Private Capital Flows in Southern Mediterranean Countries : Determinants and Impact on Economic Growth, Domestic Investment and Wage Inequality

FEM32-14 | September 2009

Title

« Private Capital Flows in Southern Mediterranean Countries : Determinants and Impact on Economic Growth, Domestic Investment and Wage Inequality »

By

Mondher Cherif, ESC Sfax, Tunisia

Contributeurs

Yan Babeski, Cerge-EI, Charles University in Prague, Czech Republic; Adel Boughrara, Faculté de Droit et des Sciences Economiques et Politiques de Sousse, Tunisia;  Samy Bennaceur, IHEC Carthage, Tunisia ; Samir Ghazouani, Université de Tunis El Manar, Tunisia ; Bassem Kamar, ERF, Egypt

Note :

This document has been produced with the financial assistance of the European Union within the context of the FEMISE program. The contents of this document are the sole responsibility of the authors and can under no circumstances be regarded as reflecting the position of the European Union.

Summary :

Part 1: The Determinants of FDI and FPI in the MEDA Countries:  An international Comparison

FDI flows to the MEDA countries have been disappointing relative to other developing countries. Data show that the growth of FDI flows into MEDA region proved to be notably inferior to that recorded in the CEE countries or in Asian economies, such as China and India. The aim of this project is threefold. First, it aims at analysing the private foreign capital flows into MEDA countries. Second, it seeks at exploring why this region is lagging behind in attracting international flows. Third, it purposes at examining whether private capital inflows contribute to improve the competitiveness of domestic economies.

Part 1 has focussed on the determinants of FDI/FPI in MEDA countries and compared them to other countries in the world. The study adds to previous ones by taking into account, in addition to traditional quantitative determinants, qualitative determinants of FDI and FPI (i.e. government stability, country risk, exchange regime quality, capital account openness…). The analysis is done by making use of dynamic panel data models with yearly data covering the period going from 1980 to 2006.

The main results can be summarized as follows: investors are attracted to a country with better growth perspectives and a growing population. Additionally, opening the economy to trade spur FDI confirming the above-mentioned hypothesis that trade openness attracts export-oriented FDI. The results show also that foreign long-term investors are more attracted by a stable exchange rate. When we introduce institutional and policy variables such as government stability, capital account openness, country risk and exchange rate regime are accounted for, the empirical results tend to indicate that: (i) Political stability is a convincing argument to attract long-term foreign investors; (ii) a risky local environment repels foreign investors for investing domestically; (iii) a fixed exchange rate regime is necessary to attract foreign investors in the long-run;  and (iv) finally, FPI seems behave as a competitor to FDI.

Besides, when accounting for the institutional variables, it is found that (i) a stable government contribute to attract FDI in Latin America and Asia where the coefficients on Government stability interacted with region dummy variables are positive and highly significant. As risky environment reduce the incentives for long-term foreign investors to pour money in the domestic market in CEE and Asian regions where foreign direct capital favours risky countries in MEDA region.

Finally, capital account openness is found to impact differently on FDI depending on the recipient region. It is an ingredient for attracting FDI in Latin America whereas it repeals FDI in CEE countries. In other regions, the impact of capital account liberalization on FDI seems to be inexistent. The results relative to the FPI estimates show that almost all domestic economic fundamentals (such as GDP growth, Inflation, CAB) are statistically significant and bear the expected signs; such findings indicate that countries with high per capita GDP growth and high current account balance succeed to attract more investors. Macroeconomic stability, as measured by lagged inflation, shows up as a minor concern to foreign investors.

Part 2:  Foreign capital flows, economic growth, domestic investment and inequality: an international comparison

To the best of our knowledge, no study has focused on the direct impact of FDI and FPI on inequality in the MEDA region. The project attempts to fill this void by providing a comprehensive analysis of the effect of capital inflow and its composition on inequality in the receiving country.  Two questions arise: why foreign as opposed to domestic investment should have an impact on long run development that is different from domestic investment? Does foreign investment increase or decrease domestic investment? An answer to these questions would help to draw policies aiming at strengthening the link between inflow and investment.

FDI is intended to be a major generator of growth since positive effect was recorded either from the whole sample or some regions such as MENA, Latin America, Africa, Asian and CEE. This detects the need of these countries for inflows of foreign capital in order to boost economic growth. A positive and significant impact of FDI on domestic investment is also exhibited. In such case, FDI seems to hop the domestic investment. So it could be considered that more inflows of foreign capital constitute an impulse factor to global investment. Such positive influence is also detected for MENA region, Asia and CEE countries. For the region of our concern, that is the MENA region, national efforts to create opportunities of investment are requested and approved, but the support coming through FDI is significant.

Part 3:  Foreign capital flows and competitiveness: an International Comparison

Part 3 focuses on the effects of capital inflows in determining the real exchange rate (RER). We develop a dynamic model to estimate the RER based on the fundamentals. Exchange rate management is a challenging macroeconomic policy issue. There has been a broad consensus in policy circles in developing countries that the overriding objective of exchange rate policy should be to avoid persistence in misalignment, which is a common problem in most emerging economies.  An important factor in identifying the equilibrium real exchange rate is the role of capital inflows, which are among the fundamentals determining the real exchange rate. According to Dutch Disease theory (Corden and Neary, 1982), excessive capital inflows lead to real appreciation of the exchange rate via its impact on both the tradable and non-tradable sectors of the recipient economy. However, the extent of appreciation as a result of capital inflows depends to a large extent on the ‘degree of reversibility’ of the particular inflow in question. Some inflows are more prone to reversal (or more likely to be associated with outflows) and therefore will have different effects on national income and the real exchange rate than other flows that are less reversible (or more permanent in nature). This suggests a merit of decomposing capital inflows according to their degree of reversibility. Unlike most empirical studies, which use aggregate capital inflows, this study decomposes capital inflows. The question in our project is to assess whether private capital flows contribute to the appreciation of the exchange rate of the recipient country and does the impact is different when we decompose capital flow into FDI and FPI?

Our main results can be summarized as follows :

  • Portfolio investments, foreign borrowing, aid, and income lead to real exchange rate appreciation and loss of competitiveness;
  • Remittances have disparate results depending on their nature and size.
  • Foreign direct investments have no effect on the real exchange rate, and in some cases even enhance competitiveness.