Chapter 1 Introduction
1.2 Background And Context Of The Study
1.2.1 Capital Flows: A Historical Perspective
Given the challenges that most developing and developed economies experience with regard to sudden surges, stops and reversals in capital flows, there is need to analyze the history of foreign capital flows. According to Sula and Willett (2009), the surge in international financial flows can be traced to the 1970s when a remarkable boom was experienced in emerging economies. The
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sudden rise in international capital flows was driven by a number of factors, including the oil shock of 1973 to 1974, the introduction of the Eurodollar market and the significant increase in global bank lending during the period 1979 to 1981 (Sula and Willett, 2009). Latin America was the major recipient of these large inflows of international capital in the form of bank lending that reached USD44 billion in 1981 (representing 6% of the region’s GDP). However, international lending came to a sudden halt in 1982 due to the significant increase in global real interest rates to levels not reached since the 1930s. The late 1980s saw the resurgence of international bank lending as flows to Latin America made a serious comeback as well as surges in capital flows to Asia.
During these surges, the composition of capital flows was altered, with FDI and portfolio flows replacing bank lending. International bank lending to both Asia and Latin America fell from 70%
of total private capital flows in the 1970s to about 20% in the 1990s. Foreign direct investment flows became the most significant source of foreign financial capital for both regions as portfolio flows increased substantially in the late 1990s, accounting for almost 40% of total foreign capital flows. In dollar value terms bond and equity flows to Asia surged to USD27 billion in 1993 and reached USD69 billion in Latin America in 1994. Similar to the 1980s, booms in the 1990s were followed by sudden reversals of capital as witnessed in the aftermath of the Mexican currency crisis of 1994. Capital flows to Asian countries were not affected as the crisis was confined to a small number of Latin American economies. However, a more severe crisis was experienced in 1997 during the Asian financial crisis which was amplified by the Russian default of 1998 and the Brazilian crisis of 1999. During the Asian crisis the sudden stop and reversal of capital flows were more substantial and sustained than in Latin America. Capital inflows fell from USD120 billion to an outflow of USD50 in 1998. In terms of short-term portfolio flows (debt and equity) to Asia, the fluctuations were huge and drastic, falling from USD52 billion in 1996 to an outflow of USD92 billion in 1998. Similarly, short-term flows declined from an estimated USD30 billion in 1996 to a negative flow of USD31 billion in 2000 (Sula and Willett, 2009).
In comparison, debate continues to rage on the reasons for the 2008 reversal and subsequent rise in international financial flows (Fratzscher, 2012). Using a factor model and high frequency portfolio flows to 50 countries, Fratzcher (2012) reveals that changes in global liquidity and risk contributed significantly to fluctuations in foreign capital flows both during the crisis and in the recovery period. However, significant heterogeneity was observed across countries and was attributed to variations in the nature of domestic institutions, country risk and the soundness of the
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macro-economy. It was concluded that global or external variables were the main drivers of foreign capital flows during the crisis, while domestic economic fundamentals were significant during the recovery period (Fratzscher, 2012).
1.2.2 CHANGING COMPOSITION OF CAPITAL FLOWS TO DEVELOPING COUNTRIES
Since the year 2000, there have been dramatic increases in foreign capital flows from the private sector (Sayeh, 2011). Globally, private capital flows to the emerging and developing world increased from USD151 billion in 2002 to USD 1.7 trillion in 2007, while net capital flows rose from USD 49 billion to USD 674 billion during the same period (Chea, 2011). Portfolio debt and equity flows also increased drastically. Given these developments and contrary to conventional wisdom, bilateral and international financial institutions are no longer the main sources of external funding for investment in developing economies (Dorsey, Tadesse, Singh, and Brixiova, 2008, Chea, 2011). In the 1990s, the sensitivity of private capital flows to opportunities in developing economies began to rise as a result of both internal (pull) and external (push) factors. Furthermore, foreign remittances from migrant workers abroad have arguably become the largest source of finance for the developing world, more than treble the magnitude of official development assistance (ODA) (Ratha, Mohapatra, and Silwal, 2010, Chea, 2011). Remittances are unilateral transfers or gifts by migrant workers sent to family or friends back home (Chea, 2011). Foreign remittances increased from USD19 billion in 1980 to an estimated USD265 billion in 2007. In 2007, foreign remittances to SSA amounted to USD19 billion, constituting 2.5% of regional GDP and a similar amount to the ODA received by the region. On a global scale, foreign remittance flows to Sub-Saharan Africa are significantly smaller as they constitute only 5% of aggregate remittances to developing economies and in terms of contribution to GDP, SSA is overshadowed by the huge remittances received in the Middle East and South Asia (Dorsey, Brixiova, Singh, and Tadesse, 2008). Six of the 25 largest recipients of remittances in 2007 were African countries, i.e.
Cape Verde, Comoros, Lesotho, Senegal, Sierra Leon and Togo (Chea, 2011, Ratha, Mohapatra, and Silwal, 2010,). However, SSA recorded the third largest percentage of GDP. As remittances can enter an economy via financial markets such as equity and debt markets, the following section sheds light on the significance of capital markets, particularly to SADC countries.
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