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January – July 2021

Understanding the link between management innovation and competitive advantage

By Elikplimi Agbloyor, Alfred Yawson and Pieter Opperman

  • JAN 2021
14 minutes to read

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Private capital inflows – the answer to Africa’s financing shortfall?

 

Recent years have seen significant growth in private capital flows to developing regions, including Africa. This has brought considerable relief and opportunity to many countries, particularly in the face of their generally low domestic savings rate, small tax base, poor tax-collection capabilities, limited local investment and inadequate returns from exports, which are often commodity-based and thus also subject to price volatility. Compounding these problems, particularly in Africa, are underdeveloped and inefficient financial systems.

 

External finance therefore acts as a valuable supplement to domestic finance, which can be used to stimulate growth and development. It can also have indirect benefits, such as improving efficiency in the financial sector, diffusing knowledge and new technologies in the local market, and unlocking trade opportunities. Yet, several recipient countries have been less than sanguine about the impact of foreign private capital on their economies, suggesting that the costs sometimes outweigh the benefits.

 

In our chapter titled ‘Private capital flows and economic growth’ – appearing in the book ‘Contemporary Issues in Development Finance’ (Routledge, 2020) – we explain why countries (even those that appear to have little going for them) attract private capital and whether this is cause for celebration or concern for the recipient countries, with specific reference to Africa. In our in-depth analysis of the literature, we emphasise that much depends on the motivation behind capital flows, where they originate and how well-equipped recipient countries are to use the capital to their advantage. While private capital sounds very alluring, it comes with consequences that need to be carefully anticipated and managed.

 

The main forms of private capital

 

Private capital takes different forms, the main ones being foreign direct investment (FDI), foreign portfolio investment (FPI) and foreign bank lending.

 

FDI involves the acquisition of an enduring management interest (10% or more of voting stock) in an enterprise located in an economy other than that of the investor. FDI can be further classified as a greenfield investment (where an operation is established from scratch) or a cross-border merger or acquisition (where a foreign enterprise merges with or acquires a stake in an existing domestic enterprise). Furthermore, FDI can either be horizontal or vertical. With the former, the foreign enterprise replicates its production process in a foreign location; with the latter, the foreign enterprise allocates different stages of its production process to different countries.

 

Enterprises engaging in FDI can be classified as: resource-seeking, market seeking, efficiency seeking or strategic-asset seeking. Resource-seeking investors, who are generally export-orientated, are looking for resources (such as natural resources or labour) that are more readily available or are less expensive than those available at home. Market-seeking investors are looking to reduce the cost of supplying a destination market by getting close to customers (thereby cutting transport costs) and overcoming tariff hurdles. Efficiency-seeking investors are looking to cut costs by concentrating their production in a limited number of countries that have locational, policy-related or other advantages. Finally, asset-seeking investors are looking for country-related assets or attributes (such as a strong research and development culture) that will help investors achieve their long-term objectives.

 

FPI refers to short-term, passive investment that is divorced from the strategic objectives and day-to-day operations of target firms in recipient countries. Investments are made in capital markets and take the form of bonds, debentures and equity stocks. Investors aim to maximize their returns without having any management control in the principal asset (as is the case with FDI). Foreign bank lending, in turn, is either of the cross-border variety (lending by foreign banks directly from abroad) or involves lending by a branch or subsidiary of a foreign bank in a recipient country. As they are commercial entities operating in a competitive environment, foreign banks are often looking to expand their market share (particularly in the lucrative, top end of the market) in other parts of the world and enhance their profitability.

While private capital sounds very alluring, it comes with consequences that need to be carefully anticipated and managed.

What drives private capital flows?

 

Investment decisions are influenced by various ‘push’ and ‘pull’ factors. Pull factors are linked to a target country’s domestic environment and make the country an attractive investment destination, such as untapped natural resources, a sizeable market, low inflation, trade and financial openness, financial market sophistication, a favourable tax regime, impressive infrastructure, economic growth potential, and political and social stability. Push factors, in contrast, are linked to global economic conditions that make outward investment a desirable option, such as positive growth and liquidity trends, a growing appetite for risky (but potentially lucrative) investments and diversification pressures.

 

In the case of FDI, the main drivers tend to be: firm-specific/ownership advantages (such as access to patents and management skills), locational advantages (such as access to natural resources, favourable tax treatment and avoidance of trade barriers), strong macroeconomic fundamentals (such as low inflation, currency stability, competitive labour costs and a positive GDP growth trend), and a good policy and institutional environment (such as low political risk, financial openness and eligibility for tax benefits).

 

A high level of political risk is one of the most significant deterrents to FDI. An extreme form of such risk is conflict, which can seriously disrupt production and logistics in a country. FDI has sometimes been found to reduce the probability of conflict because it helps to bolster businesses, create jobs and defuse tensions within the general populace. However, when FDI is used to finance initiatives that end up enriching a few, it can stoke widespread unhappiness and unrest. Curiously, studies have shown that African countries with poor-quality institutions attract more FDI than countries with high-quality institutions. This anomaly is possibly the result of multinationals and other significant investors securing favourable investment deals (as far as they are concerned) from inexperienced or compromised government officials and other decision makers in the countries concerned.

 

In the case of FPI, the main drivers tend to be: heightened global liquidity, favourable interest rate differentials, favourable growth differentials and low inflation. Studies have shown that institutional quality in Africa is not a significant factor in FPI decisions. In fact, FPI tends to accelerate during periods of heightened global risk, with firms’ characteristics being a less important consideration.

 

The main drivers of foreign bank lending, in turn, tend to be: general risk aversion globally, and favourable regulatory and competitive environments in target countries. Often, countries with poor-quality institutions attract more foreign bank lending than those with high-quality institutions. This paradox is perhaps explained by the fact that the data include lending from multilateral agencies, such as the International Monetary Fund (IMF), which are more likely to lend to countries that have mismanaged their economies and become highly indebted.

Foreign portfolio investment (FPI) tends to accelerate during periods of heightened global risk, with firms’ characteristics being a less important consideration.

The benefits and costs associated with private capital flows

 

All forms of private capital have both benefits and costs. These are discussed below from a recipient country’s perspective.

 

  • Foreign direct investment (FDI)

 

FDI can induce improvements at the firm level (productivity gains; technology transfer and diffusion; new management processes; and skills training) and at the macro level (a lifeline in the face of fiscal constraints; a boost to economic growth; and stronger trade integration, backward and forward linkages, and value-added export activity). Moreover, compared with FPI investors, FDI investors have access to more information about their investments, which allows them to manage their investments more effectively.

 

The ability of a recipient country to benefit from FDI is heavily dependent on its ‘absorptive capacity’ – as reflected in its human capital, financial market efficiency, institutional rigour and fairness, social stability and political progressiveness. Conflict, for example, is the death knell of absorptive capacity because it permeates all segments of society. Furthermore, FDI may have insignificant or even negative effects if it is not strongly linked to the recipient country’s domestic economy, such as investment in extractive industries (oil, gas, minerals) that are geared almost exclusively for export. Other downsides to FDI are when foreign-owned firms ‘outcompete’ local firms, prompting job losses, or contribute (sometimes with the tacit approval of the government) to environmental degradation in a country.

 

  • Foreign portfolio investment (FPI)

 

FPI investors help to close the savings/investment gap in recipient countries, bringing welcome foreign exchange, alleviating current account deficits, and keeping the corporate sector on its toes when it comes to financial accounting and reporting. Given its highly liquid nature, FPI is popular with pension funds and asset managers. It can also be used for infrastructural and other development projects as an alternative to bank financing.

 

On a negative note, FPI investors are susceptible to short-termism, which makes them fickle and interested only in short-term gains. Consequently, they can disinvest with little warning, upsetting the market and companies’ fortunes in the process. Excessive FPI outflows could even have a corrosive effect on a country’s balance of payments if these are not offset by strong FDI inflows. A great rush of incoming FPI, in turn, could lead to the strengthening of the local currency and therefore less competitive exports.

 

  • Foreign bank lending

 

The benefits of increased foreign bank lending in a recipient country include greater efficiency (due to heightened competition and economies of scale), more advanced technology, and (sometimes) a more trusted brand and more choice for customers.

 

However, critics of foreign bank lending say that foreign banks tend to cherry-pick the best (mainly large) customers and eschew smaller, more opaque firms which are a dominant feature of African society. This detracts from countries’ efforts to tackle developmental shortcomings. In addition, as foreign capital is more mobile than domestic capital, foreign banks could decide to reduce their liquidity and curtail lending if they are confronted by adverse conditions that call for restraint.

 

In closing

 

Private capital has an important role to play in Africa’s economic development and business optimisation efforts and should be actively pursued. However, it is all too easy to mobilise capital inflows without giving sufficient thought to what types of capital are appropriate for different circumstances and whether the investment will ultimately benefit a large number of people or only a few.

 

  • Find the original chapter here: Agbloyor, E., Yawson, A. & Opperman, P. (2020). Private capital flows and economic growth. In B. Y. Abor, C. K. D. Adjasi & R. Lensink (Eds.), Contemporary Issues in Development Finance. London: Routledge.
  • Dr Pieter Opperman lectures on the MBA and Development Finance programmes at USB. He is also Manager: Teaching and Learning at the business school.

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