VOL. XLV

No 38

23-September-2002

 

CAPITAL MARKETS

 

Report Puts Arab External Investments At $212-318Bn, Evaluates Conditions For Repatriation

 

A report entitled Arab External Investments: Relation to National Wealth, Estimation and Consequences, and Possibilities of Their Return Home by 'Ali Sadik and 'Ali Bolbol of the Arab Monetary Fund estimates the total capital outflows from the Arab world between 1975 and 2000 at $212-318bn and argues that to encourage the repatriation of flight capital Arab countries must raise their risk-adjusted marginal productivity of capital (MPK). The authors argue that capital flight has been the result of low capital productivity in the Arab world combined with unsustainable macroeconomic policies, has led to slower growth and a smaller tax base and has encouraged an increased role for government in Arab economies. In order to promote the repatriation of capital (and to attract foreign direct investment [FDI] to the Arab world), the paper advocates policies to diversify economic structure, develop financial services, encourage a leading role for the private sector and liberalize the political environment – a similar prescription to that in the Arab World Competitiveness Report (MEES, 16 September) and the recent United Nations Development Program report (MEES, 15 July).

 

Previous estimates for Arab investments abroad between 1975 and 2000 have varied wildly and ranged from $400bn to $2,400bn. The authors of this report propose a new, indirect method of calculation, since many Arab countries do not publish data for capital outflows. The method calculates capital outflows by adding the change in net foreign assets of the non-banking sector to the change in foreign assets less reserves in the banking system, and then adding an errors and omissions item. This produces the lower-bound estimate of capital outflows $212.5bn. The second method used is the residual method, which calculates capital outflows by adding the change in net debt, FDI, the current account, the change in reserves and an adjustment for errors and omissions. This method produces the upper-bound estimate for capital outflows of $318.3bn. The authors conclude that the indirect method is better suited to the Gulf countries, while the residual method is more appropriate for the non-Gulf countries, and calculate a middle estimate of $307.4bn.

 

The report finds that capital outflows from 1975 to 2000 were driven mainly by outflows through the commercial banking system. Furthermore, the contrast between the share of capital outflows of Gulf and non-Gulf countries is stark. By the authors’ calculations, the outflows from the Gulf countries totaled $364bn while the non-Gulf countries accumulated debt and depleted foreign assets to finance recurring current account deficits, producing negative capital outflows. Breaking down the 25-year period also reveals that from 1975 to 1985 the Arab world was a net creditor, with outflows of some $228.2bn, while over the period 1986 to 2000 it was a net debtor, with inflows of some $10.4bn, probably due to the declining and negative trend in the current account.

 

Capital outflows for ‘normal’ reasons such as portfolio diversification, especially when local capital markets are underdeveloped (as is the case in the Arab world), are differentiated from capital flight, which occurs as a result of economic or political instability. Between 1975 and 1982 an average of $21bn of the foreign assets of the Arab banking system could be considered capital flight. In 2000, the capital flight element of capital outflows was estimated at $191.2bn. However, there was a slowdown in the growth of capital flight after 1984, but it did not lead to an increase in domestic investment, implying that the money was used for consumption purposes. Between 1983 and 2000 budget deficits averaged 8.4% of GDP annually, which was supported by the governments drawing on foreign assets and the private sector, which was willing to substitute low-risk government bonds for foreign assets.

 

Among the causes of capital flight from the Arab world, the report argues, are poor monetary, fiscal and exchange rate policies in the region. In a simple economic model in which units of capital and labor produce output, ceteris paribus, one would expect the return on capital to be greater in developing countries, where there is a scarcity of capital, than it is in developed countries. This is not borne out by experience – large amounts of capital flow from developing countries, and more than 75% of capital flows are directed towards developed countries. It is therefore other factors which affect the return on capital, such as economic policy, which help to fuel capital flight from the Arab world, argues the report. “Monetary policy that is characterized by financial repression in the presence of high inflation produces negative real interest rates; exchange rate policy that aims at keeping unsustainable real exchange rates produces expectations of future currency devaluation with its consequent loss of value on domestic assets; and fiscal policy that imposes discriminatory taxes on capital income, and maintains budget deficits with their attendant future possibilities of debt monetization, makes foreign assets a more rewarding capital refuge.” It is the entrenched institutional framework which restricts economic growth, and the legacy of unsound economic policies which contrive to slow the growth of MPK in the Arab world (15% compared to 20% in the developed world), which explain the capital flight.

 

The capital outflows from the Arab world have three main effects, according to the report. First, the retreat of private capital pushes the government to play a greater role in the economy, although this is also due to the paternalistic and controlled nature of Arab states. As a result, the share of government expenditure in GDP is 34%, compared with an average of 21% in developing countries. Second, there is a reduction of the tax base in Arab economies which has the regressive effect of placing a greater emphasis on indirect taxes. Third, the capital outflow retards economic growth. The authors of the report calculate that, assuming a constant state of productivity in the economy, the return of capital outflows between 1975 and 2000 would have increased growth by at least 0.6% annually. By way of illustration, they point out that if all foreign assets had returned home in 2000, the minimum increase in the investment ratio would have been 58%, capable of increasing growth by 12.6%.

 

Finally, the report turns to the factors which could encourage the return of capital to the Arab countries. It is not a shortage of capital which has held the Arab world back (the share of capital in GDP is 65%, among the highest in the world), but the low MPK. Inducing the return of capital essentially involves improving MPK. Total factor productivity (TFP) ― the increase in GDP due to ‘intangibles’ after controlling for factor accumulation ― is also of concern, since this affects MPK. The determinants of TFP are not fully understood, but in most countries it is the source of half the growth in GDP. In the Arab world, by contrast, the authors calculate that tracing annual growth of 3.7% between 1975 and 2000 to its sources reveals that 1.1% is attributed to labor, 3.8% to capital and -1.2% to TFP. TFP, then, had the effect of dragging back growth rather than promoting it. The authors conclude that emphasis on the quantity of investment in the Arab world must be complemented by quality. “Improvements in investment efficiency translate to positive growth in TFP, which in turn should increase MPK and stimulate more and better investments and, consequently, more growth.” Improvements in the financial sector, more transparent government and an increased role for the private sector would no doubt go some way towards stimulating this necessary quality investment, but at present such developments are likely to be some time in coming.