14.0 Introduction
Recent changes in technology, along with the opening up of many regions previously closed to investment, have led to explosive growth in the international movement of capital. Flows from foreign direct investment and debt and equity financing can bring countries substantial gains by augmenting local savings and by improving technology and incentives. But, as was underscored recently by the economic and financial crises in several Asian countries, capital flows can also bring risks. Hence the need to evolve appropriate policies that will enable the monetary authorities to determine the optimal level of the capital flow that will support any economic agenda being pursued at a point in time.
In Nigeria today, there is no doubt that the economy requires an optimal amount of capital flow (net) in or to bridge the gap between the desired level of investment and domestic savings in to accelerate the pace of economic growth and development on a sustainable basis under the ongoing macro-economic reform programme — National Economic Empowerment and Development Strategy (NEEDS). However, because of the inherent risks involved in such flows, there is therefore the need for the relevant regulatory institutions to devise means and ways of managing such flows o as to minimize such risks bearing in mind the overall objective of seeking o promote rapid economic growth and development.
Apart from this introduction, this chapter is divided into four other sections. In Section 2, we examine some conceptual issues and experiences of other countries. In Section 3, we review the legal framework in Nigeria while Section 4 highlights development with respect to capital flows in Nigeria. In Section 5, the regulatory institutions and capital flows in Nigeria were discussed. Section 6 summarizes and concludes the chapter
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14.1 Conceptual Issues and Experience of Other Countries
14.1.1 Composition of Capital Flows
Capital flows basically consist of foreign direct investment (FDI), portfolio equity and debt flows, commercial lending and official flows. Available data from the World Bank shows that whilst medium income countries experienced more portfolio equity inflows as a percentage of total capital inflows in recent years, low income countries like Nigeria and other countries in Sub-Saharan Africa relied heavily on official debt flows.
There is no clear consensus on reasons for the existence of different forms of capital flows or why some form are dominant in one region or the other. Most empirical studies available tend to examine the composition of flow from the position of desirability. Pontes (1999) argue that FDI is a desirable form of capital flow to the host country as it may bring position externalities such as technology and management expertise. Griffith-Jones (2003) concurs with those reasons and adds that FDI tends to be more long-term and less easily reversible. On the other hand, a foreign investor may be motivated to invest in another country other than his own by other non-financial strategic reason such as market share.
Portfolio equity flows to countries with well-developed macroeconomic policy instruments and strong banking institution though they can be less stable than FDI. Short-term bank lending are often ranked the most volatile whist long-term bank flows are considered least volatile though there has not been any statistical support for such ranking.
14.1.2 Causes of Capital Flows
Beyond the primary motives of higher returns and risk diversification, several potent factors have motivated the rapid growth of capital flows among nations. Chief amongst these reasons are the removal of statutory restrictions on capital account transactions, macroeconomic stabilization and policy reforms in the developing nations, the multi-lateralization of trade and the revolutionary changes in information and communication technologies. These factors and many more are discussed below under broad categories of internal and external factors.
a. Internal Factors
One of the key internal factors driving capital flows especially to recipient emerging economies is the improved private risk-return characteristics in these countries Pontes (1999) identifies two of such characteristics to include the improved credit worthiness in most recipient countries as a result of debt restructuring and productivity gains occasioned by structural reforms in these countries. The latter led to reduction in large deficits, depreciation in the local currency and overall decrease in the rate of credit expansion in these economies. In some of the countries which enjoyed rapid capital flows, adjustment policies were followed by measures that opened the economy foreign trade and also reformed financial system. Generally and as also evidenced by the World Bank (1997),view this development as being due to structural factors because in spite of the failure experienced in some emerging economics like Mexico, capital flow from developed economices to LDCs have been on the increase. Pontes (1999)and Lopez Mejia (1999) identify some of the structural developments that drove capital flows to include falling communication costs, strong competition, technology and the growth of derivative markets amongst others. Particularly, revolutionary changes in information and communication technologies have played a tremendous role. Computer links enable investors to follow developments affecting different countries and companies much more efficiently. The advent of new technologies also makes it increasingly difficult for governments to control either inward or outward capital flow.
Another development identified was the growing importance of institution investors in the industrial nations. These investors were more willing and able to invest abroad because of higher long-term expected rates of return in developing countries and to wider opportunities of risk diversification.
14.1.3 Benefits of Capital Flows
Economists tend to favour the free flow of capital across national borders because it allows capital to seek out highest rate of return. Beyond that unrestricted capital flows may also offer several other advantages. First, international flows of capital reduce the risk faced by owners of capital by allowing them to diversify their lending and investment. Second, the global integration of capital markets can contribute to the spread of best practices in corporate governance, accounting rules, and legal traditions. Third, the global mobility of capital limits the ability of governments to pursue bad Policies.
In addition to these advantages, which in principle apply to all kinds of
Private capital inflows, Feldstein (2000) and Razin and Sadka (forthcoming)
Rote that the gains to host countries from FDI can take several other forms:
· FDI allows the transfer of technology particularly in the form of new varieties of capital inputs — that cannot be achieved through financial investments or trade in goods and services. FDI can also promote competition in the domestic input market.
· Recipients of FDI often gain employee training in the course of Operating the new businesses, which contributes to human capital development in the host country.
· Capital mobility creates valuable opportunities for portfolio diversification, risk sharing and inter-temporal trade.
By lending to foreign countries, households and firms can protect themselves against the effects of disturbances that impinge on the home country alone. Companies can protect themselves against cost and productivity shocks in their home countries by investing in branch plants in several countries Capital mobility can thereby enable investors to achieve higher risk-adjusted rates of return. In turn, higher rates of return can encourage increases in saving and investment that deliver faster rates of growth.
14.1.4 Risk of Capital Flows
Despite the strong theoretical case for the adv of free capital flows, the conventional wisdom now seems to be that many private capital flows pose countervailing risks. Hausman and Fernande (2000) suggest why many host countries, even when they are in favour of capital inflows, view international debt flows, especially of the short-term variety, as “bad cholesterol”. Most recent empirical works including Grabel (1995), and Clerke (1996), Corrigam (1989), argued that the processes of deregulation globalization, and innovation have increased both the efficiency of, and volatility in, the financial markets. Volatility adds another source of risk’ not only making the pricing of financial assets more difficult but also generating portfolio flows that are potentially more unstable.
Tesar and Werner (1995) have also argued that some components of capita flows such as short-term lending is driven by speculative consideration based on interest rate differentials and exchange rate expectations, not on long-term considerations. According to them, “its movements are often the result of moral hazard distortions such as implicit exchange rate guarantees or the willingness of governments to bailout the banking system. It is the first to run for the exits in times of trouble and is responsible for the boom-bust cycles of the 1990s”.
Capital flow in form of FDI is not only a transfer of ownership from domestic to foreign residents but also a mechanism that makes it possible for foreign investors to exercise management and control over host country firms that is ,it is a corporate governance mechanism. The transfer of control may not always benefit the host country because of the circumstances under which it occurs, problems of adverse selection, or excessive leverage. Krugman (1998) notes that sometimes the transfer of control occurs in the midst of a crisis and asks: Is the transfer of control that is associated with foreign ownership appropriate under these circumstances? That is, loosely speaking, are foreign corporations taking over control of domestic enterprises because they have cash and the locals do not? Does the fire sale of domestic firms and their assets represent a burden to the afflicted countries, over and above the cost of the crisis itself?
Even outside of such fire-sale situations, FDI may not necessarily benefit the host country as demonstrated by Razin, Sadka, and Yuen (1999) and Razin and Sadka (forthcoming). Through the FDI, foreign investors gain crucial inside information about the productivity of the firms under theft control. This gives them an informational advantage over “uniformed” domestic savers, whose buying of shares in domestic firms does not entail control. Taking advantage of this superior information, foreign direct investor will tend to retain high-productivity firms under their ownership and control and sell low-productivity firms to the uninformed savers. As with other adverse-selection problems of this kind, this process may lead to overinvestment by foreign direct investors.
Excessive leverage can also limit the benefits of FDI. Typically, the domestic investment undertaken by FDI establishments is heavily leveraged owing to borrowing in the domestic credit market. As a result, the fraction of domestic investment actually financed by foreign savings through the FDI flows may not be as large as it seems (because foreign investors can repatriate funds borrowed in the domestic market), and the size of the gains from FDI may be reduced by the domestic borrowing done by foreign- owned firms.
Beyond the points explained above, there are some other cases in which FDI might not be beneficial to the recipient country for instance, when such investment is geared towards serving domestic markets protected by high tariff or non-tariff barriers. Under these circumstances, FDI may strengthen lobbying efforts to perpetuate the existing misallocation of resources. There could also be a loss of domestic competition arising from foreign acquisitions leading to a consolidation of domestic producers, through either takeover or corporate failures.
14.1.5 Experiences of Selected Countries in Capital Flows
After the oil shock of 1973, Brazil’s reliance on commercial loans to finance both public investment and the more expensive oil led the country to the debt crisis of the early 1 980s. Following a trend common to other emerging markets, private capital inflows to Brazil disappeared in the 1980s and increased dramatically after 1991. By 1993, the fall of international interest rates had eased the external debt burden and led to an agreement with creditor banks that were concluded in April 1994 with the exchange of instruments that covered over $50 billion in debt stocks and arrears.
Since 1992, net foreign capital flows to Brazil have been sufficient to finance small current account deficits while contributing to an increase in foreign reserves (Cardoso, 1997). During this period the capital consisted primarily of short-term resources tied to portfolio investments and other short-term investments. In 1995, for instance, net capital flows amounted to more than US $40.2 billion, of which US $20 billion was short-run capital: US $2.3 billion was equity and special investment funds, and approximately $18 billion consisted of short-run capital not classified under a specific category.
In Chile, strong and well designed prudential regulations complement capital account restrictions in protecting the financial system from capital flow swings. Banks cannot lend domestically in foreign exchange, with the exception of the foreign trade-related credits. Moreover, there is a limit on the open foreign exchange position set at 20 per cent of banks’ capital and reserves, and there are other limitations on maturity mismatches (Eyzaguire and Lefort, 1998). Some observers have argued that the combination of these prudential measures and capital account restrictions has accomplished two objectives. First, it has limited the foreign exchange exposure of both bank and non-bank entities. Second, in the event of sudden capital outflow the limitation on maturity mismatches would allow the central bank to defend the exchange rate parity by raising the interest rate, without damaging banks’ Profitability.
Financial liberalization in Kenya is a recent development and international financial liberalization is even more recent. Offshore borrowing by domestic residents has been permitted only since early 1994, and portfolio capital inflows from abroad were restricted until January 1995 while supporting structural and institutional reforms have yet to be fully implemented. Many banks remain publicly owned and competition among them is limited. Although it is too early to evaluate the success of liberalization of capital account in Kenya, the lack of accompanying institutional and structural reforms suggest that financial sector reforms will provide only modest benefits to the overall Kenyan development strategy.
Finally, almost all the countries that suffered financial turmoil in recent years had one thing in common: large ratios of short-term foreign debt to international reserves. In Mexico, in 1995, Russia in 1998, and Brazil in 1999, government owed the bulk of the debts. In Indonesia, the Republic of Korea, and Thailand in 1997 private banks and firms owed most of the debt. But in all cases the combination of large short-term liabilities and scarce internationally liquid assets made these countries extremely vulnerable to crises of confidence and reversals of capital flows. For instance, the capital account reversal in East Asia caused a collapse in asset prices and exchange rates in that region.
14.2 Legal Framework for Capital Flows in Nigeria
Nigeria operated an exchange control regime, which gave way to deregulation of the foreign exchange market in the wake of the Structural Adjustment programme adopted in 1986. Since then, other legislation such as Foreign Currency (Domiciliary Account) Act, the Second Foreign Exchange Market Act governed capital flows management. However, with the enactment of the Foreign Exchange (monitoring an Miscellaneous Provision) Act 1995 all previous legislations were repeal The FEM Act sought to make Nigeria attractive for inflow of foreign investment. It established and Autonomous Foreign Exchange Market (AFEM). Some of its salient provisions include:
1. Non –disclosure of sources of imported foreign currency except as may or be required under any enactment or law (e.g. Money Laundering Act).
ii. Transaction at mutually agreed rates between the parties involved.
iii. Eligible transactions should be Supported by appropriate documentation
iv. Investment in any enterprise or security in foreign currency permissible
v. Authorized dealers must issue certificate of capital importation within 24 hours and advise the CBN within 48 hours thereafter.
vi. Guaranteed unconditional transferability of foreign currency invested in freely convertible currency in the form of:
a) Dividends or profits (net of taxes) attributable to the investment;
b) Payment in respect of loan servicing where foreign loan had been obtained and
c) Remittance of proceeds (net of all taxes) and other obligations in the event of sale or liquidation of the enterprise or any interest attributable to the investment
The FEM Act is largely foreign investor friendly It is further complemented by the Nigeria Investment Promotion Commission (NJPC) Act, 1995, whose primary mandate was to encourage, promote and coordinate investment in the Nigerian economy. In particular, NIPC was expected to initiate and support measures which shall enhance the investment climate ‘a Nigerian for both Nigeria and non-Nigerian investors.
An objective appraisal will suggest that the legal provisions are largely adequate if faithfully implemented by all stakeholders However, concerns have been expressed with regard to inadequate infrastructural facilities such as power, water supply, motorable roads as well as insecurity of life and property as inhibiting factors in attracting capital flows.
14.3 Developments in Respect of Capital Flows in Nigeria
Like in other LDC’s the desire to accelerate the pace of economic growth and development in Nigeria necessitated the quest for external capital flow to complement the variable domestic capital. By 1950s, industrial nations and multilateral agencies also started extending official assistance to Nigeria.
In recognition of its importance and role in the nation’s economic growth process, the government has over the years put in place series of policies and incentives to attract external capital into the country For instance, the government expressed its readiness in the 1997 budget, to enter into investment protection agreements with foreign governments or private organizations wishing to invest in Nigeria, as well as discuss additional incentives with prospective investors. In that regard, the government established the Nigerian Investment Promotion Commission, as a one-stop agency that would facilitate the inflow of FDI into the country. The industrial Development Coordination Committed ( IDCC) was established in 1998 for the purpose of fostering a conducive regulatory environment and serve as the first port of call to potential investor. The Nigeria Investment Promotion Act No. 16 of 1995 reflected the new enhanced liberal foreign investment policy of government. There were also tax related incentive measures such as: pioneer status; tax relief for research and development, which provides for a graduated amount of tax-allowances to be deducted from profit; company income tax, which has been amended to encourage potential and existing investors; tax-free dividends as well as tax relief for investments in economically disadvantage local government areas (Salako & Adebusuyi, 2001).
The Debt Conversion Programme (DCP) was also introduced as vehicle for the inflow of foreign investment. The Privatization and Commercial in Programme through which government disengaged activities that could be effectively undertaken by private sector was others meant to encourage the inflow of foreign investment. Similarly, the establishment of export Processing zones was aimed at attracting foreign investments through provision of infrastructural facility elimination of bureaucratic bottlenecks. The repeal of the Nigeria Enterprises Promotion Decree (NEPD) of 1972 and the Exchange Control. Act of 1962 were aimed at making the investment climate more cot for foreign investors.
The recent debt relief by the Paris Club was a major development management of the country’s capital flows. With that development country should be able to free itself from the huge debt burden the hitherto impacted negatively on the country’s credit rating, slowed the rate of growth and development as a result of huge resources devote debt servicing among others.
However these measures are observed not to have yielded the desired results in terms of attracting FDI inflow, in particular. For instance, aggregate FDI inflow into Nigeria through existing foreign/jointly c companies during the l970’ averaged US$562.3 million yearly in normal terms (Salako & Adebusuyj, 2000). As a proportion of the Gross Domestic
Product (GDP), it accounted for 3.6% during the period. Before the production of the Structural Adjustment Programme (SAP) in 1986, total foreign investment inflow for 1980s averaged US$178.2 million annually j represented 4.3% of GDP. During the period 1987-1990 average annual reign investment inflow rose to US$183.6 million, representing 3.0% GDP, while the average inflow was US$15,402.5 million or 1.4% of GDP during 1991 – 1998 (Salako & Adebusuyi, 2001). Specifically, Nigeria has not benefited significantly from this vital resource during the last two cades in spite of its high potential for the attraction of foreign vestments because some aspects of its investment policies have not been generally investor-friendly.
14.4 Regulatory Institution and Capital Flow Management
In order to appreciate the role of the regulatory institutions in the management of capital flows in Nigeria, it is pertinent to identify the relevant regulatory institutions involved in the issues of capital flows, their broad objectives in relation to capital flows, the associated risks posed by capital flows and the role of the institutions in managing such risks. In view of the et that capital flows involve cross — border transactions and are carried it mainly through the financial system, particularly, the banking system, the main regulatory institutions in the case of Nigeria will include the Federal ministry of Finance, the National Planning Commission, the Nigeria customs Service, the CBN, SEC, FIRS and the Debt Management Office well as the law enforcement agents such as the Nigeria Police and the economic and Financial Crimes Commission (EFCC) among others. These regulatory institutions would aim at achieving the following objectives in relation to capital flows:
a. Attain optimal level of capital flow that will ensure the achievement of the desired investment level with a view to accelerating the pace of economic growth and development;
b. Ensure the safety soundness and stability of the nation’s financial system;
c. Ensure price stability that is, ensure the stability of general prices of goods and services, exchange as well as interest rates in the domestic economy;
d. Ensure the protection of investors; and
e. Minimize the incidence of financial crimes associated with capital flows.
Having identified the regulatory institution and their broad objectives in relation to capital flow, the next logical step is to highlight inhibiting factors (both direct and indirect) against capital flows and which could threaten the achievement of the regulatory objectives. Some of these factors include:
i. Money Laundering;
i Weak corporate governance in banks;
iii. Malpractices in Foreign Exchange operations;
iv. Over-invoicing or under-invoicing of imports;
v. Overheating of the economy; and
vi. Financial system instability
In order to promote capital flows, the regulatory institutions should evolve appropriate means of monitoring and verifying the genuineness of capital flows. The role of the institutions in that regard will involve the adoption of the following tools:
14.4.1 Adoption of Sound Monetary Policy
Where the net capital inflow into a country exceeds the absorptive capacity of the economy, the monetary authorities should adopt appropriate monetary policies to sterilize the excess funds in order to forestall overheating of the economy, which directly threatens the attainment of price stability. The use of open market operation, and reserve requirement become instruments of monetary policy to manage such excessive net inflow.
14.4.2 Effective Supervision
All the relevant regulatory institutions, particularly the CBN and the NDIC should strengthen their supervisory capability by ensuring strict compliance with the applicable regulations on capital flows. In particular, restrictions could be placed on the quantum of short-term capital as this is highly volatile and could threaten stability of the banking system. A good number of large banks in the East Asian countries were driven to the brink of insolvency in the 90s as a result of large volume of inflow of short-term capital, which turned out to be highly volatile. Besides, where banks engage in cross border transactions, the regulatory institutions should ensure that the capital base of such institutions is adequate to support the additional risks being carried by such financial institutions. In other words, the regulatory institutions should enforce sound capital requirements. This is in addition to the fact that banks should be compelled to put in place appropriate risk management systems in order to align their regulatory capital more closely to their economic need for capital. The ongoing strengthening of risk management capability of banks through the issuance of guidelines by the CBN for the development of risk management frameworks in banks is a step in the right direction.
Given the critical role of banks in the management of capital flows certain measures were adopted since the late 1990s to promote optimal capital I in the financial system. Such measures included:
· establishment of open foreign exchange positions for each bank
· mandatory issuance of certificate of capital importation within 24 hours;
· Approval of money transfer products such as Western Union, Money Gram, et cetera.
· uninhibited remittance of dividends;
· access to foreign currency loans from multilateral institutions like IF C, ADB, Afrexim Bank, US Exim Bank for on — lending;
· Utilization of unconfirmed letters of credits for industrial raw materials.
In spite of the afore-mentioned measures, foreign exchange leakages thro’ the parallel foreign exchange market constitute a major challenge to effective management of capital flows. Combating the unwholesome pare market foreign exchange activities requires close collaboration between the bank regulators and the law-enforcement agencies.
14.4.3 Strengthening of the Financial Superstructure
A healthy domestic banking system is a pre-requisite for ensuring an optic capital flow in any economy as it improves a country’s attractiveness foreign investors. The Nigerian economy, like many other developing countries, prior to the on—going banking reform programme, had many weak banks and a relatively underdeveloped financial system. The banks F small capital base. The banking system was also prone to carrying excess credit risks by having large proportions of non-performing loans a advances. As a consequence it would not take more than a marginal shift of funds in the massive and fluid international markets to overwhelm the absorption capacity of these banks. In fact, a handful of individual private institutions can also recall the Asian crisis when as the funds flowed in the prospect of healthy expansion soon became a bubble. Something triggered an outflow, lenders ran to the door, and a financial crisis resulted.
The on-going banking sector reform programme which aims at strengthening Nigerian banks to more meaningful protect depositors, play developmental roles in the nation’s economy, and become a competent and active player in the Africa regional and global financial system will enhance the capacity of banks to absorb shocks that cross-border transactions could cause. The banking sector reforms have occasioned the increase in the required capital base of banks to N 25 billion through consolidation. The reform will among other things, promote soundness, stability, and enhance the efficiency of the institutions. A stable, sound and efficient banking system will, overtime, guarantee higher returns to shareholders or portfolio investors.
14.4.4 Strengthening Corporate Governance Practices
Responsive corporate governance remains a critical success factor for the viability and survival of banking institutions. Many banks in the country are yet to imbibe the cannons of good corporate governance. The apparent lack of transparency and accountability on the part of some operators may make tracking of capital flow a lot difficult therebymaking its management a herculean task.
