Over the past decades Africa has increasingly opened up its economy to international trade and finance. This change has often been at the bequest of, or under pressure from, the International Monetary Fund (IMF) and World Bank (WB).(2) The conditionality of assistance from the Bretton Woods institutions was seen as a moral responsibility by the creditor nations of these institutions, but not once in this process of ‘instructing’ low income countries (LICs) was the fundamental strength of the Western-style financial system ever questioned. It is hard to distance the regulation on finance from the rest of the Washington consensus on trade and economic liberalization because of the inter-linkages between them. What we should recognise is that what was deemed to be best practice in Europe and America was considered to be the only avenue for economic advancement, something that the recent global financial crisis (GFC) has proven to be wrong.(3)
Given the GFC, the question arises: what are the policy tools available to African nations to maintain economic growth and prevent financial instability? Much work has been done on the policy tools that need to be implemented to prevent a second crisis and strengthen both domestic and international financial systems. The G20, the IMF and the Basel committee on banking supervision have produced numerous papers on these tools.(4) However, considerably less work has been done on the specific needs and circumstances of Africa. This paper discusses the principle avenues through which the spill over of the GFC affected LICs in Africa, namely trade relationships (including trade finance) and price volatility. The more general issues discussed are endogenous financial vulnerabilities and exchange rate systems.(5) The paper then considers a number of means through which to protect growth and financial stability on the continent.
Channels through which the GFC spilled over into LICs
The long process of economic liberalisation which has been progressing throughout most of Africa over the past couple of decades was originally greeted with a great deal of reluctance. Many were worried about the consequences for the poor and were heavily influenced by socialist concerns for their newly independent states. With the evident failure (6) of the various protectionist measures aimed at encouraging domestic African production and a more independent and equitable economy, and a growing dependence on financial support from the IMF and WB, most African states began to move towards economic models loosely based on the liberal United States (US) model. With the onset of GFC all of the economic principles that had been propagated so widely and accepted so absolutely have become a little less certain.
It was the very openness to global trade and financial flows which provided the avenues through which the GFC was transmitted to the LICs in Africa. The forced review of the economic liberalisation agenda that has been caused by the GFC is something that should be seen as an overdue dose of critical awareness, which, if exercised slightly earlier, may have been successful in reining in the more zealous financial liberalisation proposals. What remains for Africa to decide on is how to use the overdue international review of these economic principles, which have been questioned for a long time on the continent, to develop a coherent set of macroeconomic objectives and policy measures which will allow Africa to properly deal with the negative externalities caused by rapid economic and financial liberalisation. From the experiences of LICs and those of other recently developed regions such as South East Asia, a policy tool kit should be formed, not only to support growth, but to stabilize economies in the long run.
In order to develop points on policy options it is first necessary to establish the channels through which LICs were affected by the GFC. The factor with the greatest explanatory potential for the drop in gross domestic product (GDP) growth during this period is the shock to external demand that the crisis brought about.(7) With the severe economic recession in the advanced economies, global demand in manufacturing and luxury items plummeted.
Shocks to terms of trade only seemed to have affected fuel exporting countries and oil producers in particular. In some cases this did have quite severe effects on GDP; Angola, Africa’s second largest oil producer,(8) for instance, dropped from a growth rate of 22.6% in 2007 to 2.4% in 2009.(9) The terms of trade in most other natural resources have in fact been on the rise throughout this period. That this is part of a longer term trend not directly associated with the crisis is probable, but it could be argued that the crisis served to step it up. It did so by affecting the Chinese consumption rate of raw materials: In order to mitigate the drop in global demand that China’s export industry faced as a consequence of the crisis, the government enacted an ambitious structural development plan, which, if anything, only served to raise the international price of commodities, barring oil.(10)
The least significant of the three main channels of spill over of the GFC into LICs is capital flows. As the majority of LICs do not currently have sizable domestic financial markets, they had limited direct financial contact with the imbalances that built up in the international system.(11) However, that said, the same effects were still felt through these channels. One study proposed that a drop of 10% in foreign direct investment (FDI) flows could result in as much as a 3% drop in GDP for Sub Saharan Africa.(12) While FDI is the most significant form of financial linkage between the advanced economies and the LICs, cross boarder bank lending played a part to a lesser degree.(13) Aid was another financial channel through which the effects of the crisis where transmitted to the LICs. International aid donation during the period of the GFC saw a sharp drop on the commitments made previously. While not strictly speaking a financial channel, workers’ remittances to Africa also dropped during this period, due to higher unemployment levels and tighter emigration policies in the advanced economies.(14)
Short and long term policy options
Fortunately the recovery has been relatively painless in Africa. A quick look at the GDP growth rate data for Sub Saharan Africa is sufficient to show that there has been a return to pre-crisis growth levels in most cases.(15) This should not come as a surprise, as the origins of the crisis where not African, neither did the consequent economic adjustments need to happen in Africa. The bounce back to output growth in Africa was one of the more accurate predictions made during the first years of the crisis. However, this should not lead African policy makers into complacency; the time to prepare a strong financial system based on sound foundations, resilient to the more corrosive effects of financial liberalisation, is now. In particular, any LIC considering developing its financial markets and opening them up to the global markets would do well to look at the experiences of South America and South East Asia during the 1990s, and compare them to their experiences in the 2000s.(16) Lessons were learned, and a number of policies that have protected many of these countries from the worst of the GFC put in place. If current growth rates in Africa continue, then within the next decade or two there will be a number of African nations developed enough to be exposed to the sort of financial risk that caused so much harm to the developing world in the 1990s and the advanced economies in the 2000s. Now is the time to prepare the foundations of both individual state and inter-state financial systems in Africa.(17)
Countries which had built up capital buffers prior to the GFC faired far better in almost every case. The most prominent example of this is, of course, China, but other exemplary countries are Russia, Saudi Arabia and Argentina.(18) For countries seeking to develop based on an export-orientated growth model, it would appear that the use of foreign currency buffers provides the best opportunity for protection against fluctuations in both financial markets and international trade. The foreign currency buffer is normally built up in the nation’s current account. As most of the effect of the crisis on LICs was transmitted through trade channels, the use of those trade surpluses built up during the boom years as a cushion against future shocks provides a rational means to mitigate the effects of the crises, without having to interfere unduly in the functioning of the markets.
There are a number of ways in which the build up of foreign currency reserves can be used to mitigate the effects of a crisis. Firstly, if a country which is trying to increase its trade competitiveness pegs its exchange rate, then it exposes itself to the growth of imbalances which would inevitably be exacerbated by an international financial crisis. The build up of these reserves would allow this country to intervene on forex markets to maintain its pegged exchange rate. This is without the need to resort to regulatory restrictions that might encourage domestic imbalances and reduce the effectiveness of the financial sector. Secondly, if the country has a domestic financial market which has sufficient connections to the global market, then the surpluses built up in the currency reserves in the previous years can be used to provide emergency liquidity without having to seek help from international financial institutions. Finally, if over the boom years the surpluses from the current account are used to build up a sufficient reserve of foreign currency, then a country which finds itself with dramatically reduced foreign demand due to an external shock will be able to mitigate the recession this would normally cause, by stimulating the domestic economy through infrastructural investment. The reasons listed here for why foreign currency reserves are an ideal tool to be used by LICs are not hypothetical postulations; but have all been used, rather successfully, by China and a number of other emerging economies throughout the crisis.(19)
It may seem to a country which has pressing development concerns, as do many of the LICs in Africa, that capital earned through exports should be spent on direct investment back into the economy. It is hard to argue against the need for hospitals and schools, but we must learn from history that without growth, development is near impossible to bring about. For growth to occur there must be economic stability, something which was underestimated by some parts of the developing world in the past; a wise lesson for Africa to take from the experience of others is to protect its long term financial stability.
Based on the regression models used in a number of studies, there are several other policy options available which would dampen the effects of a financial crisis and the resultant drop in global demand.(20) Unsurprisingly, countries with lower debt ratios tended to fare better during the recent crisis. The causal logic behind this is simple: lower debt levels make a country appear a safer prospect for international lenders, which, during a crisis, are looking for any safe haven in which to put their money. To put it another way, the risk premium attached to higher debt levels rises dramatically during a crisis.(21) There is some weak evidence that, after debt ratios have been controlled for, countries with a lower national deficit prior to the crisis, suffered less.(22) While some countries may opt for a form of controlled exchange rate system because of the trade advantages it might confer, there is reasonable evidence that, based on a study of 58 different countries, those with more flexible exchange rates fared better during the financial crisis.(23)
In a financial crisis, the stability of the domestic financial system or the makeup of domestic capital will inevitably play a part. As was mentioned before, financial systems in LICs tend to be small relative to GDP, meaning that this will not be a key determining factor until their economies develop a higher financial to real economy ratio. The most important financial channels through which the GFC was transmitted to LICs were FDI and, to a lesser extent, cross boarder bank lending.(24) There are extensive papers discussing the best practice rules on leverage rations, the correct forms of collateral, monitoring of systemic risk, monitoring of over-the-counter derivatives and the management of other financial tools, the necessary protection against roll-over borrowing between financial institutions and the new measures to protect against the growth of moral hazard.(25) In a nut shell, it is never a bad thing for a country to have well designed and well enforced financial regulation. Financial systems will always be prone to developing vulnerabilities, and without the constant vigilance of a regulatory body, the accumulation of bad practices in the financial economy will result in negative consequences for the real economy.
The options that stand before a LIC policymaker considering how best to manage the effects of a financial crisis originating from abroad are limited as an ex-post response. Firstly, if the domestic financial system is well regulated and has sufficient reserve requirements etcetera, and if the policymaker has sufficient fiscal space due to low government debt and a good fiscal balance, then it will be possible to implement policies similar to those seen in the advanced economies over the past six years. Very generally, these policies cover emergency liquidity supply to any healthy financial institutions in need of it in order to stop contagion into the domestic financial system. A more proactive tool available is counter cyclical spending on infrastructural investment in order to offset the drop in growth caused by the international turmoil. However, if we look at the current position of the advanced economies, even those which had sound financial systems throughout the crisis, we can see that even with their vast supplies of liquidity and their various stimulus programmes they only ever amounted to a prevention of the worst case scenario.(26) There is now unanimous agreement on the need for ex-ante policy measures in order to properly safeguard against the dangers that rapid financial growth can bring.
As always in economics, the importance of ex-ante policies does imply a trade-off for LICs. Growth objectives must be tempered with stability objectives. If we take anything from the recent crisis it must be this: not even the most powerful and expensively designed institutional systems can withstand unbridled financial liberalisation. There must always be policies to mitigate and restrain those areas of rapid financial liberalisation that expose the real economy to sizable risk. The trade-off between growth and stability may at first seem an unreasonable request for a country struggling with a population locked in poverty cycles, but what must be restated is that to maintain stability in the long run is to preserve growth. The effects of external shocks to LICs’ growth patterns are currently receiving more academic attention, but the picture of the eventual bounce back of the global economy remains unclear. What is certain is that even if an economy does return to pre-crisis levels, it could take as long as a decade. That is a decade of lost growth.
What then, are the ex-ante measures? The practical example of various emerging powers, China in particular, provides a tried and tested policy mechanism for LICs in Africa. The stability benefits of a national foreign currency reserve are enormous and the cost of holding large amounts of reserve currencies can, at least marginally, be offset by the use of sovereign wealth funds.
Written by Gerald Flanagan (1)
(1) Contact Gerald Flanagan through Consultancy Africa Intelligence’s Africa Watch Unit ( email@example.com). This CAI discussion paper was developed with the assistance of Clair Furphy and was edited by Nicky Berg.
(2) Ju, J., Shi, K. and Wei, S., ‘Are trade liberalizations a source of global imbalances?’, February 2011, http://www.nottingham.ac.uk.
(3) Sohn, I., ‘East Asia’s counterweight strategy: Asia’s financial cooperation and the evolving international monetary order’, United Nations, March 2007, http://dspace.cigilibrary.org.
(4) ‘Macroprudential policy tools and framework’, FSB, IMF and BIS progress report to the G20, 14 February 2011, http://www.financialstabilityboard.org; ‘Recent experiances in managing capital flows- Cross cutting themes and possible policy framwork’, IMF, 11 March 2011, http://www.imf.org.
(5) Berg, A., et al., ‘The end of an era?’ The medium- and long-term effects of the global crisis on growth in low-income countries’, IMF working paper, January 2011, http://www.econstor.eu.
(6) Tupy, M., 2005. Trade liberalization and poverty reduction in Sub-Saharan Africa. Policy Analysis, 557, pp. 2-24.
(7) This is supported by several extensive quantitative studies. Berg, A., et al., ‘Global shocks and their impact on low income countries: Lessons from the global financial crisis’, IMF working paper 11/27, February 2011, http://www.relooney.fatcow.com; Berg, A., et al., ‘The end of an era? The medium- and long-term effects of the global crisis on growth in low-income countries’, 2011, January IMF working paper, http://www.econstor.eu; ‘Recent experiances in managing capital flows- Cross cutting themes and possible policy framwork’,IMF, 11 March 2011, http://www.imf.org.
(8) ‘Angola facts and figures’, Organisation of the Petroleum Exporting Countries, http://www.opec.org.
(9) ‘Sub-Saharan Africa: Percentage change in GDP’, International Monetary Fund World Economic Outlook database, October 2012, http://www.imf.org.
(10) Morris, M., Kaplinsky, R. and Kaplan, D., 2012. One thing leads to another: Promoting industrialization by making the most of the commodity boom in Sub-Sharan Africa. MMCP: Cape Town.
(11) Berg, A., et al., ‘Global shocks and their impact on low income countries: Lessons from the global financial crisis’, IMF working paper 11/27, February 2011, http://www.relooney.fatcow.com.
(12) Macias, J. and Massa, M., ‘The global financial crisis and Sub-Saharan Africa: The effects of slowing private capital inflows on growth’, ODI working paper 304, June 2009, http://dspace.cigilibrary.org.
(14) Berg, A., et al., ‘Global shocks and their impact on low income countries: Lessons from the global financial crisis’, IMF working paper 11/27, February 2011, http://www.relooney.fatcow.com.
(15) ‘Sub-Saharan Africa: Percentage change in aggregate GDP’, International Monetary Fund, World Economic Outlook database, October 2012, http://www.imf.org.
(16) Sohn, I., ‘East Asia’s counterweight strategy: Asia’s financial cooperation and the evolving international monetary order’, United Nations, March 2007, http://dspace.cigilibrary.org.
(17) ‘Recent experiances in managing capital flows- Cross cutting themes and possible policy framwork’, IMF, 11 March 2011, http://www.imf.org.
(18) Flanagan, G., 2012. The global financial crisis and its implications for global financial governance. Unpublished Master’s thesis. University of Cape Town, South Africa.
(19) Sohn, I., ‘East Asia’s counterweight strategy: Asia’s financial cooperation and the evolving international monetary order’, United Nations, March 2007, http://dspace.cigilibrary.org.
(20) Berg, A., et al., ‘Global shocks and their impact on low income countries: Lessons from the global financial crisis’, IMF working paper 11/27, February 2011, http://www.relooney.fatcow.com; Berg, A., et al., ‘The end of an era? The medium- and long-term effects of the global crisis on growth in low-income countries’, IMF working paper, January 2011, http://www.econstor.eu.
(21) Berg, A., et al., ‘The end of an era? The medium- and long-term effects of the global crisis on growth in low-income countries’, IMF working paper, January 2011, http://www.econstor.eu.
(24) Macias, J. and Massa, M., ‘The global financial crisis and Sub-Saharan Africa: The effects of slowing private capital inflows on growth’, ODI working paper 304, June 2009, http://dspace.cigilibrary.org.
(25) It is not necessary for our purposes to delve into them here, see: ‘Macroprudential policy tools and framework’, FSB, IMF and BIS progress report to the G20, 14 February 2011, http://www.financialstabilityboard.org.
(26) ‘Recent experiances in managing capital flows- Cross cutting themes and possible policy framwork’,IMF, 11 March 2011, http://www.imf.org.