Int. Fin. Markets, Inst. and Money 30 (2014) 137–152

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Journal of International FinancialMarkets, Institutions & Money

journal homepage: www.elsevier.com/locate/ intf in

Private capital flows and economic growth inAfrica: The role of domestic financial markets

Elikplimi Komla Agbloyora,∗, Joshua Yindenaba Abora,1,Charles Komla Delali Adjasib,2, Alfred Yawsonc,3

a Department of Finance, University of Ghana Business School, PO Box LG 78, Legon, Ghanab University of Stellenbosch Business School, PO Box 610, Bellville 7535, South Africac University of Adelaide Business School, 10 Pulteney Street, Adelaide, SA 5005, Australia

a r t i c l e i n f o

Article history:Received 22 October 2012Accepted 12 February 2014Available online 19 February 2014

JEL classification:E44F21O16

Keywords:AfricaCapital flowsEconomic activityFinancial markets

a b s t r a c t

This study examines the relation between private capital flowsand economic growth in Africa during the period 1990–2007. Weestimate the empirical relation with a panel Instrumental Vari-able Generalized Method of Moments (IV-GMM) estimator whichallows for arbitrary heteroskedasticity and endogeneity. Decom-posing private capital flows into its component parts, we find thatforeign direct investment, foreign equity portfolio investment andprivate debt flows all have a negative impact on economic growth.Countries with strong domestic financial markets, however, benefitmore by being able to transform the negative impact of private cap-ital flows into a positive one. Private capital flows, thus, promoteeconomic growth in the presence of strong domestic financial mar-kets. These results suggest that strong financial markets are neededfor private capital flows to impact economic growth positively. Ourresults are robust to the control of population size, savings, financialopenness and institutional quality.

© 2014 Elsevier B.V. All rights reserved.

∗ Corresponding author. Tel.: +233 244973939; fax: +233 0302 500024.E-mail addresses: ekagbloyor@accamail.com (E.K. Agbloyor), Charles.Adjasi@usb.ac.za

(C.K.D. Adjasi), alfred.yawson@adelaide.edu.au (A. Yawson).1 Tel.: +233 0302 501594x117; fax: +233 0302 500024.2 Tel.: +27 021 918 4284; fax: +27 021 918 4468.3 Tel.: +61 8 8313 0687; fax +61 8 8223 4782.

http://dx.doi.org/10.1016/j.intfin.2014.02.0031042-4431/© 2014 Elsevier B.V. All rights reserved.

138 E.K. Agbloyor et al. / Int. Fin. Markets, Inst. and Money 30 (2014) 137–152

1. Introduction

Most African countries experienced anaemic growth after independence in the 1970s through tothe early 1990s. Easterly and Levine (1997) described Africa as a growth tragedy. It must be noted,however, that the growth dynamics in Africa have changed since the early 1990s. Many of the world’sfastest growing economies are now in Africa and most African countries are growing faster thancountries in the developed world and are experiencing growth rates higher than the world average.With a world economic growth rate of around 4%, the International Monetary Fund (IMF) forecasts thatsub-Saharan Africa’s GDP will grow by 5.25% in 2011 and 5.75% in 2012 (IMF, 2011). All major capitalflows to Africa have increased considerably since 1980, especially FDI, which increased eightfold overthe period 1980–2003 (UNECA, 2006).

Although private capital flows on the whole have risen sharply, there are important variations inthe growth of its various components. For example, the growth in FDI has outpaced the growth inForeign Portfolio Investment (FPI) and debt flows with each component having a potentially differingimpact on economic activities in Africa.4 Consequently, in this paper we examine how the variouscomponents of private capital flows help resolve the African growth tragedy lamented by Easterly andLevine (1997). Focusing the study on Africa is particularly significant because private capital flowsare widely considered by African policy makers and developmental partners as important investmentvehicles through which the African growth problem can be addressed. A study that systematicallyevaluates the impact of private capital flow on growth is thus warranted. This study fills this gap andgoes a step further to explore the conditions required for private capital flows to have the expectedimpact on growth. Using capital flows data from 14 African countries over the period 1990–2007, ourinitial results indicate that private capital flows have a detrimental effect on economic growth.

In theory, financial sector development has the potential to affect the allocation of savings and thusimproves economic growth (Schumpeter, 1912). Consistent with this view, Alfaro et al. (2004) provideevidence that strong financial markets are necessary institutions that a country must have for FDIsto have a positive influence on economic growth. They document that countries with good domesticfinancial markets benefit more from FDI inflows. Further, Brambila-Macias and Massa (2010) examineif slowing capital flows due to the recent global financial crises is likely to reduce economic growthin Africa. They find that FDI and cross border bank lending exert a positive and significant impact oneconomic growth. Similarly, Choong et al. (2010) show financial markets matter in the link betweencapital flows and economic growth. Recently, Kendall (2012) provides evidence that banking sectordevelopment is a necessary condition for economic growth at the district level.

Consequently, we extend our initial analysis to examine whether the presence of good financialmarkets is necessary for private capital flows to have the desired positive effect on economic growth.Our approach is innovative and different from Alfaro et al. (2004), Brambila-Macias and Massa (2010),Choong et al. (2010) and Kendall (2012) in the sense that we consider other capital flows apart fromFDI. Further, we interact private capital flows with proxies for both stock market and banking sectordevelopment, and we consider the joint endogeneity of private capital flows and financial developmentwith economic growth. We also test our hypothesis using African data which has been neglected inthis area of investigations.

We find that, indeed, having a well developed financial market is a necessary condition to transformthe negative effect of private capital flows into a positive. The results suggest that in the absence of awell developed financial market, private capital flows are unlikely to improve economic growth. Weobtain stronger results when we interact FDI with financial markets compared to the interaction withthe other components of private capital flows. This likely point to the more desirous nature of FDI

4 Foreign Portfolio investments can be divided into equity foreign portfolio investments (EFPI), debt foreign portfolio invest-ments and flows in financial derivatives. There are various forms of external debt. Total external debt is divided into short-termand long-term debt. Long-term debt is also made up of private non-guaranteed external debt and public and publicly guaranteedexternal debt. Private capital flows have surged recently to developing countries across the world. Net private capital flows todeveloping nations increased more than six-fold to reach US$230 billion per year during 1995–1997 from around US$36 billionper year during 1987–1989 (World Bank, 1998). Net private capital flows to developing countries again increased from about$110 billion in 2008 to about $386 billion in 2009 (United Nations, 2011).

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flows. However, our results suggest that countries with strong financial markets can also benefit evenfrom EFPI and debt flows. Thus, our results are consistent with the Schumpeterian view on financialmarkets development and economic growth.

The rest of the paper is structured as follows: Section 2 examines the extant literature on capitalflows and economic growth, Section 3 details the methodology employed in the empirical analysis, inSection 4 we present the results from the empirical estimations and finally in Section 5 we concludethe paper.

2. Theoretical background

The popular theories that explain economic growth include the Schumpeter theory on economicgrowth, the Solow–Swan (neo-classical) growth theory and endogenous growth theories. Accord-ing to the Schumpeterian view, finance affects the allocation of savings and improves productivitygrowth and technological change (Beck et al., 2000). In this framework, financial markets allocatesavings (which may be partly from foreign capital flows) and finance innovations which may be dueto new technology introduced by foreign firms. Therefore foreign capital flows improve capital accu-mulation and technological diffusion thus promoting economic growth. Financial markets improvethe liquidity and tradability of assets in an economy, provide opportunities for economic agents todiversify risk, reduce information asymmetry by collecting information on deficit units, promote sav-ings mobilization and the attraction of foreign capital and improve the corporate governance of firms.Thus by performing these functions financial intermediaries aid the process of economic growth.Previous studies provide empirical support to theoretical predictions that finance should exert a pos-itive influence on economic growth (King and Levine, 1993; Beck et al., 2000; Allen and Ndikuma,2000; Adjasi and Biekpe, 2006; Romero-Avila, 2007; Manu et al., 2011; Kendall, 2012). The channelsthrough which finance is likely to affect growth are through the improvement in savings, physicalcapital accumulation and total factor productivity growth.

In his classic 1956 article Solow proposed that we begin the study of economic growth by assuming astandard neoclassical production function with decreasing returns to capital (Mankiw et al., 1992). Theneo-classical theory predicts that countries with higher savings and lower population growth rates willgrow at a faster pace (see Mankiw et al., 1992). This theory highlights the importance of technologicalprogression in the process of economic growth. It postulates that economic growth will cease withoutadvances in technology. The Solow growth model assumes that poorer countries should exhibit higherrates of return on both physical and human capital. It also predicts convergence in per capita incomeacross countries whereby poorer countries grow faster and catch up with richer countries. Accordingto the neo-classical theory, apart from labour and capital, other factors account for the differences ingrowth across countries. These factors are captured by the residual term or what is termed as totalfactor productivity. Therefore growth is determined outside the system. The augmented Solow modeladds factors of production such as human capital that do not exhibit constant returns to scale. Anaugmented Solow model includes accumulation of human as well as physical capital (Mankiw et al.,1992). Therefore in this framework, foreign capital should affect the savings rate which in turn affectseconomic growth. Also, in the case of FDI for example, introduction of new technologies will ensurethat growth continues.

Beginning in the 1980s economists became increasingly dissatisfied with the neo-classical the-ory because it had a poor fit when confronted with cross-country data and because in this modelgrowth was determined outside of the model. These economists therefore sought to build a modelthat internalized the growth process. They therefore propounded a model where growth was endoge-nous to the system. The endogenous growth theory builds on the Solow approach and adds moresets of explanatory variables to the neo classical growth theories. In endogenous growth theories,crucial importance is usually given to the production of new technologies and human capital. Humancapital in the endogenous growth model is believed to exhibit increasing returns to scale. Unlike theSolow growth model, endogenous growth theories do not predict convergence. In a simple endoge-nous growth model, capital flows can promote growth by increasing the domestic investment rate,by leading to investments that are associated with positive spillovers, and/or by increasing domes-tic financial intermediation (Bailliu, 2000). Further, even if two countries receive an equal amount of

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net capital inflows, this model predicts that the country with the more developed financial systemwill have a higher growth rate, because its financial sector is more efficient at converting the foreignfunds into productive investments, and better able to allocate them to the most productive investmentprojects.

Prior studies report positive effects of capital flows, namely FDI and FPI on macroeconomic indi-cators (Borensztein et al., 1998; Bekaert and Harvey, 1998, 2000; in Durham, 2004). However, someeconomists argue that capital flows have no growth impact and that they may even be deleterious togrowth. Others argue that the growth impact of capital flows especially FDI depend on host countryconditions such as initial GDP (Blomstrom et al., 1992), trade openness (Balasubramanyam et al., 1996),human capital (Borensztein et al., 1998), macroeconomic stability (World Bank, 2001), infrastructure(World Bank, 2001) and financial development (Hermes and Lensink, 2003; Omran and Bolbol, 2003;Alfaro et al., 2004; Durham, 2004).

Using panel data for 40 developing countries from 1975 to 1995, Bailliu (2000) finds evidence thatcapital inflows foster economic growth, above and beyond any effects on the investment rate, butonly for economies where the banking sector has reached a certain level of development. Soto (2000)finds that FDI and EFPI flows exhibit a positive, significant and robust correlation with income growthin developing countries whereas short and long-term bank related inflows show significant negativecorrelation with growth. However, the negative relation holds only when domestic banks have lowcapitalisation ratios. Durham (2004) finds that the positive effect of FPI on growth is contingent onfinancial development and legal variables or comparative institutions. In particular, they find that FPIinhibits growth in countries with comparatively small equity markets and pervasive corruption.

Choong et al. (2010) investigate how FDI, portfolio investments and foreign debt flows promoteeconomic growth in developed and developing countries through the channel of domestic stock mar-kets. They find that portfolio investment and foreign debt have a negative effect on growth whilstFDI has a significantly positive effect. Even though portfolio investment and foreign debt have nega-tive effects on economic growth, the coefficients of the interaction terms are positive and significantimplying that the development of the stock market benefits the recipient country. Regarding the neg-ative relation observed between debt flows and economic growth, Alfaro et al. (2004) suggest thatthe apparent ‘puzzle’ in the literature may be no puzzle at all. They explain that the data fits the neo-classical prediction better than previously thought and that the puzzling results emanate from thefact that the capital flows data include financing from other sovereigns and aid data. They thereforeconclude that sovereigns and official donors invest in low return countries, most likely for politicalconsiderations.

Broadly, the literature suggests that the positive impact of capital flows on growth may cruciallydepend on the level of development of financial markets in the host country. Our simple conceptualiza-tion of the process through which foreign capital influences economic growth as well as how financialmarkets interact with foreign capital flows to spur economic growth is depicted in Fig. A.1. Foreigncapital flows add to domestic investment in the host country. They also affect savings in the hostcountry. Financial markets transform society’s savings into investment. These savings can be domes-tic savings or savings induced from foreign capital flows in an open economy with capital flows. Theseinvestments through foreign capital then increase human capital and technological innovation thusincreasing the level of productivity in the host economy. The increased level of productivity generatesincreases in economic growth which in turn reinforces further inflows of foreign capital. Strong finan-cial markets are needed to positively intermediate private capital flows to spur economic growth. Wetest this hypothesis using African data.

3. Data and empirical models

We utilize data on 14 African countries covering the period 1990–2007.5 We obtain all the dataapart from the financial openness measure, the institutional quality measure and the bank credit

5 The countries used in the empirical analysis are Botswana, Cote D’Ivoire, Egypt, Kenya, Malawi, Mauritius, Morocco, Namibia,South Africa, Swaziland, Tanzania, Tunisia, Uganda and Zambia.

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Fig. A.1. Foreign capital flows, financial markets and economic growth.

ratio from the African Development Indicators online database published by the World Bank. Ourempirical model is similar to Durham (2004). We utilize a panel Instrumental Variable GeneralizedMethod of Moments (IV-GMM) estimation allowing for arbitrary heteroskedasticity. The IV approachalso enables to overcome the potential endogeneity of the finance and capital flows variables. Theinstrumental variable (IV) Two Stage Least Square estimation (2SLS) can be viewed as a GMM problem.If the errors satisfy all classical assumptions and the optimal weighting matrix is proportional to theidentity matrix, the IV-GMM estimator is merely the standard IV (2SLS) estimator (Baum, 2009). Ingeneral, in the case of an over-identified equation, the IV-GMM estimator can produce different pointestimates and smaller standard errors as the IV-GMM estimator is more efficient compared to theIV/2SLS robust estimator (Buam, 2009).

We specify our model as follows;

yit = ˇ1Capflowsit + ˇ2Financeit +∑N

j=1ˇJXit + εit

where yit is real GDP in constant 2000 USD for country i in time t; εit = vi + �it; that is the compositeerror term; Capflowsit is FDI, EFPI, private non-guaranteed debt flows and total capital flows for countryi at time t. FDI is net inflows of investment to acquire a lasting interest in or management controlover an enterprise operating in an economy other than that of the investor. It is the sum of equitycapital, reinvested earnings, other long-term capital, and short-term capital, as shown in the balanceof payments. FDI is measured as FDI divided by GDP. EFPI includes net inflows from equity securitiesother than those recorded as direct investment (FDI) and including shares, stocks, depository receipts(American or global), and direct purchases of shares in local stock markets by foreign investors. EFPIis measured as EFPI divided by GDP. Debt is private non-guaranteed net flows on external debt and isdefined as an external obligation of a private debtor that is not guaranteed for repayment by a publicentity. Net flows (or net lending or net disbursements) received by the borrower during the year aredisbursements minus principal repayments. Long-term external debt is defined as debt that has anoriginal or extended maturity of more than one year and that is owed to non-residents by residentsof an economy and repayable in foreign currency, goods, or services. Total private capital flow is thesummation of FDI, EFPI and private non-guaranteed debt. We divide the capital flows variables by GDPto normalize them and to preserve the negative figures.

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We hypothesize a positive and significant relation between FDI and economic growth whilst EFPIis expected to have a negative impact. A negative effect is plausible as EFPI can be quite volatile asforeign investors can easily withdraw their funds from domestic stock markets which may adverselyaffect the stock market. Poor stock market performance can in turn lead to low growth outcomes. Apositive effect is plausible because EFPI can contribute to domestic stock market development andcan therefore lead to economic growth. Based on evidence from Alfaro et al. (2004) we hypothesize apositive link between private non-guaranteed debt and economic growth.

Financeit represents indicators for financial market development for country i at time t. The financialmarkets variables used in the empirical estimations are the stock market capitalization ratio, stockmarket turnover, bank credit to GDP ratio, private credit to GDP ratio and the M2 to GDP ratio. Marketcapitalization is the share price times the number of shares outstanding. The market capitalizationratio is defined as market capitalization divided by GDP. Turnover ratio is the total value of sharestraded during the period divided by the average market capitalization for the period. Average marketcapitalization is calculated as the average of the end-of-period values for the current period and theprevious period.

The bank credit ratio is domestic credit provided by the banking sector and includes all creditto various sectors on a gross basis, with the exception of credit to the central government, whichis net. The banking sector includes monetary authorities and deposit money banks, as well as otherbanking institutions. Private credit refers to financial resources provided to the private sector, suchas through loans, purchases of non-equity securities, and trade credits and other accounts receivable,that establish a claim for repayment. M2 is money and quasi money and comprise the sum of currencyoutside banks, demand deposits other than those of the central government, and the time, savings,and foreign currency deposits of resident sectors other than the central government. M2 is measuredas M2 divided by GDP. Based on theoretical predictions, we hypothesize a positive relation betweenfinancial development indicators and economic growth.

Xit is a vector of information conditioning set for country i in time t. These determinants followfrom the growth literature and include population, savings, financial openness and institutional qualityand are included as control variables. These variables are assumed to be exogenous to the process ofeconomic growth. We measure population as the log of population. Countries with larger populationscan achieve higher productivity and have the market base to drive economic growth. We thereforehypothesize a positive relation between population size and economic activity.

Gross domestic savings is GDP less final consumption expenditure. Savings is measured as grossdomestic savings divided by GDP. Traditional growth theories postulate that savings matter for eco-nomic growth. Choong et al. (2010) find that savings have a positive and significant effect on growthin both developed and developing countries. We therefore hypothesize a positive relation betweensavings and economic activity. We use Chinn and Ito’s (2008) measure of capital account openness asour indicator of financial openness. The index is a de jure measure of financial openness with highervalues indicating more financial openness. The index ranges from −1.83 to +2.5. We hypothesize apositive relation between financial openness and economic activity since financial openness makes itpossible for an economy to receive foreign capital flows.

The civil liberties index from Freedom House is used as an indicator of institutional quality. Civilliberties allow for the freedoms of expression and belief, associational and organizational rights, ruleof law, and personal autonomy without interference from the state. The index ranges from 1 to 7 withlower values indicating more civil liberties. Endogenous growth theorists emphasize that institutionaland governance indicators matter for growth (see Acemoglu et al., 2004). Alfaro et al. (2004) find thatgood quality institutions matter for economic growth. Countries with better and stronger institutionsshould experience higher levels of economic growth. Since we utilize the civil liberties index wherelower values represent higher institutional quality, we hypothesize a negative relation between thecivil liberties index and economic activity.

It is theoretically possible that the capital flows and financial market variables increase with theincreases in the growth rate. We use an instrumental variable set for the capital flows and financialmarket indicators. We employ instruments for these variables because they may be endogenouslydetermined with economic growth. The instruments used for the capital flows variables are one lag ofthe capital flows variable, exchange rate with the US$ and exchange rate volatility. The instruments

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Table A.1Descriptive summary statistics.

Variable Obs Mean Std. dev. Min Max

FDI 234 0.024 0.030 −0.075 0.213EFPI 252 0.003 0.011 −0.024 0.088Debt 230 0.001 0.009 −0.024 0.081Market capitalization 209 0.313 0.491 0.010 2.940Stock market turnover 146 11.966 17.311 0.000 126.000Bank credit 248 0.464 0.461 −0.730 1.980Private credit 248 0.355 0.322 0.030 1.640M2 249 0.388 0.239 0.060 1.010Population 252 16.123 1.381 13.670 18.198Savings 250 0.160 0.114 −0.050 0.560Financial openness 248 −0.237 1.390 −1.831 2.500Institutions 252 3.956 1.325 1.000 7.000

The table reports the descriptive statistics. FDI is foreign investment that reflects 10% or more of voting equity and is dividedby GDP; EFPI is foreign investment in equity securities divided by GDP; debt represents external debt accruing to the privatesector divided by GDP; the market capitalization ratio is the stock market capitalization divided by GDP; stock market turnoveris the stock market value traded divided by market capitalization; bank credit is domestic credit to the private sector providedby banks divided by GDP; private credit is domestic credit to the private sector by banks and other financial institutions dividedby GDP; M2 is liquid liabilities of the financial sector divided by GDP; population is the log of population size; savings is grossdomestic savings divided by GDP; financial openness is Chinn and Ito’s (2008) measure of capital account openness; institutionalquality is the civil liberties index and is obtained from Freedom House.

for the financial market variables include one lag of the financial market variable being estimated.In the case of the stock market indicators, we augment the lag of the financial market variable withthe number of listed firms. For the banking indicators, we augment the lag of the financial marketvariable with the deposit rate. All instruments are employed at once making five instruments for eachestimation.

We use one lag of FDI following evidence by Wheeler and Mody (1992) that FDI flows are reinforcing.Also past EFPI and debt flows influence current levels of EFPI and debt flows. Froot and Stein (1991)show that an appreciating home currency can increase the FDI decision of home firms. According toAlfaro et al. (2004) among the few consistently significant determinants of FDI are real exchange ratesand lagged FDI. We therefore follow Alfaro et al. (2004) and use the exchange rate as an instrument forthe capital flows variables. Further, we use exchange rate volatility as an additional instrument for thecapital flows variables since they are likely to affect the levels of foreign capital flows. Exchange ratevolatility is computed as the annual standard deviation of the monthly exchange rate variable over theperiod 1990–2007. Listed companies affect stock market capitalization and turnover and their effecton economic growth is likely to be through their effect on the stock market indicators. The depositrates also affect the banking indicators but are not directly linked to economic growth and shouldtherefore serve as valid instruments.

Due to the fact that capital flows may not have an independent impact on economic growth, wealso estimate a second equation to capture the interactive effect between capital flows and financialmarkets. The model closely follows that employed by Durham (2004) and it is specified as follows;

yit = ˇ1Capflowsit + ˇ2Financeit + ˇ3(Capflowsit × Financeit) +∑N

j=4ˇjXit + �it

where ˇ3 represents the interactive effect between the capital flows variables and financial markets�it = �i + �it and �i represent individual country effects.

4. Empirical results

4.1. Descriptive statistics

Table A.1 shows the summary statistics. The mean level of FDI scaled by GDP is 2.37%. The meanlevel of EFPI and private non-guaranteed debt are 0.29% and 0.10%, respectively. Therefore, the volume

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of FDI into Africa far outweighs that of EFPI and private non-guaranteed debt. The average stock marketturnover and market capitalization ratios are 11.9% and 31.34% respectively. This is lower than theaverage stock market turnover and market capitalization ratios of 64.46% and 84.29% for East Asia andthe Pacific region over the same period. This suggests that Africa’s capital markets are less developedcompared to the East Asia and Pacific region. Average bank and private credit represents 46.40% and35.46% of GDP respectively are lower compared to bank credit and private credit ratios of 64.38% and60.74% respectively for the East Asia and Pacific region over the same period. The M2 ratio whichmeasures financial depth averages 38.82% of GDP. This again is much lower compared to a financialdepth ratio of 70.48% for East Asia and the Pacific region. Banking systems in East and Pacific Asiashow significantly more depth compared to Africa. As regards the financial market variables, Africa’sbanking sector exhibits more depth compared to the stock market.

Musila and Sigue (2006) noted that the savings rate in sub-Saharan Africa declined from 10.3%during 1974–1980 to only 5.7% during 1991–1996. The mean level of savings of 15.99% suggests arebound in the savings levels in Africa. The mean level of financial openness of −0.2371 suggests thatAfrican economies are still relatively closed despite various reforms to liberalize their capital accounts.The mean level of the civil liberties index of 3.9563 suggests that institutions in Africa remain fairlyweak.

The correlation matrix shows that multicollinearity is unlikely to be a problem in our data set. FDIexhibits the highest correlation with total capital flows. The finance variables are highly correlatedwith each other. EFPI exhibits a higher correlation with the market capitalization ratio compared tomarket turnover.

4.2. Regression results

We now discuss the results from our empirical estimations. For each capital flow variable, wereport ten different regressions. Five regressions report the effect of the capital flow and financialmarket development variables on economic growth. We run these five regressions because we usefive financial market indicators and include one financial market indicator in the regressions at a timedue to potential multicollinearity (see Table A.2). A further five regressions report the effect of thecapital flows variables and financial market development on growth taking into consideration theinteraction between the capital flow variable and the financial markets indicators.

Table A.3 presents the results on FDI and economic growth. The results suggest an overwhelmingnegative relation between FDI flows and economic growth (see, Models 1, 2, 7, 8, 9 and 10). Oneplausible explanation is that FDI flows into Africa go mainly into natural resources (mainly oil) whichhave little linkages with the domestic economy (Akinlo, 2004). Also, FDI flows may crowd out domesticinvestment by pushing domestic firms out of the market. This is because foreign investors may borrowheavily from domestic financial markets thus reducing the amount of credit available to domesticfirms. However, when we interact FDI with financial markets the negative influence of FDI on growthis transformed into a positive one (see Models 2, 8 and 10 where the interaction between FDI andmarket capitalization, private credit and the M2 ratio turnout to be positive and significant). Theresults therefore suggest that FDI on its own is likely to have a negative influence on economic growthfor African countries. However, countries with strong financial markets benefit more by being able totransform this negative impact of FDI into a positive one. Our findings are similar to Alfaro et al. (2004)who show that local financial markets play an important role in the link between FDI and economicactivity.

Broadly, our results are consistent with the finance growth-nexus paradigm. The results suggestthat financial development whether in the form of an advanced stock market or banking sector helpsspur economic growth in Africa. Both stock markets and banks improve the liquidity and tradability ofassets in an economy, provide opportunities for economic agents to diversify risk, reduce informationasymmetry by collecting information on deficit units, promote savings mobilization and the attractionof foreign capital and improve the corporate governance of firms. In essence, financial developmentimproves the process whereby scarce resources are channelled to the most productive sectors ofan economy thereby promoting economic growth. Our results provide support for King and Levine’s

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Table A.2Correlation matrix.

FDI EFPI Debt Total capflows

Market cap Marketturnover

Bank credit Privatecredit

M2 GDP Population Savings Financialopenness

Institutions

FDI 1EFPI −0.0703 1Debt 0.3274 0.0274 1Total cap. flows 0.9114 0.2603 0.5479 1Market cap −0.0844 0.6801 0.0238 0.1995 1Market turnover −0.0645 0.2977 0.0969 0.0848 0.5356 1Bank credit −0.0924 0.4804 0.0854 0.1112 0.6959 0.5093 1Private credit −0.1391 0.5961 0.0525 0.1043 0.815 0.4717 0.8594 1M2 −0.123 0.1488 0.0048 −0.0498 0.3342 0.3259 0.6789 0.6492 1GDP −0.1324 0.3338 −0.0237 0.018 0.6061 0.4979 0.696 0.6812 0.6141 1Population −0.0877 0.1200 −0.0216 −0.0217 0.3141 0.3439 0.4001 0.1690 0.1230 0.7034 1Savings 0.0066 0.0578 0.0522 0.044 0.0827 −0.1524 −0.0931 0.2197 0.2766 0.2294 −0.2792 1Financial openness 0.2471 −0.1103 0.1724 0.212 −0.0594 −0.0387 −0.0607 −0.0785 0.1476 0.0118 −0.0368 0.1593 1Institutions 0.0136 −0.3097 −0.0584 −0.1044 −0.3491 0.0056 −0.0296 −0.275 −0.1034 0.0909 0.4146 −0.3917 −0.147 1

Note: FDI is foreign investment that reflects 10% or more of voting equity and is divided by GDP; EFPI is foreign investment in equity securities divided by GDP; debt represents externaldebt accruing to the private sector divided by GDP; the market capitalization ratio is the stock market capitalization divided by GDP; stock market turnover is the stock market valuetraded divided by market capitalization; bank credit is domestic credit to the private sector provided by banks divided by GDP; private credit is domestic credit to the private sector bybanks and other financial institutions divided by GDP; M2 is liquid liabilities of the financial sector divided by GDP; population is the log of population size; savings is gross domesticsavings divided by GDP; financial openness is Chinn and Ito’s (2008) measure of capital account openness; institutional quality is the civil liberties index and is obtained from FreedomHouse.

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(1993) conclusion that finance does not merely follow economic growth but importantly Schumpeter’s(1912) postulation that finance causes or leads economic growth might be right in the African context.

Further, we find population to be positively and significantly related to growth in all the estimatedmodels. A large population seems to matter for growth because it contributes to a country’s productionand also stimulates high consumption for produced goods. In countries like the U.S., it is well knownthat consumer spending drives economic activity. Therefore, countries with a large population sizebenefit more by experiencing higher economic activity. We also find that the level of savings in acountry contributes to its economic activity as it is mostly significantly positive in the estimatedregressions. Savings are needed to finance investment projects. This is because savings representfunds that can be lent to deficit units through the financial system. Our results are consistent withtraditional growth theories that postulate that savings matter for economic growth.

Financial openness is also positive and significantly related to growth in all the regression esti-mates. This suggests that countries with more open capital accounts benefit more by experiencinghigher economic activity. This is because financial openness makes it possible for these countries toreceive foreign capital to add to their capital stock and achieve investment rates far above those attain-able domestically. The results also suggest that institutions play a positive role in spurring economicactivity (Alfaro et al., 2004). The negative relation suggests that countries with stronger institutionsexperience higher economic growth. Institutional arrangements affect corruption, the independenceof the judiciary, the rule of law, property rights, social interactions, legal systems, political freedomsand commercial arrangements. Obviously, all these issues matter for the growth outcomes of a country.

We estimate the effect of EFPI on economic activity and report the results in Table A.4. Similar tothe FDI results reported in Table A.3, we find a negative relation between EFPI and economic activity(see Models 2 and 7). Again, in the absence of good financial markets, the results indicate EFPI nega-tively influences economic activity although not always significant. These results may be due to thepotentially destabilizing effect that EFPI has on stocks markets due to its inherently volatile nature.Due to the fact that these investments are not bolted, foreign investors can easily withdraw their fundsfrom the host economy if more attractive opportunities become available to them and at the least signof trouble. For example, during the recent global financial crises, stock markets across Africa sufferedsignificant declines because portfolio investors withdrew their funds from these markets (see AfDB,2009).

Countries with liquid stock markets can benefit from EFPI flows as shown by the positive andsignificant coefficient of the interaction term in Model 4. This is because the impact of EFPI on growthdepends on the assumption that well functioning stock markets promote economic growth. Similarto the results reported in Table A.3, population, savings and financial openness have a positive effecton economic growth whilst institutions have a negative impact. The negative sign actually suggeststhat institutions matter for growth.

We report the effect of private debt flows on economic growth in Table A.5. Consistent with theresults in Tables A.3 and A.4, debt flows exhibit a significantly negative relation with economic activityin all the estimated models apart from Model 3. This may appear puzzling as we focus on debt accruingto the private sector. Indeed, a negative relation between total external debt and economic growth isnot surprising especially when a country is characterized by high levels of debt (see for example, Kumarand Woo, 2010; Imbs and Ranciere, 2007; Pattilo et al., 2002, 2004). Alfaro et al. (2004) explain thatthe observed negative influence of debt on growth may be due to sovereign to sovereign lending andaid flows which are allocated based on factors such as political economy considerations. Rationalizingthe negative effect of private debt flows on growth therefore becomes difficult. However, this may bedue to the fact that foreign private lenders lending to firms in Africa are exposed to higher levels ofinformation asymmetry. Like Choong et al. (2010) we find that advanced financial markets are able totransform the negative debt effect into a positive one as indicated by the interaction term (see Model2 where the interaction between private debt and stock market turnover turns out to be positive andsignificant). The results therefore suggest that in the absence of a well developed financial market,debt flows are likely to be misallocated.

Finally, we present the result on total capital flow and economic growth in Table A.6. Controlling forpopulation, savings, financial openness and institutional quality, we find a negative relation betweentotal capital flow and economic growth (see Models 1, 2, 6, 7, 8, 9, 10). This finding is not surprising

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Table A.3FDI and economic growth in Africa: the role of domestic financial markets.

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)

FDI −3.8849*** −5.6250*** −4.9694 −5.7341 −0.9604 −0.0487 −2.8650* −3.3013** −4.2719* −10.7188**

(1.4397) (2.0116) (5.0875) (7.2760) (1.6042) (1.5100) (1.5782) (1.5755) (2.5142) (4.7424)Market capitalization 0.2198*** −0.0399

(0.0779) (0.1163)Stock market turnover 0.0035 −0.0021

(0.0042) (0.0039)Bank credit 0.3790*** 0.4020***

(0.0625) (0.0684)Private credit 0.5905*** 0.4548***

(0.1113) (0.1571)M2 0.7796*** −0.423

(0.1854) (0.6433)Interaction term 7.1377*** 0.1542 −0.4177 5.8756** 21.3663**

(2.7749) (0.1747) (1.2966) (2.9928) (10.7057)Population 1.3034*** 1.3779*** 1.7164*** 1.7278*** 1.2166*** 1.1936*** 1.2683*** 1.2299*** 1.2523*** 1.3051***

(0.1581) (0.1641) (0.4606) (0.4632) (0.0844) (0.0687) (0.0806) (0.0673) (0.1274) (0.1555)Savings 1.1663*** 1.2291*** 0.8853 0.4309 1.0889*** 0.9918*** 1.0799*** 1.0478*** 1.1948*** 1.4073***

(0.2605) (0.2719) (1.0245) (1.0072) (0.1981) (0.1952) (0.2404) (0.2086) (0.3588) (0.4305)Financial openness 0.0524*** 0.0585*** 0.0978** 0.0696* 0.0412*** 0.0369*** 0.0363*** 0.0366*** 0.0512*** 0.0605***

(0.0090) (0.0094) (0.0466) (0.0396) (0.0092) (0.0086) (0.0119) (0.0116) (0.0125) (0.0163)Institutions −0.0175 −0.0208 −0.0195 −0.0252 −0.0384*** −0.0351*** −0.0408*** −0.0386*** −0.0413*** −0.0534***

(0.0171) (0.0168) (0.0277) (0.0255) (0.0099) (0.0092) (0.0111) (0.0098) (0.0158) (0.0170)

Observations 169 169 96 96 181 181 181 181 184 184No. of countries 13 13 11 11 12 12 12 12 12 12F 62 55.57 9.66 8.42 210.88 197.81 142.74 132.13 104.47 47.64Prob > F 0 0 0 0 0 0 0 0 0 0Hansen J 4.594 5.149 1.247 0.363 7.841 7.836 9.791 9.55 5.638 1.216Chi Sq 0.2041 0.1612 0.7416 0.9477 0.0494 0.0495 0.0204 0.0228 0.1306 0.7492

Note: FDI is foreign investment that reflects 10% or more of voting equity and is divided by GDP; the market capitalization ratio is the stock market capitalization divided by GDP; stockmarket turnover is the stock market value traded divided by market capitalization; bank credit is domestic credit to the private sector provided by banks divided by GDP; private creditis domestic credit to the private sector by banks and other financial institutions divided by GDP; M2 is liquid liabilities of the financial sector divided by GDP; population is the log ofpopulation size; savings is gross domestic savings divided by GDP; financial openness is Chinn and Ito’s (2008) measure of capital account openness; institutional quality is the civilliberties index and is obtained from Freedom House. Model 2 interacts FDI with stock market capitalization, Model 4 interacts FDI with stock market turnover, Model 6 interacts FDI withbank credit, Model 8 interacts FDI with private credit and Model 10 interacts FDI with the M2 ratio.

* Significant at 10%.** Significant at 5%.

*** Significant at 1%.

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Table A.4Foreign equity portfolio investments and economic growth in Africa: the role of domestic financial markets.

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)

EFPI −1.1014 −0.4958 −0.3929 −10.0498** −0.8528 −4.6731 −3.1983*** −15.55 −0.7025 −34.7311(1.0426) (3.0113) (0.7254) (4.5881) (0.7842) (8.0400) (1.0991) (28.6592) (0.6602) (30.9868)

Market capitalization 0.1299** 0.1259*

(0.0546) (0.0756)Stock market turnover 0.0008 −0.0019

(0.0008) (0.0017)Bank credit 0.4107*** 0.4007***

(0.0527) (0.0569)Private credit 0.7414*** 0.6439***

(0.0987) (0.1901)M2 0.6892*** 0.4452

(0.1328) (0.2990)Interaction term −0.0324 0.2511** 2.5990 9.4439 61.8355

(1.4171) (0.0001) (4.9491) (21.5413) (55.8622)Population 1.3178*** 1.3157*** 1.6131*** 1.2960*** 1.2317*** 1.2126*** 1.2392*** 1.1855*** 1.1547*** 1.1298***

(0.1372) (0.1364) (0.1568) (0.1823) (0.0614) (0.0751) (0.0563) (0.1071) (0.0706) (0.0877)Savings 0.8411*** 0.8522*** 0.3884** 0.3044 0.9435*** 0.9618*** 0.8481*** 0.8353*** 0.8895*** 0.9174***

(0.1412) (0.1402) (0.17) (0.2341) (0.0950) (0.0960) (0.1122) (0.1507) (0.1142) (0.1607)Financial openness 0.0407*** 0.0420*** 0.0658*** 0.0778*** 0.0341*** 0.0357*** 0.0203*** 0.0255* 0.0405*** 0.0383***

(0.0073) (0.0075) (0.0138) (0.0170) (0.0050) (0.0056) (0.0064) (0.0138) (0.0054) (0.0083)Institutions −0.0200 −0.0177 −0.0274* −0.0470*** −0.0333*** −0.0342*** −0.0273*** −0.0300*** −0.0205*** −0.0251***

(0.0159) (0.0168) (0.0154) (0.0171) (0.0073) (0.0077) (0.0064) (0.0099) (0.0076) (0.0095)

Observations 182 182 107 107 194 194 194 194 197 197Countries 14 14 12 12 13 13 13 13 13 13F 93.12 90.7 61.99 32.79 236.94 179.91 198.7 91.41 188.61 91.73Prob > F 0 0 0 0 0 0 0 0 0 0Hansen J 14.162 14.507 5.079 1.967 6.65 7.239 8.897 8.008 6.353 5.794Chi Sq 0.0027 0.0023 0.1661 0.5793 0.0839 0.0647 0.0307 0.0458 0.0957 0.1221

Note: EFPI is foreign investment in equity securities divided by GDP; the market capitalization ratio is the stock market capitalization divided by GDP; stock market turnover is the stockmarket value traded divided by market capitalization; bank credit is domestic credit to the private sector provided by banks divided by GDP; private credit is domestic credit to the privatesector by banks and other financial institutions divided by GDP; M2 is liquid liabilities of the financial sector divided by GDP; population is the log of population size; savings is the grossdomestic savings divided by GDP; financial openness is Chinn and Ito’s (2008) measure of capital account openness; institutional quality is the civil liberties index and is obtained fromFreedom House. Model 2 interacts EFPI with stock market capitalization, Model 4 interacts EFPI with stock market turnover, Model 6 interacts EFPI with bank credit, Model 8 interactsEFPI with private credit and Model 10 interacts EFPI with the M2 ratio.

* Significant at 10%.** Significant at 5%.

*** Significant at 1%.

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Table A.5Private debt flows and economic growth in Africa: the role of domestic financial markets.

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)

Private debt −3.1849** −3.7860** −1.7973 −6.3935* −3.5340** −4.9092* −4.2564*** −4.4763** −3.7376* −7.2767*

(1.5888) (1.9111) (2.6376) (3.4453) (1.5858) (2.9271) (1.6266) (1.9356) (2.1279) (3.9727)Market capitalization 0.1946*** 0.0912*

(0.0614) (0.0491)Stock market turnover 0.0013 0.0016**

(0.0011) (0.0008)Bank credit 0.4012*** 0.3794***

(0.0531) (0.0635)Private credit 0.8007*** 0.7869***

(0.0862) (0.0883)M2 0.7261*** 0.8416***

(0.1318) (0.1808)Interaction term 3.6685** 0.1547 3.6243 2.2140 14.5438

(1.6563) (0.0968) (3.6786) (2.8307) (9.2130)Population 1.2628*** 1.2841*** 1.5521*** 1.6118*** 1.1936*** 1.1602*** 1.1849*** 1.1739*** 1.1098*** 1.0763***

(0.1579) (0.1527) (0.2147) (0.2210) (0.0643) (0.0721) (0.0613) (0.0629) (0.0872) (0.0847)Savings 0.9153*** 0.9540*** 0.2504 0.5289* 1.0862*** 1.1256*** 1.0127*** 1.0257*** 0.9524*** 0.9977***

(0.1519) (0.1591) (0.2079) (0.3175) (0.1221) (0.1460) (0.1104) (0.1179) (0.1306) (0.1386)Financial openness 0.0407*** 0.0498*** 0.0763*** 0.0711*** 0.0369*** 0.0392*** 0.0237*** 0.0249*** 0.0431*** 0.0437***

(0.0074) (0.0069) (0.0141) (0.0141) (0.0049) (0.0058) (0.0055) (0.0060) (0.0054) (0.0057)Institutions −0.0186 −0.0226 −0.0187 −0.0175 −0.0366*** −0.0378*** −0.0301*** −0.0305*** −0.0232*** −0.0229***

(0.0166) (0.0164) (0.0154) (0.0138) (0.0076) (0.0075) (0.0068) (0.0067) (0.0088) (0.0087)

Observations 165 165 95 95 179 179 179 179 180 180Countries 13 13 11 11 12 12 12 12 12 12F 90.33 86.38 53.54 46.61 251.02 206.87 218.59 186.2 198.43 152.85Prob > F 0 0 0 0 0 0 0 0 0 0Hansen J 5.657 8.422 6.241 3.273 0.922 1.007 2.291 2.417 3.588 3.198Chi Sq 0.1296 0.038 0.1004 0.3514 0.82 0.7996 0.5143 0.4904 0.3096 0.362

Note: Private debt represents external debt accruing to the private sector divided by GDP; the market capitalization ratio is the stock market capitalization divided by GDP; stock marketturnover is the stock market value traded divided by market capitalization; bank credit is domestic credit to the private sector provided by banks divided by GDP; private credit is domesticcredit to the private sector by banks and other financial institutions divided by GDP; M2 is liquid liabilities of the financial sector divided by GDP; population is the log of population size;savings is the gross domestic savings divided by GDP; financial openness is Chinn and Ito’s (2008) measure of capital account openness; institutional quality is the civil liberties index andis obtained from Freedom House. Model 2 interacts private debt with stock market capitalization, Model 4 interacts private debt with stock market turnover, Model 6 interacts privatedebt with bank credit, Model 8 interacts private debt with private credit and Model 10 interacts private credit with the M2 ratio.

* Significant at 10%.** Significant at 5%.

*** Significant at 1%.

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Table A.6Total private capital flows and economic growth: the role of domestic financial markets.

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)

Total capital flows −2.6340*** −3.9463*** −0.0009 −2.4918 −1.1481 −2.2101* −1.9989*** −2.5873*** −2.4990** −5.5386***

(1.0277) (1.5429) (1.1939) (2.0382) (0.7432) (1.2780) (0.7147) (1.0509) (1.1420) (2.1400)Market capitalization 0.2873*** −0.0159

(0.0777) (0.1644)Stock market turnover 0.0012 −0.0012

(0.0012) (0.0016)Bank credit 0.3955*** 0.3317***

(0.0589) (0.0777)Private credit 0.7126*** 0.6075***

(0.0981) (0.1415)M2 0.7544*** 0.1232

(0.1616) (0.3193)Interaction term 2.7579** 0.07476* 1.5579 2.4970* 11.3693**

(1.3941) (0.0455) (0.9834) (1.4741) (4.9742)Population 1.3109*** 1.3807*** 1.4559*** 1.4998*** 1.2472*** 1.2301*** 1.2633*** 1.2270*** 1.1965*** 1.1851***

(0.1637) (0.1794) (0.2080) (0.2474) (0.0717) (0.0711) (0.0676) (0.0698) (0.0984) (0.0980)Savings 1.1289*** 1.3852*** 0.3219 0.4198 1.1508*** 1.3198*** 1.0687*** 1.1832*** 1.1330*** 1.2656***

(0.2476) (0.3318) (0.2724) (0.4846) (0.1592) (0.2406) (0.1853) (0.2321) (0.24741) (0.2702)Financial openness 0.0472*** 0.0615*** 0.0757*** 0.0760*** 0.0407*** 0.0473*** 0.0310*** 0.0379*** 0.0490*** 0.0541***

(0.0090) (0.0099) (0.0157) (0.0223) (0.0068) (0.0095) (0.0087) (0.0116) (0.0092) (0.0100)Institutions −0.0233 −0.0361* −0.0211 −0.0260 −0.0415*** −0.0460*** −0.0397*** −0.0419*** −0.0369*** −0.0411***

(0.0178) (0.0196) (0.0146) (0.0163) (0.0083) (0.0103) (0.0087) (0.0097) (0.0118) (0.0117)

Observations 165 165 95 95 179 179 179 179 180 180Countries 13 13 11 11 12 12 12 12 12 12F 56.36 48.22 47.38 18.67 192.96 138.55 151.66 114.47 117.47 81.62Prob > F 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000Hansen J 2.701 1.690 7.923 1.3150 4.8010 2.8190 3.0880 1.640 4.5420 2.1100Chi Sq 0.4400 0.6391 0.0476 0.7255 0.1870 0.4204 0.3783 0.6504 0.2086 0.5499

Note: Total private capital flows is the summation of FDI, EFPI and private non-guaranteed debt; the market capitalization ratio is the stock market capitalization divided by GDP; stockmarket turnover is the stock market value traded divided by market capitalization; bank credit is domestic credit to the private sector provided by banks divided by GDP; private creditis domestic credit to the private sector by banks and other financial institutions divided by GDP; M2 is liquid liabilities of the financial sector divided by GDP; population is the log ofpopulation size; savings is the gross domestic savings divided by GDP; financial openness is Chinn and Ito’s (2008) measure of capital account openness; institutional quality is the civilliberties index and is obtained from Freedom House. Model 2 interacts total capital flows with stock market capitalization, Model 4 interacts total capital flows with stock market turnover,Model 6 interacts total capital flows with bank credit, Model 8 interacts total capital flows with private credit and Model 10 interacts total capital flows with the M2 ratio.

* Significant at 10%.** Significant at 5%.

*** Significant at 1%.

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as the various components of private capital flows exhibit a negative relation with economic growth.The negative effect means that private capital flows adversely affect a country’s growth outcome. Thisresult can be explained in the sense that capital flows tend to be volatile. Financial markets are ableto transform this negative effect of capital flows into a positive one because they help to efficientlyallocate foreign capital flows towards productive investments (see Models 2, 4, 8 and 10 where theinteraction between total capital flows and stock market capitalization, stock market turnover, privatecredit and the M2 ratio respectively turnout to be positive and significant). The results thereforesuggest that in the absence of well functioning domestic financial markets, private capital flows willhave a damaging impact on economic growth. Our results are similar to Bailliu (2000) who find thatcountries with advanced banking systems benefit more from private capital flows (Table A.6).

5. Conclusion

This study examines the relation between the various forms of private capital flows and economicgrowth in Africa. Our capital flows variables include FDI, EFPI, private non-guaranteed debt and aggre-gate private capital flows. In all the empirical analysis conducted, we control for population size,savings, financial openness and institutional quality as these factors matter for economic activity. Wefind overwhelming evidence that private capital flows have a detrimental effect on economic growthin Africa. However, we take into consideration the fact that capital flows may not have an independentinfluence on growth and interact the capital flows variables with financial market indicators. When wedo this, we find an unambiguous positive influence between the capital flows variables and financialmarkets on growth.

The key issue that emerges is that capital flows may be detrimental in countries with relativelyunderdeveloped financial markets. Financial markets matter in the growth process because they helpallocate foreign capital towards productive ventures. Also, countries with weak financial markets maybe more vulnerable to financial and exchange rate crises resulting in the outflow of foreign capitaland lowering their long-term economic growth. Undeveloped financial markets therefore seem tofrequently misallocate foreign capital. This study contributes to the literature on absorptive capacities.The findings suggest that financial markets are a necessary absorptive capacity for the private financialflows that we examine in the African context. The results imply that unfettered capital flows mayhave a negative impact on economic activity. Therefore, countries should endeavour to develop theirdomestic financial markets to positively intermediate foreign capital flows to spur economic growth.

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