Home > In Chapter One, I model the interaction between the government of a sub-Saharan African country and foreign providers of financ

In Chapter One, I model the interaction between the government of a sub-Saharan African country and foreign providers of financ

Tyson Roberts

Democracy, Development, and the International Political Economy

Chapter Two

Tyson Roberts

Democracy, Development, and the International Political Economy

 

 

Introduction to Empirical Section

      In Chapter One, I model the interaction between the government of a sub-Saharan African country and foreign providers of financial flows as follows:

    1. The government chooses an economic development strategy and a political regime type
    2. The providers of foreign finance decide
      1. how much investment to allocate to the private and public sector, and
      2. how much aid to allocate to the private and public sector
 

      My argument in this project is that government leaders in Africa make decisions about economic policy and changes in political institutions based (in part) on expectations of how those decisions will affect foreign capital flows.  In chapters two and three, therefore, I predict expected financial inflows conditional on economic and political choices of African governments.  In chapter four the predictions generated in chapters two and three enter the utility function of the government in a random utility model, along with control variables and an error term, to predict the decision of the government regarding economic policy and political institutions.  For example, as the expected capital inflows resulting from economic or political liberalization rise, the probability of the government liberalizing increases. In chapter two I address investment flows from private investors who send finance to Africa in order to make a profit.  In chapter three I address aid (concessional loans and grants) provided by governments and multilateral institutions in order to alleviate poverty and to influence African governments to pursue favored policies. 

 

Chapter Two:

Liberalization, Resource Endowments, and Private Capital Flows in Sub-Saharan Africa

 

Introduction

      A driving force behind the colonization of sub-Saharan Africa was the search for natural resources, both to feed the industrialization of Europe and to produce armament to fight wars throughout the world.  For example, Cecil Rhodes�� British South African Company was founded in 1889 to exploit and colonize south-Central Africa as part of the ��scramble for Africa,�� with a particular emphasis on mineral extraction.  It directly administered Rhodesia (modern-day Zambia and Zimbabwe) until 1923 and only gave up its mineral rights in Zambia in 1964.

      Following independence, African states continued to rely heavily on foreign private capital to develop their economies.  The volume and nature of these flows varied over time, however (see Figure 1).  In the 1960s, the same multinational corporations that played such a prominent role under colonization continued to play an important role.  However, the citizens of these newly independent states were not content to let foreigners control their economies.  The Father of Ghanaian independence, Dr. Kwame Nkrumah, had said, ��Seek ye first the political kingdom and all else shall be added unto you.��  Having achieved political independence, Africans expected to control their economies as well.1  Because there were few indigenous private corporations, many governments undertook ��Africanization�� policies by imposing hiring requirements on private firms, nationalizing foreign enterprises and foreign-controlled mineral and oil reserves, and establishing new state-owned enterprises.  But they still relied on foreign finance.  Commercial banks, flush with petrodollars from OPEC countries, played a particularly prominent role in the 1970s financing state investment.

      

Most state-owned enterprises weren��t profitable (Nellis 1994) and by the early 1980s governments were unable to repay their loans.  Restricted by government policy from Africa��s private sector and lacking profitable opportunities in its public sector, foreign investors largely left Africa alone from the mid-1980s until the early 1990s.  By then, investors were looking for profitable opportunities throughout the developing world.  Again, multinational firms returned to Africa, as did investors in new (for Africa) financial opportunities such as portfolio equity and bonds. Although international crises led to a fall in investment for certain years, generally there has been a rise in equity investment (FDI and portfolio) since 1990. 

      This brief summary of Africa��s economic history vis-��-vis the world economy explains the broad pattern of investment flows to sub-Saharan Africa as a region. But foreign private investors are faced with the decision of which country to invest in, and in what form.  Economic factors at the domestic level – such as market size, exploitable natural resources, productivity levels, and the cost of doing business – play an important part in these investors�� decisions.  However, domestic political factors also play an important role, in particular investment-related economic policies and the nature of the political institutions.  In this chapter, I focus on how these two political factors influence private investment flows to sub-Saharan Africa, including flows to the private sector (including foreign direct investment, portfolio equity, commercial loans, and bonds) and flows to the public sector (commercial loans and bonds).

      I find that investors are motivated by both economic indicators of future profit opportunities (such as natural resource wealth and economic growth) and by political factors such as investment-related economic policies and political institutions, which also affect profit opportunities. Furthermore, the effect of these political factors depends on the nature of the economy. Capitalist policies attracts investment to the private sector, particularly foreign direct investment, and the yield from a shift to capitalist policies is particularly high for countries that are highly dependent on natural resources.  On the other hand, capitalist policies reduce investment (or, statist policies increase investment) in the public sector inn countries that are natural resource-dependent countries.  As for regime type, democracy attracts investment to the private sector, particularly foreign direct investment, but this is only the case for countries that are not dependent on natural resource endowments.  In natural resource-dependent countries, democracy appears to have a negative effect on equity investment. 

 

Theory

      Most theories of the determinants of capital flows focus on economic factors.  My theory builds on these fundamental insights but focuses on two political factors: political institutions and investment-related economic policies.  I highlight how these factors affect investment, how they interact with each other, and how they interact with economic factors .  

      The motivation of private investors is to maximize expected returns on capital invested. Foreign finance has a certain amount of capital available for investment, F.  In addition to sending capital k to a given host country in Africa, the foreign investor has the option of utilizing its capital elsewhere, where it will receive some fixed returns = Ro. R0 is thus the opportunity cost, or the reserve value, for the foreign investor, which is external to each recipient nation. This can be termed the ��push�� factor. There are also factors within each recipient nation that the host country government can control, such as regime type , economic strategy s, and domestic economic factors x. These can be termed the ��pull�� factors. The economic strategy s determines what percentage of each economic sector j is reserved for state-owned enterprises. The balance, , is open to foreign investors in the private sectors.  Foreign investors may also invest in the public sector, and the public sector has a productivity discount , since public enterprises tend to be less efficient than private enterprises (Boardman and Vining 1989).2 The share of investment k that goes into the public sector for economic sector j is j.

      The utility of foreign finance is therefore 

      Each return function R is positive with diminishing returns, (R() > 0, R() < 0). Therefore, the optimal strategy for foreign finance, if the host country government is pursuing a capitalist strategy, is to invest k such that . If the government is pursuing a statist strategy, foreign finance will choose in sectors where  > 0.  That is, in any sector where public enterprises are less efficient than private enterprises, the government will invest the minimal amount required in the public sector and the rest in the private sector.  Investors will invest k such that in sectors where there is no minimum level reserved for the state, and such that where there is a minimum level reserved for the state.

      This analysis yields the following propositions:

    • Foreign investors will invest less in host countries when there are attractive investment opportunities in the home country relative to those in the host country.
    • Foreign investors will invest more in countries pursuing capitalist policies than those pursuing statist policies.
    • Foreign investors will be less deterred by statist policies in economies where the public sector��s disadvantage is small relative to the private sector.  In such cases, statist policies will divert investment from the private sector to the public sector.
    • To the extent that democracy increases expected returns for foreign investors, it will have a positive effect on foreign investment.
 

      Both external push factors and domestic pull factors have been included as explanations for the rise in private capital flows to the developing world over the past 20 years or so (Calvo, Leiderman and Reinhart 1996, Fernandez-Arias and Montiel 1996), and it has been found empirically that both play a significant role (Taylor and Sarno 1997, Jeanneau and Micu 2002). According to these studies, the most significant push factors are interest rates and economic growth in developed countries.  As interest rates fall in developed countries, capital seeks opportunities for higher rates of return in developing countries.  Low interest rates in developed countries also encourage governments and private firms in developing countries to borrow from developed countries. Another important push factor is the rate of economic growth in developed countries; when economic growth is low in developed countries, profit opportunities in the developed world are low, and so investors are more likely to seek profit opportunities in developing countries. Other push factors that are mentioned in the literature include excess liquidity in the developed world, increased risk appetite, trends toward diversification, and improvements in communication technology which make it easier to manage international business operations. In this project, the focus is on pull factors, and so the net effect of push factors will be proxied with the total flow of each form of capital into sub-Saharan Africa.

      After being motivated to send their investment dollars out of the developed world to earn a higher return, the providers of foreign finance must decide where to allocate their finance.  This decision is determined by ��pull�� factors, some exogenous and others controlled by the government. 

      Foreign direct investment generally has one of three goals.  Market-seeking FDI establishes productive enterprises to serve a group of customers in a foreign country.  Although trade can also be used by firms to serve customers abroad, FDI is necessary or more profitable in the service and retail industries and for some types of manufacturing (e.g., when transport costs are high relative to sales price or when tariffs on the finished good is high). Efficiency-seeking FDI establishes operations in a foreign country to manufacture products at lower cost for export.  Resource-seeking FDI exploits minerals, oil, or other location-specific resources.  In each case, FDI generates profits by applying proprietary knowledge capital (technology, managerial practices, or business networks) to the host country��s physical or human capital.  FDI, therefore, is an investment substantial enough to provide the investor with some managerial influence or control over the enterprise (10% is the common threshold between FDI and portfolio equity). 

      While foreign direct investors play an active role in the management of their investments, other investors are passive.  Portfolio equity investors, like foreign direct investors, share in the up- or downside of profitable operations. Although they exert no managerial control over the enterprise, they can generally withdraw their investment on short notice (FDI is less liquid and therefore more long-term).  Thus, such investors are motivated by both profit opportunities and short-term risks. Buyers of debt, whether commercial lenders or bondholders, receive regular repayment plus interest.  They therefore lend where they are confident they will be repaid.  Indicators of creditworthiness include growth, the presence of money generating resources such as oil, and low levels of debt.

      An important political factor to investors is the economic policies of the host country government.  Specific policies are difficult to analyze since they are diverse, complicated, and include many exceptions when applied.  Even obvious candidates can have surprising results; for example, the tax rate on income and profits doesn��t seem to matter to FDI (Markusen 1995, Chakrabarti 2001).  However, the overall economic stance of the government should have a significant effect on the government.  I simplify matters by categorizing the economic strategy into two categories: a ��statist�� approach, where the government is the primary investor in productive enterprises, and a ��capitalist�� approach, where it lets private enterprises play the primary role. A statist strategy has two components: (1) international flows of finance are restricted by the government, and (2) the government establishes and expands state-owned enterprises.

      In Africa, private finance is often restricted but never banned completely. Restrictions may take the form of a requirement for approval from the Ministry of Finance for investments and divestments, exchange control requirements, restrictions on repatriation of profits, or banning foreign equity investment in ��strategic�� sectors such as real estate, utilities, communication, or transportation.  State-owned enterprises can be fully state-owned or majority state-owned and can be established by purchasing or seizing the majority of shares (and thereby control) of private (often foreign-owned) firms, or by creating new firms (sometimes with foreign investors as minority shareholders).

      Unlike the communist governments of Asia and Eastern Europe, no African government has had a pure socialist system. Instead, African states pursue a ��mixed economy�� strategy, in which the both the state and private (including foreign) investors have some ownership in productive enterprises. A public or state-owned enterprise is ��an organization (1) whose primary function is the production and sale of goods and/or services, and (2) in which the government or other government-controlled agencies have an ownership stake that is sufficient to ensure them control over the enterprise, regardless of how actively that control is exercised�� (Tanzi 1984). Thus, ��nationalization�� occurs when the government increases its ownership share above 50%, sufficient to achieve control. 

      Even governments with Communist single-party rule, such as Mattheiu Kerekou��s regime in the People��s Republic of Benin, allowed foreign direct investment. Although Kerekou��s government nationalized foreign-owned banking, oil supply, insurance, and communications companies in 1974, foreign firms continued to play an important role in other parts of the economy.  In 1976, for example, Benin��s most important industrial complex opened: a textile plant majority owned by foreign firms (and 48% owned by the state) (EIU 1976). In Guinea, Sekou Toure��s government pursued a massive state enterprise program,3 but the state generally owned ��just�� 49%-51% of mining companies, with the balance owned by foreigners (who contributed the lion��s share of cash and know-how). In Ghana, Nkrumah nationalized five of the country��s six producing gold mines, but not the largest, Ashanti Goldfields,4 and invited the foreign firms Kaiser and Reynolds to build the aluminum smelter in his most ambitious development project, the Volta River project. 

      Although some foreign firms have profited to some extent under statist policies, and no African countries governments completely nationalized or banned all foreign investment, statist policies have a negative impact on foreign investment as a whole in the private sector.  State-owned enterprises crowd-out and/or compete with private enterprises, and the playing field is sloped against private firms. Furthermore, when foreign firms are nationalized, investors are rarely paid full market value.5

      Statist policies will thus reduce investment to the private sector, both because there are fewer private firms (i.e. firms in which private investors are majority shareholders), and because these private firms have reduced profit opportunities.  On the other hand, statist policies should have a positive effect on foreign investment to the public sector.  Although five-year development plans often proclaim an intention to rely heavily on domestic funding, the implementation of statist policies consistently relies on borrowing heavily from abroad to finance investments.  Because the state undertakes the profit opportunities that are denied to private capital, there are an increased number of high-return lending opportunities in the public sector.  For example, if the state nationalized a private mining company, foreign lenders who would have bought debt from the private firm will now buy debt from the publicly owned firm directly, or will lend money to the government that will in turn invest in or subsidize the mining concern.

      The response of foreign investors in the private sector to statist versus capitalist policies by the host country government depends in large part on the industry.  The value of resource-seeking FDI is largely derived from the control of the location of the natural resources, and so foreign investors are relatively unlikely to be deterred by statist policies.  If the host country government is willing to give foreign firms a minority share in an enterprise to extract oil or precious minerals, many foreign investors are willing to provide the majority of the necessary capital.  The value of efficiency-seeking, on the other hand, to a larger extent derives from the proprietary knowledge of the multinational firm, so investors in such industries are generally less interested in investing in public firms in which they lack managerial control. Furthermore, cheap labor is more readily available throughout the world than oil and precious minerals, and so when faced with nationalization – full, partial, or threatened – investors in such industries will withdraw and invest elsewhere.  Thus, it is expected that industries where public firms are not heavily disadvantaged relative to private firms, such as natural resource extraction, it can be expected that investors will respond to statist policies by shifting some investment from the private to the public sector, while in other industries investors will respond to statist policies by withdrawing.

      Another political factor that will affect foreign investment is political institution, or regime type. The response of foreign private investors to regime type also depends upon the endowments of the host country and whether the FDI is market-, efficiency-, or resource-seeking. A stable democracy should carry a number of benefits for investors.  The long time horizons resulting from orderly succession via elections should encourage the protection of property rights (Olson 1993). Free elections and a free press imply transparency and the free flow of information, which enables investors to make efficient decisions (Przeworski et al 2001, p. 144).  The accountability of the government to voters should reduce corruption and increase investment in public services favorable to investors such as human capital (Lake and Baum 2001, Boix 2003, Stasavage 2005).  However, the presence of oil and mineral wealth can undermine many of the investment-enhancing features of democracy. Resource wealth encourages vote-buying and other corrupt practices, which undermine the rule of law and support for democratic regime, thus making democracies in such environments short-lived.6  Most resource-abundant countries spend most of their history as dictatorships. The presence of natural resources such as oil encourages autocracy by providing the government with the means to buy support and repress opposition without needing to invest in its citizens (Ross 2001). The flow of FDI into such countries multiplies this dynamic because it doesn��t require human capital and provides the government with foreign capital to supplement export revenues for political purposes. Resource-seeking FDI is motivated by the presence of oil or mineral reserves and so is relatively indifferent to the level of human capital or transparency.  Furthermore, some argue that FDI prefers authoritarian rule because of increased stability and the ability to suppress demands among the populace (or a large support coalition) for benefits such as higher wages, the creation of additional jobs, investment in schools or healthcare, or compensation to residents for displacement or environmental degradation.

      Governments in countries without heavy endowments of resource wealth rely more heavily on their populace to generate income to tax, or to attract foreign investment.  Whereas resource-seeking FDI is location specific and thus relatively indifferent to any potential benefits of democracy, market- and efficiency-seeking can be located anywhere there are customers or workers. These types of investors are therefore more likely to be influenced by the advantages of democracy, including rule of law and transparency. 

      Although results vary, studies covering earlier years (Olson 1994, Li and Resnick 2004, Resnick 2001) are less likely to find a positive relationship between democracy and FDI than those covering later years (Li and Reuveny 2004, Jensen 2004, Leblang and Eichengreen 2006). When periods of time are looked at separately, it appears that democracy begins to attract FDI in the 1990s (Busse 2004), lending support to the argument (Spar 1999) that the shift from resource-seeking FDI in the primary sector to efficiency- and market-seeking FDI in manufacturing and services has created a positive relationship between democracy and FDI in regions such as Latin America and Asia, where the share primary sector FDI declined in the late 1980s.  In Africa, however, where the share of primary sector FDI was highest, this share actually increased (UNCTAD 1999).

      Statist policies from popularly elected governments might be expected to be particularly threatening to foreign-owned firms.  While governments led by small coalitions might be bought off with some bribes or other favors, a government that relies on a broad coalition will need more to be more satisfied, ranging from jobs to high taxes to nationalization.  For example, in 1974 the foreign-owned phosphate mining company in Togo, COTOMIB, allegedly offered President Eyadema a bribe of 1.5 million francs CFA to maintain the tax and investment privileges (EIU 1974).  Although Eyadema was an autocratic ruler throughout his reign, in the early 1970s he was pursuing a large coalition strategy in which state jobs and other benefits were distributed throughout the population.7  By nationalizing the phosphate mining company, he was able to increase state revenues to finance a large share of 400 billion francs CFA worth of state enterprise investments (the country also ran up debts of 5.6 billion francs CFA) (Decalo 1990, pp. 229-30). 

      To summarize, I have the following expectations with regard to political institutions, economic policies, and private capital flows in Africa:

  • Countries with high natural resource endowments will receive high levels of capital inflows, including those with authoritarian regimes, to exploit location-specific resources.
  • In countries with high natural resource endowments, investors will respond to capitalist policies by investing heavily in the private sector, and to statist policies by shifting investment to the public sector. 
  • In countries lacking natural resource endowments, investors will respond to statist policies by withholding investment.
  • In countries lacking high natural resource endowments (and therefore striving to attract market-seeking and efficiency-seeking FDI), there will be a positive relationship between democracy and capital inflows, while investors in natural resource-rich countries will be indifferent or prefer authoritarianism.

 

 

Data and Methodology

 

Dependent variables

 

      There are four dependent variables, three flows to the private sector and one to the public (and publicly guaranteed) sector (see Table 1 for descriptive statistics):

  • Foreign direct investment net inflows per capita - equity ownership of a substantial share (10% or more) of an enterprise. 
  • Portfolio equity net inflows per capita - equity ownership of an insubstantial share (less than 10%) of an enterprise 
  • Total net inflows per capita from private creditors to nonguaranteed private enterprises – includes bonds, loans from commercial banks, and other 
  • Total net inflows per capita from private creditors to public or publicly guaranteed institutions – includes bonds, loans from commercial banks, and other 
 

      In order to compare across years, I use per capita constant US$ for all measures.8  I use net inflows to capture both investment and divestment decisions. In order to compare across countries, I use inflows per capita, which is common (Chakrabarti 2001) although not universal and seems most appropriate for the goals of this project.  A primary motive for domestic governments to attract capital is to create jobs and other benefits for supporters in order to continue to hold office.  Even in countries where the ruler does not rely on popular support, population matters in the sense that more soldiers will be required to repress any potential uprisings.  An exception that is common in Africa is ��enclave economies�� (Leonard and Strauss 2003), in which the government survives by controlling some natural resources that have low labor or infrastructure requirements.  I deal with this in two ways.  First, I drop countries whose populations average below one million during the period studied – these include some of the most extreme enclave economies such as Gabon, Equatorial Guinea, and Guinea-Bissau.9 Second, I interact the two explanatory variables of interest, regime type and economic strategy, with a measure of the prominence of natural resource extraction in the economy (see below).

      The largest flow over the entire period is FDI per capita, which averaged over $11 per capita per year for the entire period for countries with average populations over one million and peaked in the late 1990s.  The second largest is credit to the public sector per capita, which averaged over $3 per capita per year over the entire period and peaked in the 1970s.  Portfolio equity and credit to the private sector totaled less than $1 per capita annually over the entire period, although portfolio equity rose to high levels in the late 1990s (mostly to South Africa).

 

Explanatory variables

      The domestic explanatory variables of interest are the level of democracy and economic policies.  For democracy, I use the measure developed by Przeworski et al 2001 (and updated by Cheibub and Gandhi 2004). This indicator is a dummy, which in its reversed form is 1 for democracies and 0 for non-democracies.  The decisive factor for this measure is the institutional factor of primary interest for this overall project, i.e., in democracies the government leader risks electoral overthrow, whereas in non-democracies he doesn��t.  Because a leader may win free and fair elections, the ACLP democracy measure is coded retroactively for democratization – when a leader who was a dictator loses an election, the regime is coded as a democracy back to the date when the new electoral rules were established.  For example, J.J. Rawlings of Ghana ruled without elections until the end of 1992, and then allowed for multi-party elections, which he won in late 1992 and 1996.  In 2000, however, his chosen successor, Atta Mills, was defeated in an election.  Ghana is therefore coded as a democracy beginning in 1993, when multiparty elections started. Although the coding in such cases depends on future events, many observers considered the election in Ghana to be free and fair in 1992 and 1996, and democracy measures that rely on expert opinion such as FreedomHouse and Polity also date Ghana��s democratization to 1992. The correlation among the three measures of democracy ranges from 82-86%.

      Because no single measure is ideal to differentiate between ��capitalist�� and ��statist�� investment policies,10 I have created a summary measure, similar to the approach of Sachs and Warner (1995) in creating a trade openness dummy.  There are two policy areas of importance in investment policies when comparing statist to capitalist policies.  First, statist policies restrict international capital flows, including foreign investment in private enterprises.  Second, statist policies invest in state-owned enterprises and nationalize existing foreign-owned enterprises.  Capitalist policies, on the other hand, allow for the free flow capital, do not invest in new state-owned enterprises, and divest existing state-owned enterprises.

      I therefore code economic policy as statist if they follow any of the following criteria:

    1. The Financial Openness Index (Brune 2004) index is 0, meaning all forms of capital inflows and outflows are restricted (FOI).
    2. Public Investment (which includes state enterprise investment and government fixed investment, Pfefferman et al 1999) is greater than 10% of GDP (SPI).
    3. Major state enterprise investment or private enterprise nationalization occurs in more sectors than does state enterprise privatization or liquidation (SEI). 11
 

      Otherwise, economic policy is coded as capitalist.  See Appendix 1 for a further explanation of each component in the economic policy variable.

      Most countries in sub-Saharan Africa pursued statist economic policies in the 1970s until the debt crisis.  The debt crisis also coincided with some democratization, but these democracies were short-lived.  The share of countries pursuing capitalist polices increased in the 1980s, leveled off for several years, then rose dramatically again at the end of the 1990s.  The number of democracies increased during the early part of the 1990s, stalled for a few years, then rose again into the turn of the century.

      

      In addition to the explanatory variables of interest, I also include the following control variables:

      The total volume of net inflows (in millions of US 2000 dollars) to sub-Saharan Africa for each category in a given year proxies for the various push factors such as interest rates, economic growth, and herd behavior in the developed world.

      Domestic control variables come from the capital flows literature.  (All economic data come from the World Bank��s World Development Indicators unless indicated otherwise.) I begin with four of the determinants found to be the most robust in predicting FDI inflows in an Extreme Bound Analysis (Chakrabarti 2001): 12

      Income level (GDP per capita) has the most robust, and positive, effect on FDI, since a more developed economy can absorb more FDI, and wealthier consumers can purchase more products from market-seeking FDI. (Since much of the FDI to Africa is resource-seeking, however, the effect of this factor might be attenuated.) Furthermore, low income levels are correlated with capital scarcity, and standard economic models expect capital to flow from capital abundant to capital scarce economies.13

      Trade Openness (exports plus imports as a percentage of GDP) has the second most robust, and positive, effect on FDI.  Although FDI can serve as a substitute for trade, and the literature discusses ��tariff-jumping FDI,�� trade openness generally has a positive effect on FDI. Easy access to imports lowers the cost of doing business for foreign subsidiaries, and the ability to export is attractive to efficiency-seeking FDI.

      Economic growth (percentage change in GDP) is an indicator of high productivity and future profit opportunities, and therefore should attract FDI.

      Net exports (exports minus imports as a percentage of GDP) is a proxy for the current account balance.  Negative net exports (or a current account deficit) tend to be correlated with positive capital inflows. When imports exceed exports, an excess of currency will be held in foreigners�� hands, and one use for that currency is to send it back as capital flows.

      Where FDI inflows are the dependent variable, I also include the stock of FDI per capita, whose expected effects are ambiguous.14  On the one hand, accumulated FDI should decrease the need for additional FDI (and higher levels of FDI stock enable higher levels of reversed flows).  On the other hand, there may be agglomeration effects, whereby existing FDI makes new inflows of FDI more productive.  Agglomeration effects, however, generally occur in knowledge-intensive industries, which are less prevalent in Africa.

       Since much of the capital flowing to sub-Saharan Africa is resource-seeking, I also include a measure of natural resource endowment.  I use the sum of the value of mineral and ore production and energy production (oil, natural gas, and coal).

      When portfolio equity flows are the dependent variable, I also include a dummy indicating the presence of a stock market.15  Although FDI is long-term, portfolio equity is short-term, and therefore more likely to consider short-term risks such as volatility. I use the standard deviation of (official) exchange rates over the previous ten years to measure exchange rate risk. I also include a dummy for South Africa, which received the lion��s share of portfolio investment.16

      Lenders are influenced by the perceived ability of the borrower to repay loans.  African governments and firms must repay loans in foreign currency, which is earned with exports.  I therefore measure the perceived ability to repay loans with the total debt service (TDS) as a percentage of exports.   (The need for foreign currency to repay loans is also a reason that natural resource endowments are important to lenders).

      Data permitting, the analysis includes observations from 34 countries covering the years 1972-2003.  I use ordinary least squares (OLS) with panel-corrected standard errors (PCSE), as recommended by Beck and Katz (1995).  Because the number of years is roughly equal to the number of countries, techniques such as FGLS are inappropriate. 17 I include the lagged dependent variable, which also serves as a proxy for any omitted variables. All explanatory variables are lagged one year to address endogeneity concerns unless otherwise noted.

       

Results and Discussion

      The coefficients of the control variables are generally in the expected direction, although not always at statistically significant levels (see Table 2; coefficients in bold are statistically significant at the 90% confidence level). The lack of consistent statistical significance is not surprising. Very few determinants of FDI inflows are robust; statistical significance often depends upon model specification (Chakrabarti 2001).  Furthermore, the inclusion of the lagged dependent variable, which is always positive with high levels of statistical significance, is likely soaking up the explanatory of some of the other variables.  Since the primary goal for this exercise is to generate accurate predictions using the best estimate for the effect of the two political factors of interest, this is not problematic.

      The proxy for push factors, total Africa inflows, is generally positive although not always statistically significant.  The exception is portfolio equity and debt to the private sector, which due to volatility have a negative coefficient.  I also ran these regressions with current year total equity inflows; the resulting regressions are in the expected direction and statistically significant.18  Thus one determinant of capital flows to a given sub-Saharan African country is the total flows of foreign capital into sub-Saharan Africa as a region.  For example, if net debt flows to the public sector in Africa as a region rise by $1 billion, the flows to a typical African country will rise by $1.40 per capita. Net flows to the public sector ranged from over $80 billion per year in the 1970s to less than zero.

      Capitalist policies generally have a positive (but not statistically significant) effect on capital flows.  Substantively, the greatest effects of capitalist policies are on FDI. Compared to statist policies, capitalist policies are associated with an additional $1.84 per capita in FDI net inflows.  Reflecting the fact that most FDI to Africa is resource seeking, capitalist policies yield higher FDI inflows if a country is well endowed with natural resources.  For every percentage point of GNI of production in oil or minerals, capitalist policies will yield an additional $0.80 in FDI inflows.

      Capitalist policies interacted with debt flows to the public sector, on the other hand, have a negative effect when interacted with natural resource endowments.  This finding can be interepreted as follows: while investors in extractive industries prefer to invest in the form of FDI under capitalist policies, they will lend to the public sector under statist policies. Although statist policies reserve a majority share for the government in critical industries, African governments generally have insufficient capital to fund their share of the investments, thus creating new profit opportunities for foreign capital in the public sector.  A typical example: in 1976 the Mauritanian government borrowed $40 million to finance the state��s share in a new copper and steel processing plant, while foreign equity made up the balance (EIU 1976).

      Democracy is also generally positive, but only statistically significant for foreign direct investment: democratic countries attract an additional $3.57 relative to nondemocracies.  However, the positive effect of democracy on FDI is reduced as natural endowments become more important in the economy.    These findings lend support to the argument that the benefits of democracy, such as transparency, rule of law, and more education and income for the average citizen, is less important to investors in the extractive industries than those in other industries

      To summarize these results, I calculated expected values for a typical country, both with and without abundant natural resources, conditional on changes in economic policy and political regime type (see Table 3).  I define a country with abundant natural resources as one where the value of energy and mineral extraction exceeds one third of gross national income.19 The average value of production in the extractive sector (energy and minerals) for these cases is 45% of GNI (for countries with average populations over one million).  The average value of production for the other countries is just under 3% of GNI.  I used the mean values for all other variables (using data from countries with an average population of over one million).

      According to Table 3, in a typical year, the highest level of investment in the private sector  (over $50 per capita) can be expected to flow to countries with high natural endowments with an authoritarian regime (note, however, that the level of flows also depends on the level of flows in a given year).  Flows to the private sector in natural endowment-rich countries is expected to be lower if statist policies are applied, or if the regime is democratic.  It is rare for natural endowment rich countries to be democratic, however, and the only case of an endowment-rich country with both democracy and statist policies (among the cases coded so far) is Nigeria, 1979-1982, under President Shehu Shagari, whose government became a ��colossus of corruption�� (Othman 1984).  For example, state governments were issued licenses to import rice and then sold these contracts to the highest bidder.  Such practices bankrupted the country and soon led to a coup.  It is little wonder that foreign investors found these circumstances of corruption and instability unappealing.  In the public sector, however, statist policies are associated with a high level of investment flows (over $18 per capita for nondemocracies) for countries heavily endowed with natural resources, while such countries receive virtually no flows to the public sector under capitalist policies

      In non-resource abundant cases, investment in the private sector is highest under democratic capitalist regimes (over $12 per capita) and lowest under authoritarian statist regimes ($7 per capita).  This suggests that democratic capitalist regimes are likely the most hospitable to market-seeking FDI, and, to the extent that Africa attracts such FDI, efficiency-seeking FDI.  (The greatest recipient of efficiency seeking FDI is probably Mauritius, known as the ��African tiger,�� which has no extractive resources, a stable democracy, scores high on the financial openness index and has almost no state-owned enterprises).  Flows to the public sector, on the other hand, tend to be low (less than $3 per capita) no matter what the regime type or economic strategy.   

 

Conclusion

      As do economic variables, political variables such as political institutions and economic policies have an important effect on capital inflows per capita.  Capitalist policies and democratic political institutions tend to attract investment, particularly FDI. 

      Investor response to economic strategy and political regime type depends on the economy��s dependence on natural resources, however. Since mineral and oil extraction are the major profit opportunities in Africa, countries with such resources receive the highest levels of capital inflows per capita, and since these investment opportunities rely on location rather than the benefits of private ownership, investors respond to economic policies by shifting their investments, to the private sector under capitalist policies and to the public sector under statist policies.  In countries lacking natural resource endowments, however, statist policies deter investment.  Such economies, however, attract investment in the private sector with both capitalist policies and democratic institutions, each of which can be expected to increase the profit opportunities of knowledge-dependent industries.  Investor decisions do not depend solely on the decisions of governments in host countries, however.  They are also influenced by external factors such as the profit opportunities in their home country relative to the profit opportunities in Africa, proxied here by the total flow of capital to Africa, as well as factors such as openness to trade, income level, and economic growth.

      Based on these coefficients and annual data for each country, I have generated predicted values of public and private sector investment for each country-year, conditional on economic policy and regime type.  These predicted values will be used to predict government decisions in each year.  In years when funds for the public sector are particularly abundant, such as the 1970s, governments are expected to be drawn toward statist policies.  In years when predicted funds for the public sector are scarce and/or funds for the private sector are abundant, governments are expected to shift to capitalist policies. Furthermore, a rise in the availability of capital for the private sector relative to the public sector is expected to motivate governments of economies that are not resource abundant to democratize, but not governments of resource-abundant economies. Instead, authoritarian governments of such regimes are expected to be more motivated than ever to retain hegemonic power, both to ensure the continuing inflow of private investment and to enjoy the benefits of holding office under such conditions. 
 
 

 

Appendix 1

      I code economic policy as statist if they follow any of the following criteria:

    1. If the Financial Openness Index (Brune 2004) index is 0, meaning all forms of capital inflows and outflows are restricted (FOI).
    2. If Public Investment (which includes state enterprise investment and government fixed investment, Pfefferman et al 1999) is greater than 10% of GDP (SPI).
    3. If there is major investment in state enterprises or nationalization of private enterprises in more sectors than there are privatization or liquidation of state enterprises (SEI).

      Because I haven��t finished coding all country years for the SEI measure, I also code economic policy as capitalist if they have initiated a privatization program post-1988 and have a FOI greater than zero. 

      An ideal operationalization of policies regarding international private investment flows (such as FDI) would capture nuances such as how restrictive policies are, or, if incentives are offered, how attractive these policies are.  Unfortuntately, operationalizing policies addressing foreign direct investment specifically is difficult.  One data set that attempts to do this is the investment freedom variable in the Heritage Foundation��s Index of Economic Freedom.  For this variable, 

    ��Questions examined include whether there is a foreign investment code that defines the country��s investment laws and procedures; whether the government encourages foreign investment through fair and equitable treatment of investors; whether there are restrictions on access to foreign exchange; whether foreign firms are treated the same as domestic firms under the law; whether the government imposes restrictions on payments, transfers, and capital transactions; and whether specific industries are closed to foreign investment.�� (Beach and Kane 2008, p. 48).   

    However, data only go as far back as 1995, and it is difficult to code for earlier years – descriptions for different levels of freedom use measures such as ��very few,�� ��few,�� and ��significant;�� and the description of actual policies in sources such as the IMF��s AREAER are often vague, incomplete, difficult to compare, or missing altogether for early years, particularly for African countries.

          For the foreign investments constraint I therefore use Brune��s Financial Openness Index (FOI), which is blunt regarding FDI (0 for restrictions, 1 for no restriction), but at least the measures are comparable.  In order to capture finer gradations, Brune includes other types of international transactions that are likely to influence the decisions of foreign investors.

      ��The FOI is available for 187 countries over the period 1965-2004�� it includes twelve categories of current and capital account transactions: (1) exchange rate arrangements (multiple/dual v. unified); (2) payments from invisible transactions (referring to payments for services such as financial or legal advice, royalties, transfers to overseas residents); (3) proceeds from invisible transactions; (4) proceeds from exports; (5) inward controls on money market transactions; (6) outward controls on money market transactions; (7) inward controls on credit operations; (8) outward controls on credit operations; (9) inward controls on foreign direct investment; (10) outward controls on foreign direct investment; (11) real estate transactions; and (12) controls on provisions and operations of commercial and credit institutions. Each category is coded as either having significant restrictions (��closed��=0) or not (��open��=1)�� (Brune and Guisinger 2007). 

            The most common measure of the prominence of state enterprises comes from the Economic Freedom of the World data set (Gwartney and Lawson 2008), which is a 1-10 index that uses two types of data to categorize country-years - the sectors where state enterprises are active, and government investment as a percentage of total investment. For example, when state enterprises are limited to economy-of-scale industries such power utilities (and government investment is 15-20% of total investment) the economy is given a rating of 8 out of 10; if SOEs are present in energy, transportation, and communication sectors (and government investment is 25-30% of total) the economy is given a rating of 6, etc. I do not use this measure for two reasons.  First, the data is only available every five years until 2000.  Second, government investment as a percentage of total investment, which is appropriate for some purposes, is not appropriate for this project since I am using the state enterprise policy as a determinant of private investment.20 

            In the spirit of Gwartney and Lawson, however, I use investment dollars and sectors to measure state enterprise activity. The first measure I use is public investment as a percentage of GDP (SPI).  Public investment is the sum of investment by the government and all state enterprises. Using state enterprise data alone, such as the data from the Bureaucrats in Business data set (World Bank 1995), is problematic because different countries categorize state enterprises different ways.  Some are considered individual entities, in which case separate statistics are maintained, others are considered part of the government, in which case they are not (see Pfefferman et al 1999 for a discussion). I use the public investment as percentage of GDP data from Easterly 2001, which updates the Pfefferman et al (1999) data set.

            The second approach is to count sector level state enterprise activity.  Because of the lack of annual data on how many sectors have active state enterprises (for example, the data set in Short 1984 includes sector data for 21 sub-Saharan African countries in the ��late 1970s��), I take the approach of counting sectors in which governments are actively investing in or divesting from state-owned enterprises to create a State Enterprise Activity Index (SEI).  I utilize the following definition: a public or state-owned enterprise is ��an organization (1) whose primary function is the production and sale of goods and/or services, and (2) in which the government or other government-controlled agencies have an ownership stake that is sufficient to ensure them control over the enterprise, regardless of how actively that control is exercised�� (Tanzi 1984).  I use a 50% threshold to determine control.  To operationalize investment I code the following events: establishment of a new enterprise in which the government has majority control; major expansion or rehabilitation of a state-owned enterprise; or nationalization, which I define as increasing the government��s share or equity above 50%.  In some cases nationalization is achieved through market prices and in other cases compensation is significantly below market prices. In this sense, the sector count approach is superior to the level of investment measured in dollars.  Divestment occurs when the state privatizes or liquidates the state-owned enterprise.  Following the definition I use, I do not consider contracts for private management as privatization. I count the net number of investment activities (i.e. investment activities minus divestment activities) by sector for 27 sectors.  If a government has a positive net number, meaning it is investing in state enterprise activities in more sectors than it is divesting, then it is considered to be implementing a statist economic strategy.21 
       
       
       
       

       

      Bibliography 

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    Table 1

     
    Table 2 
    Table 3

     

    1 A typical example: The three goals of Cote d��Ivoire��s Five Year Plan in 1971 were: ��i. Strong economic growth; ii. Greater participation by Ivory Coast citizens in the economy; iii. An improvement in the standard of living of the rural population�� (EIU 1971). Note that Cote d��Ivoire was among the most market-friendly regimes in Africa at that time.

    2 Africa is full of examples of state enterprises that were unproductive until they were bought by foreign private capital, such as the Bonagui soft drinks factory in Guinea, which was installed under Sekou Toure with an annual capacity of 2 million cartons of soft drinks but never entered production until it was bought by Coca Cola Corporation of the USA and Stella Artois of Belgium in 1986 (EIU 1987).

    3 Guinea had 181 public enterprises in 1980 (Nellis 1994).

    4 It was eventually nationalized in 1973 by Colonel Acheampong.

    5 For example, in 1974-75, the government of Benin nationalized petrol stations, insurance firms, banks, telecommunications firms, transport companies, the brewery, and one hotel; for all this, compensation was a mere $8m (Allen 1989, p. 80).

    6The short-lived democratic government in Nigeria from 1979-1983 quickly became a ��colossus of corruption�� (Othman 1984) whose overthrow by the military was welcome. Corruption is a common excuse for militaries to overthrow democratic regimes in Africa (Decalo 1990).  Politicians in Nigeria��s current democracy are also succumbing to the temptation to buy votes to win elections (Collier 2009, p. 39).

    7 ��Through patronage, popular economic policies, and astute cabinet appointments, attention to the demands of all segments of the population, �� Eyadema adroitly nibbled at Ewe opposition to his rule���� (Decalo 1990, p. 223). 

    8 An alternative would be to measure capital inflows as a percentage of GDP.  Since government policies affect GDP, I chose to use a denominator (population) that depends less on government choices.

    9 The nine countries that are thereby excluded are Cape Verde, the Comoros, Djibouti, Equatorial Guinea, Gabon, the Gambia, Guinea Bissau, Sao Tome and Principe, and Swaziland.  Most of these countries (all but Gabon, the Gambia, and Swaziland) are missing many data for many years. They also tend to have extreme outliers for many of the data.  For example, while the average FDI inflows per capita for sub-Saharan African states was $11 for countries with average populations over one million, it was $105 per year for smaller countries. Equatorial Guinea had FDI inflows per capita as high as $2,897 per year, while Gabon had inflows as high as $502 per year and as low as -$411 per year. Similarly, the average level of public investment for countries with average populations below one million was 15.3% of GDP, almost double the average level of public investment for countries with larger populations, 8.6% of GDP. See the descriptive statistics in Table 1 for more evidence of outliers.

    10 One rejected candidate, for example, is Kornai��s (1992) list of socialist countries.  Most of Kornai��s socialist countries are in Asia and Eastern Europe.  Those in Africa (as of 1987) are limited to Congo-Brazzaville, Somalia, Benin, Ethiopia, Angola, Mozambique, and Zimbabwe (Kornai 1992, pp. 6-7). The reason why Kornai��s list is so restricted is because of his operationalization: ��The undivided power of the Communist party is the sole criterion for inclusion in this table.  From now on those included will be referred to in this book as socialist countries�� (Kornai 1992, p. 5).  The problematic nature, for my purposes, of this operationalization is highlighted by the fact that China, the developing world��s largest recipient of FDI, continues to be coded as socialist. 

    11 I haven��t finished coding all country-years for the SEI measure.  I��ve done about 800 and have about 400 left to do.

    12 Other relatively robust variables are tariff rates and wage rates are not included because of lack of data. The most complete wage data set (Freeman and Oostendorp 2001) has 95% of the country-years missing data, and 75% continue to be missing data after using linear interpolation to impute for missing values.  Inclusion of the data including imputations indicates that wage levels have an insignificant (negative) effect, which may reflect the fact that Africa does not tend to be a destination for efficiency-seeking FDI.  Inclusion of wage data eliminates some of the findings, but it is unclear whether this is due to 75% of the cases dropping out

    13 However, this economic prediction rarely plays out in practice.  According to Lucas (1990), this can be explained with levels of productivity via human capital, but Markusen (1995) argues that this is because most FDI is market-seeking rather than efficiency seeking.

    14 The FDI stock data from UNCTAD begins in 1980, while the flow data begins in 1970.  I used the net inflow data to calculate stock data, and replaced negative values with zeroes.

    15 Until recently, twelve African countries had stock markets: Botswana (opened 1989), Cote d��Ivoire (1976), Ghana (1989), Kenya (1954), Malawi (1996), Mauritius (1989), Namibia (1992), Nigeria (1961), South Africa (1887), Swaziland (1990), Zambia (1994), Zimbabwe (1946) (Kenny and Moss 1998).

    16 The mean portfolio equity inflows per capita for all SSA countries is $1 per year; for South Africa it is $28.  Most of this took place in 1997-2000.

    17 Running the regression using a GLS model with random effects returns the same coefficients but with much smaller standard errors.  For example, the interaction terms using the variables of interest that are significant at the 90% level using OLS with PCSE are significant at the 99% level using the random effects model.

    18 There is a 76% correlation between total portfolio flows into Africa and its lag, and so I will use the lag to generate predictions for chapter four.

    19 This is an adaptation of the rule used by Fearon and Laitin (2003). I use the value of fuel and mineral and ore production as a percentage of gross national income (GNI) rather that fuel primary commodity exports as a percentage of GDP because of superior data availability.  Five oil-producing countries in Africa are heavily endowed by this criterion, two with small populations (Gabon and Equatorial Guinea) and three with populations above one million (Angola, Nigeria, and the Republic of Congo).  Two countries met this criterion with mining activity from 1970-1976: Liberia (primarily iron) and Zambia (primarily copper).  Namibia also met the criterion from 1984-1989 but is missing data for all four dependent variables for all years. Chad meets the criterion after 2003.

    20 The Gwartney measure is calculated using private investment (public investment divided by pulblic + private investment).

    21 I use the Economist Intelligence Units quarterly reports and the World Bank��s Privatization Database to count sector investment and divestment activities.

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