Finance and Trade in Africa

Notwithstanding the recent optimism about African economies, the performance of these economies since the time of political ‘independence’ can only be described as dismal. There has been a secular deterioration in their terms of trade (particularly from the mid-1970s); the level of external debt has grown enormously, leading to near insolvency; dependency on foreign aid has grown at an alarming rate (and this has been exacerbated by stagnation in exports); and, finally, levels of investment have been extremely low. Partly as a result of the latter, physical and social infrastructures have deteriorated rapidly. Political instability, frequent wars, and natural disasters have further aggravated this situation. The major question to be asked then is ‘why?’

In Chapter 1, the external finance problems of Africa were discussed. This chapter will focus on providing a theoretical perspective to this analysis. More specifically, the chapter will attempt to identify key analytical elements, which may be used to explain Africa’s external finance problems. With this objective in mind, the theoretical determinants of capital flows to Africa, and the ‘South’, in general, will be identified. The major systemic explanations found to be relevant in explaining Africa’s external finance problems will form the basis of attempts to develop a formal model. The development of such a model will be set out in subsequent chapters. The general approach chosen will be to examine the issue of Africa’s external finance problems across different financial instruments, each of which is assumed to have its own specific features. With these broad objectives in mind, the remainder of this chapter is organized as follows. In section 2.2, international finance theories, which may have relevance for the modelling of Africa, within a North-South framework will be discussed. Section 2.2.1 will examine the determinants of foreign direct investment (FDI) with a view to arriving at an explanation for such flows, which might have relevance for Africa. Section 2.2.2 focuses on theories of bank lending and their relevance for Africa.

This chapter will examine some of the main features which might usefully be included in a macro model for Africa. It is hoped that this discussion will help in formulating an actual prototype African macro model, which might form a working component of the North-South model developed in Chapter 6. Although the relevant African macroeconomic framework for this should broadly be similar to that outlined in Trap (1993), there are, nevertheless, a number of other specific features not properly dealt with in Trap (1993), which an African macroeconomic framework might usefully include. The first such feature is an ‘import compression argument’, as discussed in Ndulu (1986, 1991) and Rattsø (1992b). Two other features, which I will argue should also be incorporated into macro models of Africa, are the ‘fiscal response to external finance’ and ‘Dutch disease’ phenomena. Hence, an attempt will be made to integrate these features into the prototype African macro component of the North-South model developed in Chapter 6.

In previous chapters we examined the trade and external finance problems of Africa from a historical and theoretical perspective. In this, and the subsequent chapter, I will attempt to investigate this issue empirically. The econometric results obtained in these two chapters will then be used in the construction of a North-South model, which will be detailed in Chapter 6. The empirical analysis which follows will be split between two chapters. In this chapter, some determinants of foreign exchange supply to African economies will be examined. In Chapter 5, a number of macroeconomic impacts of such flows will be noted.

In the previous chapter, some determinants of the supply of external finance were discussed. Such flows have a number of macroeconomic implications that require careful management. Specifically, three such implications may be outlined. The first of these relates to the recipients’ fiscal response in the face of such flows. Section 5.2 will discuss this issue in the context of the wider literature on recipients’ fiscal response. The second and related impact of such flows relates to the upward pressure, which they place on the level of domestic prices, and the resulting appreciation of the real exchange rate. As discussed in Chapter 2, this falls within the ‘Dutch disease’ literature. Section 5.3 will examine this issue in relation to Africa. In section 5.4 the positive impacts of external finance will be examined. In most African economies this relates to the possibility that external finance offers to finance imports. The latter, in turn, will have a positive effect on investment and growth, by relieving the import compression situation discussed in Chapter 3. An econometric analysis focusing on this issue is given in section 5.4. Finally, section 5.5 brings the chapter to a close by highlighting a number of conclusions, arising out of the preceding discussion.

In the preceding chapters, the trade and finance problems of Africa were examined from both theoretical and empirical angles. In this chapter, I will attempt to locate these problems within a global economy context. This is important for two main reasons. Firstly, it helps one to identify the position of Africa within the world economy. Secondly, it allows one to assess the extent to which Africa’s entry into the world economy represents an obstacle to development efforts being undertaken in that continent. This exercise will be formally undertaken using the increasingly popular methodology of modelling North-South economic interaction. Notwithstanding the proliferation of such models, the modelling of the South remains, at best, rudimentary. Indeed, almost no examples of North-South models focusing specifically on Africa have been developed to date.¹

In this chapter, an attempt will be made to assess the impact of a range of global shocks on African economies, using the model specified in Chapter 6. The chapter does not exhaust the full potential of AFRIMOD for the analysis of external shocks and economic policies. Rather, the model will be used to examine a number of crucial external shocks and policy simulations. The chapter is organized as follows. Section 7.2 describes the accounting framework used in the model. This framework serves both as a consistent database of the world and as a base run value in the calibration of the model. Section 7.3 briefly discusses the model solution algorithm employed, the stability conditions of the model and calibration procedure followed. In section 7.4 the results of selected external shocks and policy simulations are discussed. Finally, section 7.5 brings the chapter to a close by highlighting a number of conclusions arising out of the preceding discussion.

This study has attempted to model the macroeconomic interaction between Africa and the North. There are two main reasons why such an exercise might be considered important. Firstly, building a macroeconomic model of Africa which is based on stylized facts and econometric estimation within a world economy framework is an exercise that has value in itself. This claim may be justified since no such models of Africa may currently be found within the literature. Indeed, a number of policy questions and external shocks, not discussed in this book, may be analysed using the model developed here. Nonetheless, models are usually built with specific objectives in mind. In this respect, the model developed in this book is no exception. Hence, the second main justification for the present study, which is to examine the questions outlined in Chapter 1, using the simulation exercise set out in Chapter 7. Chapter 7 also outlined various policy implications of the model, as well as how such a model might be used to analyse external shocks and policy questions by locating these within a North-South macroeconomic framework. The main points arising out of this exercise are summarized below.