FOREIGN CAPITAL INFLOWS, FINANCIAL DEVELOPMENT, AND ECONOMIC GROWTH IN SELECTED ECOWAS COUNTRIES

ABSTRACT

This research work investigated the empirical relationship and impact of foreign capital inflows,

financial development on economic growth in 14 ECOWAS countries (excluding Guinea). It tried to look at the impact of foreign capital inflows and financial development on economic growth. The study made use of quarterly data series from 2000 to 2017 for the variables. The work utilized  the panel  fixed-effect  regression  and  the panel  Vector  Auto  regression  model  in  a Generalized Method of Moments framework to test its objectives. The study discovered that Foreign Direct Investment (FDI), net domestic credit (CRE), Gross Capital Formation (GCF), and Foreign Aid (AID) have positive relationship with economic performance in ECOWAS region while labour force (LF) and Trade Openness (OPEN) exhibit negative relationship with economic performance. In addition, employing a pVAR, we discovered that FDI, CRE, and ECG all have significant relationships with each other, while GCF, LF, AID had significant relationships with FDI, CRE and ECG. FDI and CRE in the short-run had negative relationship with economic performance but had positive impulse response functions with economic performance in the long run. FDI and CRE exhibited positive relationship between themselves in the short  run  and  negative relationship  in  the  long  run.  Thus,  the  study  recommends  that concerned policy makers should pursue financial deepening and strengthening policies that will strengthen the financial system. In addition, a conducive socio-economic environment should be actively maintained so as to attract the required foreign capital inflows while controlling for trade openness. Finally, more efforts should be made towards the establishment of a single monetary union, as it will further strengthen the region and improve the trade among the member-countries. This can lead to further growth within the region.

CHAPTER ONE

INTRODUCTION

1.1 BACKGROUND TO THE STUDY

The Lagos treaty established the Economic Community of West African States (ECOWAS) on May 28, 1975 with the aim of promoting economic integration in all fields of activity of the member countries. It also had the aim to achieve “collective self-sufficiency” as a trading union through the creation of a single large trading bloc through the economic cooperation of member countries. Its member countries are Nigeria, Ghana, Cape Verde, Liberia, Benin, Guinea, Burkina Faso, Sierra Leone, Cote d‟Ivoire, Senegal, The Gambia, Niger, Guinea Bissau, Togo, and Mali. In recent times, in terms of economic performance and relative to other regions of the world, Africa have shown to be the weakest. For example, in 2010, while the lower-middle income group average was US$ 2530.50, Africa‟s per capita GDP averaged US$ 1669, which is far below the former. Furthermore, ECOWAS countries have also had some negative experiences even as the average GDP per capita of the region in 2010 was US$669.5 effectively placing the region in the low-income group (World Bank, 2013).

From the literature, capital accumulation has been argued to be a major contributor to growth and the ECOWAS countries need to increase their capital either domestically or through foreign capital in order to support their growth agenda. Given the ever-widening mismatch between their present stock of capital and their capital requirements as well as their meagre capital budget, the only way forward to supplement this shortfall was to attract foreign capital for domestic investment. Thus, leading to the wide acknowledgement or the relative advantage(s) of foreign capital inflow as a productivity-enhancing package. Given the need to fill their savings and foreign exchange gaps, developing economies such as ECOWAS countries need a substantial inflow of capital to enhance capital  accumulation  and  growth,  and  thus,  help  in  overcoming  widespread  poverty in  these countries (Orji, Uche, and Ilori, 2014). Increasingly, economic development literature shows that a well-designed  financial  system  provides  incentives  and  stimulates  investment  by  mobilizing savings and facilitating capital inflows and fosters trade and business linkages thereby facilitating technological diffusion and improved resource use.

In the light of the above, different national authorities have been making serious efforts to attract foreign capital to their various economies. Examples of these efforts include the successful integration of African countries in large regional blocs such as the Economic Community of West African States (ECOWAS), Southern African Development Community (SADC) among others. In addition,  measures  such  as  tax  holidays,  accelerated  depreciation  allowances,  signing  of investment and promotional activities among others were implemented in a bid to attract foreign capital. However, in spite of these efforts, the foreign capital flow into these economies have not been very encouraging (Ajide, Eregha 2014). Available statistics have shown that while the share of global FDI going to the developed countries maintains astoundingly high levels, the share of global FDI going to developing countries, more specifically, the sub-Saharan African (SSA) region has been meager and fluctuates consistently over time. The developed countries are the highest recipients of global foreign capital inflows in form of global FDI inflows, with almost three- quarters of total inflows going to them. They had a percentage share of 71.6% in 1970, which rose to 86.36% in 1980 and only declined to 83.05 in 1990 and has been declining steadily to reach a

54.62%. The developing countries‟  share excluding Africa, on the other hand, was 17.82% in

1970,  which  declined  to  12.64%  in  1980  but  rose  to  a  peak  of  41.67%  in  1982  and  with fluctuations in the flow, it was 40.33% in 2015. About the same period, the share of African countries in global FDI was drastically low in comparison to other regions of the world. The percentage share, which stood at 9.55% in 1970 and declined to 0.73% in 1980, rose to 1.39% in

1990 and declined to 0.71% in 2000. From 2001, it has maintained an average of 3.27% up to 2015 (IMF, International Financial Statistics (2017)).

Researchers argue that financial development can be a driving force in economic growth through increased access to the global economy. Following the McKinnon-Shaw (1973), which argued that financial  liberalization,  which  leads  to  financial  development  is  supposed  to  foster economic growth through increasing savings and encouraging investments especially in developing economies. This thesis gained a lot of attention following the directive of the Washington Consensus and the Bretton Woods Institutions that led to many developing economies liberalizing their financial sectors. In addition, the International Monetary Fund (IMF), and the World Bank included it in their economic policy prescription package by developing a  programme called “Structural Adjustment Programme” which was aimed at liberalizing distressed economies. Following this, most ECOWAS member countries liberalized their economies in the 1980s. The

financial liberalization of the ECOWAS member countries enabled them to be able to compete globally with others both as distinct economies and as a regional economic group. The various ECOWAS member countries adopted and implemented this package in varying approaches with respect to their initial conditions in both the financial sector and the real sector, speed of its sequencing, and their credit markets. For instance, the reform in Ghana involved establishment of agencies tasked with the replacement of nonperforming loans with central bank bonds in its banks. Nigeria‟s reform involved the establishment of deposit insurance schemes explicitly charged with the role of insuring deposits in case of a bank failure (Soyibo, Aryeetey, Inanga & Ajakaiye,

1996). However, there were points of convergence such as the objective of strengthening the existing supervisory and regulatory framework of the financial sector in each member country and even in sub-regions of ECOWAS, which led to the establishment of BCEAO (Banque Centrale des Etats de l‟Afrique de l‟Quest) and WAMZ (West African Monetary Zone).

ECOWAS francophone countries in a bid to consolidate its monetary policies and facilitate monetary integration established L‟Union Economique ET Monetaire Ouest Africaine (UEMOA) in 1994 with the creation of a regional central bank, BCEAO (Banque Centrale des Etats de l‟Afrique de  l‟Quest). The  second  monetary  zone  within  ECOWAS  was  the  West  African Monetary Zone (WAMZ) established in 2000 by The Gambia, Nigeria, Ghana, Sierra Leone, Guinea, and Liberia with the objectives of facilitating the monetary integration of the sub-region through sound management of the economies and the establishment of a single currency for these countries. With the introduction of WAMZ saw the dismantling of the capital inflows restrictions and controls within the sub-region all in a bid to attract foreign capital inflow. However, these efforts seem not to yield much result, as there has been an established pattern of inflows into the sub-Saharan African economies. The South African economy takes the bulk of the capital inflows with the rest of the economies sharing the rest of the capital inflows. Even so, the ECOWAS region receives just on the average 3.20% of the capital inflow with Nigeria taking the bulk of it.

It is discomforting that Africa has not attracted adequate amount of foreign capital that will boost her to the path of economic development despite the attendant benefits of the foreign capital that accrues to the host economy.

Foreign Direct Investment Inflow in %

100

80

60

40

20

0

970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

1

Developing economies(Africa) as a % of World                                     Developed economies as a % of World

Developing economies(ex. Africa) as a % of World

Fig. 1, Source: UNCTADSTAT (2017)

Fig 1 above shows the foreign direct investment inflows into various regions for various periods. It shows from the figure below that foreign direct investment flows majorly into the developed countries with 68.02% going to them. Developing countries share the rest of the inflows, however, Africa attracted merely 3.2% of the total capital inflow (about between 1970 and 2015 while the

rest 27.08% was directed to other developing countries.

1

0.9

0.8

0.7

0.6

0.5

0.4

0.3

0.2

0.1

0

-0.1

-0.2

Percentage of World FDI Inlows to ECOWAS countries

Benin

	Burkina Faso	Cabo Verde	Côte d’Ivoire
Gambia	Ghana	Guinea	Guinea-Bissau
Liberia	Mali	Niger	Nigeria

Fig. 2, Source: UNCTADSTAT (2017)

From the figure above, we can see that after the mid-1990, the percentage of the FDI inflows into

the ECOWAS region had been approximately on the decrease relative to the 1980‟s. From the

graph above, Nigeria is the biggest attractor of FDI in the ECOWAS followed by Liberia in the

1980‟s however, the second position shifted to Ghana in the late 2000‟s.

This decrease can be attributed to a number of factors, which include high cost of production due to poor infrastructure in the ECOWAS economies. Most ECOWAS countries face epileptic power supply leading to the usage of alternative power supply especially generators, poor road network among others. Nigeria, the largest economy in ECOWAS has the highest cost of production in the world, which has led to the relocation or outright closure of numerous multinationals out of the country (Musibau, Mahmood & Agboola, 2017). In fact, looking at the depressing state of the economies,  Musibau,  Mahmood  & Agboola (2017) suggested  that  the behavioural  pattern of residents in ECOWAS countries towards spending is still very strong and high, thus creating a major internal advantage for the continual attraction of FDI into the economies. Second, political instability has also negatively affected the inflow of FDI into some ECOWAS countries. For instance, Liberia was once the second biggest attractor of FDI into the region following Nigeria, but due to the prolonged civil war in the country, its FDI inflow has decreased greatly. She even experienced a negative FDI inflow in 1996. Nigeria, due to the socio-political crisis ranging from Boko-Haram in the Northern region to Militants in the Southern region which became more prominent from the late 2000‟s, the FDI inflow experienced a sharp drop, though not entirely attributed to the crisis, but some companies relocated from the country due to destruction and vandalization of their infrastructure. Third, most ECOWAS economies experience high level of corruption. According to CPI 2016, apart from Ghana, which is the least corrupt nation in ECOWAS followed by Mali and Togo, all the other ECOWAS countries are very corrupt. The high level of corruption in the institutions have discouraged the inflow of FDI into the ECOWAS economies. In addition to this, is investors‟ poor perception of ECOWAS and its member countries (Ceesay, 2011). The perception of the international community, and invariably, the foreign investors‟ perception on the economic and political environment is a major influence on whether they invest in the economies or not. Most ECOWAS countries have a history of discontinuing policies at the end of a political regime and the beginning of a new one, while some ECOWAS countries still struggle with political instability. This erodes investors‟ confidence and create doubt as to the consistency and dependability of formulated policies and the government‟s ability to deliver.

1.2 STATEMENT OF PROBLEM

Economic growth in the ECOWAS region has not be stable. As can be seen from fig. 3, many

ECOWAS        economies        have        experienced        fluctuations        in        their        output.

GDP GROWTH RATE (in %) for SELECTED ECOWAS COUNTRIES

33

28

BEN

23                                                                                                                                                                                                                                 BFA

18

13

8

3

-2

-7

-12

-17

-22

CIV CPV GHA GMB MLI NER NGR SEN SLE

TGO

Fig. 3, Source: World Bank Data, Author’s Compilation

In the developed countries, economic growth fluctuates around a positive mean, while from the above graph, economic growth in ECOWAS countries fluctuate around a zero (or even negative mean). This lends credence to the notion that ECOWAS economies do not have stabilized economies. For instance, Sierra Leone experienced recession (-20%) in 2015 while experiencing a growth rate of 6.28% in 2016. These wide fluctuations in economic growth is not helpful for pol In addition, most ECOWAS economies exhibit similar growth rates which can be due to the similarities  in  their  economies  with  regards  to  nature  of  exports  and  imports,  nature  of  the

domestic industrial sector among others.  This has prompted various ECOWAS economies to look for ways to improve the economy and minimize the impact of external shocks on the domestic economy.

One of such channels, according to theory, that will engender development in their economies is capital investment/infrastructural investment. However, following that capital does not flow into financially repressed economies, thus, it became imperative for the national authorities to attract foreign capital through the dismantling the international capital flows barriers. This is done in order to shorten the ever-widening gap between the current capital stock and the capital requirements caused by perpetual budget deficit and inadequate capital investment from the private domestic sector.  Following the directive of the Bretton Woods institutions (World Bank and International Monetary Fund); all ECOWAS member-countries liberalized their respective economies in the 1980s and early 1990s. Though one might argue that, though the ECOWAS member-countries liberalized their economies, what is the strength of this liberalized financial sector? As the effect of the liberalized financial sector is yet to be felt optimally. Moreover, has it actually lead to financial development in their respective financial sectors?

Although ECOWAS member-countries in a bid to integrate its monetary policies established two monetary zones – L‟Union Economique et Monetaire Ouest Africaine (UEMOA) and the West African Monetary Zone (WAMZ) in the 1990s and 2000, these systems are still fragile. In the WAEMU, the interbank market is not yet developed and the regional Central bank and some national banks are still fragile. Despite the establishment of a single banking commission to reinforce and  consolidate the regional  banking  supervision,  there  are still  wide disparities  in banking sector regulations among the member nations  (Wakeman-Linn  & Wagh,  2008). The WEAMU still simultaneously experience surplus liquidity in some member countries and liquidity shortage in the other countries, indicating inadequate financial integration and deepening in the region. However, since 2000, the market for treasury bills and government bonds have been on the increase following the cessation of the governments funding its fiscal deficits from the central bank.

Though the ECOWAS region has tried to undergo financial integration through the establishment of the Monetary Unions (UEMOA and WAMZ), the foreign capital flow into the region is still below par. Evidence from the UNCTADSTAT in fig. 1 shows that Africa could attract only 3.2%

of the average of the total capital inflow between 1970 and 1990, while 27.08% flowed to other

developing countries, and the bulk percentage of 68.02% flowed to the developed world.

70.00

60.00

50.00

40.00

30.00

20.00

10.00

–

Domestic Credit to Private Sector (% of GDP) for Selected

ECOWAS countries

BEN BFA CIV CPV GHA GNB NGR

SEN

Fig. 4, Source: WORLD BANK DATA

From the above figure, we can see the financial deepening indicator (Credit to Private Sector as a ratio of GDP) declined from 1944 – 2007 on the average for ECOWAS economies excluding Cape Verde, then fluctuates around an increasing trend from 2010 for the ECOWAS countries. It is seen that though, ECOWAS communities liberalized their economies; the liberalization did not achieve the expected results, as the financial sectors are still not optimum. From fig. 4 above, the financial sector-deepening indicator is on a slow but increasing trend, but the economic growth as seen in fig. 3 is yet to tow that pattern as it still heavily fluctuates in recent years.

From financial development theory, it has shown that there is a positive nexus between financial development, foreign capital flows, and economic growth. However, empirically, the relationship between financial development and growth has not still reached a consensus. For instance, Cho and Khatkhate (1989) while studying the financial liberalization experience of five Asian countries Sri  Lanka,  Indonesia,  Republic  of  Korea,  Malaysia,  and  Philippines  suggested  that  financial

reforms from evidence did not make any significant impact to the saving and investment activities in the liberalized economies. In another study by Sinha and Macri (2001) which studied financial development and economic growth in eight Asian countries and found the results to be inconsistent hence leading to the conclusion that there is no clear and positive impact of financial development and economic growth, thus, supporting Cho and Khatkhate (1989). However, Odhimabo (2011), while studying the relationship between financial deepening, capital flows and economic growth in Tanzania using a trivariate model, reached a conclusion that financial development in Tanzania follows growth. This was supported by Orji, Uche, and  Ilori (2014),  which when discussing foreign capital inflows and economic growth in the WAMZ region, found out that foreign inflows had positive impact on most of the WAMZ member- countries excluding Guinea. Furthermore, Agbélénko and Kibet (2015), also found supporting evidence for financial development positive contribution to economic growth in ECOWAS region. Given the above, studies on ECOWAS countries reveal that financial development leads to economic growth but there are not enough literature on foreign capital inflows, financial development, and economic growth nexus in the ECOWAS region.

Hence, this research study will focus on finding the relationship and impact of foreign capital inflows and financial development on economic growth in ECOWAS countries.

1.3 RESEARCH QUESTIONS

The study seeks to answer the following questions:

1.   What is the impact of Foreign Capital Inflows on Economic Growth in the ECOWAS

region?

2.   What is the Impact of Financial Development on Economic Growth in ECOWAS region?

3.   What are the channels through which shocks from Foreign Capital Inflows and Financial

Development are transmitted to Economic Growth in the ECOWAS region?

1.4 OBJECTIVES OF THE STUDY

The broad objective is to investigate the impact of foreign capital inflows and financial development on economic growth in ECOWAS region.

The specific objectives include:

1.   To estimate the impact of Foreign Capital Inflows on Economic Growth in the ECOWAS

region

2.   To estimate the Impact of Financial Development on Economic Growth in ECOWAS

region

3.   To  determine  the  channels  through  which  shocks  from  Foreign  Capital  Inflows  and

Financial Development are transmitted to Economic Growth in the ECOWAS region

1.5 STATEMENT OF HYPOTHESIS

Based on the above research objectives, we have the following hypotheses:

H01: Foreign Capital Inflows have no significant impact on economic growth in the ECOWAS

region

H01: Financial Development has no significant impact on economic growth in the ECOWAS

region

H01: There are no significant channels through which shocks from Foreign Capital Inflows and

Financial Development are transmitted to Economic Growth in the ECOWAS region

1.6 THE SCOPE OF THE STUDY

This paper will center on all ECOWAS member countries with the exception of Guinea (due to unavailability of data for selected indicators) with emphasis on their financial sector and capital inflows including variables such as foreign capital inflow, domestic credit, and foreign aid, a measure for economic growth (GDP per capita), and trade openness. It will empirically study the effect of financial development, and foreign capital inflows on the economic growth of the ECOWAS member countries while employing the dynamic Panel model from the period 2000q1 to 2017q4.

1.7 THE SIGNIFICANCE OF THE STUDY

There have been arguments and counter arguments among academics and economists on the relevance of financial development on growth. While foreign capital flows and financial development contributes to economic growth, evidence from the literature shows the latter has a weaker consensus than the former. However, the level of impact and  significance of these

variables in many Sub-Saharan African economies and in ECOWAS as a region is yet to be explored fully.

Based on the above, this research paper would be of benefit to policy makers that operate within the jurisdiction and geographical area of ECOWAS, as it would inform them and provide support for their choice of policies. The study will also be useful to the monetary authorities because it will aid their decision in adopting the right policies, which can lead to increased economic growth through the attraction of foreign capital inflows and further development of the financial sector simultaneously. To the federal governments of the ECOWAS countries and the governing body of ECOWAS as an economic group, this study will inform them on the areas of weakness. It will also inform them on how to attract foreign capital inflows that will lead to a substantive positive impact in the domestic capital accumulation, which will lead to the development of key sectors that are the drivers of growth in the economies. This will in turn lead to the development of the group as a whole. This is because, when all individual countries are experiencing economic growth, inadvertently, it will lead to the growth of the region, which will bring about many positive changes and attract key players to the region. To the academia, this research will add to the existing body of literature, and serve as a reference for future research studies into

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