in particular the risk of policy reversal.' This conclusion is on the face of it surprising, since aid agencies, led by the Bretton Woods Institutions, have supposedly been conditioning their large flows of aid on policy reform. And yet there appears to be insufficient reform and risk of policy reversal in Africa. What is going on? Collier (1995) provides the following explanation: Conditionality has been intrinsically foiward looking; that is, it has concerned itself with promises of policy reform. By being prospective rather than retrospective it has failed to reward past policy performance and so governments have little incentive to acquire reputation. Since donors have no scope for foreclosing on assets, their only mechanism for enforcing conditionality has been very short-term suspensions of aid if intra-programme targets are breached. If targets are breached and the programme is aborted, then a new programme might be negotiated before the date when the aborted programme would have ended. The new programme will again be foiward looking. In an attempt to keep the government to the programme, conditionality is highly specific as to short­ term targets. Because African Governments have few instruments for short­ term economic management, while economies are highly volatile, it is common for these targets to be breached at times. Donors then choose whether to abort the programme or to ignore the targets. With this

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structure, governments have the incentive to agree to more than they can implement, in the hope that the breaches will either be ignored or suffer only short-term punishment. This is likely to give rise to policy volatility. Even if the government does not in fact reverse policy (because it believes in reform) private agents will be unable to distinguish such a truly reforming government from an opportunistic government which is reforming temporarily to receive aid. What is the solution? Restricting himself to programme aid, Collier (1995) offers the following guidance: Aid cannot be conditioned on promises because the penalties for non­ compliance are too low . . . Aid can, however, be given on the basis of reputation . . . Because aid would follow rather than anticipate policy reform, governments would have no incentive to exaggerate the costs and difficulties of policy change, and no incentive to agree to what they did not wish to undertake. Only governments which were serious about reform would undertake it. I have quoted at length from the Collier (1995) paper because it captures quite closely some of the internal analysis and discussions within the World Bank. And, of course, many of the same issues are also present in recent discussions of the modalities of debt relief. I am personally very sympathetic to this line of argument. The question, however, is how to move in the direction suggested in the practical, operational context. Consideration of this question leads, in turn, to some refinements of the diagnosis, and a new set of questions for analysts.

SOME BASIC PRACTICAL CONSIDERATIONS Before moving to a redesign of aid conditionality, it is worth considering whether the current instruments are inherently defective in the way suggested by Collier's (1995) discussion. Take, for example, the 'structural adjustment lending' instrument of the World Bank and other donors. How does this work in practice? The practical operation of this instrument is by analogy to aid for projects. In the latter, money is disbursed against returns of actual expenditures, suitably audited. By the same logic, disbursements of programme aid are done, at least formally, against fulfillment of conditions. Thus there are pre-negotiation conditions, Board presentation conditions, effectiveness conditions (after which the first tranche is released), second tranche conditions third tranche conditions, etc. Thus, at least formally and

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legally, under this instrument money is given not on promises of reform, but after specified actions have actually been undertaken. So where is the problem? The problem may lie, for example, in the balance of money attached to the different tranches and different conditions. It might be argued that in fact the conditions for the first tranche are very light, their lightness being justified by the 'promise' of actions for future tranches ( even though for these later tranches money will only be released if the conditions are fulfilled). But if this is the problem the solution is to 'frontload' the conditions - in the extreme, have only one tranche that will be disbursed after all the conditions are fulfilled. Another, related problem might be that having a sequence of tranches permits the pushing off of conditions from one tranche to the next - even if conditions are not satisfied for tranche t, the tranche can be released on condition that they be satisfied before tranche t + 1 is released. Again, the solution is either to stand firm and not release tranche t, or to design the operation so that nothing is released until all the conditions are satisfied. The issue of standing firm is key, and here the practical and political interact with technical considerations. Suppose the conditions for a tranche are not satisfied. If the non-satisfaction is for reasons truly outside the control of the government, there are legal provisions that allow for the tranche to be released. But suppose the conditions are not satisfied because the government, having originally signed the agreement, cannot now deliver for political reasons. What are the consequences of tranche non-release? Recall that this is programme aid - which is part of a tight macroeconomic programme where the gap between the government's current revenues and expenditures has been filled by external programme assistance. If the sum tied to the tranche is small, presumably the programme can be adjusted at the margin to accommodate the shortfall. But if the sum is large, then serious disruption is inevitable, with short run destabilizing repercussions, for example in the foreign exchange markets. But, more important, the shortfall leaves the government with the invidious choice of cutting expenditure drastically in a number of sensitive areas. Should it pay the army, the creditors, or the teachers? Faced with facing the government with such a choice, donors have strong internal and external pressures to release the tranche. It is clear that in the above scenario the problem is not that money is given in advance of reform. The problem is precisely that the money will only be given after the policy reform, in a context where the reform is difficult but the money is needed desperately for short term needs - including the repayment of old debts of the very donors who are giving out the new money. What is the solution? One possibility is to design things so that no single tranche is so large that withholding it will cause serious disruptions. But it is clear that this is no more than a band aid. The basic issue is the extent to which donors as a

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group are willing to countenance major disruption i n the country in question. Whether the conditionality is retrospective or prospective, this issue remains, and I will return to it presently. Yet another practical consideration is that, in fact, programme aid is only around a quarter of total assistance to Africa. Project aid is much bigger than programme aid, and is becoming more and more like programme aid, with good reason. Instead of thousands of separate projects, donors are discussing ways of coordinating aid sectorally so that, for example, donors as a group finance a time slice of the primary education programme. With such a perspective, and even without it, it is clear that the productivity of assistance depends crucially on sector-wide policies, and that the distinction between investment and recurrent expenditures is not all that clear cut. Thus, in some sense, what is important is not simply programme aid but the overall assistance (in fact, the illustration Collier, 1995, gives on the poor correlation between aid and policy reform is for total aid). But here donors do have various, more or less elaborate ways of allocating resources using, among other things, indicators of actual performance. Now, one may criticize the indicators used, but then the task for analysts is to come up with indicators that are better while still being implementable. SOME FUNDAMENTAL ISSUES I have hinted that underlying the practical considerations are some fundamental issues which will be present no matter how we redesign conditionality. In this section I want to highlight the most important of these. Let us start by recognizing what has and has not happened in the area of policy reform in Africa. It is now generally recognized that there have been tremendous advances in key areas such as exchange rates and import quotas. Black markets in foreign exchange have basically disappeared from Africa, as have import licences. Price controls, in general, are a thing of the past. But, by the same token, there have not been similar advances in the areas of privatization and parastatal reform, financial market reform, civil service reform, taxation reform, reallocation of public expenditure, reform of the judiciary, and so on (see, for example, World Bank, 1995). Why? One of the most important reasons, I believe, is that there is now a broad consensus in Africa on the devastating effects of overvalued exchange rates and black markets in foreign exchange. This consensus was helped by a professional consensus among economists of different stripes on this issue. But I do not believe that there is the same degree of consensus on issues such as financial sector reform. At the same time, divestiture, civil service reform, and so on, have very clear and immediate negative effects on key constituencies, and tie in to deep seated ethnic and regional divisions. Building a professional and

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local consensus on these issues is key to advancing reform - no amount of clever design of conditionality will get around this. Given the lack of consensus, particularly among African elites, on the 'second generation' of reforms (and perhaps even some backsliding of the consensus on the macroeconomic basics), how should donors proceed assuming that they know the right thing to do? One way is to work with a group of like minded people - politicians, technocrats, etc. - in the polity. But if there is no consensus, it is quite likely that this group will ask donors, implicitly or explicitly, to include conditionality in aid agreements, to strengthen their hand against the opponents of reform. In fact, they may argue, implicitly or explicitly, that only tight linkage of money to specific, concrete actions, will carry the day against those who would fight a rearguard action. In fact, the present state of affairs might be explained to some extent by this dynamic. Should donors not play this game at all? Should they simply set out their criteria and say even to their likeminded counterparts in the country: 'when you have convinced your compatriots, come back to us'? And even if they do this, what are the criteria, and how will we know that there is a true consensus - that the reforms will not be undone once the money is released? I have argued that the current instruments are in principle quite amenable to what Collier (1995) calls retrospective conditionality, and indeed practice it to some extent. They can be easily modified and strengthened in the required directions. The real questions are: What conditions, and what sanctions for non-compliance? On the first, I have already noted that there is less professional consensus on the precise nature of the second-generation reforms. But even if we take a mainstream liberal economic perspective, this still doesn't take us very far in actually specifying the criteria according to which money will or will not be released. Should these be 'output' variables or 'input' variables? For example, suppose we take private investment as an indicator of success, and condition (in some way still to be made precise) aid flows on the level of private investment. But, even leaving aside the empirical issues in measuring private investment, there are many ways of increasing private investment (protection, huge tax concessions, environmentally unsound practices, etc.) with which we would not agree. And if we stipulate that none of these should happen, we are slipping into the sort of detailed conditionality which is criticized for being difficult to implement. I want to take a moment here to elaborate on the complexity of conditionality, especially in light of recent arguments that conditionality should be 'simplified' to focus only on one or two key features. I am sympathetic to this position, but the fundamentals of the African situation intervene. First of all, as noted above, there is rarely a consensus on key policy thrusts, in Africa or among donors. One result of this is that the final agreement is in fact a bargain between different internal and external partners

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and it reflects the complexity of the underlying differences of opinion. Second, even at the purely technical level, one finds that issues are intimately interconnected. Thus, for example, consider a policy of a dramatic reduction and simplification in tariffs. But such a reduction will require government revenue to be made up elsewhere, or expenditure to be cut. A change in the tariff structure without a change in the domestic tax structure will lead to large, dramatic and arbitrary changes in effective protection rates which, apart from being inefficient, will undermine the political case for reform. Thus it is that one is drawn into reform of the domestic tax structure at the same time as the reform of the tariff structure. Even just simply changing the tariff structure may make matters worse if, for example, the old computer programs are not changed and customs staff are not trained and monitored. But these things won't happen of their own accord - they have to be part and parcel of the overall plan. Of course, one could claim a simplified conditionality on paper by labeling it 'reduction of tariffs', but what purpose does it serve not to specify all the other things that this entails? Even if we know what 'retrospective' conditionality to lay out, the next question concerns the sanctions for non-compliance. This problem is present as much in a retrospective scheme as in a 'prospective' scheme. Suppose we find non-compliance, ie, some of the key criteria we were looking for have not been satisfied. Do we pull the plug completely? Presumably not. Presumably we tailor the punishment, or the reward, to the outcome relative to criteria, taking into account the circumstances of time and place. But what constitutes a big violation, and what is a small slippage? The recipient countries will want to know this. But then we are somewhat on the road to 'pricing' reforms. To the extent that the 'price menu' is not explicit, to the extent that it is based on judgment and discussion among donors, where factors other than the original criteria can find their way in, are we not actually introducing a new level of uncertainty? In my experience, recipient countries are often tom between asking for flexibility in the conditions, which leaves room open for interpretation, and specificity, at least makes clear what will be received in return for what. Suppose there is a big violation, somehow defined. Then there should be a big response. But a big, and thus sudden, response will cause severe disruption. Are the donors ready for this? There have, of course, been major pullouts by the donors in the past. Collier (1995) cites the case of Kenya, where aid suspension led to an acceleration of economic reform. But there are two observations to be made here. In some cases, eg, Zaire, donor pull out did not lead to economic reform. And second, in the case of Kenya the donor pullout was occasioned not by insufficient reform, but due to political factors linked to corruption and repression. The interesting question, for both Kenya and Zaire before the donor pullout, was why aid continued despite lack of progress on reform. I would suggest that that there are two generic reasons. First, aid flows are linked not simply to economic reform but to other political

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considerations. However, a second reason which weighs heavily on those who have to make the pull-out decisions in real time is the genuinely not knowing whether this is the right time to administer the sanction, and whether the shock treatment of the sanction, whose short term negative effects appear immediately, might not actually make he situation worse. No amount of design of 'retrospective' conditionality will remove this uncertainty. There is also the issue of 'new beginnings', for which 'retrospective conditionality' may well be inappropriate. Suppose, after a long period of isolation, a country acquires a government which is willing to reform - or at least says it is willing to do so. But the situation is such that without immediate and massive support the reformers will not survive. In such a situation, the initial injection may need to be unconditional. Moreover, given the risks involved, there may well need to be close monitoring of specific, perhaps even symbolic, actions which signal the government's intentions. In this sort of a situation, a plan would need to be worked out with the government whereby financing and actions were laid out for the months to come, and even linking the financing to the actions. But this is precisely the antithesis of the 'retrospective' conditionality that we have been discussing. And such situations have not been unusual in Africa in the decade of political liberalization. In some cases, such as Mali, it can be argued that the financial support has paid off. In other cases, such as Zambia, some have argued that the jury is still out. In yet other cases such as Ghana, where an economic reform programme was under way when the political transition hit, a strict interpretation of conditionality would have meant, perhaps, jeopardizing the transition itself. With such cases, and there are plenty more in Africa, it should be easy to see why simple correlations of aid flows and policy reform need great care in interpretation. Moreover, as African countries which liberalized politically in the late 1980s and early 1990s hit their second or third wave of elections towards the end of this decade, the 'new beginnings' question will be present like never before. Is the 'other party' a new beginning? How much initial support is this worth? Whatever its election platform, what are the concrete actions that we specify now as conditions for continued support? And is this not prospective conditionality? Finally, it should be clear that many of the arguments on aid and conditionality apply equally to conditionality for debt relief. But applying the concept of retrospective conditionality in this context is perhaps even more problematic. As is well known, in discussing debt and debt relief we should distinguish between stock and flow effects. The flow of debt servicing in any year can be financed in one of many ways, and we have seen that one of the reasons why donors tend not to stand firm on aid flows in the face of poor performance on reform is to ensure, as a collectivity, refinancing rather than formal default on debt - which has severe repercussions given current institutional arrangements. However, the stock of debt - the anticipated flow

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of debt servicing into the future, can have severe incentive effects in the present since the benefits of investment (in capital or in policy reform) are seen to flow out to external creditors. The logical answer to the debt overhang problem is debt cancellation, in one of many institutionally appropriate ways. But nobody is suggesting outright cancellation of debt. Rather, the consensus - among the NGOs as much as in the Bretton Woods Institutions - is that this cancellation has to be conditional. But conditional on what (the NGOs have different views to the Bretton Woods Institutions)? And how will we know if the conditions are met? The current framework, which is proposed to be extended and strengthened, is that debt stock relief will start after three years of compliance with a Bank-Fund programme. But these are the very programmes which, apparently, have led not only to insufficient reform but also have not countered the risk of policy reversal, partly because of creditor and donor incentives. With debt relief now tied to a successful completion of a three year track record, what will this do to the incentives to declare a programme off-track? Also, since debt cancellation is not being given up front, and since the essence of the incentive effect of cancellation on a debtor is the certainty that future debt servicing will not tax away the gains of investment, for the scheme to work a commitment has to be given now by creditors that if the debtor fulfills certain conditions over a certain time period, then debt will be cancelled at the end of the period. But this looks very much like the conditionality that is currently practised, imperfectly, with respect to the flows. It would appear, then, that the distinction between retrospective and prospective conditionality is not that easy to make! WHAT TO DO? I have tried to argue that the concept of retrospective conditionality, while based on a diagnosis which I find persuasive, is not, as yet, a robust or operationally useful concept. The contrast between 'retrospective' and 'prospective' conditionality, while useful as a starting point, can be too sharply drawn in terms of practical operation, and may actually distract attention from some fundamental issues which lie at the heart of the aid­ conditionality link. Thus, for example, the current instruments are indeed retrospective in their formal operation, and can be made even more so. And many donors do indeed attempt retrospective evaluation and try to link this to overall aid allocation - almost certainly imperfectly, but the mechanisms exist and can be improved upon. At the same time, there are some fundamental features which better explain the poor performance of conditionality in encouraging policy reform. We are increasingly moving into areas where there is not a strong professional

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consensus on the reforms to pursue and the way to pursue them, and where distributional effects are more concentrated. Even where there is consensus, it is not clear how to evaluate success in concrete terms. It is not clear how to 'price' different outcomes in terms of their aid consequences, and whether donors have the stomach to engineer major aid cutbacks for economic, as opposed to political, reasons. And when new regimes come in, the initial injections of resources required, if accepted, lead to nothing other than 'prospective' conditionality. The recent discussions on debt relief highlight some of these fundamental issues even more sharply. Given these fundamentals and practicals, what are we to do? My basic principle is that we should be radical about the fundamentals, but pragmatic about the practicality of instruments. I take this position not only because I believe that the current instruments already contain or can easily be given the design features to improve the effects of conditionality on policy reform, but also because I believe that an overly elaborate and seemingly radical redesign or invention of new instruments will not solve the problem unless the fundamentals are tackled - in fact, they could make matters worse by introducing new uncertainties as the new instruments find their operational feet. Let me suggest, then, some practical ways in which current instruments can be modified. For programme aid, I have noted that the formal structure of the 'adjustment support' instrument is in fact one where money is released after actions have been undertaken. The problem, rather, is the operation of the instrument - there is insufficient 'frontloading' of conditions, the conditions relate to one-off actions rather than the sustaining of actions, there is too tight a link between the macrofinancing plan and the timing whereby the conditions have to be satisfied, there is too much money attached to individual conditions, the conditions which are to be satisfied on a tight timetable in fact have great political and technical uncertainties of timing, and so on. In order to overcome these problems, in the World Bank we have begun to modify, in a pragmatic, incremental, way, the adjustment lending instrument. Thus, for example, we are looking to put into place some 'single tranche' operations, in which all the conditions required are satisfied before approval is sought from our Board - and the case made for financing is then completely on the basis of past actions. Failing this, we are attempting to move as much of the conditionality as possible to the pre-Board stage. We are also trying to 'price out' reforms by having many smaller tranches, which diversifies the risk of resource transfer and strengthens the possibility of 'standing firm' on any single condition since non-release of the specific tranche will not be disrupted. This might seem contradictory to the notion of retrospective conditionality and single tranche operations, but it is in fact a pragmatic response to the fundamental problem, in a context where the current structure of instruments might have to be maintained (in many cases, it is the countries that prefer to have specific conditionality in the form of a contract).

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The above is for programme aid. But, in fact, project aid is moving in similar directions. Thus we are moving towards a 'sector investment programme' approach, where donors as a group agree an overall programme of public investment and recurrent expenditure, and policy, in a sector, and then fund time slices of it based on adequate performance to date. Thus what becomes important is not just the level and modalities of programme aid, but the overall level of aid. As I have noted, most donors have various indicator­ based methods or allocating scarce aid resources between competing countries. The real issue is to improve the methodology, make the criteria clearer and empirical, make it more sensitive to sustained performance rather than to one-off events. With this, the split between programme aid and project aid, to the extent that it will continue to have significance, can be made on a country by country basis. Helpful as these pragmatic steps are, they do not begin to address the more fundamental questions I have raised. But these are questions for scholars and the international community generally. I want to end by highlighting how I think academic analysis and international discussion can contribute. First, I believe that an enormous service can be rendered by building a broad-based consensus on the second generation of reforms - we need to do for financial sector reform in the 1990s what we did for exchange rate reform in the 1980s. Second, and emerging out of this, the analysts can help by developing a consensus on the priorities - the proliferation of policy reform proposals reflects this lack of consensus once we get beyond macrostability and appropriate exchange rates. But in doing this we should avoid the fetish of simplicity for its own sake - some problems are indeed complex, and interlinked. Third, I believe analysts have to develop practical indicators to which aid allocations can be tied. I can assure you that there is an enormous demand for simple but convincing rules of thumb which are based on empirical analysis. This is so for evaluating past performance, and even more so (because, as I have argued, we cannot completely dispense with prospective conditionality) as predictors of future performance. But none of the above will work if there is not the will in the international community to really tie aid to performance. Our discussion, and that of Collier (1995) and others is based on the notion that aid which rewards good performance will induce good performance. I believe this to be true in the short run, but I also believe that we should take seriously another proposition - that in many cases it has been the lack of aid in the short run, or a pre­ announced and steady reduction of aid over the medium term, which has induced good performance. There are many examples of the former in Africa, and it has been argued by some that the latter explains much of the policy reform in East Asian economies in the 1960s and 1970s. But is the international community, of which the donors and the Bretton Woods Institutions are but a manifestation and reflection, ready to undertake aid cut

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offs based on economic performance? And is it ready, prospectively, to announce and stick by a steady planned reduction of non-humanitarian aid over a period of, say, 10 years? These truly fundamental questions are perhaps best tackled in a different forum. To conclude, then, I believe that the distinction between 'retrospective' and 'prospective' conditionality, important as it has been in starting a discussion, has now run its useful course. In fact, continuation of the distinction at the simplistic level may lead us into an unproductive discussion of form as opposed to substance, and perhaps a wasteful attempt at major redesign of aid instruments, when in fact we have our work cut out, as analysts and practitioners, in addressing the fundamentals while moving forward in pragmatic fashion. REFERENCES AND FURTHER READING Paul Collier (1995). 'The Marginalisation of Africa', International Labour Review, 134, 541-57. World Bank (1995). 'A Continent in Transition: Sub-Saharan Africa in the mid-1990s', Africa Region, Office of the Chief Economist.

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DISCUSSION Stephen A. O'Connell on 'Aid and Debt Conditionality as Restraints' by Ravi Kanbur This chapter provides an insightful discussion of Paul Collier's 'retrospective conditionality' and in the process lays out a research agenda for enhancing the effectiveness of aid. I'll take up these issues in turn. Collier characterizes traditional conditionality as an exchange of donor funds for recipient promises. The trouble, he argues, is that donors choose not to enforce their own conditions. Broken promises then beget more promises; good money ends up chasing bad. Retrospective conditionality, in contrast, would be based on previous rather than future performance and would not be linked to specific criteria. Donors would reward countries with proven recent track records, but with the precise dimensions of the track left implicit. Collier argues that a shift to retrospective conditionality would improve aid effectiveness by moving donor money out of low-yield countries and providing recipient governments with strong incentives for good performance. Kanbur finds these ideas appealing but argues that retrospective conditionality is (a) difficult to distinguish from traditional conditionality, and (b) to the degree it can be distinguished, already substantially reflected in the Bank's lending programmes. I'm sympathetic to this assessment and will make similar points from a slightly different perspective. I will argue first that an increase in country selectivity is the essential feature of Collier's proposal, and that such an increase is already underway in Africa. This is, on balance, a good thing for aid effectiveness. My second point, however, is that greater selectivity is emerging for reasons that are not only unrelated to Collier's critique of traditional conditionality but that reduce the force of that critique. Exogenous forces have increased the credibility of donors, thereby undercutting the value of strategic innovations - like retrospective credibility - whose major justification is to substitute for that credibility. As a final point I will explore retrospective conditionality as a way of formalizing or institutionalizing the existing move to greater selectivity. In essence, Collier is arguing the virtues of a footrace between aid recipients. Races are good for eliciting high effort from contestants, because the benchmark provided by other contestants invalidates a host of excuses for poor performance. But it is not clear that they can do this while also economizing on donor commitment to particular performance measures or on donor knowledge of the initial capabilities of contestants. I'll begin with selectivity. A quick look at DAC data suggests that the distribution of increases in bilateral aid flows across African countries has become more unequal since the end of the Cold War. In other words, there has been an increase in the country selectivity of bilateral aid flows within Africa. Some countries are receiving dramatic increases in aid while others are experiencing dramatic decreases. This is in contrast with the 1980s when most African countries were able to trade promises for increased aid. A simple calculation supports this impression: the cross-country coefficient of variation in growth rates of bilateral aid rose from 1.1 in 1982-88 to 3.4 in 1989-94. More sophisticated calculations are needed, but they seem unlikely to overturn the point that aid selectivity has already increased substantially among the bilaterals. The multilaterals appear, so far, to be serving as a counterweight against this trend. Increased selectivity can enhance the economic return on aid by shifting aid from low-yield to high-yield countries and/or by providing incentives for countries to choose better policies. These are exactly the virtues Collier sees in retrospective conditionality, and in my view retrospective conditionality is fundamentally about selectivity. But the

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increase in selectivity currently underway has relatively little to do with the design of conditionality. From the perspective of donors, the political, strategic and ideological benefits of African aid have declined in the wake of the Cold War and the democratic transition in South Africa. Simultaneously, for reasons of fiscal stringency, the perceived opportunity costs of aid have risen. Aid clientilism has therefore declined in Africa. The result has been a kind of 'zero-based budgeting' in which bilateral donors have evaluated their African aid programmes against economic criteria for the first time in decades. This has had two results, one clearly important and the other potentially so. The clearly important result is an exit from countries in which political disintegration or predatory dictatorship has for some time undercut the effectiveness of development assistance. The resulting shift has increased the average quality of the African aid portfolio. The potentially important result is to increase both the coherence of donor policy advice and the credibility of donor threats. Donors are more likely now to agree on broadly appropriate policy settings and to back up threats with aid reductions. If incentives associated with aid are important in African economic performance, the incentive environment has been improved for reasons exogenous to aid design. This reduces the appeal of any scheme, including retrospective conditionality, that is largely predicated on the need to economize on donor credibility. One response may be that the credibility of the multilaterals has not been enhanced by the developments referred to above. This is questionable given the strong influence of the major bilaterals on multilateral aid policy; but if it is true, then there may be little scope for increased selectivity by the multilaterals, via retrospective conditionality or any other mechanism. While aid clientilism is down, it is certainly not out. A natural question is therefore whether retrospective conditionality represents a useful way of formalizing or institutionalizing a move to greater selectivity ( and in particular, whether the multilaterals should be encouraged to reinforce the move to greater selectivity by bilaterals to the degree possible). I will focus on two features of retrospective conditionality that in my view differentiate it more fundamentally from traditional conditionality than its et ante or et post nature. The first is its vagueness: retro­ spective conditionality would not specify conditions in detail. The second is the tendency of retrospective conditionality to set up what game theorists call a 'tournament' between recipients. Consider first the benefits of vagueness. Traditional conditionality is highly detailed. Collier argues that this makes it non-credible, because donors find it impossible to hold up major aid disbursements for what appear, et post, to be minor or readily dismissable violations of programme conditions. But would a move to vague conditions economize on donor credibility? As Kanbur suggests, vague conditions are not conditions. There may be some gain in transparency, because vague conditions are more obviously irrelevant than detailed ones; and there is a potentially important reduction in transactions costs for both donor and recipient. But a move to vagueness is essentially an acknowledgement that threats and rewards are irrelevant to recipient policy. It represents a giving up on the incentive effects of aid. While the historical record may support such an interpretation, I have argued above that donors are in a more coherent, powerful position now than ever before. Giving up on donor credibility seems an odd choice at such a juncture. This raises a deeper issue, which is that vagueness may economize not on donor credibility but on donor knowledge. How should donors behave if they are ignorant of the detailed policies that would enhance economic development in the recipient countries? Or, for that matter, of how their own domestic politics will evolve and influence future aid allocations? What if they acknowledge this ignorance at the precise time that their bargaining power over recipient policy is at historically high levels? Here

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there seems to be a strong argument to avoid micro-management and to focus on a short list of widely agreed features of the policy environment. Such an approach avoids tying up the domestic policy process in recipient countries and creating donor-driven mistakes. It acknowledges the potential diversity of paths to economic success in Africa (as observed within Africa and elsewhere) and enhances the probability of national ownership of development policy. But these are not as much virtues of vagueness as of prioritizing. This of course leaves the question of how to allocate the aid budget on an operational level, and here we are back to selectivity. The move to greater selectivity has already brought African countries into competition for a declining budget of aid to Africa. Should this development be enhanced? It may be useful to think of a move to retrospective conditionality as setting up a footrace among potential recipients. A footrace is an arrangement in which relative rather than absolute performance is rewarded: the top five finishers (say) get large increases in aid; the rest get decreases. Game theorists call such arrangements 'tournaments' and point out that they can substitute powerfully for knowledge when incentives are important. More precisely, they provide a natural way of eliciting high effort from contestants when judges cannot distinguish effort from exogenous factors and when the important exogenous factors are common across contestants. Common factors might include institutional features that are important for development but poorly understood by donors. A footrace also seems likely to maximize learning, both by participants and by observers, about 'how' to succeed in African conditions; this is a very valuable side effect given that the race is to be repeated. There are various downsides of a footrace, however. For example, a race may elicit inefficiently high effort from contestants, or no effort at all (the latter if the contestants are not properly handicapped, so that the winners are virtually known in advance). It may allocate too much risk to contestants, in a world in which there are important exogenous shocks (whether common to countries or not) and in which uncertainty about aid flows matters for economic performance. Moreover, it leaves the question of what to do with the losers. In a race, the losers are no worse off than before the race, except for the effort expended; in a selectivity exercise, they face actual reductions in aid which if excessive may make their subsequent prospects even worse. It seems to me that these are issues will need exploring in any cost-benefit analysis of selectivity. A final theme of Collier's analysis and Kanbur's paper is the role of interruptions of aid. The issues call to mind the welfare debate in the United States. Following my earlier comments, I would urge a distinction between (a) interruptions that acknowledge the hopelessly low yield on foreign assistance; (b) interruptions, or threats of interruption, that are designed to produce good incentives in an ongoing, open-ended aid relationship; and (c) terminations that either recognize graduation or (when pre­ committed) are designed to produce credible incentives for it. I have argued that a kind of zero-basing may give retrospective conditionality some comparative advantage over traditional conditionality in keeping donors out of hopeless cases. These are cases in which the domestic political economy is so distorted that the social return to aid, even taking these constraints into account, is below the opportunity cost of funds to the rich countries. But in these cases, aid has flowed historically not because of design flaws but because it has been geared towards strategic rather than development objectives of donors. The Cold War is over; the donors have no money; the hopeless cases will now receive support only to the degree that this is viewed as reducing the systemic risks they pose. In my view, the design issues are (b) and (c ). Since I have discussed (b) above, let me end by a comment on aid termination and graduation. It is now being noticed that both Korea and Taiwan experienced a dramatic reduction in US bilateral aid at the time of their tum to outward-oriented policies.

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How relevant is this for Africa? My view is that these countries already had substantial advantages in human resources and leadership, and that these two in particular had further features - such as a pressing external security threat - that might have pushed them in the direction of a 'developmental state'. They also had very low debt levels. Most African countries have yet to enter the structural transformation, and if anything this is more acute on the institutional side than on the economic side. Moreover, they have high debt burdens. The key issue, it seems to me, is not creating incentives for graduation, but rather capitalizing on the exogenous events that have already created new possibilities for the aid relationship. The aim should be to find the combination of deep debt stock relief, reduced aid flows, and prioritized conditions that will raise the return on aid for the great majority of African countries. Collier's work and Kanbur's chapter represent the kind of thinking that is needed to make this happen.

13 Investment Insurance in Africa Gerald T. West* 1.

INTRODUCTION

We know that the foreign investment decision-making process is a complex one that is affected by a more complicated set of strategic, economic and behavioural considerations than the decision to invest domestically. The investigation process is also usually longer and more costly. Financial evaluations of new foreign investments do not rely as heavily on traditional discounted cash-flow techniques because of higher perceived business, political and foreign exchange risk. There is no dearth of theoretical explanations for the motivations of firms making foreign direct investments (FDI). Indeed, it is surprising how many theories exist. In strategic terms, FDI can be explained in terms of firms seeking new markets, raw materials, increased production, efficiency and knowledge. In economic terms, FDI can be explained in terms of comparative advantage, capital movements, imperfections in the markets for real assets or for the factors of production, economies of scale, managerial expertise, technology, and oligopolistic competition. In behavioural terms, FDI can be explained as arising from the stimulus of an outside proposal, fear of losing a market, the 'bandwagon effect', and strong competition in the home market. With such a plethora of alternative explanations for FDI, it is not surprising that the range of advice on how to attract it, promote it, induce it or enhance it is characterized by great diversity. It is easy for someone far from Africa to weave complex theoretical models about FDI and pay little attention to the language, the concerns and apparent thinking of investors as they consider a prospective African investment. On the individual investor level, there is little attention to economic theory; the working vocabulary is one of market, risk, return, trade-offs, uncertainties, payback, leverage, deterrence and hedging. The cool, analytical process of FDI decision-making the textbooks describe is a myth; in reality, it is made in an environment where the investor struggles with incomplete information and with many poorly measured risks and uncertainties. The investor often has difficulty integrating widely differing considerations into a summative judgment and recommendation. There seems to be little appreciation in the academic literature of the tremendous integrative challenge an investor faces

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in making the simple statement: 'All risks considered, the prospective returns of this proposed African investment warrant its acceptance.' Subsequent to a few observations about FDI flows, I shall briefly discuss the subject of political risk and its assessment and management. Since one of the more useful political risk management tools is investment insurance, the activities of one investment insurer (MIGA) in Africa will be briefly described. 2.

CAPITAL FLOWS AND FOREIGN DIRECT INVESTMENT1

The composition of capital flows to developing countries has changed dramatically over the past five years, with FDI playing an increasingly prominent role. From 1990 to 1995 net capital flows more than doubled, reaching $231 billion. While portfolio equity flows have slightly decreased, FDI flows continued their steady and uninterrupted growth, reaching a new estimated high of $90 billion in 1 995. As a result of sustained increases in the 1990s, developing countries increased their share of global FDI from 12 per cent in 1 990 to 38 per cent in 1995. However, Sub-Saharan Africa's share in total FDI to developing countries is very modest. Despite its increase from negligible amounts in 1 990 to $2.2 billion in 1 995 (accounting for nearly 3 per cent of total FDI), Sub­ Saharan Africa has, in the 1990s, the lowest regional share of FDI. This low percentage of total FDI clearly indicates that Africa has lagged behind other regions in creating attractive investment opportunities. Within Africa, FDI is concentrated in a handful of countries. Nigeria, Angola, Ghana and Gabon account for more than 60 per cent of net flows to Sub-Saharan Africa. This is partly due to the fact that foreign investments in Sub-Saharan Africa continue to be mostly resource-based, with petroleum and mineral producing projects attracting the most investment. Behind the increase in FDI in developing countries: prospects for the future Despite short-term variations in emerging market investments, long-term prospects for sustained private flows, in particular FDI flows, remain promising. FDI flows to developing countries have been driven by diverse factors, many of which are likely to continue in the future; they include: • Growing opportunities in economies undergoing domestic economic refonn and privatization. Recent studies suggest that economic growth and an open trade regime are closely associated with FDI flows. One percentage point increase in the economic growth rate of developing countries could raise FDI inflows by about $10 billion. 2 With the increased recognition of the potential benefits of FDI - transfer of technology and management

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skills and access to export markets - developing countries are expected to adopt more open policies toward FDI, as well as more active privatization programs. For example, in 1994, 49 countries introduced changes in their investment regulatory regimes; of 110 such changes, 108 were for further liberalization or promotion of investment, and only two proposed greater control. Intensifying pressures from international competition encourages corporations to invest outside their home country and technological advances allow coordination of a jinn 's international activities. Technological advances, and declining transport and communications costs are allowing firms, including a number of small and medium size enterprises, to divide production processes into discrete activities that can be transferred to locations that offer the greatest cost and efficiency gains. Forty of the 100 largest multinational corporations today have more than half their activities located outside their home country. Expanding possibilities for market access as a result of trade liberalization around the world. The globalization of production both profits from and induces increased world trade and financial flows. World trade, after rising roughly 5 per cent annually over the preceding 20 years, increased by an unprecedented 1 1 per cent in 1995 and 1996. Free trade agreements and other regional integration schemes between industrial and developing countries or among developing countries have boosted inflows by providing a large regional market protected by tariff and other barriers that can be best circumvented by FDI. Patterns of global production are also shaped by cost considerations. These take into account worldwide productivity differences and the skilled and cost-efficient labour forces in many developing countries. The globalization of corporate production, a major factor underpinning FDI flows to developing countries, is expected to continue. Improved creditworthiness and increased financial integration. Most capital flows have gone to countries whose progress on macroeconomic stabilization and structural and financial sector reforms has been greatest, and whose gains in creditworthiness and expected rates of return have been therefore greater. Further improvements in the investment climate and growth prospects of many developing countries will be conditional on sustaining their reforms.

Implications for Africa The preceding discussion of the most important factors fueling an increase in FDI to developing countries suggests that this promising outlook is likely to benefit only a group of more experienced developing countries that offer the most conducive environment for private foreign investment. Against this

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background of increasing competition amongst developing nations, African countries face an enormous challenge in attracting FDI flows. I would suggest, ceteris paribus, those general factors contributing to the increase in FDI flows will tend to widen the gap between African countries and other developing countries in attracting foreign capital. Hence, the factors fuelling the surge in FDI to the developing world currently (and which, I would argue, are likely to continue in the future), are not likely to benefit Africa. Indeed, Africa has lagged behind other regions in most of the factors discussed above. African economic reforms and privatizations have been slower than the market reorientation efforts by Latin American countries and the drastic liberalization of their economies by Eastern European govern­ ments. 3 Sub-Saharan African countries have also been relatively slow to adopt sector reforms encompassing principles of liberalization, deregulation, and private participation to facilitate more private involvement in the economy. African countries will also face the problem of becoming more attractive to foreign investors in terms of cost and efficiency gains. As many studies have suggested, Africa's productive base (including its human resource base) needs to be developed in order to be competitive with other regions. While most developing countries with large shares of FDI have also improved their creditworthiness, African countries remain among the poorest and uncreditworthy in the world. Recent ratings by various entities uniformly allocate high to moderate risk ratings for Sub-Saharan African countries. Basic change in investor attitudes will only come slowly. In particular, perceptions of political risk by investors change slowly. 3. POLITICAL RISK: DEFINITION AND MEASUREMENT More than 20 years ago, I wrote4 that there was a great deal of semantic and conceptual confusion surrounding the analysis of political risk from an investment perspective. I still believe that is true today. At that time, I also lamented the excessive focus on the country rather than the specific investment; I am still lamenting today. Without detailing all my concerns, allow me to make a few observations about definitional and measurement issues. Corporate exposure to risk as a result of politically and socially generated change is commonly referred to as political risk. Political risks are usually distinguished from conventional economic risks that arise from uncertainties relating to future changes in cost, demand and competition in the market­ place. Risks that do not fall into the latter category (apart from insurable casualty risks such as fire and theft) are generally considered political risks by many investors. In practice, economic and political risks are often difficult to distinguish. The intimate government involvement in national economies

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frequently obscures whether changes in cost, competition or demand result from economic or political forces. For an investor, whether risk has political or economic roots is often of lesser importance; the investor is concerned with the complete set of factors that may affect a prospective investment. Political and economic risk to an investor is often distinguished according to the investor's perception of the proximate cause of the risk. Pragmatically, a risk is often perceived to be political if it relates to: • a potential government act (law, decree, regulation, administrative decision, etc.); or • general instability in the political/social system (war, strife, frequent changes in government). For most purposes - including this chapter - a simple definition of political risk will suffice: Political risk is the probability of the occurrence of some political event that will change the prospects for the profitability of a given investment. Many distinctions can be made about political risk for various purposes. In terms of effects, political risk can be separated into return-on-investment (ROI) risks that threaten to reduce or eliminate the ROI, and repatriation risks that threaten to limit the availability of income or other payments to the investor. The former includes expropriation, mandatory joint ventures, price controls, and the like, while the latter covers restrictions on the distribution of dividends or the imposition of royalties, interest, management fees, and the like. Exposure to a political event is usually defined as the maximum amount that an investor would lose if a given event occurred. The expected loss from political risk is the investor's risk exposure multiplied by the probability of occurrence of the event in question. Political risk and the investor 'Know thyself was the inscription that greeted ancient Greeks who came to the oracle at Delphi to discover what the future held for them. The same injunction applies to investors that seek to evaluate political risk and the potential impact of such risk on their prospective investments in Africa. The critical focal point for the process of political risk assessment and management should not be the country, but the investor and the specific investment. Beginning with the initial step of identifying and measuring one's exposure to various political risks, the objectives and uniqueness of each individual investor should largely determine how one assesses risk and seeks to manage it.

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It is important to note that risk is not a quality inherent in a country or a government, or the environment; risk is a property associated with an individual investor and a specific investment. What represents an unaccep­ table risk to one investor may be simply a routine manageable situation for another. The management style in one firm may dictate that nearly all variables affecting a potential investment need to be controlled with a high degree of certainty; management in another firm may be willing to venture forth in the face of high risk and many unknowns. Only the firm itself can decide what perils are relevant to it, what degree of risk is acceptable, and how to manage that risk. A computer firm wishing to license its technology in an African country is likely to have quite different corporate goals and views on political risk than a company wishing to develop oil reserves in the same country. Similarly, a firm that plans to reinvest all foreign earnings into its local operations for the next five years views its currency transfer risks in a different light than a firm which plans to repatriate a high percentage of its earnings each year. While macro-investment climate studies or country risk ratings may have some limited utility to prospective investors as initial screening mechan­ isms, knowledgeable investors know that they are, at best, a starting point for more project-specific analysis. These investors realize that their political risk analysis should be based on the specific nature of its prospective venture. The unique characteristics of an individual firm should also determine how an analyst should sift through the imposing array of information on potential political risks to identify and measure the political risks relevant to their firm's prospective foreign investment. The challenge for the analyst is to sort the informational wheat from the chaff to determine what is relevant to their firm's particular situation. Such a determination can only be based on an intimate knowledge of the firm's operations and objectives. The analyst also must determine whether a specific event (say, a change in government) is likely to constitute an actual risk to their firm. To distinguish merely potential from actual risks, one needs answers to such questions as: Why are we considering entry into this market? What kind of risks is the firm prepared to take for a given rate-of-return? What precise assets will we have at risk? What is the desired life span of the investment? Poor measurement of political risk has obviously contributed to both miscalculation about some investments that have proceeded ( and resulted in losses) as well as to missed opportunities in many other instances. To make a gross, intuitive judgment across all of Sub-Saharan Africa and all prospective investors and investments, I believe that, on balance, there has been an over-estimation of the political risk associated with prospective African investments.

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Approaches to the analysis of political risk The measurement of political risk, presumes its definition. The definition of what constitutes political risk depends not only on the perspective of the definer, but on a host of other considerations; this makes generalization difficult. One major approach to the definition and measurement of political risk has been to stress the unique aspects of a particular investment. This could be termed the particularistic approach. Obviously the precise set of possible political events affecting a particular investor will be governed, among other factors, by the investor's definition of the nature and purpose of the investment. Such definitions can vary. Some will calculate profitability according to repatriated profits while others view success in terms of market share within the host country; yet others will view it in different terms. Thus, some investors may be interested in possible political events affecting repatriation of profits, while others will be more interested in events affecting internal operations. In either case, the nature of the investment is determinative of which events are of interest. For example, investments whose profitability depends heavily on factor import or product export will be sensitive to potential changes in trade restrictions. Investments that use factors available in the host country and that serve mainly the local markets will be sensitive to changes resulting from shifting political priorities of localities and those resulting from internal political instability - changes that can threaten the very existence of the enterprise. The precise set of political events that would constitute political risk for a given investor can only be uncovered by careful research. The difficulties of undertaking such research have deterred analysis of political risk in many instances - especially for smaller investments. There will always be a need for particularistic evaluations of political risk, especially for large investments. However, the difficulty of doing this kind of analysis and the shortage of appropriate skills in many corporations has left a void. To fill this need, a broad, somewhat amorphous, approach has arisen to evaluate/measure political risk; it might be termed a holistic approach. Rather than deal with the complexity of political risk as it applies to an individual investor, this approach attempts to provide a general assessment of risk - usually on a country basis, occasionally on a country/sector basis. The 'country risk ratings' prepared by various publications and consultant groups are somewhat seductive in their appeal. After all, they often purport to evaluate/measure all the important political/economic/social factors in a country and reduce them to a single number or letter grade. While some of these services do distinguish between the short-term vs. long-term risk, trade exposure vs. investment exposure, economic vs. political risk and different

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sectors, most of these services implicitly, if not explicitly, promote the concept that they serve the needs of all investors. However, any social scientist who is able to penetrate the 'black box' of methodologies underlying these ratings would likely be appalled by the primitive scaling and selection of variables, the manner in which sub-indices are constructed, the small sample of expert opinions solicited and the measurement/aggregation rules that are followed. (It is not without reason that many of these services conceal how their ratings were derived.) These 'holistic' ratings - faulty though they may be - tend to discourage some investors from looking further into investment opportunities in low­ ranking countries. Unfortunately, Africa is a common victim of this phenomenon. Those interested in promoting FDI in Africa need to encourage investors to see and evaluate for themselves the risks and prospective returns on particular investment opportunities in Africa and not rely on these rating services to shape their orientation toward a particular project. Risk, uncertainty and the investor One additional distinction that is important to note is that between risk and uncertainty. In the classic words of Irving Pfeffer: Risk is a combination of hazards and is measured by probability; uncertainty is measured by a degree of belief. Risk is a state of the world; uncertainty is a state of the mind. 5 In discussing 'political risk' this distinction is important for several reasons. At least potentially, political risk is measurable, avoidable, insurable, transfer­ able, hedgeable and manageable; uncertainty is not. It is also important to note a corollary to this statement. By undertaking a thorough political risk analysis of a prospective investment, the knowledge acquired by an investor directly serves the firm in two ways - it helps identify more accurately the political risks to be managed and reduces the uncertainty surrounding that investment. 4.

MANAGEMENT OF POLITICAL RISKS

The subject of how investors actually assess and seek to measure political risk (and how they should do it) is beyond the scope of this brief chapter. However, once the analysis is completed (by whatever means), the key question for each investor is: What can one do to manage the risk? Like all risk, political risk can be managed once it has been identified and analysed. After analysis, an investor should turn attention to the management

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of those risks so as to minimize one's potential exposure to those risks and, hence, one's potential losses. A number of traditional risk management strategies available for this purpose can be employed in conjunction with one another: avoidance, insurance, transfer, loss prevention/risk minimization, and retention. A brief comment on each of these strategies is useful. Some of these strategies, including insurance, transfer, loss prevention, and retention can be used both before and after an investment is made, while others, such as avoidance or purchase of public insurance, are available only in the pre-entry stage. In practice, a risk manager will likely employ a mixture of risk management tools at all stages of an investment. What kind of risk management strategy a firm adopts, depends to a large extent on the firm's goals and management style. • Avoidance : This strategy is the simplest to understand. Risk can be avoided by foregoing the investment opportunity completely. The investor thus forfeits a possible profit, but does so because the perceived risk outweighs the potential profit. • Insurance Public and private insurance coverage against certain political perils is available to firms for coverage of their foreign investment in Africa. The US, like most other industrialized countries, makes available long-term investment insurance coverage to private investors; since 1969, such coverage has been written by the Overseas Private Investment Corporation (OPIC). A number of private insurers (including AIG and Lloyds of London) also write coverage for a variety of political risks. Finally, there are a number of multilateral insurers, including MIGA, that offer long-term coverage. Multilateral, national, and private insurers can, and increasingly do, cooperate in underwriting custom-tailored, compre­ hensive coverages for individual investments. Coinsurance and reinsurance arrangements among these insurers are becoming common. The political risk insurance market is in a period of dynamic change and growth as increasing numbers of investors discover its usefulness. (MIGA's activities in Africa are described below.) • Transfer: Another method for an investor to reduce risk exposure is to share ownership of a proposed investment with other firms, project financiers, or local interests in the host country. This technique is particularly relevant for smaller firms or for very large investments that could represent an unacceptable amount of exposure to a firm. The firm's goal in equity sharing is, of course, to reduce the political risk in an amount disproportionate to the amount of ownership relinquished. One transfer technique that has come into greater use in recent years, especially in extractive industries, is limited recourse financing. Such financing can be a loss-prevention as well as a transfer technique since

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some of the institutions involved may be creditors of the government involved and, therefore, have some leverage with the government. • Loss Prevention/ Risk Minimization: An investor can often do a great deal to prevent a loss resulting from certain political events. Again, the basic outlines of a loss prevention programme are largely determined by the individual circumstances surrounding each investment. A number of financial techniques (eg, currency swaps, payment leads and lags) can serve to reduce the amount an investor has at risk at any one time. After some analysis of its particular situation, an investor can match cost-effective loss-prevention techniques with the risk exposures previously identified. Techniques of loss prevention abound. Whether specific techniques actually work in practice, however, is difficult to determine. For example, the expropriation or non-expropriation of a firm's investment is usually very difficult to trace to the presence or absence of a specific action by the investor. Evidence on the efficacy of various investor actions is often difficult to obtain. • Retention: Finally, a firm can develop contingency plans to absorb a loss should one occur, if it cannot be avoided, insured, transferred, or prevented. The firm, of course, should carefully calculate the potential loss it faces and the likelihood of that loss. A loss retention programme clearly depends entirely on the individual firm's situation.

5. POLITICAL RISK INVESTMENT INSURANCE AS A MANAGEMENT STRATEGY Insurance, as mentioned in the preceding section, is a risk management mechanism that allows investors fearful of loss to pay a fixed annual premium in return for compensation in the event of an actual loss. Through pooling of such premiums, insurance entities can manage the exposure of a large number of insured investors to various perils and allow the insureds to conduct their business more confidently. Political risk insurance responds to a unique kind of imperfection in the workings of international investment markets. Private investors generally feel competent and confident in their ability to assess and manage commercial risk in their field of business. However, concerns about the continuity and future course of the political, legal, and regulatory regimes governing FOi constitute an often difficult form of risk to assess and manage from the point of view of prospective foreign investors. On the opposite side of the fence, host government authorities are often equally concerned about how to demon­ strate the credibility and continuity of their policy reforms to sceptical investors.

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Without some kind of 'intervention' to resolve this credibility and continuity problem, international investment markets will perform sub-optimally and international investment flows will be reduced to a level far below their full potential. Investors have been quick to recognize that investment insurance is uniquely able to help manage political risk. To stimulate FDI in developing countries, public investment insurers are interested in both improving information flows and improving investor confidence. A brief word on each of these roles is useful. With respect to information flows, it is important to lower the cost for firms to acquire knowledge about foreign investment opportunities and operating conditions; this both reduces uncertainty for investors and helps them more clearly identify and manage political risk. Investor confidence is also important. Although the incidence of nationalization or expropriation of FDI has fallen dramatically in the past decade, investors' concerns about possible changes in the terms and conditions governing their prospective operations in a host country is still sufficient, in many instances, to prevent an investment from going forth. (Investment insurers can play an important role in reducing investor's uncertainties about the stability of regulatory regimes.) Investors' feelings of vulnerability plague virtually all prospective foreign investment. It is particularly pronounced, however, in certain types of projects: • Projects with large initial fixed investments and long payback periods, where foreign investors fear being 'locked in' by their investment. • Projects that depend on prices and rates of inputs, outputs, or currency conversion that are set by host country authorities rather than the markets. • Projects that involve private participation in infrastructure and other sectors heavily dependent on regulatory decisions by the host country that may attract broad public concern about the price and quality of output or service that has no export potential. 6. INVESTMENT INSURANCE: THE QUIET FACILITATOR Investment insurance has been rightly termed the 'quiet facilitator' of FDI in the developing world for several reasons. The first is secrecy about its existence and under-estimation of its value. It is a condition of almost all private investment insurance policies that the existence of the policy not be revealed. If it is revealed and there is a claim, the insurer has a sound legal basis for denying payment of the claim. Hence, millions of dollars in premiums are quietly paid to private insurers and many claims quietly settled. This silence about political risk investment insurance is also reflected in academia and the media; there is little attention paid to political risk insurance.

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A different kind of 'secrecy' exists among the twenty-two national (public) insurers. While a few of these insurers notify both the public and host country of the existence of an investment insurance policy, most national insurers do neither. Hence, the fact that firms purchase billions of dollars of coverage annually from national insurers goes largely unnoticed by other investors, academicians, and the media. Another reason why investment insurance is under-appreciated as a facilitator of investments concerns its role in the settlement of investment disputes and claims . Few investment insurers make public their claims payments. Moreover, very little is ever said or written about an insurer's role in the resolution of investment disputes. At one large national insurer, the experience was that only one of four notifications of a potential claim by an insured investor actually resulted in a claims payment. The other three were quietly resolved before they resulted in a loss. Why is little said or written about this phenomenon? One might answer that question with a question: what national investment insurer from an OECD country wishes it known that it has convinced/cajoled/pressured/ induced/ persuaded or otherwise reasoned with a developing country government so that a specific investment was not expropriated? No one. For similar reasons, it is not in the interest of the investor who has benefited from such a dispute resolution to publicize it. Silence about such events obviously makes good business sense for an investor who wishes to continue to operate. The host country, in turn, is not eager to publicize the resolution of a conflict or dispute with foreign investors for two reasons. First, it is difficult for most governments to admit publicly that a reversal of government decision or action has taken place; and second, they do not wish to undermine the government's credibility or their country's image of being an attractive investment site. Together, these two phenomena (that is, investment insurance secrecy and its role in the settlement of investments disputes and claims) have had the interesting effect of making some investors who have benefited from interventions by investment insurers very staunch 'believers' and users of investment insurance. Conversely, other firms who have viewed such insurance solely in terms of compensation for a possible loss and never seriously evaluated insurance in terms of its deterrence value, often cannot understand why investment insurance is so highly valued by others. Needless to say, such firms tend to never seriously look at investment insurance - much less purchase it. Investors' demand for political risk insurance from private, national and multilateral agencies has grown extremely rapidly. The Berne Union, comprising 22 national investment insurers (and MIGA), reported a significant increase in coverage issued from $2.3 billion in 1989 to over $8 billion in 1995. When published, their 1996 results should also report a significant growth in coverage.

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7. MULTILATERAL INVESTMENT GUARANTEE AGENCY (MIGA) MIGA was created as an affiliate of the World Bank Group to facilitate the flow of FDI in developing countries by mitigating major political risk concerns associated with investing in these countries. It does this by providing: • guarantees against the risks of currency transfer, expropriation, and war and civil disturbance to foreign investors in developing countries; and • investment marketing and advisory services to assist developing countries attract foreign investment. MIGA can insure new investments and the expansion, modernization, privatization, or financial restructuring of existing investments. As a development institution, MIGA requires its projects to benefit the host developing country through the creation of jobs, transfer of technology, and/ or generation of export revenues; they must also be environmentally and financially sound. Three aspects of MIGA's coverage are particularly noteworthy: 1. It is non-cancelable by MIGA (unless the insured defaults on its contractual obligations), though it can be terminated by the insured on any anniversary date; 2. it is long term, and can be issued for up to 15 (sometimes even 20) years; and 3. it can cover foreign private investments to, as well as between, developing member countries. MIGA also enjoys great flexibility in covering different forms of investment, such as equity, shareholder loans, loan guarantees, and technical assistance and management contracts. In its seven year operational history, MIGA has issued 223 contracts totalling more than $2.3 billion in coverage with respect to $15 billion of investment. Business has been brisk. FY96 business increased on all counts over FY95 levels: the number of guarantee contracts signed (68 versus 54), amount of coverage issued ($862 million versus $672 million), number of developing countries benefited (27 versus 21), and income earned from premiums and fees ($21.9 million versus $14.4 million). There are three indicators of the apparent value of MIGA's political risk insurance coverage that are worthy of note. First, and not to be overlooked, is the fact that MIGA's premium system is designed to allow the Agency to be self-sustaining and thus investors tend to pay higher rates than national insurers charge. Second, the volume of MIGA's preliminary applications has surged in the last few years to an average of more than 50 a month; the active portfolio of preliminary applications now totals about 1000. Third, the value of political risk insurance is indicated by response to a recent survey question was as follows:

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With regard to your last contract of guarantee, how important was it for your firm to secure a MIGA guarantee before proceeding with the investment? Absolutely Critical

1 29%

2 28%

3 20%

4 12%

5 11%

Useful

Investors clearly value the investment insurance coverage they have procured from MIGA MIGA in Africa: Guarantees MIGA is still a small organization (70 persons and a budget of $11 million); hence its efforts to promote investment is Africa are modest in absolute terms. Yet in relative terms, MIGA has focused substantial efforts on encouraging the flow of FDI into Africa. MIGA membership in the continent currently includes 40 countries that are eligible for MIGA's services; seven other African countries are in the process of fulfilling membership requirements. Since 1991, when MIGA signed its first guarantee for a project in Madagascar, the Agency has issued 25 contracts totaling about US$ 190 million in coverage with respect to approximately US$ 1.2 billion of foreign investments in ten African countries (See Table 13. 1). These investments are in many sectors - agribusiness, financial, telecommunications, manufacturing and mining - and have engendered significant developmental benefits. MIGA is optimistic about its future guarantee activity in Africa, with more than 140 active applications for prospective investments in 30 African countries, of which 12 are in advanced stages of underwriting. MIGA officers have recently visited a number of African countries, including Angola, Gabon, Guinea, Kenya, Mozambique, South Africa, Tanzania, Uganda and Zim­ babwe, to meet with local and foreign businesses interested in expanding their investments in these countries. MIGA hopes to increase significantly its guarantee activity in Africa.

Notes 1.

I a m indebted t o Ms. Ethel Tarazona for her assistance i n writing this article. Data referred in this section have been taken from World Debt Tables 1996, External Finance for Developing Countries, Vol. 1 . The World Bank, Washington, DC March 1996.

Investment Insurance in Africa Table 13. 1

MIGA guarantee contracts issued in Africa, 1990-96

Country

Guarantee Holder

Project Type

Societe Internationale de Plantations d'Heveas Agribusiness Manufacturing Egypt Harsco Investment Corporation Gold Mining GSM Gold Limited Ghana Tourism Madagascar Holding Savana S.A. et al. (3) Anglo American Corporation Mali of South Africa Ltd Gold Mining Morocco Banco Exterior de Espana SA Finance South Africa Multiserv International N.V. Manufacturing Multiserv International N.V. Manufacturing Finance Habib Bank AG Zurich Standard Chartered Bank Africa Finance Tanzania Wilken Group Limited (2) Telecommunications Tunisia British Gas plc/ECGD Oil & Gas Mine Or Uganda Cobalt Mining La Source Cobalt Mining Clovergem AG Agribusiness France Commodities S.A. Manufacturing France Commodities S.A. Manufacturing Starlight Telecommunications Ltd. (2) Telecommunications Wilken Group Limited (2) Telecommunications La Source Cobalt Mining Cameroon

Total

2. 3. 4. 5.

337

MIGA Coverage($) 370 000 2 237 000 9 850 000 3 699 000 50 000 000 9 900 000 4 000 000 4 500 000 12 300 000 8 308 000 430 379 64 800 000 3 200 000 3 200 000 5 375 700 405 000 1 300 000 2 620 000 983 195 3 600 000 191 069 274

Harinder Singh and Kwang W. Jun (1995). 'Some New Evidence on Determinants of Foreign Direct Investment in Developing Countries', Policy Research Working Paper, No. 1531, World Bank, November. For a detailed discussion of domestic reforms and liberalization, see From Plan to Market, World Development Report 1 996, The World Bank, Washington DC. Dan Haendel and Gerald West (1975). Overseas Investment and Political Risk, Philadelphia, PA, Foreign Policy Research Institute, Monograph, No. 21. Pfeffer, Irving (1956). Insurance and Economic Theory, , Homewood, Ill.: R . D . Irwin, p . 42.

14 The Potential for Restraint through International Trade Agreements Paul Collier and Jan Willem Gunning 1.

INTRODUCTION

The liberalization of trade and exchange rate policy has been the core component of African economic policy reforms. Correspondingly, the probability that they will be maintained is the core of the risk assessment made by investors. In this chapter we first briefly review African trade policy and then consider ways of enhancing the credibility of liberalization. In Section 3 we suggest that non-African countries that have faced the problem of limited credibility in trade policy have used inter-governmental reciprocal threats as a restraint. The rest of the chapter then reviews three ways in which African governments could construct such agencies. Section 4 considers using regional cooperation between African governments and concludes that this would be ineffective as a restraint. Section 5 considers a North-South arrangement between Africa and Europe. Section 6 considers using the provisions of the World Trade Organization. Section 7 compares the two latter options.

2. AFRICAN TRADE LIBERALIZATIONS Most African governments have until recently imposed high trade restrictions. For example, Kenya, which adopted relatively liberal economic policies by the standards of the continent, had an implicit tariff rate on manufactures in excess of 100 per cent during the late 1980s (Gunning, 1994). In less liberal economies trade restrictions have been even more severe: in Tanzania by 1 985 the exchange rate premium, a reasonable measure of the severity of trade restrictions, had reached 477 per cent. In addition to high levels of protection, trade policy was volatile. Many governments, wishing to maintain fixed exchange rates and holding negligible foreign exchange reserves, have relied on changes in trade policy to accommodate external shocks. Under such a 338

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policy rule positive shocks lead to trade liberalization, negative shocks to a tightening of trade restrictions, so that investors have been faced with highly uncertain relative prices. Evidence of the harm done by these restrictive and volatile trade policies is provided by Easterly and Levine (1997) who analyse why Africa grew so slowly during 1 960- 89. Their conclusion is that, to the extent that the difference in growth rates can be attributed to policies, trade restrictions are the most important cause of slow growth. They show that simultaneous trade liberalization in a group of African countries would raise the growth rate by 1.4 percentage points. Elsewhere, we show that even a given level of trade restrictions has been significantly more damaging to growth in Africa than in other developing countries (Collier and Gunning, 1 999). Presumably this is because African economies are typically very small so that they have more to gain from international trade. Despite the high costs of trade restrictions in Africa unilateral trade reforms have often been reversed, sometimes even before being fully implemented. Kenya embarked upon three far-reaching trade reforms within a decade, each time reversing the liberalization (Mwega, 1995). Zambia started seven different adjustment programmes, all involving trade liberal­ ization and all ending in policy reversal. Cote d'Ivoire twice within a decade partially reversed trade liberalization measures. The Nigerian liberalization of 1986 was slowly eroded and then finally abandoned in 1993. Zimbabwe initiated far-reaching trade and exchange liberalization in 1991. So far this liberalization has been maintained but the government stance is not fully credible: there is a large fiscal deficit which requires either massive exchange rate depreciation (which would be politically difficult) or a return to trade restrictions and foreign exchange rationing. There is a similar concern about the sustainability of the liberalization in Ghana (Tutu and Oduro, 1 995). Oyejide et al. (forthcoming) and Foroutan and Nash (1998) each review ten African trade liberalizations and find that half suffered major reversals. Evidently, the penalties incorporated into Structural Adjustment Programmes are either insufficient, or insufficiently credible, to prevent these reversals. Such reversals are costly, both in terms of the reduction in fixed investment discussed in Part II of this volume, and the increase in speculative hoarding of imports (Calvo, 1988; Reinikka, 1996). Given both the centrality of trade and exchange rate policies to economic liberalization and this history of reversals, it is these reforms on which investor fears are primarily focused. Investors fear that convertibility will not be maintained so that profits cannot be repatriated, and that relative prices will be changed by policy so that projects which are currently profitable will cease to be so. This chapter considers how governments can construct agencies of restraint which specifically address these fears.

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3. EXTERNAL AGENCIES OF RESTRAINT FOR AFRICA: RECIPROCAL THREATS Unsurprisingly, the need now encountered by African governments for credibility in trade and exchange rate liberalization has previously been encountered by other governments. The demand for restraint was met by the inter-governmental creation of agencies that worked by means of reciprocal threats. With respect to trade liberalization the major institutions have been the GATT/WTO, the EU and NAFTA. All supplied mechanisms by which a government could credibly lock in to trade liberalization, the enforcement being supplied by the certainty of punishment by the other partners to the agreement. With respect to exchange rate liberalization the major institutions have been the Bretton Woods fixed exchange rate agreement underpinned by conditional borrowing facilities from the IMF, the Franc Zone (Bretton Woods with the IMF played by France), and the EMS (Bretton Woods with the IMF played by the Bundesbank). The common form of these institutions is that they are reciprocal: the governments that choose to be bound by them also participate in the design of the rules and in the supply of enforcement. This contrasts with donor conditionality where the governments that are restrained are the borrowers and the enforcement is supplied by the lenders. This reduces the risk that the agency will use its power to enforce preferences that differ markedly from those of the restrained government and so makes the agency better suited to a restraint role. The collapse of Bretton Woods in 1971, the devaluation of the CFA Franc in 1994, and the exit of Britain from the EMS in 1992 indicate both that there are limits on the powers of external agencies of restraint and that they can sometimes accentuate the economic mismanagement they seek to contain. However, the record is on the whole impressive. The GATT and the EU have been able to enforce massive trade liberalization among their members for long periods. NAFTA helped to maintain liberal trade policies in Mexico during a macroeconomic collapse that would more usually have triggered trade restrictions. Bretton Woods helped secure twenty years of fiscal order before being destabilized by the Vietnam war. The Franc Zone achieved over a decade of fiscal restraint for its members before its rules came to be circumvented. The EMS helped France to overcome the fiscal populism of the early 1980s. The question is not whether reciprocal threat external agencies of restraint are universally beneficial, but rather whether some African governments need them now. Those governments which have implemented reforms but which have low levels of private investment prima facie have a credibility problem. Attempts to overcome this by appointing foreigners as governors of central banks, and by signing up to detailed conditionality concerning future reform

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with the donors have evidently not proved up to the task. With the exception of the Franc Zone, African governments have not made much use of reciprocal threat agencies of restraint. Instead they have depended upon non­ reciprocated relationships. In trade policy they have relied upon the 'special and differential' approach of UNCTAD rather than the reciprocity of the GAIT. In fiscal policy they have relied upon the 'charity with threats' approach of the donors, rather than the reciprocity of Bretton Woods or the EMS. It is time for African governments to harness the supra-national reciprocal threat institutions to their own needs. 4. CAN RECIPROCAL THREATS AMONG AFRICAN GOVERNMENTS CREATE CREDIBLE RESTRAINTS? Both NAFTA and the European Union are regional trade agreements: restraint is achieved by the reciprocal threats of governments in the region. We first consider whether this would constitute an effective restraint mechanism for Africa. We argue that African regional trade groups would not provide effective enforcement mechanisms for two reasons. First, African regional cooperation schemes have a long history of limited implementation and this itself gives rise to a credibility problem. If there is a likelihood that stipulated penalties will not be implemented, then member governments will not be deterred from breaches, and investors will not take reassurance from the institution. A common feature of many of the schemes is that treaty provisions have never been implemented and that the institutions set up under the treaties are barely functioning. In many cases serious implementation is not even feasible: there is considerable overlap in the membership of the schemes and many countries belong to schemes with mutually incompatible provisions. One of the oldest schemes, the sixteen member Economic Community of West African States (ECOWAS) may serve as an example. ECOWAS became effective in 1977. According to the 1975 treaty trade liberalization was to start in 1979 and to be completed by 1989. In fact trade liberalization did not start until 1990 (Jebuni et al. , 1995) and so far none of the goals set out in the treaty have been reached. Even the relatively successful schemes have low implementation. The Customs Union of Central African States (UDEAC) had a common external tariff as an objective. In fact, as documented by Decaluwe et al. (1995, eg Table 3), the members adopted widely different tariff rates. In one case all six member countries used different rates, ranging from 8 to 49.5 per cent. Similarly, the CEAO is supposed to have a common external tariff but this is not effective and the members frequently use non-tariff barriers against each other. Second, unlike the members of the European Union and NAFTA, most African countries have little to gain from regional integration. Srinivasan

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(1993, pp. 23-4), discussing regional trade in South Asia, stresses four conditions for successful preferential regional trade arrangements in the form of free trade areas (FTAs): (1) pre-FTA tariffs should be high, (2) there should be substantial intra-regional trade prior to the formation of the FTA, (3) there should be complementarity in demand, and, finally, (4) the participating countries should have substantially different factor endowments. Only the first condition is satisfied in the African context. The second of Srinivasan's condition highlights a major difference between NAFTA and the African schemes. The US and Canada already accounted for over 80 per cent of Mexico's exports prior to NAFTA while intra-regional trade was insignificant in all African cases. The structure of both demand and production is remarkably similar across African countries so that neither the third nor the fourth condition is satisfied (Foroutan and Pritchett, 1 993). Because African countries are too similar in endowments for there to be much scope for trade (with the exception of schemes involving South Africa) the economic effects of regional integration are at best 'vacuous' ( de Melo et al. , 1993) and at worst trade diverting. Whatever trade creation may be realized through trade reform can be attained through unilateral trade liberalizations: on Vinerian grounds alone there is no gain from regional arrangements. Without a substantial gain from regional trade the penalties which can be inflicted by the group on a member who breaks the rules are consequentially small so that the group does not provide effective enforcement. Foroutan (1993) takes the argument a stage further. She suggests that in Africa non-discriminatory liberalization is a necessary prelude to regionally discriminatory liberalization. Until African trade barriers are reduced, the transfers generated by regional preferences are too powerful to be politically sustainable. Thus, far from regional preferential trade agreements being a means to reinforce trade liberalization, the dependency is reversed: only if trade liberalization can be made secure by other means can regional preferences be made politically feasible.

5.

THE POTENTIAL OF LOME V AS A RESTRAINT

The literature on optimal partners in regional groupings stresses that partnership should be determined by the purpose of the association. If the purpose is trade creation then major trade partners are obvious candidates. In the case of Africa this suggests that regional groups should involve Europe. In such an association there is reason to believe that the main gains would accrue to Africa. Anderson and Snape (1994, p. 8) conclude on the basis of a review of formal modelling of regional integration agreements (RIAs) that the

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largest benefits accrue to small countries which join already-large entities. This is because of: proportionately greater (a) competitive effects, (b) opportunities to exploit economies of scale, and (c) the assumed 'safe haven' effects of being subject less to contingent protection (eg, anti-dumping actions) by being inside the RIA The proportionate gain is even greater if - as with Mexico in the case of NAFTA - that smaller economy was at the outset (a) relatively closed to foreign trade and investment and (b) relatively prone to investment-reducing macroeconomic instability and micro­ economic reform reversals but becomes more disciplined as a consequence of joining the RIA Trade between Europe and Africa is at present not characterized by reciprocity in either direction. African exports enjoy preferential treatment in the EU under the Lome convention but this relationship is asymmetrical. African countries are under no obligation to let in imports from EU countries. Conversely, when an African government agrees (under donor pressure) to liberalize its import restrictions, it does not thereby gain improved access to the markets of European (or any other developed) countries. The proposed arrangement would, however, be reciprocal and indeed access for the exports of the regional grouping to the European market would be conditional on the regional group removing restrictions on imports from Europe. This would amount to a North-South free trade area, as in the case of NAFTA The participation of Europe would ensure that the three Srinivasan conditions that are currently violated, would be satisfied. Indeed, dissimilarity within the FfA would be so great that Africa could not expect to gain more from global free trade. How should the regional group be organized? This could be a small group of nations submitting themselves to a participatory supranational agency, following the model of the Franc Zone. A notable feature of the two monetary unions that make up the Franc Zone is that they each have a central bank that is governed by the member countries, not by France. This institutional arrangement implies a relatively effective form of external discipline: a country which violates the rules can be expelled by its fellow member countries and it would thereby lose the advantages of convertibility and of automatic temporary financing of budget deficits. Hence the Franc Zone, unlike donor conditionality as currently practised, relies on a convincing penalty. The key elements of this arrangement, participatory supranational control and convincing penalties, can be applied to the proposed customs unions. Europe could offer association accords 1 to groups of countries that set up customs unions under supranational control of the participating African

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countries. Association would imply reciprocal free trade, ie the two markets, the EU and the African customs union, would form a free trade area. This would have three advantages. First, the arrangement would be entirely voluntary. The EU could make such an offer as part of a menu of options within Lome V: there would be no pressure on African countries to accept. Such an optional arrangement will not generate the resentment often associated with donor conditionality. A country may, of course, decide that the political costs of abandoning protection are prohibitive so that it chooses not to participate. However, such a country would have been an unwilling participant in trade liberalization under a SAP. Hence the fact that the reciprocal arrangement is voluntary makes it more likely that trade reform, if it is undertaken, will be sustained. Second, self-government makes reform more acceptable and therefore more likely to be sustainable. Discipline is not imposed by an external agency such as the IMF or the World Bank but by a self-governing regional group. An important corollary is that if this form of regional cooperation is to work effectively, the number of members has to be small. While there is a tendency to aim for the expansion of existing African regional integration schemes into continent-wide organizations, this is likely to make an institution that has to rely on self-imposed discipline ineffective. Finally, and most importantly, the scheme would achieve credibility by offering a lock-in mechanism. For if a government were to restore trade restrictions it would not only lose the free access to the rest of the customs union but also the access to the European market which is tied to union membership. This would make it easier to resist pressures for a return to protection: a domestic firm lobbying for protection would in fact be asking the government to give up its membership of the customs union. For as long as the country remains within the union trade policy is not a national decision: it can be changed only through a joint decision of all union members. That makes a return to trade restrictions most unlikely. Such a decision would end the access of all the members of the customs union to the EU automatically. Obviously, in Africa, not all governments would at the same time want to join a reciprocal trade arrangement with Europe, but ideally an institutional form should be designed in which it is possible eventually to include the whole of Africa without that requiring 50 bilateral negotiations between the EU and each African entrant. This could be achieved if the membership of an African customs union linked to the EU could be expanded without having to reopen negotiations: a potential new member would negotiate entry into the union only with the existing members. By joining it would automatically gain access to the EU market and reciprocate by removing restrictions on imports from the EC. Such an arrangement whereby existing arrangements are adopted without change by new members has been followed effectively in Western Europe, not

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only in the expansion of the European Union itself but already in the Middle Ages when frontier towns adopted existing laws of 'mother' towns, thereby rapidly spreading effective institutions (Bartlett, 1990). For this arrangement to be self-enforcing a combination of asymmetry and value of access probably is essential. In the case of NAFTA access to the US­ Canada market is obviously valuable to Mexico and the relation is clearly asymmetric so that revoking the valuable access in the case of non­ compliance is an effective threat. The Salinas administration, realizing this, saw NAFTA as a way of locking in its economic reforms. In the case of Eastern Europe the 'Europe Agreements' involve the same combination of asymmetry and valuable benefits, including the prospect of full EU membership. In the case of the Africa-Europe proposal the condition of asymmetry is obviously satisfied. In addition the access to the European market is valuable because the present preferential access is by no means unrestricted. African exporters enjoy GSP and ACP tariff preferences but these are subject to quantitative limits. Successful exporters of products considered 'sensitive' (eg agricultural products) by the EU face quotas or 'voluntary' export restraints. For example, voluntary export restraints were used against Mauritius when its exports of knitwear started growing rapidly. The successful conclusion of the Uruguay Round means that these benefits will gradually be eroded. Under the WTO the MultiFibre Arrangement (MFA) will be phased out in ten years, although most of the liberalization will not occur until the last two years. MFN tariffs on tropical products such as coffee will be removed (eliminating the value of preferential ACP access) and reform of US and European agricultural policies (much of it only indirectly related to the Uruguay Round) will eliminate preferential access for eg sugar from which Mauritius has long benefited. In addition, the WTO has clarified the rules of world trade and has improved procedures to deal with violations. The 'defensive argument' for joining a regional block, ie to ensure that as a member one cannot be the subject of harmful trade policies of the block, has thereby lost some of its force. However, the quid pro quo for the Uruguay Round liberalizations was that it has been made considerably easier to bring anti-dumping suits. This is commonly described as contingent protection (the risk of such a suit) having replaced protection through quantitative restrictions. The rules governing anti-dumping suits are so structured that they bear virtually no relationship to whether dumping in the economic sense has actually occurred. A country can therefore face an anti-dumping suit simply because its products are competitive in a foreign market. Defence against such suits may become one of the major issues in trade policy. The European Union has recognized this in trade relations among its own members. No intra-EU anti-dumping

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suits can be brought. Importantly, this defence against anti-dumping suits has been extended by the European Union in a reciprocal trade arrangement with a non-member, Iceland. If Iceland can negotiate such an agreement with the EU there seems no reason in principle why other small countries or groups of countries could not do so in Africa. With such an agreement, an African country would look safer to investors than other locations in this important respect. If an investment for manufactured exports to Europe was based in (say) Indonesia, it could be subjected to an anti-dumping suit. If it was located in (say) Kenya, although some risks would be assessed as higher, this risk would be eliminated. Possibly, with such a compensating risk advantage, many more African countries would make the shortlist for international investment locations, so that firms would make serious investments in country risk assessment. The 'Africa dummy' in risk ratings might then start to be reduced. In summary, a regional customs union tied to Europe would offer several advantages. First, it would achieve almost as much as Africa could hope to gain under global liberalization, second, it would serve a defensive purpose, preventing Africa being harmed in a world of trade blocs insufficiently policed by the WTO, and third, it would lock-in trade reform and thereby achieve credibility. Finally, it may attract foreign investment, for three reasons. First, credibility attracts investment by reducing option values. If there is no uncertainty about whether (and in what direction) policy will change then investors have no incentive to remain liquid. Second, by achieving regional market integration it may attract foreign firms wanting to set up production in Africa to serve regional demand. Finally, by ensuring market access, it might attract foreign direct investment of firms wanting to produce in Africa for export to Europe. The first published proposal that we have found for such a trade arrangement between Africa and Europe was made by the African Development Bank. It stated: A revised form of association between the Southern African region and the EEC involving some reciprocal arrangements could have several beneficial effects in making commitments to trade liberalization virtually irreversible and encouraging intra-regional trade and cross-border investment (ADB, 1992). This statement of the proposal captures the essence of the restraint mechanism: credibility can be achieved through reciprocal threats. Since 1992 the case for the proposal has been strengthened: more African countries have reduced trade restrictions and need a mechanism for locking-in to their new liberalizations.

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6. THE POTENTIAL FOR THE WORLD TRADE ORGANIZATION AS A RESTRAINT The main trade restraint mechanism used outside Africa has been the GATT and its successor the WTO. Under GATT/WTO the procedure for restraint has been a combination of declaring some types of trade barrier illegal and of placing ceilings on others. As a result of the Uruguay Round quantitative restrictions on trade are made illegal and those in existence are being phased out as discussed above. The use of ceilings relates to tariffs. As part of a trade negotiation a government will offer to 'bind' its tariffs at particular levels. Once a tariff line has been 'bound', it cannot exceed this level. Governments may, however, bind a tariff at a level above its current actual rate. The tariff may then be raised, but only by a certain amount. Negotiations focus only on bound rates of tariffs because otherwise they would encounter a credibility problem: a government could agree to reduce tariffs only to increase them again after the negotiations. African governments have made little use of either the GAIT or the WTO. Indeed, Cadot and de Melo (1994) have argued that this is why they were able to accumulate such high trade barriers at a time when almost all other countries in the world were reducing them. African governments were exempted from the GAIT reciprocity rule. They actively sought non­ reciprocity and other governments were willing to concede it because Africa was considered unimportant. In the process, African governments connived in their own marginalization. Few African governments were either observers at the Tokyo Round or were signatories to its agreements. During the negotiations for the Uruguay Round no African government sought to join the Cairns Group of primary commodity exporters. Although most African governments are now members of the WTO, they have yet to use its provisions effectively. With respect to tariff bindings, which are the core of the restraint system, most African tariff rates are either unbound or bound at very high levels. Consider, for example, the strategies adopted by two recent trade liberalizing governments, Uganda and Zimbabwe, both in need of credibility for their liberalizations. In Uganda, only 15 per cent of the tariff lines on imports of industrial goods were bound. The average rate at which they were bound was in the range 40 to 80 per cent whereas the average actual tariff rate was only around 18 per cent (Collier, 1997). In Zimbabwe the government chose a particularly convoluted strategy in order to bind its tariffs at their 'actual' rates. Announced tariff rates were raised to 100 per cent for the day on which the Uruguay Round Agreement came into force and promptly lowered again. Thus, tariffs are only bound at 100 per cent, despite actual tariff levels being well below these levels. If the Zimbabwean government had been seeking a way to signal that it was not committed to maintaining tariffs at their liberalized levels it could hardly have

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found a more effective means of doing so. Rather like the Gorbachev example discussed in Chapter 1, the Zimbabwean government revealed that while it had recognized that there was a credibility problem, it had not understood how to reassure potential investors. The lesson behind the Zimbabwean example can be generalized. African governments are transmitting a signal simply by neglecting to use the restraint mechanisms that other governments have used. As noted above, the GATT originally catered for the credibility problems of newly liberalizing governments. The current candidate governments for this function are mainly African. However, just as African governments have ignored the GATT/WTO, so the GATT/WTO has largely ignored its appropriate client base. The WTO is now largely focused upon trade relations between the three main trading blocs, and has largely abandoned its traditional function of reinforcing the credibility of liberalizations. There is a severe danger that Africa's policy credibility problems will be seen as the proper domain of the donor agencies rather than of the reciprocal threat inter-governmental institutions. For the WTO to cater effectively for African liberalizations it would need to consider changing one of its escape clauses. Currently, governments may impose temporary trade restrictions for balance of payments purposes. This is an anachronism from the time of Bretton Woods fixed exchange rates: in an era of flexible rates trade restrictions are an inappropriate response to a payments problem. However, the re-introduction of foreign exchange rationing as a means of coping with a payments problem is precisely the fear that is dominant among foreign investors to Africa. Governments need to be able to bind themselves to convertibility in the same way that they can bind themselves to tariff ceilings. At present the WTO has no such instrument to offer a government with a credibility problem with respect to convertibility.

7.

CONCLUSION

In recent years changes in trade policy in Africa have occurred in two forms: unilateral liberalization in the context of structural adjustment programmes and multilateral liberalization in the context of regional integration. Both forms have been problematic. Unilateral trade liberalization has often suffered from lack of credibility, in part because the involvement of donors introduces the possibility of time inconsistency. A government may agree to trade reform only because donors offer aid for the promise of reform. It then has an incentive to reverse the liberalization when the aid runs out. Under present arrangements there is no credible penalty for such policy reversal: there is no lock-in of reform. Regional integration efforts, which have recently

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proliferated, are problematic because there is little scope for trade creation between the member countries of a customs unions. We have argued that the form of collusive trade policy most pertinent for Africa is North-South reciprocal discrimination along the lines of NAFfA. This would involve small groups of African countries setting up customs unions under supranational control and negotiating reciprocal free trade with the European Union. This would amount to an effective agency of restraint: lock-in would be achieved because policy reversal would carry a heavy penalty, the loss of unrestricted access to the Northern market. As long as the new WTO order is untested that access is valuable. Regional integration schemes are politically attractive. That attraction can be harnessed to achieve what is currently lacking: credibility of trade reform. The chapter suggests that the proposed scheme would attract multinational investment aimed at production for export to Europe. Comparing the potential for Lome V as a restraint against the WTO, the former has three major advantages. First, it is timely. The WTO works through intermittent negotiating rounds which typically take over a decade, and the last one has only recently been completed. By contrast, Lome V is soon to be negotiated and the proposal to include in it a reciprocal threat option for those ACP countries which wish to use it in this way is under active consideration. Second, whereas the liberal trade order which the WTO can enforce has been weakened by the need to concede greater contingent protection in order to conclude the Uruguay Round, this provides an opportunity for Lome V to offer Africa a superior degree of secure trade liberalization, free from contingent protection. Third, whereas the WTO cannot address the risk of the suspension of currency convertibility, Lome V is sufficiently flexible to incorporate many aspects of trade and exchange rate risk. An African government could commit itself to the maintenance of a convertible currency as a condition of access to the European market. In negotiating reciprocity into an agreement with the European Union African governments have reasons for urgency. Once Lome V is determined, negotiations will cease for some years. Further, Europe's interests in developing countries are shifting away from Africa towards Asia (Grilli, 1993; Kanbur, 1993). However, the principle reason is that African governments are in current need of credibility enhancement. Whereas the institutions of African regional integration have to date reflected the acknowledgement of an aspiration the realization of which governments can afford to postpone, the point of constructing agencies of restraint in the sphere of trade policy is that they should have effects during the next decade.

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350 Note 1.

This involves a legal difficulty. As Cadot and de Melo (1994) point out association accords can only be a stepping stone to full membership. In the case of the Europe Agreements in Eastern Europe this is indeed envisaged, but otherwise association cannot be permanent. The Maghreb agreement is already an exception to this rule.

REFERENCES African Development Bank (ADB) (1992). 'Integration Strategy for Southern Africa', paper presented at the ADB Workshop on Economic Integration of Southern Africa in the Post Apartheid Period, 28 September-3 October, Abidjan. Anderson, K. and R. H. Snape (1994). 'European and American Regionalism: Effects on and Options for Asia', CEPR Discussion Paper No. 983. Bartlett, R. (1990). The Making of Europe, London, Penguin. Cadot, 0. and J. de Melo (1994). 'The Europe Agreements and EC-LDC Relations', CEPR Discussion Paper No. 1001, August. Calvo G. (1988). 'Costly Trade Liberalizations' IMF Staff Papers, 35, 461-73. Collier, P. (1997). 'Ugandan Trade Policy: Liberalisation with Limited Credibility', in C. Milner and S. Arndt (eds), The World Economy: Global Trade Policy, 1996, Oxford, Blackwell. Collier, P. and J. W. Gunning (1995). 'Trade Policy and Regional Integration: Implications for the Relations between Europe and Africa', The World Economy, 18, 387-410. Collier, P. and J. W. Gunning (1999). 'Explaining African Economic Performance', Journal of Economic Literature, 37, 64-1 1 1 . Davenport, M . (1992). 'Africa and the Unimportance o f Being Preferred', Journal of Common Market Studies, 30, 233-51. de Melo, J. and A Panagariya (eds) (1993). New Dimensions in Regional Integration, Cambridge University Press for the Centre for Economic Policy Research. de Melo, J., A Panagariya and D. Rodrik (1993). 'The New Regionalism: a Country Perspective', in: J. de Melo and A Panagariya (eds), 159-93. Decaluwe, B., D. Njinkeu and L. Bela (1995). 'UDEAC Case Study', paper presented at the Africa Economic Research Consortium workshop on Regional Integration and Trade Liberalisation, Harare, 18-20 March. Easterly, W. and R. Levine (1997). 'Africa's Growth Tragedy: a Retrospective, 196089', Quarterly Journal of Economics, 1 12, 1203-50. Foroutan, F. (1993). 'Regional Integration in Sub-Saharan Africa: Past Experience and Future Prospects', in: J. de Melo and A Panagariya (eds), 234-71. Foroutan, F. and J. Nash (1998). 'Lessons from the Trade Expansion Program', in J. Nash and W. Takacs, (eds), Trade Policy Reform: Lessons and Implications, Washington, DC: World Bank. Foroutan, F. and L. Pritchett (1993). 'Intra-Sub-Saharan Trade: Is It Too Little?', Journal of African Economies, 2, 74-105. Grilli, E. R. (1993). The European Community and Developing Countries, Cambridge University Press. Gunning, J. W. (1994). 'Trade Reform in Africa: the Role of Donors', in J. W. Gunning, H. Kox, W. Tims and Y. de Wit (eds), Trade, Aid and Development, London, Macmillan.

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Jebuni, C. D., E. 0. Ogunkola and C. S. Soludo (1995). 'A Review of Regional Integration Experience in sub-Saharan Africa: a Case Study of the Economic Community of West African States (ECOWAS)', paper presented at the Africa Economic Research Consortium workshop on Regional Integration and Trade Liberalisation, Harare, 18-20 March. Kanbur, R. (1993). 'EC-Africa Relations: a Review Article of Enzo R. Grilli's, The European Community and Developing Countries, Cambridge University Press, 1993', Journal of African Economies, 2, 434-46. Mwega, F. M. (1995). 'Trade Liberalization, Credibility and Impacts: a Case Study of Kenya, 1972-93', paper presented at the Africa Economic Research Consortium workshop on Regional Integration and Trade Liberalisation, Harare, 18-20 March. Oyejide, A., B. Ndulu and J. W. Gunning (eds) (forthcoming). 'Regional Integration and Trade Liberalization in Sub-Saharan Africa: Volume 2', Country Case Studies, London, Macmillan. Reinikka, R. S. (1996). 'The Credibility Problem in Trade Liberalisation: Empirical Evidence from Kenya', Journal of African Economies, 5, 444-68. Srinivasan, T. N. (1993). 'Preferential Trading Arrangements in South Asia: Theory, Empirics and Policy', mimeo, Yale University. Tutu, K. A. and A. D. Oduro (1995). 'Trade Liberalisation in Ghana', paper presented at the Africa Economic Research Consortium workshop on Regional Integration and Trade Liberalisation, Harare, 18-20 March.

15 The Potential for Restraint through an International Charter for FD I Mark A. A. Warner INTRODUCTION I have been asked to discuss a Charter for Foreign Direct Investment (FDI) in Africa as means of reducing the perceived risk of investing in Africa. I am ambivalent about the ultimate effect of such a Charter on stimulating much needed FDI in Africa. As a lawyer, I am trained to believe in rule-governed behaviour, so to that end, I have an instinctive reaction that a Charter, any Charter perhaps, is better than no Charter at all, so long as it can provide for predictability and certainty of transactions. As an economist, however, I am more chastened by the knowledge that in the long term, FDI flows are probably more likely to be determined by the size and growth of markets, and other macroeconomic fundamentals. However, at the margin, with respect to certain countries and certain projects, the presence or absence of certain and predictable legal rules might exert a strong influence on the other macroeconomic variables. So in the steadfast pursuit of that marginal investment, I proceed. First, I will briefly review the recent African experience with FDI. Second, I will look at attempts to integrate investment disciplines in existing plurilateral agreements on the African continent. Third, I will outline certain necessary provisions of an African Charter for FDI. Finally, I will conclude with some observations of the way forward towards implementing such a Charter. THE ECONOMIC FRAMEWORK Sub-Saharan Africa, with the exception of South Africa, offers few evident market opportunities at this time, but the medium- and long-term horizon appears more promising. Sub-Saharan Africa comprises 48 countries, 32 of which have populations of less than 10 million. Although the region has a population and a land mass that is roughly three times the size of the United States, it is perceived as a collection of small, fragmented, low-income, 352

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relatively closed markets. Sub-Sahara's total gross domestic product of $400 billion amounts to about one twentieth of that of the United States, and its per capita income averages less than $700 per person. After four years of decline or stagnation, average real GDP growth in the region increased to 3.8 per cent in 1995, the highest rate thus far in the 1 990s. That was also the first increase on a per capita basis (1.1 per cent) since 1 989. Growth also appears to be more widespread, exceeding 3 per cent in nearly 30 countries. A number of reforming countries have recorded growth rates exceeding 4 per cent. Botswana, Ghana and Mauritius among others have been good performers. While this in part is the result of higher commodity prices, which may be transitory, it also reflects the positive impact of more effective development programmes, better economic policies, political transition in South Africa and other emerging democracies, and greater civil peace in some areas, all of which should make economic growth more sustainable. The United States has an important economic stake in Africa's success - in 1995 two-way trade between the United States and Africa reached a new high, $18 billion, 11 per cent greater than in 1994. The United States' exports to Africa increased 23 per cent above the 1994 level, to $5.4 billion. Already, the African market is nearly as large as those of the Newly Independent States, including Russia, of the former Soviet Union. During 1995 the United States imported $12.6 billion from Africa, mainly oil, a 1 2 per cent increase from 1 994. Thirty years ago the 'Asian tigers' were no better off than the African countries. Today, the disparity in Asian and African income levels invites both questions and answers. Of course, disease, drought and civil strife have had a disastrous impact on individual countries at certain periods during the past decades, but why has this lack of growth been so widespread and so systemic? A recent study by Jeffrey Sachs and his colleagues at the Harvard Institute for International Development suggests that about 40 per cent of Africa's slow growth in the 1970 to 1989 period was due to the fact that most African markets have been historically closed to trade. During this period of time, the Member States of the European Union opened their markets to these countries under their special trade programme for their former colonies. This openness by the European Union - and they do absorb about one-third of the region's exports - was obviously not enough to produce acceptable rates of growth in the region. I believe that an important reason is that multilateral exchanges of market-opening concessions are the best way for developing countries to grow, because this system gives them a legal right to foreign market access, but it also compels them to open their markets for the capital goods they need. The mutual exchange of benefits can be good politics and good economics. To date, Sub-Saharan Africa simply has not been heavily involved in trade, neither intra-regional nor international. Most of the 48 Sub-Saharan countries

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were members of the GATT 1 947 and participants, at least nominally, in the Uruguay Round. Two-thirds of those have become members of its successor institution, the World Trade Organization (WTO). Nevertheless, national trade barriers remain high, restraining international trade and keeping intra-regional trade between Sub-Sahara's fragmented markets as levels on average less than 7 per cent of their combined GDP. Sub-Saharan Africa, with 10 per cent of the world's population, generated only 1.3 per cent of the world's $4.2 trillion exports, or $56.3 billion in 1 994, mainly commodities - gold, diamonds, oil and agricultural products such as cocoa and coffee. One way of addressing this situation, is to encourage more active participation in the WTO by Sub-Saharan African countries, both individu­ ally, and as a by-product of efforts at regional trade liberalization. Another practical step to extend trade liberalization by countries of the region is to encourage freer trade within the region or parts of it. Africa has a long history of attempts at integration and liberalization, but their success has been limited. More on this below. Of course, no amount of easing entry to international markets can succeed unless the African countries develop a relatively competitive proficiency in producing goods within the price/quality trade-off range that is in demand in world markets, and particularly in US markets. Export growth, then is dependent on a substantial inflow of investment to provide the country's workforce with efficient plant and equipment. The World Bank has calculated that a country must achieve a level of investment equal to 25 per cent of the country's GDP in order to achieve a GDP growth rate of 6 per cent. By that criterion, Sub-Saharan Africa would need investment levels of $100 billion annually. African countries' annual savings rates vary widely, with some at negative rates, and most clustered around the 10 per cent range, which would amount to $40 billion for Africa. Foreign aid and funding from the multilateral development banks (MOB) which are already owed $185 billion by African countries, are unable to bridge a $60 billion gap in any given year, much less every year. The only potential funding source that could bridge that gap is private foreign investment. Direct investment brings with it an important bonus; an infusion of managerial, technical and marketing expertise from foreign corporations setting up facilities in the host country. Private capital flows to developing countries and the Newly Independent States (NIS) quadrupled during the 1990s reaching $211 billion in 1995. Private foreign investment amounted to $126 billion; trade financing and other financial sources and official aid made up the rest. Unfortunately, the investment response - both domestic and foreign - to reform measures in Africa has been disappointing. During the early 1 990s, investment flows into Africa stagnated while those to other developing regions, notably Asia and Latin America, increased. Africa's

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share of foreign investment flows declined form 8.9 per cent in 1981 to only 2.9 per cent by 1994, according to an International Finance Corporation study. African countries, however, have attracted only $2.2 billion of those private foreign investment flows. Of that, $2.1 billion was for direct investment, most of which is believed to be tied to the petroleum sector in African oil-exploring countries. The fact that Asian countries attracted $72 billion suggests how more open investment policies and trade liberalization practices were helpful in stimulating their rapid growth. Moreover, 70 per cent of investment flows into Africa in the early 1990s were concentrated in oil-exporting countries, mainly Nigeria. Weak financial sectors, poor infrastructures, a relatively unskilled work force, macroeconomic instability, and unpredictable legal and regulatory systems have contributed to this result. Consequently, export growth in Africa has lagged (behind) the growth of world trade and African exports remain highly concentrated in primary commodities. In a similar way, additional private foreign investment could be attracted to African ventures, given the right assurances about the treatment such foreign investment would receive in African countries. Africa might provide the right assurances by negotiating bilateral investment treaties (BITs) whose terms provide for national treatment, unconditional repatriation of capital, the protection of intellectual property rights, and access to international forums of arbitration for US investors. The United States has BITs with four African countries (Cameroon, Congo, Senegal and Zaire) and the United States is in the process of negotiating a BIT with South Africa. Investors' concern about their physical facilities is equaled by their concern that the intangible qualities that make their products and services unique are protected through the grant and enforcement of intellectual property rights. For that reason, it has been US policy to negotiate bilateral investment treaties in parallel with bilateral intellectual property agreements. Higher levels of intellectual property protection create a favourable climate for investment and the transfer of technology, both of which will help spur development in these countries. Strong intellectual property protection will also protect indigenous artistic, inventive and commercial activities and create incentives for the further development of those activities. Critical to increasing foreign investment in Africa in a sustainable way is making African economies more investor-friendly. As I noted above, evidence suggests that it has been restrictive African trade policies which have resulted in reduced economic growth. PAST PLURILATERAL AFRICAN INVESTMENT AGREEMENTS As mentioned above, there are no shortage of African trade liberalization agreements. Many of these agreements also address investment issues. In this

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section of the chapter, I want to give a few examples of the laboratory and non-binding nature of these agreements in general, and their investment provisions in particular. Let us start with an examination of the very recently revised Economic Community of West African States (ECOWAS) Revised Treaty. 1 The parties to the Revised ECOWAS Treaty are: Benin, Burkina Faso, Cape Verde, Cote D'Ivoire, the Gambia, Ghana, Guinea, Guinea Bissau, Liberia, Mali, Mauritania, Niger, Nigeria, Senegal, Sierra Leone and Togo. The aims and objectives of the treaty are set forth in Article 3: 1: The aims of the Community are to promote co-operation and integration, leading to the establishment of an economic union in West Africa in order to raise the living standards of its peoples, and to maintain and enhance economic stability, foster relations among Member States and contribute to the progress and development of the African Continent. In order to achieve these aims, Article 3:2 provides that the Community shall, by stages, ensure, inter alia: c) d)

e) f) h) i)

the promotion of the establishment of joint production enterprises; the establishment of a common market through: the liberalisation of trade by the abolition, among Member i) States, of customs duties levied on imports and exports, and the abolition, among Member States, of non-tariff barriers in order to establish a free trade area at the Community level; ii) the adoption of a common external tariff and a common trade policy vis-a-vis third countries; iii) the removal, between Member States, of obstacles to the free movement of persons, goods, services and capital, and to the right of residence and establishment; the establishment of an economic union through the adoption of common policies in the economic, financial, social and cultural sectors, and the creation of a monetary union. the promotion of joint ventures by p rivate sector enterprises and other economic operators, in particular through the adoption of a regional agreement on cross-border investments ; the establishment of an enabling legal environment ; the hannonisation of national investment codes leading to the adoption of a single Community investment code ; [emphasis added]

While the treaty does establish some form of institutional structure (which could be critiqued more extensively elsewhere), the basic point is that even if the best of institutions were created, it would still not be enough without a

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clearer set of obligations to interpret and enforce, particularly with respect to investments. It is also instructive to examine the Treaty Establishing the Common Market for Eastern and Southern Africa. 2 The fifteen signatories are Eritrea, Ethiopia, Kenya, Lesotho, Madagascar, Malawi, Mauritius, Mozambique, Namibia, Rwanda, Sudan, Swaziland, Tanzania, Uganda and Zambia. The aims and objectives of this Common Market are set forth in Article 3: a) b)

c)

d) e) f)

to attain sustainable growth and development of the Member States by promoting a more balanced and harmonious development of its production and marketing structures; to promote joint development in all fields of economic activity and the joint adoption of macro-economic policies and programmes to raise the standard of living of its peoples and to foster closer relations among its Member States; to co-operate in the creation ofan enabling environment for foreign, cross border and domestic investment including the joint promotion of research and adaptation of science and technology for development [emphasis added]; to co-operate in the promotion of peace, security and stability among the Member States in order to enhance economic development in the region; to co-operate in strengthening the relations between the Common Market and the rest of the world and the adoption of common positions in international fora; and to contribute towards the establishment, progress and the realization of the objectives of the African Economic Community.

Interestingly, however, none of the specific commitments enumerated in Article 4, or general commitments enumerated in Article 5 address investment directly. Perhaps, the most interesting provision of this treaty is its embrace of competition policy in Article 55: 1.

2.

The Member States agree that any practice which negates the objective of free and liberalised trade shall be prohibited. To this end, the Member States agree to prohibit any agreement between undertakings or concerted practice which has as its objective or effect the prevention, restriction or distortion of competition within the Common Market. The Council may declare the provisions of paragraph 1 of this Article inapplicable in the case of: (a) any agreement or category thereof between undertakings; (b) any decision by association of undertakings; ( c) any concerted practice or category thereof;

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Investment and Risk in Africa which improres production or distribution of goods or promotes technical or economic progress and has the effect of enabling consumers a fair share of the benefits: Provided that the agreement, decision or practice does not impose on the undertaking restrictions inconsistent with the attainment of the objectives of this Treaty or has the effect of eliminating competition. The Council shall make regulations to regulate competition within the Member States.

This prov1s10n if properly implemented could help to encourage foreign investment to the extent that perceptions of corrupt or cartelized African markets have hindered foreign investment to date. In Article 151, the parties agree to certain measures aimed at creating an enabling environment for the private sector. Among the measures mentioned for the purpose of implementing this objective, the Member States undertake to: ' (a) improve the business environment through the promotion of conducive investment codes, the protection of property and contract rights and the regularising of the informal sector'. Chapter 26 specifically addresses issues of investment promotion and protection. It provides by way of Article 158 that the Member States recognize the need for effective resource mobilization, investment and the importance of encouraging increased flow of private sector investment into the Common Market for development. To this end, the Member States agree to adopt harmonized macroeconomic policies that shall attract private sector invest­ ment into the Common Market. Article 159 set out what the parties shall do to facilitate investment promotion and protection: 1.

2.

I n order t o encourage and facilitate private investment flows into the Common Market, Member States shall: a) accord fair and equitable treatment to private investors; b) adopt a programme for the promotion of cross-border investment; c) create and maintain a predictable, transparent and secure investment climate in the Member States; d) remove administrative, fiscal and legal restrictions to intra­ Common Market investment; and e) accelerate the deregulation of the investment process. For the purposes of investment protection, the following activities shall be considered as investment: a) movable and immovable property and other property rights such as mortgages, loans and pledges;

Potential Restraint through an International Charter for FD/ b)

3.

4.

5.

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shares and any other rights of participation in the management or economic results of a company or a firm, whether incorporated or not, including minority shares, corporate rights and any other kind of shareholding; c) stocks, bonds, debentures, guarantees or other financial instru­ ments of a company or a firm, government or other public authority or international organisation; d) claims to money, goods, services or other performance having economic value; e) intellectual and industrial property rights, technical processes, know-how, goodwill and other benefits or advantages associated with a business; and f) such other activities that may be declared by the Council as investments. The Member States agree that part of the conducive climate to investment are measures aimed at protecting and guaranteeing such investment. To this end, the Member States shall: a) subject to the accepted principle of public interest, refrain from nationalising or expropriating private investment; and b) in the event private investment is nationalised or expropriated, pay adequate compensation. For the purposes of paragraph 3 of this Article, expropriation shall include any measures attributable to the government of a Member State which have the effect of depriving an investor of his ownership or control of, or a substantial benefit from his investment and shall be interpreted to include all forms of expropriation such as nationalisation and attachment as well as creeping expropriation in the form of imposition of excessive and discriminatory taxes, restrictions in the procurement of raw materials, administrative action or omission where there is a legal obligation to act or measures that frustrate the exercise of the investor's rights to dividends, profits and proceeds of the right to dispose of the investment. The benefits to private investors include the right to: a) repatriate investment returns including dividends and interest or other equivalent charges; b) repatriate royalties and other payments deriving from licences, franchises, concessions and other similar rights; c) repatriate funds for repayment of loans; d) repatriate proceeds from the liquidation or sale of the whole or part of the investment including an appreciation or increase of the value of the investment capital;

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6.

payments for maintaining or developing the investment project, such as funds for acquiring raw or auxiliary materials, semi­ finished products as well as replacing capital assets; f) remit the earnings of expatriate staff of the investment project; and g) the right to enjoy exemption from customs duties and other fiscal exemptions for the period provided for in the investment package of a Member State and depending on the area of investment. The Member States agree that a reasonable period of stability of investment climate is the period required to refinance the investment.

Article 160 asserts article 159 by embedding the principle of transparency into the agreement such that the Member States undertake to increase awareness of their investment incentives, opportunities, legislation, practices, major events affecting investments and other relevant information through regular dissemination and other awareness-promoting activities. Article 161 addresses future negotiations with respect to issues of double taxation. Article 1 62 provides the icing on the cake by establishing the notion of effective investor-state dispute settlement as the Member States agree to take necessary measures to accede to multilateral agreements on investment dispute resolution and guarantee arrangements as a means of creating a conducive climate for investment promotion. To this end, the Member States undertake to accede to: a) b) c)

the International Convention on Settlement of Investment Disputes Between States and Nationals of Other States, 1965; the Convention Establishing the Multilateral Investment Guarantee Agency; and any other multilateral agreements designed to promote or protect investment.

Once again, assuming that the institutions created in the treaty to interpret and enforce these provisions were strong and effective, the achievement of these high ideals is hampered somewhat by the gradual establishment of an economic community for Eastern and Southern Africa. Article 177 provides that: at a date to be determined by the Authority after the entry into force of this Treaty, the Council shall propose to the Authority for its approval, measures which in addition to the provisions of this Treaty would be required to be implemented in order to assist in the eventual development and establish­ ment of an Economic Community for Eastern and Southern Africa.

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Once again, in the absence of strong institutions and clear, binding principles, the promising provisions remain, at best hortatory, and at worst, illusory. NECESSARY ELEMENTS OF AN AFRICAN FDI CHARTER In the previous section, I referred to two recently concluded African trade agreements to highlight the problems posed in arriving at a meaningful, enforceable African Charter for FDI. In this section I want to suggest what elements would have to be included in any such Charter that is to rise off the pages, and echo throughout the continent. An effective FDI Charter would contain five central elements, of which three are statements of basic obligations of nations to investors, one is an institutional arrangement, and one is a set of further obligations of nations of investors. The three basic national obligations would be: (1) transparency; (2) right of establishment; (3) national treatment. The institutional arrangement would be some form of binding dispute settlement mechanism for disputes between investors and states. Here, useful models could be drawn from the arbitral scheme of the Investment Chapter, Chapter 16, of the North American Free Trade Agreement, and the ICSID procedures, where applicable. The additional obligations that I would envisage would include; the adoption of international standards with respect to compensation in the event of expropriations; an agreement to avoid double taxation; some restrictions on the use of 'beggar thy neighbour' type performance requirements; prohibitions on bribery and other foreign corrupt practices; and some basic commitment to competition principles such as the prohibition of cartels (export or otherwise), and behavioural disciplines on abuses of dominant positions within relevant product and geographic markets. In this regard, the Eastern and Southern African Economic Community Treaty points in the right direction. However, the devil, as we all know, is in the details. Whatever commitments are made in an African Charter must be credible and enforceable. I fear that the international investment community has long grown tired of bold pronouncements, preferring instead to observe the reality on the ground. An empty gesture may be worse than no gesture at all. THE WAY FORWARD One of the first questions concerning an African Charter for FDI is 'Why, an African Charter?'. At this stage in the game, having regard to the very real concerns over credibility and enforceability, the best approach may be to seek multilateralized obligations. In short, if the credibility of African governments

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is at a low ebb, then the best strategy might be to join on to other multilateral initiatives that by virtue of their members or substance would grant almost instant credibility to their African adherent. We are moving forward with Asia-Pacific Investment Code and an OECD sponsored Multilateral Agreement on Investment. Both of these initiatives may well be open to investors of all nations so as to be true to the sacred principle of most favoured nation. If that eventuality occurs, then African nations should be the first in line to sign on the dotted line. CONCLUSION I end with my sense of ambivalence intact. While an African FDI Charter may be of some modest marginal short term benefit, the greatest gains to FDI flows to Africa will come by achieving credible, stable, consistent and enforceable laws across many aspects of social, political and economic life. To a limited degree, the willingness to be bound by such a Charter may act as an important signal of a willingness to embrace the wider sphere of necessary social, political and economic change. To that end, and to that degree, the exercise is an important one that should be encouraged.

Notes 1. 2.

35 I.L.M. 660 (1996) (July 24, 1993), amending the Articles o f Association for the Establishment of an Economic Community of West Africa, 6 I.L.M. 776 (1967) (signed 4 May 1967). 33 I.L.M. 1067; ( 1994) (signed 5 November 1993).

Part V Conclusion

16 So What Have We Learned? Robert H. Bates The chapters in this volume address a contemporary conundrum: the exceptional nature of Africa's development experience. They probe the possible reasons for Africa's lagging development and its failure to grow, despite over a decade of policy reform. In so doing, they also contribute to theory. AFRICA'S EXCEPTIONALISM Africa contains fifty or so nation states; their economies vary nearly as much as their cultures, typographies and political systems. The economic performance of Botswana or Mauritius would inspire envy on the part of most people in most regions of the world. That of Chad or Zambia would inspire dread. While granting the extent of this variation, the contributors to this volume nonetheless highlight the central tendency: the poverty of Africa's population. The average income of its inhabitants places them in the ranks of the worlds' poorest. And although poor, Africa's economies grow but slowly; there is no discernible tendency for Africa to catch up with other regions of the world. And while the nations of Africa have, like nations elsewhere, reformed their economic policies, the response has been profoundly disappointing. The stabilization of the macroeconomy and the liberalization of markets may have ignited economic growth elsewhere in the world; they appear not to have done so in Africa. The contributors to this volume can be seen as inquiring into the sources of African exceptionalism. They point to a central phenomenon: the failure to form capital. The 1990s were marked by a surge of private investment elsewhere in the developing world, but not in Africa. Thus Jaspersen et al . note that whereas the ratio of private investment to GDP stood at 18 per cent in 1994 for nations throughout the developing world, it stood at less than 10 per cent in Sub-Saharan Africa. The behaviour of foreign investors highlights the disparity: In the 1990s East Asia attracted large inflows of foreign capital, Jaspersen et al . note; 1 1 per cent of total private fixed investment came from abroad. In Africa, by contrast, foreign capital exited the continent; there was a net outflow of foreign long-term investment.

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In their contributions to this volume, Erb et al. stress the vestigial nature of Africa's capital markets. Their capitalization comprises less than 2 per cent of the total capitalization of emerging markets; South Africa alone comprises the near total of the capital that is traded in Africa. In the most populace of Africa's nations, Nigeria, the shares of stock traded in capital markets total roughly $2 billion; a single 'mid-cap' firm in the United States would be valued at $3 billion. Africa thus remains distinctly poor. Its growth rate lags. By comparison with other developing economies, reform has proven disappointing. And a major reason for this failure, it would appear, is the failure to mobilize capital. ATTACKING THE PROBLEM Thus the nature of Africa's exceptionalism, as conveyed by the contributions to this volume. Having characterized the problem, the authors then attack it. In doing so, they break new ground: they suggest the outlines of a new approach to the political economy of development. This volume addresses poverty, growth and development. But it also focuses on the role of governments. Thus Collier launches the volume by exploring a series of political models which serve to highlight his principal theme: the need for political agencies of economic restraint in Africa. Collier's chapter is followed by Widner's study of the judiciary; Ailola's of the law; and Adam and Bevan's of budgeting in Zambia. Many of the chapters thus focus on politics. At first glance, this emphasis on the political should occasion little surprise. For long before politics and economics began to re-unite in the study of the advanced industrial economies, development economists had recognized the significance of politics to the economics of poor societies. Initially, development economists were motivated by notions of the public welfare: they viewed governments as agencies for correcting market failures, compensating for deficiencies in aggregate demand, and setting right the maldistribution of wealth and income. 1 More recently, they have taken inspiration from the new growth theory, viewing governments as the sources of polices that determine the steady-state rate of growth attainable by an economy, given its initial income and its stock of capital. 2 In effect, the study of development has thus long constituted a branch of political economy. While thus joining in the well-established tradition of viewing development as a problem in political economy, the chapters in this volume nonetheless mark a new departure. Insight into the nature of that initiative can be gained by reflecting upon the standard 'Barro' growth equation. 3 The core variables of that equation include initial levels of per capita incomes, to account for convergence effects, and levels of investment in physical and human capital.

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Then variables that provide measures of government policy enter, helping to determine the steady state rate of growth attainable in that economy. Even portrayed so baldly, several problems stand out. The standard equation treats the level and rate of investment as exogenous to growth. There is a lack of microfoundations. And politics enters largely through policy variables. And yet, clearly investment can not be treated as exogenous to growth. Insofar as faster growing economies promise higher rates of return, the pattern of growth shapes the pattern of investment. The lack of micro­ foundations might be forgiven, given that analysts address the growth of national economies. But an examination of the justification of the specification of the equation reveals an absence of microlevel motivation, either by considering the behaviour of private agents or the functioning of markets. So too with the treatment of politics. Where they are characterized at all, governments are treated merely as the providers of public policy. These and other criticisms have, of course, been registered by others. 4 Interesting here is the response taken in these chapters. They build on an explicit microlevel model of the choices of investors, one advanced by Dixit and Pindyck. 5 Their framework provides a rationale for treating investment as an exogenous determinant of growth. And they explore in considerable depth the impact of politics on development. In so doing, they provide the outline of a new political economy of development: one that emphasizes the impact of politics upon growth by focusing on its impact upon the formation of capital. POLITICS AND GROWTH Dixit and Pindyck5 emphasize the inter-temporal property of the investment decision; thus their central emphasis on uncertainty. Examining choices in which investments are irreversible, or reversible only at a cost, they note that investors possess the option to wait, that is, to defer or postpone investments. The greater the perceived risk, the stronger their incentive to retain this option, ie to refrain from investing. Dixit and Pindyck's model suggests that investors respond primarily to 'bad news'. The rate and level of capital formation is therefore influenced not only by the possibility of high rates of return but also by the down side risks that threaten investment programmes. One implication is that growth models should employ not only the means but also the variances of variables. More relevant here is a second: that investment can be treated as exogenous in growth equations, in so far as investors respond to factors, such as variances, that may not directly affect growth but that may affect investment. Dixit and Pindyck's model also contains implications for the study of politics. Governments affect growth not only by shaping the nature of policies,

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as in the standard Barro model, but also by affecting the level of risk. As in the African case, policies might change but growth not resume, should investors fear that policies might be reversible. And the effect would be registered through the failure of investment to respond to the more favourable set of policies. Given high levels of political risk, there would be a weak response on the part of investors to policy reform. This reformulation of the relationship between politics and growth thus provides a means of addressing Africa's exceptionalism, and a new perspective on the political economy of development. The volume provides considerable support for this way of addressing Africa's exceptionalism and the role of politics in economic development. Thus Jaspersen et al . find private capital flows to be strongly influenced by the level of repayment risk. Erb and his associates focus on emerging markets and find a strong correlation between risk and return. And Cathy Patillo, in her pioneering study of over 200 firms in Ghana, finds that over the period 1 991 93 a higher level of uncertainty led to lower levels of capital formation by firms whose investments were irreversible . Most relevant of all: the African countries are perceived by investors to pose higher levels of risk than do economies in other regions. Investors thus behave, the authors suggest, in the way that theory would predict. The higher the level of risk, the lower the level of investment, or the higher the level of reward necessary to induce it. What, then, appears to determine the level of risk to investors? Patillo focuses on domestic firms. She stresses the variability in expected demand, relative prices, and the costs of imported equipment. Haque, Erb and Jaspersen et al . focus on foreign investors. Such investors focus on factors that affect their ability to secure repayment in foreign exchange: the size of a nation's foreign reserves, its burden of external debt, its balance of payments, and the rate of growth of its exports. Should the investment take the form of portfolio holdings, then changes in the value of the local currency also affect its value. Should the investment be direct, then the level of risk is shaped as well by the prospects of expropriation. As revealed in the surprisingly high relationship between investment and the Business Environment Risk Intelligence (BERi) index, the behaviour of regulators and bureaucrats shapes the security of property rights. This factor too influences the willingness to locate one's business within a particular jurisdiction. In addressing the political origins of risk, some of the contributors, such as Jaspersen, partition the regressors into separate economic and political variables. But it is clear that even the so-called economic variables, such as the level of foreign reserves, are themselves affected by governments. Whether by imperiling repayment in foreign exchange, shifting the relative fortunes of sectors of the domestic economy, or threatening the property rights of those who seek to form capital, the behaviour of governments is fundamental in

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shaping the risks faced by foreign and domestic investors, and thus the level and nature of capital formation in the national economy. A major implication of this analysis, then, is that the sources of African economic exceptionalism lie in Africa's politics. One source of political risks is too little government: a lack of political order and a resultant insecurity of rights in property. Indeed, the data suggest that countries in Africa more frequently experience riots, coups, and rebellions than do nations in other regions, and more months of civil war. A second source of political risk, paradoxically, is 'too much' government. Governments may possess unbridled power and therefore themselves pose threats to investors. They may possess the power rapidly to alter policies or to seize resources from the private economy. Indeed, Africa's governments appear to suffer from what is frequently called 'the sovereign's paradox'. Being sovereign, they can with impunity act any way they might choose. Their promises therefore cannot be believed. And they therefore find it difficult to make binding pledges. Thus the skepticism with which many will read the investment codes and legal guarantees discussed by Ailola and Warner. As keenly perceived by the jurists discussed by Widner, governments with the power to make such laws also possess the power to break them. Governments themselves pose some of the greatest threats to law and order in Africa. As noted by Erb and his associates, international investors perceive Africa as the riskiest region in the global economy. As intimated by others, it would appear that governments themselves have begun to recognize the origins of this risk. They have therefore begun to reform. In keeping with the intellectual framework that motivates this volume, the chapters explore the prospects for economic renewal in Africa by addressing these reforms. Widner stresses that the origins of reform lie in part in learning. In Africa, as elsewhere, executives possess a disproportionate share of coercive power: they can do what they wish, and therefore confront the sovereign's paradox. But, Widner suggests, they have come to appreciate the significance of that paradox, and have increasingly sought to disable their capacity for discretion. In order to strengthen themselves, she writes, they have begun to invest resources in the legal system, thereby subjecting themselves, for their own good, to the rule of law. Examining reform in the financial sector, Kasakende notes a similar trend. Increasingly, he argues, the Central Bank of Uganda has exchanged independent power over money supply, and refused to act as a 'printing press' for the central government. While Widner and Kasakende document the benefits that reforms can bring, Adam and Bevan document the costs and therefore the problematic nature of the progress that has been achieved. To limit its capacity for discretion, the government of Zambia, they report, shifted to a cash-budget. This innovation limited public deficits to the magnitude of the government's holdings in the Central Bank. While stabilizing the supply of money, it failed

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Table 16.1 Political Reforms in Africa Year

1975 1980 1985 1991 1995

Percent of Nations Where

Percent of Gross Product Produced in Nations Where Heads of State Elected

43.4 54.3 58.7 65.2 76

Percent of Population Residing in Nations Where

38.2 66.4 44.7 43.2 n.a.

50.9 78.8 54.2 52.4 n.a.

Percent of Nations Where

Percent of Population Residing in Nations Where

Legislatures Existed 47.8 73.9 80.4 65.2 85

39.8 74.8 54.9 47.3 n.a.

Percent of Gross Product Produced in Nations Where 52 80.4 64.7 56.7 n.a.

to take into account variation in the demand, however. And the innovation therefore precipitated an increased demand for foreign exchange and a devaluation of the domestic currency. Ending one source of risk and economic instability, the cash budget introduced another. Historically, of course, other ways have been devised for limiting the discretion of governments. One is to compel governments to compete for votes from an electorate. Stability in policy choices by governments can be induced in two party, plurality systems by the opportunistic pursuit of the support of the median vote; 6 in the coalitional politics of proportional representation electoral systems, it can be induced by the tendency of winsets to be empty. 7 Another is the creation of Parliaments. By conceding to legislatures the power of policy making and, in particular, power over taxation and spending, executives can credibly signal their willingness to surrender discretion and thereby lower the perceived risks to investors. 8 As indicated in Table 16.1, while striving for economic rejuvenation, African governments have adopted these kinds of reforms. A greater percentage of their executives are now elected and share power with legislative bodies. The data thus suggest a systematic tendency toward political reform and the movement toward the kinds of political institutions that in other settings have lowered the political risks facing private investors. There is ample reason to doubt the efficacy of these reforms, however. The switch to democratic institutions may simply represent an additional example of political instability in Africa. Nor are democratic governments necessarily themselves stable. Gambia, once democratic, is now authoritarian, for example. To be democratic is not necessarily to be economically constrained. The governments of both Ghana and Zambia, for example, held elections in the early 1990s, and ran massive deficits in seeking to purchase their return to

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power. And even apparently stable and rational polities appear unable to overcome the reputation for poor governance. As has been discovered by the Museveni government in Uganda, reputations are costly to regain. And has been learned by others, the excesses of one nation on the continent can cloud the reputations of others. South Africa suffers from events in Rwanda, thousands of miles to the north. Democratic political reform therefore encounters difficulty in generating economic rewards. One response, it would appear, is to turn to international institutions in an effort to lower, and to be seen to lower, the economic risks to investors. The World Bank and the International Monetary Fund are more important in Africa than in other regions of the world, it would appear. Both agencies impose policy and political conditionalities in their lending programmes. But they too, it would appear, fail to secure positive responses from the investor community. As stressed by Collier, the paradoxical result of conditionality may be to weaken the impact of domestic reform. In conforming to the dictates of the international institutions, both governments seriously committed to reform, as well as those who reform merely in order to secure external aid, adopt the same policies. The result is the inability of 'good governments', ie those genuinely committed to responsible economic policies, to signal their type, ie to distinguish themselves from 'bad' ones. It, therefore, becomes more difficult to form a reputation as a trustworthy recipient of investments. Insofar as African governments seek to alter the expectation of investors in ways that would lower the level of perceived risk, international agencies may operate in ways that impede their ability to do so. Rather than relying on the World Bank and the Fund, then, Collier and others argue, African governments may do better forming regional trade agreements. Such blocs may raise the costs to governments of unilaterally altering their policies, particularly should the blocs be anchored by foreign powers, such as France, as in the case of the Franc Zone, or the Union, should the regional trade zones seek access to the European market. Such agreements may therefore act as external agencies of restraint, enabling governments to make commitments that will be believed by private agents. CONCLUSION The chapters thus address the nature and origin of Africa's exceptionalism. Private investors, they demonstrate, respond adversely to risk, and perceive Africa as posing higher levels of risk than other regions of the world. The chapters also stress that the behaviour of governments constitutes a major source of these risks, both because governments can capriciously alter public policies and because they can threaten the security of rights in property. In stressing the central role of governments in economic development, the

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contributors also furnish insight into the sources of political change. The reform of governments, of the ways they manage their finances, and of their relationships with each other and the international community - these, they imply, can be tied to the search for the renewal of access to international capital. The arguments resonate with Marxian themes: The search for political reform in Africa - changes in the relations of production - represents an attempt to enhance the productivity of its resource base - the underlying forces of production - by gaining infusions of capital. But the foundations of the analysis are fully modem: they are based upon the microeconomics of information and uncertainty, in intertemporal settings in which choices are irreversible, or reversible only at high cost. The volume thus not only addresses the economics of Africa, but also provides an intriguing way of approaching the political economy of development.

Notes 1.

2. 3. 4.

5. 6. 7. 8.

See the collection of essays published by the World Bank: Gerald M. Meier and Dudley Sears, eds. Pioneers in Development (Washington DC: The World Bank, 1984) and Gerald M. Meier, ed. Pioneers in Development (Washington DC: The World Bank, 1987). For an introduction and review, see Robert Barro and Xavier Sala-i-Martin, Economic Growth (New York: McGraw Hill, 1995). See the discussions in Ibid. See, for example, Ross Levine and David Renelt, 'Sensitivity Analysis of Cross­ Country Growth Regressions', American Economic Review, XXC (1991), 942-63 and Lance Pritchett, 'Divergence, Big Time', Policy Research Working Paper 1522, The World Bank, Office of the Vice President, Development Economics, October 1995. Dixit and Pindyck, Investment Under Uncertainty (Princeton: Princeton University Press, 1994). Duncan Black, A Theory of Committees and Elections (Cambridge: Cambridge University Press, 1958) and Anthony Downs, An Economic Theory ofDemocracy (New York: Harper and Row, 1957). Michael Laver and Kenneth A. Shepsle, Making and Breaking Governments (Cambridge: Cambridge University Press, 1996). Douglass C. North and Barry R. Weingast, 'Constitutions and Commitment'. In Monetary and Fiscal Policy, Vol. 1: Credibility, ed. Torsten Persson and Guido Tabellini (Cambridge, MA: The MIT Press, 1994).

Index Note: bold page numbers refer to tables and italic page numbers refer to figures. ACP countries see Africa, the Caribbean and the Pacific (ACP) countries Africa agencies of restraint: external, 340-1; reciprocal threats, 341-2 countiy risk, 153-6, 164: implications, 160-3 countiy risk ratings, 1 7, 136-7 creditworthiness, 326 economic environment, risks, 5-7 economic reforms, 326 economies, 122 equity investment, 15 1-65: critique, 146-9; research, 146-7; risk and expected returns, 122-50 exceptionalism, 365-72 and France, reciprocal relationships, 276-7 Francophone, 286 governments, and risk reduction, 3 gross domestic product, 3 income levels, 353 inflation rates, 185 international portfolios, 149 investment agreements, plurilateral, 355-61 investment in, risk, 3-27 investment insurance, 323-37 jury systems, 225 market risk, 164 Multilateral Investment Guarantee Agency activities, 336, 337 natural resources, 151 perceptions, 147, 152 policy reforms, 31 1-13 political reforms, 370 politics, and growth, 367-71 portfolio composition, 6, 7 portfolio investment, and risk, 15 1-65 poverty, 365 privatizations, 13, 326 rating, risk indicators, 33-66 regional integration, 341-2 risk: categories, 157; popular images of, 15 1-3; ratings, 1 1 stock exchanges, 159 stock markets, 122: characteristics, 159-63 tariffs, 345 trade: with European Union, 343-6; regional, 371; with United States, 353

trade liberalization, 338-9 see also East Africa; North Africa; Southern Africa; Sub-Saharan Africa Africa, the Caribbean and the Pacific (ACP) countries, 345 agreements, 26 Africa indicator, 94 African Development Bank, and regional customs unions, 346 African Economic Community, proposals, 357 agencies of restraint domestic, 23-5 external, 25-7: reciprocal threats, 340-2 incentives, 291 penalty-based, 25, 26 as risk-reduction mechanisms, 19-27 use of term, 23 aid and cash-budgets, 199-200, 21 1-12 and donor conditionality, 189 non-project, 282-4, 288 and policy reforms, 311 and policy risk, 21 programme, 311, 316-17 project, 3 1 1 , 317 shortfalls, Zambia, 207-8, 212-13 aid conditionality issues, 3 1 1-15, 371 and non-compliance, 313-14 as restraint, 308-22: critique, 319-22 retrospective, 314, 315 AIG, investment insurance, 331 Altman's Z score, 152 Amin, Idi, 229 Angola capital flows, 324 war, 158 anti-dumping suits, 345-6 anti-governmental demonstrations, definition, 49 Arbitration Act No. 42 (1965) (South Africa), 259 Argentina expected returns, 141 foreign direct investment, 79 private investment, 73 transfer risk, 85

373

374

Index

Ashanti Goldfields, risk ratings, 158 Asia country creditworthiness ratings, 34 income levels, 353 Asia-Pacific Investment Code, 362 assassination, definition, 48 asset pricing theory, and country risk, 122-6 avoidance, and political risk, 331 balance of payments, variables, 95 Balladur, Edouard, 288 Bank of America World Information Services, country risk ratings, 127, 129 Bank of Botswana, 250 Bank of England, 171 bank loans, probabilities, 106-11 Bank of Uganda (BOU) base money programme, 172-3 credibility, 184 financial liberalization, 176 monetary regimes, 173 recapitalization, 175, 179 roles, 170, 182-3 statute (1993), 174-5 strategies, 24 Bank of Zambia, 201, 207 devaluation strategies, 206 loans, 195

Banque Centrale des Etats de l'Afrique de l'Ouest (BCEAO), 297

banking regulation, 292 consolidated bank credits, 281 direct central bank lending, 279 and French Treasury, 285 governance, 277, 293 and governmental relations, 288-9 monetary policies, 275, 288 refinancing credit, 280 as restraint, 289-90

Banque des Etats de l'Afrique Centrale

(BEAC), 279 aid, non-project, 284 banking regulation, 292 consolidated bank credits, 281 domestic arrears, 281 external debt, 282 and French Treasury, 285 governance, 277, 293 and governmental relations, 288-9 gross foreign assets, 280 monetary policies, 275, 288 operations account balances, 283 refinancing credit, 280 as restraint, 289-90

Bantustan, foreign investment, incentives, 256 Barro model, 366, 368 BCEAO see Banque Centrale des Etats de l'Afrique de l'Ouest (BCEAO) BEAC see Banque des Etats de l'Afrique Centrale (BEAC) Benin, private investment, 73, 74 BERi see Business Environment Risk Intelligence (BERi) Berne Union, 334 beta factor, as country risk measure, 126, 127 bilateral investment treaties (BITs ), negotiation, 355 BITs see bilateral investment treaties (BITs) Biya, Paul, 287 borrowings and country creditworthiness ratings, 40 informal, and lending, 114-15 Botswana Business Advisory services, 250 Constitution, 250-1 country risk ratings, 19 courts, as restraints, 219-45 Department of Customs and Excise, 250 economic performance, 365 foreign investment, 247, 253: incentives, 249 growth rates, 353 Income Tax (Amendment) Act (1984), 250 judges, knowledge, 237 judicial independence, 222-4, 230: and politics, 229 judicial systems, influences, 231 lawyers, 238 Ministry of Commerce and Industry, 250 National Development Plan (1985-90), 249 Partnership for Productivity Group, 250 taxation, 249-50 Trade and Investment Promotion Agency, 250 Botswana Enterprises Development Unit, 250 BOU see Bank of Uganda (BOU) Brady bonds, 157 Brady Plan, 34 Brazil foreign direct investment, 79 private investment, 73 transfer risk, 85

Index Bretton Woods System (BWS), 281, 287, 308, 3 15, 317 collapse, 340 exchange rate agreement, 340, 348 reciprocity, 341 Britain see United Kingdom (UK) budget deficits, variations, 185 budgets definitions, 190-1 inter-temporal, 190 see also cash-budgets Bundesbank, 171, 177 Business Environment Risk Intelligence (BERI) country risk ratings, 9, 14, 84, 127, 368 political risk ratings, 85 businesses see companies BWS see Bretton Woods System (BWS) Cameroon aid, non-project, 282 bilateral investment treaties, 355 and France, 287 multilateral surveillance, 294-5 Canada, regional trade, 342, 345 capital asset pricing model (CAPM), 126 and market risk, 158-9 capital flight, as risk indicator, 6--7 capital flows and country creditworthiness ratings, 34-5 and foreign direct investment, 324----0 private sector, 91: developing countries, 75-80, 354 public sector, 77-8 and repayment risk, 368 see also net capital flows capital-labour substitutability, 106 capital markets, perfect vs. imperfect, 97 CAPM see capital asset pricing model (CAPM) cash-budgets advantages, 193 cash-budget rule, 24 commitment mechanisms, 188, 200-1 concept of, issues, 189-90 and donor conditionality, 189, 201-2 efficacy, 24 and external debts, Zambia, 207-9 and fiscal correction, 187-9 limitations, 189-93 as restraints, 185-218: critique, 216--18 and short-term fluctuations, 191-2 as stabilization anchors, issues, 192-3 technical issues, 187-8 Zambia, 193-213, 369-70

375

CEAO see Communaute economique de l'Afrique de l'ouest (CEAO) Central African Republic, private investment, 73, 74 Central Asia, foreign direct investment, and privatization, 77 central banks controls, 173-9 effectiveness, 178-9 independence, 170-3: financial-sector support, 290; formal sources, 289-90 and inflation bias, 170-1 inflation targets, 171-2 and interbank market, 177 markets, 176--9 reform, 292-3 as restraints, 169-84: critique, 182-4; failure, 288-91 roles, 23-4 supranational, monetary policy rules, 277-8 Centre for the Independence of Judges and Lawyers, 220 CFA see Communaute financiere africaine (CFA) Chad, economic performance, 365 Chile, private investment, 73 China, foreign direct investment, 79 civil delays, perceived seriousness, 236 clerks (legal), roles, 221-2 cluster analysis, applications, 5 1 CMB see Coffee Marketing Board (CMB) (Uganda) Cobb-Douglas production function, 103, 1 18, 120 Coffee Marketing Board (CMB) (Uganda), loans, 174 commodity prices and private investment, 73 volatility, 5-6

Communaute economique de l'Afrique de l'ouest (CEAO), tariffs, 341 Communaute financiere africaine (CFA)

fiscal indiscipline, 278-84 Franc, devaluation, 340 Franc Zone, 275-307 government deficits, 278 governments, direct central bank lending, 279 inflation, 182 private investment, 73 restraints, 276--8 companies foreign direct investment, motivations, 323

376

Index

companies (continued) investor analyses, 328 risk management, problems, 10-1 1 transnational, and foreign investment, 254 competition, and foreign direct investment, 79 Congo, bilateral investment treaties, 355 Control Risks Information Services (CRIS), country risk ratings, 127 Convention Establishing the Multilateral Investment Guarantee Agency, 360 Convention on the Settlement of Investment Disputes, 252 Coplin-O'Leary Rating System, country risk ratings, 127 correlation, and expected returns, 141, 142 corruption index, 94 and political risk, 155-6 types of, 155 cost-benefit approach, country default risk, 43, 45 Cote d'Ivoire, 289, 290, 293 aid, non-project, 282 commercial borrowing, 281 direct central bank lending, 279 and France, 287 multilateral surveillance, 294-5 private investment, 73, 74 stock market, 159 trade liberalization, 339 country creditworthiness ratings, 36-8 assessment, 64--6 association, 41 and borrowings, 40 and capital flows, 34-5 comparisons, 129-33 correlation, 41 country specific factors, 58 determinants, 62 determination, 45 early studies, 49-51 empirical framework, 41-9 empirical studies, 36: results, 5 1-63 and export orientation, 39, 40 and gross domestic product, 38, 50 and gross national product, 50 historical background, 33-6 methodologies, 64--6 over time, 39-41 persistence, 51-8 regional averages, 39 regional and structural factors, 59 trends and covariance, 38-41

variables: economics, 46; economics vs. political, 60-3; explanatory, 46-5 1; external, 59-60; political, 48-9 country default risk cost-benefit approach, 43, 45 debt-service capacity approach, 43-4 variables, 44 country risk Africa, 153-6, 164: implications, 160-3 and asset pricing theory, 122-6 components, 82 definition, 7 developed countries, measures, 122-33 in developing markets, 126-7 measurement, 87 measures, 82-5, 127-9, 157-8: beta factor, 126, 127 and private investment, 8, 81-5 systematic, 122-7: capital asset pricing model, 126 country risk ratings, 6-9, 82-3, 127-33 Africa, 1 7, 13�7 comparisons, 129-33, 134-5 criteria, 37 developing countries, 1 1 , 84 global, 138-9 and gross domestic product, 14 investor analyses, 328: criticisms, 329-30 limitations, 329-30 negative correlation, 9 and policy reforms, 16-18 primary components, 132 specific factors, 131 coups definition, 48 as risk measure, 94 courts characteristics, 224-5 delays, perceived seriousness, 236 effectiveness, 235-8 independence, 220 location issues, 226 officers, roles, 221 as restraints, 219-45: critique, 243-5 credit, variables, 94 criminal delays, perceived seriousness, 236 CRIS see Control Risks Information Services (CRIS) Cross-National Time-Series Data Archive, 48 currency boards, strategies, 24 currency risk, 153 Customs Union of Central African States (UDEAC), tariffs, 341

Index debt conditionality issues, 31 1-15 as restraint, 308-22: critique, 319-22 debt-service capacity approach, country default risk, 43-4 decentralization, industrial, incentives, 254-5 decision-making, reform, 292-3 default risk, 153 De Klerk, Frederik Willem, 256 demand variables as uncertainty proxies, 102-8, 1 14: criticisms, 120--1 developed countries, country risk, measures, 122-33 developing countries country creditworthiness ratings, 33-4 country risk ratings, 1 1 , 84 creditworthiness, 325 economic activity, global, 123 external debts, 77 foreign direct investment, 71, 79-80, 324-5, 365: and privatization, 77 gross domestic product, 72-3 net capital flows, 78 private investment, 71-95, 365 : and property rights, 85 private sector, capital flows, 75-80, 354 and privatization, 72 developing markets, country risk in, 126-7 discountable earnings model, 156-7 domestic credit growth, 94 variability, 94 domestic economic performance, measures, 47 donor conditionality, and cash-budgets, 189, 201-2 Dugdale, Judge, 232 Durbin-Watson statistic, 87 East Africa economic communities, 360 investment risk, 9-10 East Asia foreign direct investment, 79, 365 private investment, 72 private sector, capital flows, 76 Eastern Europe economic liberalization, 326 foreign direct investment, and privatization, 77 regional trade, 345

377

Economic Community of West African States (ECOWAS) aims, 356 Revised Treaty, 356-7 trade liberalization, 341 economic growth and foreign direct investment, 324-5 and trade liberalization, 339 economic management, quality, proxy measures, 44 economic reforms, Africa, 326 economic risk determination, 128-9 vs. political risk, 326-7 economics, and politics, 366-7 economics variables, 46 vs. political variables, 60--3 Economist Intelligence Unit (EIU) country creditworthiness ratings, 36-7, 56-7, 65 : methodology, 65-6 country risk ratings, 7, 9, 37, 82, 127 ECOWAS see Economic Community of West African States (ECOWAS) EEC see European Union (EU) EFTA see European Free Trade Association (EFTA) Egypt private investment, 73 stock market, 159 EIU see Economist Intelligence Unit (EIU) Elysee, 287, 288 EM see Euromoney (EM) EMS see European Monetary System (EMS) endogenous trade policies, use of term, 22 equity investment critique, 146-9 research, 146-7 risk, 151-65: and expected returns, 122-50 equity market risk, vs. lending market risk, 148 ERM see European Exchange Rate Mechanism (ERM) Ethiopia, aid flows, 2 1 1 E U see European Union (EU) Euro, and policy reforms, 26 Euromoney (EM) country creditworthiness ratings, 36-7, 39, 50, 54-5: methodology, 64-5 country risk assessment, 64-5 country risk ratings, 7, 9, 82, 127, 157: criteria, 37 European Exchange Rate Mechanism (ERM), United Kingdom membership, 171

378

Index

European Free Trade Association (EFTA), 19 European Monetary System (EMS) exchange rate liberalization, 340 reciprocity, 341 European Union (EU), 19 agreements, 26 anti-dumping suits, 345-6 market access, 253 market opportunities, 353 restraint, 341 trade: with Africa, 343-6; regional, 345 and trade liberalization, 340 exceptionalism, Africa, 365-72 exchange rates, liberalization, 340, 348 exchange risk, concept of, 82 expected returns and correlation, 141, 142 estimation, 133-41, 142 volatility, 141, 142 explanatory variables, 46-9 definitions, 47-8 exports and country creditworthiness ratings, 39, 40 growth, 95 orientation categories, 48 and policy reforms, 16 restraints, 345 expropriation, and political risk, 155 external debts and cash-budgets, Zambia, 207-9 developing countries, 77 Mexico, 33-4, 35 external sector performance, measures, 47 external shocks, measures, 47 external variables, 59-60 FDI see foreign direct investment (FDI) financial constraints binding vs. non-binding, 23 and uncertainty, 96-7: bank loan channel, 106-1 1 ; liquidity channel, 112-15 financial liberalization effects, 15-16 Uganda, 178-9 financial risk, determination, 128-9 firm investment models, 99-100 firms see companies fiscal correction, and cash-budgets, 187-9 fiscal policies multilateral surveillance, 293-7 performance, 278-9 and private investment, 73-5

fixed effect models, of investment, 109, 110, 113 foreign direct investment (FDI) and capital flows, 324-6 charters: economic framework, 352-5; future trends, 361-2; requirements, 361; restraints, 352-62 companies, motivations, 323 and competition, 79 determinants, empirical, 89-90 developing countries, 71, 79-80, 324-5, 365 and economic growth, 324-5 growth, 78-80 models, 323 and private investment, 78-80 and privatization, 77, 79, 324-5 and technological advancement, 78-9, 325 and terms-of-trade shock, 90 foreign direct investment-to-gross domestic product ratios, analyses, 89-90 foreign investment decision-making processes, 323 impact assessment, 263-8 and incentives, 246-7 statutes and policies: South Africa, 253-8; Southern Africa, 247--63 foreign investors, surveys, 9-10 formal sector credit determinants, 108 and uncertainty, 107-9 France and Africa, reciprocal relationships, 276-7 as agency of restraint, 284-8 aid, non-project, 288 fiscal populism, 340 political interests, 285-8 trade, regional, 371 Francophone Africa, 286 Franc Zone deficit finance: domestic sources of, 279-80; external sources of, 280--3 exchange rate liberalization, 340 fiscal policies: multilateral surveillance, 293-7; performance, 278-9 institutional reform, 292-7 monetary reforms, 292 monetary unions, 343 as restraint, 26, 275-307: critique, 305-6; failure, 284-92, 297-9 sight liabilities rule, 279 trade, regional, 371 free trade areas (FTAs) advantages, 344 formation, 342

Index French Treasury, criticisms, 285 Gabon, capital flows, 324 Gambia, governments, 370 GATT see General Agreement on Tariffs and Trade (GATT) GDP see gross domestic product (GDP) General Agreement on Tariffs and Trade (GATT), 19 reciprocity, 341 as restraint, 347 Tokyo Round, 347 and trade liberalization, 340 Uruguay Round, 345, 347, 354 general strikes, definition, 48 Germany, monetary transmission mechanisms, 177 Ghana aid flows, 211 capital flows, 324, 368 commodity-linked finance, 10 country risk ratings, 17-18, 158 economic reforms, 314 elections, 370-1 growth rates, 353 investment: predictions, 98-103; and risk, 96-121 manufacturing: finance sources, 98; uncertainty measures, 15, 96-121 press freedoms, 154 stock market, 159 trade liberalization, 339 GNP see gross national product (GNP) Gorbachev, Mikhail, 20 government elections, 370-1 and parastatals, 170, 173-6 roles, 366 government crises, definition, 48 gross domestic product (GDP) Africa, 3 and country creditworthiness ratings, 38, 50 and country risk ratings, 14 developing countries, 72-3 per capita, growth rate, 94 Sub-Saharan Africa, 353 weights, 162 Zambia, 1 99 gross national product (GNP), and country creditworthiness ratings, 50 growth equations, 366 and politics, Africa, 367-71

379

variables, 94 see also economic growth guerrilla warfare, definition, 48 Heavily Indebted Poor Countries (HIPC) Debt Initiative, implementation, 91 Houphouet-Boigny, Felix, 287 human capital measures, 87 variables, 95 human rights, legislation, 248-9 ICRG see International Country Risk Guide (ICRG) IDIC see South Africa, Industrial Development Investment Centre (IDIC) IDPs see industrial development points (IDPs) IFC see International Finance Corporation (IFC) II see Institutional Investor (II) IMF see International Monetary Fund (IMF) incentives for agencies of restraint, 291 and foreign investment, 246-7 industrial decentralization, 254-5 income levels, Africa vs. Asia, 353 INDECO see Zambia, Industrial Development Corporation (INDECO) India, county risk, 84-5 Indonesia county risk, 84-5 foreign direct investment, 79 industrial development points (IDPs), 255 Industrial Relations Courts, 222 inflation controls, 185-6 targets, 171-2 Zambia, 194 inflation bias, and central banks, 170-1 inflation rates Africa, 185 as economic management proxy measure, 44 Uganda, 182 Institutional Investor (II), 9 country creditworthiness ratings, 36, 39, 49, 50, 52-3, 64: critical factors, 128; methodology, 64 country risk ratings, 7, 8, 1 7, 82, 83, 84, 85, 127, 129: criteria, 37 credit ratings, 128

380

Index

insurance, and risk management, 10-11 interbank market, and central banks, 177 interest rates, Uganda, 179 internal funds, and uncertainty sensitivity, 113-14 International Commission of Jurists, 220, 222 International Convention on Settlement of Investment Disputes Between States and Nationals of Other States ( 1965), 360 International Country Risk Guide (ICRG) country risk ratings, 7, 9, 14, 87, 89, 94, 127, 128-9: critical factors, 130 International Finance Corporation (IFC) global indices, 122, 124-5, 133-5, 138-9 studies, 355 international institutions, and risk reduction, 3 International Monetary Fund (IMF) initiatives, 156 policies, 371 international trade agreements, and restraints, 338-51 investment determinants, 80-1 expenditures, models, 99 fixed effect models, 109, 110, 113 and incentives, 246-7 irreversibility, 109-1 1 and net present value, 1 1-12 opportunity costs, 12 predictions: econometric method, 100-2; trigger point determination, 99-100 and risk, 4-18: in Africa, 3-27; empirical studies, 13-15; in Ghana, 96-121 theoretical models, 80-1: neoclassical, 81 see also equity investment; foreign direct investment (FDI); foreign investment; portfolio investment; private fixed investment; private investment investment agreements, plurilateral, Africa, 355-61 investment codes future trends, 362 impact assessment, 263-8 implementation, 25 as restraints, 246-71 Investment Guarantee Agency, 252 investment insurance advantages, 334 in Africa, 323-37 and political risk, 331: as management strategy, 332-3

as 'quiet facilitator', 333-4 secrecy, 334 investment rates, regression analyses, 86 investment-to-GDP rates, Latin America, 72 investment-uncertainty relationships, 81, 96-7 prediction testing, 98-106 theoretical models, 99: critique, 120-1 investment under uncertainty model, 1 1-13 with irreversibility, 104-5 investors confidence, 333 and political risk, 327-8, 329-30 and risk, 330 Iraq, expected returns, 141 Ivory Coast see Cote d'Ivoire Japan, monetary transmission mechanisms, 177 judges knowledge, 237 remuneration, 225 restraint, 232 roles, 221 judicial independence, 220-1 characteristics, 227-8 definitions, 220-1 indicators, 241-2 and party competition, 233-5 and politics, 228-9 and public opinion, 229-33 strategies, Tanzania, 228-38 violations, 222 judicial systems influences, 231 pluralism, 226, 238 remuneration, 225-6 resource limitations, 225-6 shortcomings, 219 jury systems, Africa, 225 Kaunda, Kenneth, 154 Kendall coefficients, 39 applications, 41, 42 Kenya aid, suspension, 313 anti-fraud legislation, 156 country risk ratings, 17-18 judicial independence, 227 judicial systems, 232 lawyers, 230 private investment, 74 stock market, 159

381

Index trade reforms, 339 trade restrictions, 338 Khama, Sir Seretse, 247 Knightian uncertainty, 13 criteria, 5 Kreps-Wilson paradigm, 172 land tribunals, Tanzania, 222 Latin America country creditworthiness ratings, 34 foreign direct investment, 79: and privatization, 77 inflation rates, 6 investment-to-GDP rates, 72 market reorientations, 326 private investment, 72 private sector, capital flows, 76 laws, South Africa, 253-8 lawyers judicial independence estimates, 222 remuneration, 225-6 roles, 221, 230 legal systems see judicial systems legislation, and political risk, 156 lending, and informal borrowing, 114-15 lending market risk, vs. equity market risk, 148 Lesotho foreign investment, 248, 253 Human Rights Act (1983), 248-9 Independence Constitution (1966), 248 Industrial Licensing Act (1969), 248 Pioneer Industries Encouragement Act (1969), 248 LIBOR see London Interbank Offered Rate (LIBOR) limited recourse financing, and political risk, 331-2 liquidity, constraints, 1 1 2-15 Lloyds of London, investment insurance, 331 loan status, and irreversibility, 111 Lombard rate, 177 Lome Convention, 277 Lome V agreement, 27, 349: as restraint, 26, 342-6 membership, 253 London Interbank Offered Rate (LIBOR), 33 Madagascar, 285, 336 stock exchange, 159 magistrates knowledge, 237 remuneration, 225

Malawi constitution, 251 foreign investment, 251 : incentives, 249 Industrial Developmental Act (1966), 251 jury systems, 225 private investment, 73, 74 stock exchange, 159 Malaysia foreign direct investment, 79 private investment, 72 Mali, aid, 314 management risk, 153 Mandela, Nelson, 256 Manuel, Trevor, 256-7 manufacturing investments, 13: Ghana, 96-121 uncertainty measures, 15 marginal revenue product of capital

(MRPK)

definition, 102-3 and firm investment models, 100-2 as investment trigger proxy, 14, 102-3 marketability risk, 153 market capitalization, weights, 161 market opportunities, Sub-Saharan Africa, 352-4 market risk, 153 Africa, 164 and capital asset pricing model, 158-9 markets capital, perfect vs. imperfect, 97 capitalization, 366 and central banks, 176-9 developing, 126-7 see also stock markets mark-up factors, definition, 103 Marshall Plan, 19 Mauritania, 285 private investment, 73, 74 Mauritius country risk ratings, 19 economic performance, 365 export restraints, 345 growth rates, 353 private investment, 73, 75 stock market, 159 Mbeki, Thabo, 256, 264 MDBs see multilateral development banks (MDBs) meta-policies, 20 concept of, 19 Mexico external debts, 33-4, 35 foreign direct investment, 79

382

Index

Mexico (continued) private investment, 72-3 trade, regional, 342, 343, 345 trade liberalization, 14, 340 trade restrictions, 25 MFA see World Trade Organization (WTO), MultiFibre Arrangement (MFA) Middle East foreign direct investment, 79 private investment, 72, 73 MIGA see Multilateral Investment Guarantee Agency (MIGA) Mitterrand, Fram;ois, 287 monetary policies, Uganda, 172 monetary reforms, Franc Zone, 292 monetary regimes, categories, 173 monetary transmission mechanisms effectiveness, 178 Uganda, 176-8, 184 money, variables, 94 Moody's Investor Services, country risk ratings, 127, 133 Morgan Stanley Capital International (MSCI), indexes, 133-5, 141 Morocco, private investment, 73 Mozambique, Investment Law, 249 MRPK see marginal revenue product of capital (MRPK) MSCI see Morgan Stanley Capital International (MSCI) Mtikila, Rev. Christopher, 235 Multilateral Agreement on Investment, 362 multilateral development banks (MDBs), funding, 354 Multilateral Investment Guarantee Agency (MIGA), 4, 324, 334 activities, 335-6 in Africa, 336, 337 investment insurance, 331, 335-6 policies, 26 multilateral surveillance Franc Zone, 293-4 possible contributions, 295-7 potential weaknesses, 294-5 multiple discriminant analysis, applications, 51 Museveni, Yoweri, 183, 184, 229, 371 NAFTA see North American Free Trade Agreement (NAFTA) Namibia foreign investment, 253 Foreign Investment Act, 249 private investment, 73, 75 stock market, 159

National Industrial Corporation of Swaziland (NIDCS), 251 nationalization, and political risk, 155 net capital flows developing countries, 78 private sector, 76 public sector, 76 net present value (NPV), and investment, 1 1-12 newly independent states (NIS), 354 New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards, 252 NGOs see non-governmental organizations (NGOs) NIDCS see National Industrial Corporation of Swaziland (NIDCS) Nigeria anti-fraud legislation, 156 capital flows, 91, 324, 355, 366 foreign investment, 264 press freedoms, 154 stock market, 159 trade liberalization, 339 NIS see newly independent states (NIS) non-governmental organizations (NGOs), 315 North Africa foreign direct investment, 79 private investment, 72, 73 North American Free Trade Agreement (NAFTA), 277, 343, 349, 361 cooperation policies, 25 regional trade, 342, 345 restraint, 341 and trade liberalization, 340 NPV see net present value (NPV) Nyalali, Francis, 228, 231 , 234, 235, 244-5 Nyerere, Julius, 233-4 ODA see official development assistance (ODA) Odoki, Justice, 235 official development assistance (ODA) availability, 77-8 support, 91 Olivera-Tanzi effect, 183 OLS see ordinary least squares (OLS) OPIC see Overseas Private Investment Corporation (OPIC) ordinary least squares (OLS), in investment rate studies, 86 Overseas Private Investment Corporation (OPIC), 331

Index parastatals and government, 170, 173-6 privatization, 175-6 PCA see principal component analysis (PCA) Poland, private investment, 73 policies, South Africa, 253-8 policy reforms Africa, 31 1-13 and aid, 3 1 1 and country risk ratings, 16-18 and exports, 16 historical background, 19-20 and risk, 12-13: perceived, 15-16 policy risk and aid, 21 'poor reputation' problem, 22, 23 'rotten descendent' problem, 21 sources of, 20--3 and time consistency, 20, 22-3 and trade liberalization, 22 policy uncertainties, proxies, 14 political reforms Africa, 370 democratic, 371 political risk, 153 analysis, 329-30 avoidance, 331 concept of, 82 definition, 326-30 determination, 128-9 vs. economic risk, 326-7 and investment insurance, 331: as management strategy, 332-3 and investors, 327-8, 329-30 and limited recourse financing, 331-2 loss prevention, 332 loss retention, 332 management, 327, 330-2: strategies, 331-2 measurement, 87, 326-30 measures, 83-4, 157 minimization, 332 reduction, 154 scenarios, 154-6 sources of, 369 and transfer, 331-2 Political Risk Services country risk ratings, 127, 140 see also Coplin-O'Leary Rating System; International Country Risk Guide (ICRG) political variables, 48-9 vs. economics variables, 60--3

383

politics and economics, 366-7 and growth, Africa, 367-71 portfolio composition, Africa, 6, 7 portfolio investment, and risk, Africa, 18, 151-65 portfolio risk management, determinants, 160 poverty, Africa, 365 primary schools enrolment rates, 95: and private investment, 87 principal component analysis (PCA), applications, 41, 43 private fixed investment determinants, empirical, 85-90 regression model, 85-90 private fixed investment ratios, determination, 87-9 private investment and commodity prices, 73 and country risk, 8, 81-5 determinants, macroeconomic, 88 developing countries, 71-95, 365: recent trends, 71-5 and fiscal policies, 73-5 and foreign direct investment, 78-80 and property rights, developing countries, 85 and school enrolment rates, 87 weighted averages, 72 private sector capital flows, developing countries, 75-80 net capital flows, 76 privatization Africa, 13, 326 developing countries, 72 and foreign direct investment, 77, 79, 324-5 parastatals, 175-6 policies, 16 production, globalization, 325 productivity, variables, 94 profit rates, standard deviation, 107 property rights, and private investment, developing countries, 85 public sector capital flows, 77-8 net capital flows, 76 purchasing power risk, 153 purges, definition, 49 Q-theory, 81

384

Index

ratings of Africa, risk indicators, 33-66 risk, 7-9 see also country creditworthiness ratings; country risk ratings RDCs see recurrent departmental charges (RDCs) recurrent departmental charges (RDCs), volatility, 205 Regent Fund Management (UK) Ltd. (RFM), 151, 152 weights, 162-3 regional customs unions, advantages, 346 regional integration, Africa, 341-2 regional integration agreements (RIAs), membership benefits, 342-3 Regional Program on Enterprise Development (RPED), Ghana survey, 98 registrars, roles, 221-2 regression model, private fixed investment, 85-90 repatriation risk, definition, 327 reputations, and policy risk, 22, 23 restraints aid and debt conditionality, critique, 319-22 cash-budgets, 185-218: critique, 216-18 central banks, 169-84: critique, 182-4 courts, 219-45: critique, 243-5 debt conditionality, 308-22 Franc Zone as, 275-307: critique, 305-6 and international trade agreements, 338-5 1 investment codes, 246-71 Lome V Agreement, 342-6 mechanisms, 341-2 and trade liberalization, 340, 341-2 via foreign direct investment charters, 352-62 World Trade Organization, 347-8 see also agencies of restraint return-on-investment (ROI) risk, definition, 327 revenues, instability, 191-2 revolutions definition, 49 as risk measure, 94 RFM see Regent Fund Management (UK) Ltd. (RFM) RIAs see regional integration agreements (RIAs) riots, definition, 49

risk categories, 152, 153, 157 currency, 153 default, 153 effects, on investment, 4--18 equity market vs. lending market, 148 exchange, concept of, 82 financial, 128-9 and investment: in Africa, 3-27; empirical studies, 13-15; in Ghana, 96-121 management, 153 measures, 94, 133, 156-9: discountable earnings model, 156-7 perceived, and policy reforms, 15-16 and policy reforms, 12-13 and portfolio investment, Africa, 18, 15 1-65 purchasing power, 153 reduction mechanisms, agencies of restraint as, 19-27 repatriation, 327 systematic vs. unsystematic, 158-9 and uncertainty compared, 330 see also country default risk; country risk; economic risk; market risk; policy risk; political risk; transfer risk; uncertainty risk indicators, economic and political content, 33-66 risk management company-level approach, 10-11 and insurance, 10-11 risk ratings, 7-9 ROI risk see return-on-investment (ROI) risk Romania, private investment, 73 RPED see Regional Program on Enterprise Development (RPED) Rwanda, and South Africa, 371 SACU see Southern Africa Customs Union (SACU) SADC see Southern African Development Coordination Conference (SADC) (1996) SAPs see Structural Adjustment Programmes (SAPs) secondary schools enrolment rates, 95: and private investment, 87 Senegal, bilateral investment treaties, 355 Seychelles, judicial systems, remuneration, 225 SIDC see Swaziland Industrial Corporation (SIDC)

Index Sierra Leone press freedoms, 154 war, 158 sight liabilities rule, Franc Zone, 279 Slovenia, private investment, 73 South Africa Arbitration Act No. 42 (1965), 259 bilateral investment treaties, 355 capital flows, 91, 366 constitution, 258 country risk ratings, 19 Deposit-Takings Institutions Act, 268 foreign investment: forms, 253-4; and recession, 264-5; statutes and policies, 253-8 Framework for Growth, Employment and Redistribution Programme, 256 Industrial Development Investment Centre (IDIC), 257 investment codes, 25, 266-8 Investment Promotion Board, 257 lawyers, 229 market opportunities, 352 Ministry of Trade and Industry, 256 private investment, 73, 75 Regional Development Programme, 256 Reserve Bank, 256 Revenue Amendment Act (1996), 258, 267 and Rwanda, 371 Simplified Regional Industrial Development Incentives Scheme, 256 statutory provisions, 258-9 stock market, 161 South Asia foreign direct investment, 79 private sector, capital flows, 76 trade, regional, 342 Southern Africa decentralization, incentives, 254-5 economic communities, 360 foreign investment, statutes and policies, 247-63 investment codes, as restraints, 246-71 Southern Africa Customs Union (SAClJ), 253 Southern African Development Coordination Conference (SADC) (1996), 264 Soviet Union (former) policy reforms, 20 trade, 353 Spearman's rank correlation coefficient, applications, 41

385

stabilization policy indicators, 87-9 Standard and Poor's Rating Group, country risk ratings, 127, 133 stepwise regressions, applications, 60, 61, 87 stock exchanges, establishment, 159 stock markets Africa, 122: characteristics, 159-63 turnover, 161 stripped yield spreads, applications, 158 structural adjustment lending, 309-10 Structural Adjustment Programmes (SAPs), 339 and trade reforms, 344 Sub-Saharan Africa economic reforms, 326 foreign direct investment, 79, 90, 324: and privatization, 77 foreign investment, 264 gross domestic product, 353 investment, 354 market opportunities, 352-4 private investment, 71, 72, 73, 91-2, 365 private sector, capital flows, 76 public sector, capital flows, 77-8 substitution elasticity, and uncertainty, 106 Swaziland foreign investment, 247, 251-2, 253: incentives, 249 Swaziland Industrial Corporation (SIDC), 251-2 Table of Government Financial Operations (TOFE), adoption, 296 Tanzania Commission on Single Party or Multiparty System in Tanzania, 234 courts: effectiveness, 235-8; as restraints, 219-45 Economic Crime and Corruption Act, 232 judges, 233-5: knowledge, 237; restraint, 232 judicial independence, 222-4, 227: effectiveness, 235-8; historical background, 228-9; and party competition, 233-5; and politics, 228-9; strategies, 228-38 judicial systems, 225: influences, 231; remuneration, 225 land tribunals, 222 laws, integration, 238 National Executive Committee, 232 opinion polls, 234 stock exchange, 159 trade restrictions, 338

386

Index

taxation, Botswana, 249-50 technological advancement, and foreign direct investment, 78-9, 325 terms-of-trade shock, 95 and foreign direct investment, 90 Thailand, private investment, 72 time consistency, and policy risk, 20, 22-3 TNCs see transnational companies (TNCs) Tobin, James, Q-theory, 81 TOFE see Table of Government Financial Operations (TOFE) Togo, private investment, 73, 75 trade reciprocal, 298-9 regional, 341-2, 371 variables, 95 trade liberalization Africa, 338-9 and economic growth, 339 global, 325 Mexico, 14 and policy risk, 22 and restraints, 340, 341-2 reversals, 339 unilateral, 348 trade policies, reform, 15 trade reforms, unilateral, 339 transfer, and political risk, 331-2 transfer risk, 82 measures, 83 transnational companies (TNCs), and foreign investment, 254 Treaty Establishing the Common Market for Eastern and Southern Africa aims, 357-61 competition policies, 357-8 investment policies, 358-60 trials, official records, accuracy perceptions, 224, 225 Turkey, private investment, 73 UCB see Uganda Commercial Bank (UCB) UDEAC see Customs Union of Central African States (UDEAC) UEMOA see Union Economique et Monetaire Ouest-Africaine (UEMOA) Uganda aid flows, 211 central bank, 269: effectiveness, 178; as restraint, 169-84 constitution, 235 country risk ratings, 17-18 courts, as restraints, 219-45 economic performance, 169-70

financial liberalization, 178-9 government, 371 hyperinflation, 184 inflation rates, 182 interest rates, 179 judges, knowledge, 237 judicial independence, 222-4, 227: and politics, 229 judicial systems, 225: influences, 231; remuneration, 225--6 macroeconomic indicators, 169 monetary policies, 172 monetary transmission mechanisms, 176-8, 184 National Resistance Movement, 229 stabilization, 182-3 stock exchange, 159 tariffs, 27 trade liberalization, 347 Uganda Commercial Bank (UCB) privatization, 176 roles, 174 UMOA see Union Monetaire Ouest-Africaine (UMOA) uncertainty and financial constraints, 96-7: bank loan channel, 106-1 1 ; liquidity channel, 1 1 2-15 and formal sector credit, 107-9 and risk compared, 330 sensitivity, and internal funds, 10-1 1 and substitution elasticity, 106 see also risk uncertainty-investment relationships see investment-uncertainty relationships uncertainty proxies definition, 102 and demand variables, 102-8, 1 13: criticisms, 120-1 UNCITRAL see United Nations Commission on International Trade Law (UNCITRAL) UNCTAD see United Nations Conference on Trade and Development (UNCTAD) Union Economique et Monetaire Ouest­ Africaine (UEMOA), multilateral surveillance, 293-7 Union Monetaire Ouest-Africaine (UMOA), 275, 279 aid, non-project, 283 banking regulation, 292 consolidated bank credits, 281 direct central bank lending, 279

Index domestic arrears, 281 external debt, 282 and French Treasury, 285 governance, 293 operations account balances, 283 sight liabilities rule, 279 United Kingdom (UK) European Exchange Rate Mechanism membership, 171 monetary transmission mechanisms, 177 policy risk, 21 United Nations Commission on International Trade Law (UNCITRAL), 253, 259 United Nations Conference on Trade and Development (UNCTAD), 341 United States (US) bilateral investment treaties, 355 capital flows, 366 expected returns, 141 investment insurance, 331 manufacturing, uncertainty measures, 15 monetary transmission mechanisms, 177 trade: with Africa, 353; regional, 342, 345 USSR see Soviet Union (former) variables in country creditworthiness ratings, 46-51 definitions, 94-5, 102-3 see also demand variables; economics variables; explanatory variables; external variables; political variables Venezuela, private investment, 73 Vietnam country risk ratings, 18 war, 340 volatility commodity prices, 5--6 expected, weight comparisons, 163 and expected returns, 141, 142 indicators, 6 Zambia, 203-5 war effects of, 158 and political risk, 154--5 weights comparisons, 163 equal, 162 expected volatility, 163 market capitalization, 161 World Bank, 98, 122, 309, 335 Adjustment in Africa (1994), 17 Board of Governors, 252

387

global indices, 133-5 initiatives, 156 policies, 371 World Trade Organization (WTO) agreements, 26-7 membership, 354 MultiFibre Arrangement (MFA), 345 as restraint, 347-8, 349 and trade liberalization, 340 WTO see World Trade Organization (WTO) Zaire aid, donor pull out, 313 bilateral investment treaties, 355 Zambia aid, 314: shortfalls, 207-8 cash-budgets, 369-70: and aid flows, 199-200, 21 1-12; and aid reductions, 212-13; costs, 202-9; critique, 216-18; expenditure changes, 203-5; and external debts, 207-9; future trends, 209-13; graduation from, 209-12; historical background, 193-4; interpretation, 200-2; and public finances, 196-9; as restraints, 185-218; roles, 186; and stabilization, 205-7; structure and operational implications, 194--6 Central Bank, 194--6, 208 commodity-linked finance, 10 domestic budget, 196-9 drought, 201 economic performance, 365 elections, 370--1 expenditure, volatility, 203-5 fiscal controls, 186 foreign investment, 259-63, 265--6 gross domestic product, decline, 199 Income Tax Act, 259 Industrial Development Corporation (INDECO), 259, 265 inflation, 194 Investment Act (1993), 260--3 investment codes, 259-63 Investment Disputes Convention Act (1970), 260 Investment Promotion Act, 260 Lands Acquisition Act, 268 Local Government Act, 268 macroeconomic programmes, 207 Ministry of Finance, Budget Office, 201 MMD government, 193-4 Mulungushi Economic Reforms, 259

388

Index

Zambia (continued) Municipal Corporations Act, 268 Pioneer Industries (Relief From Tax) Act, 259, 265 political risk, 154 stabilization crisis, 195 trade liberalization, 339

Zimbabwe constitution, 253 foreign investment, 252-3 judicial systems, remuneration, 225 trade liberalization, 339, 347-8 Zimbabwe Investment Centre Act (1992), 252