PRIVATE CAPITAL FLOWS TO LICS: DEALING WITH BOOM AND BUST

Development Finance International

Presentation to ODI Seminar

27 April 2010

OUTLINE

Context and Methodology

Key Findings:

Trends and Composition of Private Capital Flows: Boom and Bust

What Drives Flows ? Investor Perceptions, Intentions and Responsibility

Policy Implications

CONTEXT AND METHODOLOGY Study on the behaviour and development impact of foreign private capital

(direct investment, portfolio flows, bank loans etc) before and during the financial crisis.

Based on surveys of 9000 investors in 24 countries. Includes foreign and domestic, MNEs and SMEs, all sectors, source countries etc

Conducted under Foreign Private Capital Capacity-Building Programme, funded by Swiss (especially) and UK governments, with Danish, Swedish and World Bank country-specific funds, and 40-60% funded by the national stakeholders

Objective is to build country capacity to maximise the contribution of FPC to development, via more effective monitoring, analysis and policy actions.

Programme executed in partnership with regional capacity-building organisations (BCEAO/BEAC, CEMLA, MEFMI, WAIFEM), activities decentralised to them as of September 2009

In each country, a national taskforce of government (Central Banks, Investment Promotion Agencies, Stats Offices, line ministries) and all key private associations conduct the survey work and write analytical reports of up to 150 pages: they are the ones who deserve all the credit !!

Provides a platform for design of wide range of government policies through dialogue between government and private sector.

TRENDS AND COMPOSITION OF CAPITAL FLOWS: IMPLICATIONS

OF BOOM AND BUST

PRE-CRISIS TRENDS Rapid rises in FPC to developing countries well known, but

many tend to assume LICs not receiving much. Reality (see graphs) is that LICs were also having a boom

of FPC, especially worker remittances and FDI, but all other rising: also 50% underestimates of FDI/ST loans

In many cases very high proportions of their GDP and capital formation.

Nevertheless global policy tended to lag in noticing this, as a result little put in place to protect them against strong potential effects of crisis

LICs were experiencing dramatic volatility with hugh macroeconomic and social impacts well before the crisis, often reflecting external or investor-specific factors (Anglo in Zambia; Ashanti in Ghana).

Yet it took a global crisis before the international community began to worry about LIC FPC instability

Chart 1

Net Flows to LDCs (2003-8, USD m)

-100000

0

100000

200000

300000

400000

500000

600000

2003 2004 2005 2006 2007 2008

FDI

FDI Profits

remitted

Portfolio equity

Bonds

Other borrowing

Worker

remittances

Chart 2

Net Flows to LICs (2003-8, USD m)

-10000

0

10000

20000

30000

40000

2003 2004 2005 2006 2007 2008

FDI

FDI Profits

remitted

Portfolio equity

Bonds

Other borrowing

Worker remittances

Chart 3

FPC Stock to GDP (%)

0% 10% 20% 30% 40% 50% 60% 70% 80%

Zambia (2007)

Bolivia (2008)

Gambia (2008)

Tanzania (2006)

Cameroon (2004)

Uganda (2007)

Ghana (2007)

Malaw i (2004)

CRISIS AND POST-CRISIS In the crisis, countries saw:

Cancelled or postponed new equity projects Higher capital repatriation via repayments of FDI-related

debt, and remittance of profits Reversals of portfolio flows, leading to decline in market

value of equity listed on stock markets, and instability in government bond markets

Contractions in borrowing and especially trade credit vital for exports and imports with commodity price falls

Some of these trends have reversed, especially trade finance as commodity prices rise, stock markets and exchange rates have recovered somewhat, but FDI to most LICs still stagnant, repatriation levels higher, loans and bonds minimal

COMPOSITION AND STABILITY Very high proportion of debt in “FDI” deals (part

equity and part intra-company debt), also very high short-term debt: by 2008/9, in many LICs private sector debt much higher than public sector debt

Traditional “hierarchy” of volatility whereby FDI more stable and portfolio/bank flows (esp short-term) more volatile does not hold at all

New equity can be volatile if cancelled, postponed or withdrawn (as seen during the Crisis)

Contains debt with undefined terms which can (and has been) recalled by HQ quickly during busts or rolled over during booms

Enterprises can reinvest profits during booms or repatriate during busts

COMPOSITION AND STABILITY Much more attention needs to be paid to

composition of flows (esp intra-company debt seen as FDI, short-term debt, profit remittances)

International community and national authorities need to encourage higher proportions of new equity via e.g. cofinancing & guarantees

Debt needs to be monitored in detail (debt/ equity ratios, risks from interest/exchange rates and refinancing) and excessively leveraged projects discouraged.

Govts and international organisations need to request more information (e.g. when approving projects) on proposed financing composition and be much more accurate in forecasting future trends

DIVERSIFYING SOURCES Non-OECD

OECD FDI continues to be important, but rapid growth in non-OECD FDI (>50% in some countries) and less volatile during the crisis – see Tanzania graph for example

Not just from China and India, but intra-regional, MENA, other Asia

Some LICs have responded by diversifying promotion to the new sources, but others need to make stronger efforts

Tax Havens Many foreign investors are registered there, although they

make decisions elsewhere, and domestic investors “round-trip” investment to take advantage of FDI incentives

The growth of havens as sources of investment and destinations for repatriated earnings complicates monitoring, and promotion targeting, and connects more closely to them, underlining the need to oblige them to report on enterprise assets, and pursue tax evasion claims

Chart 4

Tanzania: Source of FDI Stock (2003-6, %)

0%

20%

40%

60%

80%

100%

2003 2004 2005 2006p

Other

China

Brit Virgin Is.

Switzerland

Kenya

Mauritius

Netherlands

USA

UK

Canada

South Africa

SECTORS AND REGIONS Some countries still vulnerable to concentration on few

sectors, but many diversifying into manufacturing, finance, tourism, real estate, construction, telecoms, with very high returns

Implies more scope for investment, need to diversify sectors benefiting from promotion efforts and international support through cofinancing/ guarantees, and need for host countries to be flexible in targeting dynamic sectors

Special efforts are needed to diversify recipient regions within countries, as investment tends to concentrate in or around business centres (where infrastructure is better) or natural resources

Promotion policies need to pay more attention to national development strategies, and target incentives to accelerate development in poorer regions, as well as identifying regional comparative advantages, and providing missing infrastructure

Chart 5

Gambia: Share of FDI Stock by Sector

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2003 2004 2007 2008

Other

Wholesale &

retailReal Estate

Hotels

Finance

Construction

RESPONDING TO INVESTOR PERCEPTIONS

COMPANY OPINIONS 1 Publication also covers ACTUAL investor views on

factors determining initial and current investment decisions, medium term outlook, and practical contributions to development

What are key factors encouraging or discouraging investment ?

Market size and political and economic stability are more important than “stabilisation” (very low inflation) or “competitiveness” (a low real exchange rate, which encourages only exporters)

Labour productivity and availability are more important than liberal labour laws or regulations

Investment (especially tax) incentives are of marginal importance. Many countries applied blanket incentives for foreigners but lesson is to ensure level playing field for locals too, and target sectors, regions or behaviour (eg encourage training, technology transfer) and maintain precious tax revenue

COMPANY OPINIONS 2 Corporate corruption (ie companies being corrupt in dealings with

one another) needs to receive as much attention as govt corruption. This implies tightening up OECD conventions and individual country laws, extending Extractive Industries Transparency Initiative / GRI to other sectors and industries, and enhancing enforcement (tendency for standards to be voluntary at the moment)

Infrastructure is mixed, and requires far more public (and private) investment. There have been improvements in eg telecoms and roads, but still major headaches from low availability and high cost of energy, non-road transport and water

Health issues impact on staff turnover, absenteeism, and maintenance of a stable, trained labour force. Education is also critical to boosting quality of human capital. Particular focus needed on malaria, health systems and secondary or vocational education. Role for private sector to fill public spending gap

Environmental issues (including climate change effects on coastal erosion – impacts tourism, drought and floods – impacts subsistence and cash crops) are rising rapidly up the list, and climate change adaptation spending needs to be increased rapidly

Chart 6.9

Burkina: Top Catalysts and Constraints

M alaria

HIV/AIDS

Inf lat ion

Drought

Tuberculosis

Commerce

M inistry/IPA

Access to Credit

Regional polit ical

stability

Finance M inistry

Domestic polit ical

stability

VARIATIONS AND VOLATILITY

Perceptions vary among different investor groups and need to be tracked/analysed in a disaggregated way: exporters vs importers; seekers after markets, resources, or efficiency gains; primary / secondary / tertiary sectors; domestic vs foreign; potential vs actual investors (Perception and Reality book); large vs SMEs; and different source countries).

Perceptions can change dramatically, especially in light of a crisis (eg in 2007-08, inflation rose up concerns far faster than warranted, due to blanket media coverage) and govt therefore needs to conduct regular surveys and respond rapidly with dialogue to address concerns

RESPONDING TO PERCEPTIONS Perceptions provide valuable insights and reflections as to how well

countries are doing on promoting investment climate. However, views should not lead to knee-jerk policy changes because: Investors may be wrong or ill-informed: e.g. they always complain about tax

even when this is lower than other countries or has recently been reduced, or about interest rates while spreads are narrowing. This may imply a lag in the rate at which perceptions change. Govt can address this by announcing positive changes, in addition to which investors want to see that changes are sustained!

Large, non-resident investors are only one of many stakeholder groups, and their perceptions should not necessarily predominate (eg over domestic investors, trades unions, civil society, and SMEs)

Perceptions thus need to be weighed up and compared with objective analysis, and impacts on other groups assessed

Govt and business likewise need to maintain dialogue about whether perceptions are justified and what are appropriate policy responses

Govt needs to have same dialogue with the other stakeholders and make policy recommendations to improve their circumstances in the context of wider national development strategy to avoid conflicting action

INCREASING DEVELOPMENT PROSPECTS AND IMPACT

DEVELOPMENT IMPACT 1 Urgent need to know more about what investors intend to do

(forward looking, in the context of predicting the likelihood of future PCF related shocks) and their actual and potential contribution to development

Study also covers investors’ intentions (will they increase, reduce or maintain investment levels) and what they are currently spending it on or will spend it on (capital, labour etc)

It also covers issues on the practical steps they are taking to contribute to national development. This necessarily goes beyond lip service to global CSR declarations and broad policy statements, to cover: paying taxes, (avoiding tax holidays), and undertaking spending on human resources (e.g. training, health, education, gender balance), environmental protection, and infrastructure

DEVELOPMENT IMPACT 2: INTENTIONS

In normal times, at least 50% of investors (as high as 70% in many countries) planning to increase their investment. Generally less than 10% intend to contract their investment

See following graph: interesting, investors remain bullish in the wake of the global crisis, as evidenced by positive data for Gambia, Uganda, Zambia and Senegal (2008/9)

High proportion of this to be spent on training, employing nationals, bringing in technology

Picture is less positive with respect to investing in joint ventures, local supply chains, transfer of technology to domestic partners etc

Chart 6.5

Future Investment Decisions

0% 20% 40% 60% 80% 100%

Cameroon (2006)

Burkina Faso

Senegal (2009)

Malaw i (2005)

Zambia (2009)

Nicaragua (2005)

Uganda (2008)

Gambia (2008)

Tanzania (2003)

Expand Maintain Contract

DEVELOPMENT IMPACT 3: RESPONSIBILITY/CONTRIBUTIONS

On the plus side, we have found that most businesses are aware of the issues and several may have policy statements, either formal or unwritten (SMEs tend to be informal, MNEs might have policies that comply with HQ)

They also have awareness of extent to which they are meeting their targets In this respect, there is wide variation in levels of attainment within and

across countries. Generally targets are being met for recruiting nationals over ex-patriate staff more than in promoting gender balance, although both fall well short. However, only a small number indicate zero progress

There is also willingness to do much more, and wide acknowledgement that is not a philanthropic exercise but increases business returns

Action can be increased by encouraging enterprises to emulate best practices (showing how this can be done profitably)

And by spreading practices through supply chains, and perhaps by targeted tax incentives

But while companies may be willing to indicate the existence of targets, verifying their assessment of progress remains a challenge, and ways of addressing this are under consideration. E.g. would it be better to follow up with more detailed questions, or to hold informal meetings in consultation with relevant ministries such as those for labour or the environment

Development Impact 4: Private Contributions to Public Investment

Companies are acting in their own interests to supplement shortfalls in public spending (again not philanthropic, but can have social and development benefits). Some examples:

Infrastructure: local roads (esp mining), generators

Health: free provision of care for staff and families (maintains a stable workforce)

Education: training labour force (improves HR quality)

CONCLUSIONS AND POLICY IMPLICATIONS

AT LIC NATIONAL LEVEL Major changes in thinking by Finance and Planning

Ministries and Central Banks in LICs – “early warning system” monitoring to foresee problems, enhance analysis of FPC to include forecasts of sustainability/risk, monitor composition much more closely, analyse PSED

Major changes in the way Investment Promotion Agencies and policies operate – more monitoring and analysis of FPC, information dissemination on high profit levels, nuanced promotion policies for new sources, sectors, monitor perceptions and behaviour regularly to design policy, have own performance assessed based on qualitative targets e.g. job creation, technology transfer

The international community could help in two ways: Building LIC capacity more extensively – analysis and policy –

including reviewing structures and policy focusses of Central Banks and IPAs

Reviewing policy interactions with LICs and own country analysis and forecasts, to ensure focus on all relevant factors for FPC promotion and stability (eg health rather than focussing on regulation and process), as well as FPC contribution to development

AT GLOBAL LEVEL

More detailed analysis of FPC to LICs and huge impact on LIC economies and prospects for reaching MDGs - need detailed analysis of composition, volatility, drivers (perceptions), development impact

More information exchange on global trends and drivers by BIS, IMF, WB so as to help with early warning of any potential problems for LICs

More dissemination of positive information on FPC (high profits, sector and source country diversification) and analysis of what these trends mean for how Development Finance Institutions (IFC, CDC etc) should change their strategies for mobilising FPC

Assess performance of DFIs based on “additionality” of funds mobilised and contribution to development, not just by amounts

Change policy recommendations and analysis even more to reflect what really matters for promoting FDI eg investment in infrastructure, health, education, not focussing on tax incentives (or makng more targeted), etc

G20 needs to do much more to ensure FPC contribution to development in LICs is maximised – should be key part of development discussions planned by Korea presidency in Seoul