CHAPTER ONE 1.0 1.

1 INTRODUCTION Background of the study Over the years, the issue of capital flight from developing countries, including Nigeria, has received appreciable attention from researchers. Concerns have been expressed about the magnitude, causes and consequences of these capital outflows, not least because the lack of financial resources for appropriate economic development has pushed Nigerian and most other sub-Saharan African (SSA) countries into external borrowing to augment domestic resources in their quest for economic growth. Acquisition of foreign assets by residents has escalated even as developing counties search for external borrowings to enhance the inflow of resources. Authors like Cuddington (1987) and Pastor (1990) have shown that developing countries borrowing is substantially diverted into private assets abroad.

Capital flight has been regarded as a major factor contributing to the mounting external debt problems and inhibiting developmental efforts in the third world, Cuddington (1986). External debt in Nigeria, for example, increased by 700 percent from $3.5million in 1980 to $28.0 billion in 2000. Most analyst have attributed sluggish growth and persistent BOP deficits to most developing countries including Nigeria, despite private transfers and long term capital flows to capital flight Ajayi (1996). Capital flight in turn is caused by so many factors such as speculation that any of the vehicle currencies will fall e.g. Dollar, unfriendly investment climate facing both the local and foreign investors, inflation, repressive financial system (under developed financial structure) etc. Capital flight, in economics, occurs when assets and/or money rapidly flow out of a country, due to an economic event that disturbs investors and causes them to lower their valuation of the assets in that country, or otherwise to lose confidence in its economic strength. This leads to a disappearance of wealth and is usually accompanied by a sharp drop in the
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exchange rate of the affected country. It also refers to all private capital outflows from developing countries, be they short term or long-term portfolio or equity investments, Oloyede (2002, pp160). Conceptually, divergence views on what really constitute capital flight has led to concern about the need for policy intervention to stem it and about the interaction between economic policies in developing and industrial countries. Capital flight also raises question about the role of International financial institutions which lend to developing countries and act as depositors for the capital exports from the developing countries. Views on the concept of capital flight are largely unsettled. While some analysts view it as a symptom of a sick society characterized by break down of social cohesion, reduction in growth potentials, erosion of tax base, failure to recover from debt problems, and a redistribution of wealth from poorer to richer social groups, others consider the very use of the word Capital flight as unnecessarily pejorative description of natural,

economically rational responses to the portfolio choices that have confronted

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wealthy residents of some debtor countries in recent years . Economic theory explain the so-called capital flight from developing countries as a product of natural and economically rational behavior of wealthy residents of these debtor countries to diversify their portfolio in order to protect themselves against riskiness of any one particular investment. Thus, the arguments makes the concept more complex to define and given the present magnitude of Nigerias external debt, the possible impact of capital flight on her debt-servicing capability and following the words of Nigerias former minister of finance and external affairs, Iweala (2006) Nigeria may benefit from remittance form Diaspora funds as a result of what is described as anecdotal evidence of high levels of capital from the Nigerian economy, a study of capital flight is appropriate at this time. Relating this concept of capital flight to the Nigerian economy, she is a sleeping giant with a lot of potentials to develop and emerge as a world giant because of its natural endowments in human and natural resources in terms of production, investment and in general, but in terms of economic
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development shes still crawling. The question is what is the cause(s) of the sluggish growth and development? Capital flight is an academic issue and difficult to understand. It is a serious problem particularly in the third world counties. The primary reason for the sluggish growth in Nigeria is not lack of raw materials, markets or labour rather, it is the result of the institutional obstacles that had their origin in the colonial economic structure, controlled by foreign trading houses which saw industrialization as a threat to their commercial activities. That is, the colonial master neglected the development of manufacturing sectors instead, they encouraged rapid improvement in the production of cash crops such as cocoa which they take to their countries to feed industries. They sell their outputs e.g. cars to developing nations then repatriate their profit, this is an ugly situation that Nigeria emulated as a way of sending stolen money to a safer economy (secret foreign account). Besides that, there is also, large movement of Nigerian intellectuals, highly skilled manpower and professionals to foreign countries (Brain drain).
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1.2

STATEMENT OF THE PROBLEM In most developing nations such as Nigeria which is characterized by

foreign exchange shortage, chronic poverty and heavy debt burden, capital flight constitutes a large proportion of resources which are useful for financing economic growth and normalizing the adverse economic trends. Taking Nigeria as a case study, large percentage of people that engage in capital flight are economic and political groups who seize the opportunity of their position to acquire both legal and illegal funds and siphoned them abroad. Such illegal funds consist of kickbacks on public and private sectors contracts, diversion of export revenue to private accounts and the likes. At this point, given the complex nature of capital flight and its sever effect on Nigerian economy one needs to ask questions as to: (i) Where to draw the line between what is and what is not capital flight? (ii) What are the major causes of and how do we measure the magnitude of capital flight?
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(iii)

Is capital flight something bad, which requires policy intervention to stem or reverse?

(iv)

What major effect does capital flight have on the growth and development of the Nigerian economy?

(v)

What are the measures that can be employed to reverse the problem of capital flight?

(vi)

Is their any relationship between the concept of capital flight and investment instruments?

This study intends to investigate the above-itemized questions.

1.3 RESEARCH QUESTION The questions to be answered are: 1. Is Capital flight something bad which requires policy intervention to stop or reverse it? 2. Is it not true that Capital flight would deter policy makers from making wrong political and economic decision?
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3. Why is it when an American or a Briton puts money abroad it is called Foreign Investment and when an African does the same it is called Capital flight? 4. Why is it that when an American company puts 30% of its equity abroad it is called Strategic Diversification and when a Nigerian businessman puts only 4% abroad it is called Lack of Confidence. Such arguments make the definition of Capital flight complex. This is basically true because capital flight has had inhibiting consequences on the economies concerned despite reflows that some countries have experienced. Whether or not a country impose capital controls, the immediate consequences of capital flight is to reduce foreign exchange reserves which may, in turn, require increase external borrowing to finance development expenditures. When both the foreign exchange reserves and external borrowing capacity have been exhausted, the country will be forced to initiate balance of payments adjustment through either devaluation or equivalent expenditure switching policy, or by
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expenditure reduction. Devaluation will result in the reduction of domestic savings required for financing domestic investment and hence reducing future growth potential. The reduction in expenditure or demand also reduces output both in the current and in future periods. In countries with capital controls, capital flight is associated with a rising parallel market premium as the demand for foreign exchange increases due to the need to finance capital flight. The premium will also result in the drain of some foreign resources from official reserves into the parallel market. In extreme case, the diversion of the reserves into the parallel market may exhaust the countrys foreign reserves and thus forcing both the government and the private sector to increase their foreign borrowing. Capital flight also has some income distributional consequences especially if the country follows the Origin principle of taxation, since there may be little foreign investment which can be taxed. On the other hand, even when a country follow the residence principle of taxation, it would not be easy to tax flight capital, since such capital is
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normally not reported to the tax authorities. However, strong conclusions on the consequences of capital flight is strictly an empirical matter which is beyond the present work. The damaging effects of capital flight may make rational lenders hesitate to increase credits to the debtor countries. On the other hand, the behaviour of individual agents to diversify their portfolio by keeping some of their wealth in foreign assets is postulated as rational by economic theory and accepted as normal in industrial and some developing countries. 1.4. PURPOSE OF THE STUDY From the perspective of the different angles from which capital flight can be viewed, it is important to study it for any economy. The economic argument against capital flight from developing countries are not only convincing but are often too strong to be ignored. Firstly, the outflow of capital can cause a shortage of liquidity in the economy and thereby create a shortfall in the amount of funds that are needed for the importation of equipment which are needed for development.
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In addition, the shortage of liquidity in the economy can lead to the exertion of upward pressure on interest rates. Furthermore, given the fact that capital outflow is a diversion of domestic savings away form domestic real investment, the pace of growth and development is retarded from what it would have been otherwise. It can also cause a depreciation of the domestic currency if the authorities are operating a floating exchange rate system. If attempts are being made to defend a particular exchange rate, a loss of reserves will ensue. Secondly, the income that is generated abroad and the wealth that are held abroad are outside the purview of domestic authorities and therefore cannot be taxed. Thus, potential government revenue is reduced and hence the debt-servicing capacity of governments debt is affected. The aforementioned consequences of capital flight call for prompt attention. This, is the purpose for which the study is to be carried out. 1.4.1 OBJECTIVE OF THE STUDY

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The broad objective of the study is to examine the effect of capital flight on Nigerian economy. This broad objective will lead us to the specific objectives which are: (i) To estimate the magnitude and determine the causes of capital flight from Nigeria. (ii) To briefly examine the political and macro-development in Nigeria. (iii) To discuss the policy implication of what to do in order to stem or recapture the capital flight. (iv) To identify factors influencing port folio choice of private wealth holders in Nigeria. 1.4.2 JUSTIFICATION FOR THE STUDY At the inception of the current civilian government in Nigeria in 1999, a campaign for external debt relief from Nigerias foreign creditors and a bid to attract foreign investment were launched as cardinal goals in the pursuit of economic growth and better living conditions for Nigeria. The policy
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direction was informed bys the belief that he countrys debt burden and inadequate inflow of investment capital were strong hindrances to the growth of the economy. When that government assumed office in 1999 the ratio of Nigerias external debt to GDP was as high as 84% and the domestic debt/GDP ratio was 25%. On the investment flow side, the net flow of foreign private capital declined by more than 92% in 1999. Basically, a large volume of capital flight is considered as evidence of excessive taxation and economic mismanagement in the home country. It casts doubts about debt relief as an appropriate response to the debt service problem (Eggerstedt et al, 1995) and sends wrong signals to investors. A recent study by Boyce and Ndikumana (2001) reports that as much as US$ 3.5 billion flew out of Nigeria in 1996. In the light of the external debt burden of the country, the recently approved debt relief by the Paris club and the urge to reverse capital flight in the process of economic growth, this study is a starting point in providing new and more recent insights into the

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issue of capital flight from Nigeria, and possible policy measures or strategies to reverse the trend. In the particular case of Nigeria, capital flight has been a recurrent phenomenon and was estimated to be taking place even before the adoption of the structural adjustment programme in 1986. could it perhaps be that capital flight has continued unabated even under democracy?. In view of the adverse implications of capital flight, providing insight into possible strategies to effect capital flight reversal is crucial at this time. 1.5 STATEMENT OF HYPOTHESIS Based on data to be gathered in relation to the concept of capital flight and in order to facilitate this research work, an hypothesis will be formulated and tested for reliability or otherwise purposes. The hypothesis to be tested include: H0: Capital flight has no significant effect on Nigerian economy. H1: Capital flight has significant effect on Nigerian economy. Where: H0 is a Null hypothesis
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H1 is an Alternative hypothesis. 1.6 SCOPE AND LIMITATION OF THE STUDY Capital flight and its effect on Gross Capital Formation (GCF) and Gross Domestic Product (GDP) are being examined which are major economic indices of growth in the economy. The time horizon cover by the study is 38 years (1970-2007). The period cover is justified based on observation that enormous capital outflow from Nigeria to foreign nations occurred during this period majorly by political office holders. This study is constrained by a number of factors. The major ones are: i. Financial constraint as this could not allow us to access and exploit some potential sources of data. ii. Time constraint also limit our ability because class-work also deserves prompt and full attention. iii. Data collection problem because the only recognized empirical studies on capital flight conducted for Nigeria is by Ajayi (1992) as cited in Onwioduokit (2001).
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1.7

OUTLINE OF THE STUDY The study will be divided into five (5) separate but highly related

chapters. Chapter one is the general introduction of the study, it focuses attention on the historical background of the study. It gives the objective of the study, statement of problem, statement of hypothesis, significance of the study, scope and limitation of the study which covers the period of 38 years. Chapter two deals with the theoretical framework and review of past studies on capital flight. Also, it examines briefly the political; and macroeconomic developments in Nigeria and how they influence capital flight. Definition of terms and magnitudes are also discussed there in and also a review of Nigerians experience. Chapter three deals with the methodology framework to be used in this study and this consists of re-statement of hypothesis, model specification, definition of variables, estimation of techniques types & sources of data used in the study.
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Chapter four will be exclusively reserved for the statistical inference. In other words, giving the economic interpretation to the empirical results of descriptive estimation. Chapter five which is the last chapter summarizes, concludes and give detailed recommendations on capital flight for policy-makers and others who are concerned. 1.8 DEFINITION OF TERMS In the context of this study, some terms will be employed to analyse and are defined as follows: (i) Brain Drain: It refers to the movement of educated elites from one county to another for development purpose due to better offer such as incentives: (ii) Capital flight: The term capital flight as used in this study connotes illegal movement of capital or funds from one country to another usually from developing countries to developed countries. This

17

connotation implies that there may be normal or legal and abnormal or illegal flows. (iii) Capital outflow: It is used as a proxy for capital flight which implies movement of investible resources out of developing country such as Nigeria to a developed country like Britain. (iv) Inflation: it refers to a persistent increase in price of goods & services in an economy over a period of time. It is an economic situation in which there are plenty money chasing fewer goods. (v) Money laundering: It refers to an act of converting financial proceeds realized from illegal dealings such as necrotic drugs into legal investment.

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CHAPTER TWO 2.0 THEORETICAL REVIEW FRAMEWORK AND LITERATURE

2.1

Introduction Most studies on capital flight have been done for Latin American,

Cuddington (1986) and Conesa (1987). However, capital flight has been argued to stem from many factors, classified into political and economic factors, Ajayi (1992). He argued that the political aspect is often ignored in most analysis on capital flight and said this is predicated on corruption ( a problem which is hardly limited to LDCs) and access to foreign funds by political leaders. Beginning in the mid-1980s, the phenomenon of capital flight from developing countries received considerable attention in the literature. A number of country-specific case studies and cross-country studies have examined the magnitude of capital flight, its causes, and its effects (Ajayi
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1997). Until recently, however, sub-sahara Africa has received less attention than other developing regions. Yet capital outflows from African economies deserve serious attention for several reasons away from domestic investment and other productive activities. In recent decades, African economies have achieved significantly low investment levels than other developing countries ( International Finance Corporation, 1998;Ndikumana, 2000). These low levels of domestic investment are attributable, in part, to the apparent scarcity of domestic savings, weak and shallow financial systems, and high country risk due to unstable macroeconomic and political conditions. Capital flight is both a cause and a symptom of this weak investment performance. Secondly, capital flight is likely to have pronounced regressive effects on the distribution of wealth. The individuals who engage in capital flight generally are members of the sub-continents economic and political elites, who take advantage of their privileged positions to acquire and channel funds abroad. Both the acquisition and the transfer of funds often involve legally questionable practices, including the falsification of trade documents
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(trade misinvoicing or faking), the embezzlement of export revenues and kickbacks on public and private sector contracts (Ndikumana and Boyce, 1998). The negative effect of the resulting shortages of revenue and foreign exchange fall disproportionately on the shoulders of the less wealthy members of the society. The regressive impact of capital flight is compounded when financial imbalances results in devaluation, the wealthy who hold external assets are insulated from its effects, while the poor enjoy no such cushion. A third reason for greater attention to African capital flight is that most developing countries remain in the grip of a severe external debt crisis. Debt service today absorbs a sum equivalent to more than 6% of developing countrys GDP. In so far as the proceeds of external borrowing are used not to the benefit of the African public, but rather to finance the accumulation of private external assets by the ruling elites, the moral and legal legitimacy of these debt-service obligations is open to challenge.

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This section of the study shall deal with several issues on capital flight such issues will cover those on prior studies, issue of measurement, causes and effects, political and macro-economic developments in Nigeria, a detailed analyses of trade-faking, that is, the under-invoicing/over-invoicing of exports and imports, definitions of the concept and others that can increase the flight of capital from Nigerian economy. 2.2 THEORETICAL FRAME WORK Over recent years, the deteriorating impact of capital flight on economic growth and development has received increasing attention from researchers, economist, analysts and policy makers, especially in the third world. Sutherland (1996), based on the new open macro economic models by obstfeld and Rogoff (1996) studied the implications of financial openness on macro economic fluctuations. Buch et al (2003) modified the above model in three respects and this modified version is used as the theoretical framework in the study of Nair (2006) on India economy. In the study, he made 32
22

observations, the period is 1973 to 2005 while he selected GDP and GNP as the macro-economic violatility and the degree of capital account openness is proxied by capital outflow liberation among others. He checked out the time series properties of the variables using Augmented Dickey Fuller (ADF) tests. In the study, he used Akaike information criteria to select optimum number of lags and concluded that all the variables are integrated of order one except the world bank estimates of capital flight. So, he carried out multivariate tests and suggest a robust long run relationship between capital account openness and the volatility of all macro economic aggregates. He proceeds to multivariate error correction modelling (ECM) to capture the dynamic (shortrun) casual relationship between variables. He found out that the t-ratios are significant and the ECM are acceptable. The model adequacy tests were also satisfied. Adeniyi and Obasa (2004) in their study, set out to empirically investigate the impact of interest rates and other macro economic factors on performance in Nigeria using co-integration and error correction mechanism
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(ECM) technique with annual time series covering the period between 1970 and 2002. They stated their analysis by examining stochastic characteristics of each time series by testing their stationarity using Augmented Dickey Fuller (ADF) test. After that, they proceeded to estimate the error correction mechanism (ECM) model. From their study, many interested conclusions were drawn. First, they found that interest rate spread and government deficit financing have negative impact on the growth of manufacturing subsector in Nigeria. Secondly, their study reveals that liberalization of the Nigerian economy has promoted manufacturing growth under the period of study. The findings were further reinforced by the presence of a long run equilibrium relationship as evidenced by the co-integration and stability in their model. In addition, the results of the tests in Nair (2006) study tally with results for the growth equation showed that not only does past debt accumulation deter growth but so do current flows.

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Alberto and Guido (1987) have shown that capital flight will result when future governments are expected to follow income re-distribution policies that are not desirable for holders of domestic wealth. Capital flight is thus, more a consequence than a cause of unequal income distribution. Obasa and Adeniyi (2004) also argued that a way of avoiding spurious regression results stationarity of variables and co-integration among them should be tested prior to estimation of error correction model and Granger causality regressions. This claimed that the co-integration for stationary variables would be meaningless because variables have to be integrated individually in order to be co-integrated. While the study of Nair (2006) for India was concluded through the error correction term which showed debt to have negative implications on growth potential of the economy. Using both the Gross Domestic Product (GDP) and Gross National Product (GNP) as important determinants of growth. Onwiodukit (2007) also employed co-integration analysis for the determinants of capital flight from Nigeria. In this model, he identified
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important variables explaining capital flight to include domestic inflation, parallel market premium comparative growth rate of the economy. His results showed that these variables determined capital flight in Nigeria as the expected signs hold in the model. The unit root tests also confirmed the variables stationarity at their various levels. Thus, the author confirmed based on his empirical findings that capital flight could deter growth if not given prompt attention by the policy-makers. 2.3 REVIEW OF EMPIRICAL STUDIES By its very nature, it is difficult to measure capital flight. The difficulties involved, not withstanding, a number of capital flight estimates have been made over the last several years. The preponderant of these studies cover a number of countries including mostly Argentina, Brazil, Chile, Korea, Mexico, Peru, the Phillipines and Venezuela. A recent study by Rojasuarez (1991) covers Argentina, Bolivia, Chile, Columbia, Ecuador, Gabon, Jamaica, Mexico, Nigeria, Peru, the Philippines, Venezuela and Yugoslavia. These various studies differ from one another in terms of the
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methodological approaches of measurement, country coverage and lifespan. The most significant of these studies which have made impact on capital flight estimates include the studies by Dooley (1986, 1988), Dooley et al., (1986), Worldbank (1985), Morgan Guaranty Trust Company (1987), Cline (1986), Cuddingtom (1986), Cumby and Levich (1987), Lessard and Williamson (1987), Khan and Ul Haque (1987) and Verna Schneider (1991). In the Cuddington (1986) approach, capital flight is defined as a short term speculative outflows which according to him is the typical meaning of capital flight. It is defined as short term external assets by the non-bank private sector plus the errors and omissions in the balance of payments. This approach is concentrated on what is popularly referred to as hot money flows method because of the fact that funds are expected to respond quickly to changes in expected returns or to changes in risk. Variations in economic conditions are likely to affect the magnitude of such flows. These in essence are funds on the wings that are expected to return very quickly to the
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country of origin when economic conditions are favourable, that is, when appropriate macro economic policy stance is adopted. Khan and UI Haque (1987) calculated capital flight for eighty highlyindebted developing countries for the period 1974-1982. Capital flight is defined in two ways. First, it is defined simply as gross private short term capital flows plus net errors and omissions in the countrys balance of payment accounts. This is the same as the Cuddington estimate. The second method tries to take account for normal capital flows. Capital flight is defined as that part of the increase in external claims that yields no recorded investment income, this in essence is the Dooley (1986) approach. Cuddington (1986) also estimated the economic determinants of residents capital outflow of four countries (Argentina, Mexico, Uruguay and Venezuela). His empirical findings differed from country to country. In mexico, capital flight was highly related with over-valuation of the exchange rate, while in Venezuela, there were over-valuation and foreign interest rates. In Argentina and Uruguay it lagged effective exchange rate and error
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of the model were related to capital flight. Conesa (1977) had similar results except that it had 16 annual observation while Cuddington (1986) had 91. Conesa (1987) had growth as an additional explanatory factor and did not attempt to estimate over-valuation of the real or effective exchange rates but used level of government borrowing in his study of seven developing countries (Argentina, Mexico, Brazil, Chile, Peru, Venezuela and Philippines). Dooley (1988) discovered that capital flight is significantly related to domestic inflation, financial repression and a measure of country risk premium. Chang and Cumby (1991), in their sample of 36 African countries discovered that with the exception of Nigeria, the absolute levels of capital flight from the individual African countries were smaller than Latin American countries. But in relation to external debt and Gross Domestic product (GDP) many African countries experienced higher capital flight than their Latin American counterparts. Hermes and Lensuk (1992), estimated capital flight from six-sub-Saharan African countries (Congo,
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Zaire, Cote d ivore, Nigeria, Sudan, Tanzania and Uganda) from 1976 to 1989, using their estimates, capital flight may seem small compared to Latin American countries but the burden as a percentage of GDP is higher by 61% of sub-Saharan compared to 22% for Latin American. Also, by their calculation, Murinde et al., (1996) discovered that Nigeria experienced the biggest capital flight over the period $21billion representing 60% of the combined total of the six countries in the sample. Their econometric analysis of the determinant of capital flight indicated that the most explanatory variable is public external borrowing. The results implied that capital flight and external debt are closely dependent. In this study of three countries (Cote divore, Nigeria and Morocco,), Ojo (1992) opined that Nigeria had the largest capital flight of $35billion and emphasized the importance of domestic economic environment including policy related variables as government budget deficit and changes in external debt. AJayi (1992) discovered in his study that cumulative capital flight in the period of 1980 to 1991 averaged 40% of external debt to run 18
30

countries sampled. The ratio was as high as 94% for Nigeria, 74% for Kenya and 60% for Sudan. He also discovered that countries that exhibited the greatest capital flight often are the most highly indebted and referred to them as twin problems. Ajayi (1992) estimated capital flight from Nigeria in 1972 to 1989, drawing attention to the role of trade faking (misinvoicing) in the countrys oil sector and to the link between capital flight, corruption and governance failure. He concluded that most of the capital flight from Nigeria is recorded in the BOP and debt statistics and that is not only explained by economic factor but also political factor or uncertainty. Owiodukit (2001) in his study stated that the major determinants of capital flight from Nigeria are domestic, inflation, availability of foreign exchange reserve, comparative growth rate of the economy and parallel market premium. Using empirical evidence of the magnitude of capital flight from debtor countries in the 1980s, Gaydeezka and Oks of the IMF and the World Bank respectively looks for satisfactory explanations of this phenomenon. The study argues
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that the nature of capital flight pre-1982 can be explained by poor domestic policies resulting in adverse economic incentives for domestic investors and facilitated by large inflows from foreign creditors. The authors then search for an explanation for the resurgence in capital flight since 1986, and argue that debtor governments not only lost external credit worthiness (in 19821983) but have now also lost domestic credit worthiness. As confidence in governments has been eroded , the perceived risk of domestic assets rises and residents have sought to diversify through investing abroad. While this continues still at the core of the problem of capital flight, the authors also looked at several other explanations of the problem for example continuing policy distortions, debt overhang and uncertainty over debt negotiations. According to the authors, large capital flows out of developing countries have ample evidence of high capital mobility between LDCs and the outside world and of private capitals stronger responsiveness to changes in both domestic and foreign economic incentives. They also hold the view that because LDC governments largely ignored capital mobility and allowed
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policy distortions to persist, capital flight continued until external credit was denied and some corrective measures were undertaken. They concluded that the price LDCs paid for capital flight was already high. They argued further that massive foreign lending played instrumental role in facilitating private capital outflows and that the deeper roots of capital flight is traceable to their economic dis-incentives created by domestic policy distortions. They observe that the decline in outflows from the early 1980s through 1986 can be ascribed in part to the correction of some distortions such as the reduction in exchange rate. The study by Ajayi(1995) provided link between capital flight and external debt in Nigeria. He concluded that most of the capital flight from Nigeria is recorded in the balance of payment and debt statistics and that capital flow is explained by not only economic factor but also political instability. Econometrics study on Africa seem to suggest that capital flight results mainly from macro economic mismanagement, especially domestic
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inflation. Ngeno (1994) for example, found capital to be positively correlated to domestic inflation and lagged capital flight. Olopoenia (1995) study for Uganda showed unsatisfactory results. In fact the R2 was less than 0.30. The explanatory power in Olopoenia (1995) raises concern on the difficulty of estimating capital flight in African countries which arises mainly from poor quality of the data. The poor results of empirical studies on capital flight from Africa may not be unconnected to the use of estimated statistics of capital flight as a dependent varaiable. Attempts to empirically determine the factors that affect an estimated statistics on capital flight is suspect and is bound to produce spurious results, as none of the methods of estimation discussed can capture the very nature and character of the developing countries, including Nigeria. The relative under developed nature of statistical gathering as well as the very nature of the applied concept of capital flight makes the adoption of any model developed for the industrial economies for the purpose of measuring capital flight in the developing country like Nigeria, irrelevant.
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In the light of the above, and given our earlier discussion on the consequences of capital flight on the economy, which cannot be separated from the impact of genuine capital movement, we shall adopt for this study the capital outflow as the dependent variable. In an alternative model, we shall adopt the error and omission statistics, as proxy for the dependent variable. The use of the two alternative variables is more relevant to a developing economies like Nigeria since illegality of the so-called capital flight cannot be modeled.Ngeno(1994) As noted earlier, the only known empiricalsties on capital flight in Nigeria is Ajayi(1992). However, the author did not test for unit roots in the regression models before running the econometrics model with the variables in levels. In order to avoid spurious regression, the author should have first established the levels of the variables. In addition Ajayi (1992)empirical work was based on estimated capital flight figure as the dependent variable. The problem of attempting to determine the determinants of an estimated dependent variable is very obvious as the result of the regression can best be
35

interpreted with caution. To adequately take care of the short comings of Ajayi(1992), we intend to test for statistical properties of the variables used in the equation as well as used firmed figure of capital outflow as a proxy for capital flight the reason for this has been adumbrated earlier. 2.4 SHORTCOMINGS OF PAST ESTIMATES It is observed that past studies on capital flight have taken into account the effect of exchange rate fluctuations of the dollar value in deriving residual measures of capital flight. Depending on whether these currencies appreciate or depreciate against the dollar, this can introduce a downward or upward bias in relevant countries where a substantial portion of the debt is dominated in other currencies as in the francophone countries of sub-Saharan African where much debt is dominated as frame. Secondly, past studies of capital flight from sub-Saharan Africa except Chang and Cumby (1991) and Ajayi (1992) cover a small number of countries. As a result, they do not offer a basis for expansive cross-country analysis of the magnitude, causes and consequence of capital flight. Those that cover a
36

large sample only refer to a fairly short time period which limits the ability to examine the trends in capital flight over long time frame. For time series analysis, it would be useful to have estimated capital flight for a good number of years. Thirdly, many past estimates, ignored analysis on falsification of trade transaction. Exception is given to Chang and Cumby (1991) and Ajayi (1992, 1997), Ndikumana and Boyce (1998). Instead they take trade statistics unlike capital account statistics in official balance of payments table at the fact value. In practice, the official BOP data on exports and imports are of ten of poor quality due to trade misinvoicing i.e. exporter may understate the value of the export revenue with the intention of retaining abroad the difference between their actual export value and declared export value. On the import side, there are incentives for both over-invoicing and under-invoicing. Over invoicing allows importers to obtain extra foreign exchange, which can be transferred abroad from the Central Bank on favourable term, while under invoicing and outright smuggling allows
37

importers to evade custom duties and restriction. Thus, this weakness suggest that caution should be taken in the interpretation of the regression results due to problems inherent in determining the determinants of the estimated capital flight. 2.5 FOREIGN LENDING AND CAPITAL OUTFLOWS The estimations of Gajdeezka and Oks shows a very strong correlation between capital outflows and foreign lending. However, they believe that this high correlation does not necessarily reveal conclusive causality linkages in either direction. They argued that the nature of the relationship between net lending and capital flight has changed over time. They also discussed the relationship between net lending and capital flight in the context of risk assymetrics and scarce investment opportunities in developing countries. Their estimates revealed a close relationship between foreign lending and capital flight. During the 1980-1987 period, the total value of capital outflow from highly indebted countries (HICs) was $84billion and which
38

corresponded to roughly 40% of the total net long term resource inflows to these countries in the group of high capital flight countries (Argentina, Brazil, Colombia, Mexico, Nigeria, Peru, Philippines and Venezuela), for each dollar in net lending, approximately 60% was expatriated as capital outflows. They argued that this is an important observation given that foreign lending was a major source of exchange reserves financing and that these reserves were a source of foreign exchange for capital flight. They added that the correlation between foreign lending and capital our flows can be explained in several ways. Prior to 1982, the most straight forward explanation is that governments borrowed to replenish foreign exchange reserves and thus enabled capital outflows. External lending and capital showed when voluntary lending to developing debtor countries stopped in 1982. However, they observe that the linkage between capital flight and borrowing changed after the outbreak of payments difficulties in 1982, in particular the large foreign debt meant that foreign creditors faced much
39

higher levels of risk than before. They explained that the disbursement of additional loans were made condition in the implementation of policies which by themselves required less external finding. Therefore, the resulting contraction in lending by 1986 was accompanied by the conspicuous reduction in capital flight. On this note, Gagdeezka and Oks suggested that the decline in capital outflows until 1986 was achieved by better economic policies negotiated in conjunction with lower borrowing requirements and the imposition of capital controls. 2.6 DOMESTIC POLICY DISTORTIONS, DEBT

ACCUMULATION AND CAPITAL OUTFLOWS Domestic policy distortions were an integral part of the growth and stabilization policies pursued by most Latin American countries. Policy distortions led to a loss of governments credit-worthiness, exchange rate over valuation and financial instability, which in turn generated incentives for capital flight. These factors are examined below.

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2.6.1 LOSS OF CREDIT-WORTHINESS During the 1970s, governments of large Latin American countries for example pursued expansive fiscal and monetary policies associated with relatively fast rates of growth and received massive financial support from foreign commercial banks. Foreing lending help avert the short-term inflationary consequence of large domestic deficits but as foreign debt accumulated, both the foreign and domestic credit worthiness of these governments were impaired. As the internal perception of governments solvency deteriorated, thus raising inflationary risks and devaluation expectations, even extremely high interest rates could not prevent capital flight. The reason was that the risk involved in holding domestic debt grew faster than their nominal interest rate and when corrected for risk factors (including unexpected devaluation risk) foreign asset remained a better choice capital flows in and out of a country arbitraged differentials between these risk-adjusting domestic and foreign rates of return.

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2.6.2 EXCHANGE RATE OVER-VALUATION Exchange rate policy was often aimed at fighting inflation rather than at preventing future balance of payments difficulties. For example in Argentina, Chile and Uruguay, a pre-announced path of decreasing exchange rate devaluations was deliberately enforced to contain inflation. These policies, which were conducted without controls on capital movements were facilitated by favourable terms of trade, initially low real foreign interest rates and massive foreign lending. These anti-inflation policies led to exchange rate over valuation and fed capital outflows as speculators brought foreign assets when the real exchange rate became unsustainably overvalued. In this way, central banks financial capital flight, thus rechanelling abroad a substantial portion of foreign lending to governments, with controls on capital movements unlike in the open capital account situation described above, currency over valuation is reflected in a premium, the black market offers above the official exchange rate. This tends to raise the unofficial surplus, an alternative source of capital flight, because the
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black market premium creates an economic incentives for smuggling, export under-invoicing, import-overvoicing and unofficial trade transactions related to tourism. Capital flight through smuggling and under-voicing of exports is also induced by export taxes or in the case of drugs by legal restrictions. On the other hand, import tarriffs induce import under-invoicing (as importers seek to avoid trade taxes) that tends to reverse capital flight. 2.6.3 FINANCIAL INSTABILITY Although financial instability was partly a consequence of fiscal deficits and exchange rate policies, in many countries it was also a byproduct of financial repression, that is interest rate fixed below inflation rates, high legal reserve requirements of banks the other institution rigidities imposed on financial systems. Financial repression encouraged capital flight both by lowering returns on domestic investments and feeding overall financial instability for example through its potential impact on financial disintermediation when inflation rises.

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In countries with more liberal financial systems for example with market determined interest rates, large fiscal deficits and exchange rate overvaluation resulted in high real domestic interest rates thus creating a different type of financial instability as firms and governments became highly indebted domestically. Domestic firms that took advantage of relatively cheap foreign credit experienced financial instability after corrective devaluations were implemented. Financial instability also activates what can be regarded as a secondary source of capital flight the stock of assets held by residents abroad. Financial instability induced foreign asset holder to reinvest abroad the returns on their assets such as interest, dividends and capital gains. While policy distortions tends to have an immediate effect on capital flight, reversing them may only have positive results in the longrun. In the short-run, trade and fiscal reforms may promote rather than reverse capital flight as they pose a threat to heavily protected sectors, privileged tax loopholes and tax evasion. However, a substantial

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reduction of fiscal imbalance could accelerate the beneficial effects of removing other policy distortions. Table 2.1: Capital flight estimates for highly indebted countries (US&billions). Total outflows Hot money Residual method Banking Assets (Deposits) Long term resource inflow Memorandum item: Total outflow/revenues 1980-1987 -83.7 -77.9 -46.2 NA 209.8 -39.9% 1983-1987 -30.9 -27.9 -21.6 NA 83.0 -37.2% 1986-1988 -14.1 -13.5 -8.0 5.64 33.9 -42.7

Notes: Negative sign denotes outflow 1. Total outflows: - Long term and short-term assets of the

official, deposit money banks and other sectors plus errors and omissions. 2. Hot money: Short term capital of other sectors and errors

and omissions.
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3.

Residual methods: Sum of current account, change in

reserves, foreign direct investment and net lending 4. Banking assets: Exchange rate adjusted changes in balance

sheet report deposits of the non-bank private sector. 5. long term resource inflow: sum of official transfers, net

foreign direct investment and net lending. Sources: IMF balance of payments statistics, World Banks Debtor reporting system, Bank for international settlements and estimates. Table 2.2: Capital outflows from HICs (US $ billions) 1988-7 A -1.7 0.6 -0.4 0.5 -1.8 -0.5 0.10 0.0 -0.3 -10.7 B 0.6 0.6 -5.5 0.2 -2.8 0.2 0.5 -0.3 0.6 -6.8
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Argentina Bolivia Brazil Chile Columbia Cote dIvory Coasta Rica Jamaica Ecuador Mexico

1986-8 C 1.1 1.5 2.3 0.7 -3.8 -1.3 -0.1 0.3 -1.0 -17.9

C 2.1 0.3 -2.2 0.8 -1.5 -0.1 0.2 0.4 -0.4 -10.4

Morocco Nigeria Peru Philippines Uruguary Venezuela Uruguary Total Notes: A= B= C=

-0.4 -5.1 -1.1 -0.4 -0.1 -6.4 0.3 -30.9

-0.4 -7.9 -0.9 0.7 -0.3 -5.7 0.3 -27.9

0.3 6.8 0.3 -2.3 -0.1 -5.5 -2.2 -21.6

-0.9 2.7 1.6 1.2 -0.1 0.9 -0.4 -8.0

Negative sign denotes outflow Total outflow Hot money Residual method

Source: See table 1 2.7 INTERNATIONAL TRADE FAKING AND CAPITAL FLIGHT The term trade faking is used to describe the over-invoicing /under invoicing in international trade i.e. of exports and imports. The analyses here will be in three steps. In the first step an analysis is undertaken of the extent of trade faking in Nigerias trade using UN trade data system. The focus of attention here is Nigerias trade with Industrial Market Economies. In the
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second step, we analyze using the SITC classification of the extent of trade faking that exists in the fuel section of Nigerias export trade. Oil is nigerias most important export. The last step deals with the industrial countries. The data from industrial countries which is adjudged reliable is subsequently used to arrive at the adjusted capital flight estimates. It is necessary not only to discuss the rationale behind trade faking, but also analyze the reasons for the existence of discrepancy in recorded data on exports and imports. Most of the studies on trade faking started in the early 1960s and 1970s of note are the studies by Bhagwate (1974, 1967), Bhagwati, Krueger and Wibulswaschi (1974), Simkin (1970), Richter (1970), Yeats (1978), Nayak (1977). Recent studies since the 1980s include that of McDonald (1985), Dewulf (1981) and Yeats (1981, 1990). It is true that the imports of one country is the export of another country. Thus, it is expected that the ratio of the values of imports of a country (say country A) that originate from another country (say country B) over the values of exports from country B to country A which is called the
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valuation ratio should be unity. There are a variety of reasons, however, why trade statistics (i.e. exports and imports) may not match. One of the reasons is the under-invoicing or over-invoicing of trade transaction as a means of effecting capital flight. The differential in the export-import statistics may however, not be due to illicit or illegal activities connected with under invoicing or over invoicing of trade statistics. There are a number of other factors that may be responsible for the data discrepancy. These include shipping costs, diversions en-route to final destinations, re-export of goods, differential lags in reporting, potential discrepancies arising from the conversion from one currency to another and then to a common currency usually the US dollar and variations in exchange rate (De Wulf, 1981; and Yeats, 1990). Perhaps one of the basic causes of trade data discrepancy in sub-Saharan African countries is due to the routing process for trade transactions. This problem occurs when goods are routed through several countries bordering the exporter and/or importer country before the final destination is reached.
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Thus, in these cases the country of origin may inaccurately list a routing country as the importer or the country of final destination may report the routing country as the exporter. A range of discrepancies may thus appear between the three (or more) parties for the transactions (Yeats, 1990, p. 137). Countries that maintain overvalued currencies and restrict access to foreign countries are often the setting for invoice alterations. One of the basic reasons for trade faking in developing countries is the fact that exchange controls are common place. Consequently, foreign currencies can be brought or sold at a premium in the black market for foreign exchange. As a result of the premium on foreign exchange, the tendency exists to under-invoice exports and over-invoice imports. That of course is not the only reason, the existence of high import duties can also provide the incentives among importers to under-invoice imports in contrast to the usual case of over-invoicing of imports when a premium exists on foreign exchange in the black market. If there is a subsidy on imports it will likely
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cause over-invoicing of imports. A tariff on exports will lead to underinvoicing while over-invoicing of exports exists when a subsidy exists on exports. Under-invoicing of imports can systematically arise in the following two cases. The first case is one where the imported commodity carries a tariff duty. The second situation is one in which the importation of the commodity is strictly controlled. In the case of the tariff duty, it pays the importer to understate the value of his imports when the amount of savings he will make in tariff duties exceeds the extra price that he must pay to procure foreign exchange in the black market. Thus, the importer benefits by under-invoicing if: T Bp > 0 Where, T = tariff rate and BP = black market exchange rate at premium (Bhagwati,1964). In the case of quantitative importer restrictions, under-invoicing is profitable if two conditions are met. The first is that under-invoicing enables
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a larger quantity to be imported under license and secondly the premium on the imported commodity in the domestic market is greater than the foreign exchange premium. Over the last several years, there has been a thriving black market in foreign exchange in Nigeria. In addition, the tariff policy has consistently varied allowing at one time the importation of certain commodities at either zero or positive rate to a situation of total ban at another time. Also during the 1979-1984 civilian administration, the issuing of import licenses to business men was in vogue. The existence of these situations inevitably provided the fertile ground for the over-invoicing and /or under-invoicing of exports and imports. One of the mechanisms for preventing customs abuse is pre-shipment inspection (PSI). PSI verifies the quantity, quality and price of imports before shipment from the exporting country. As a complement to its foreign exchange control, Nigeria implemented a PSI program in January 1979. This was carried out by Societe General de Surveillance (SGS). On October 1,
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1984, the previous contract with SGS was ended and three other companies were hired. These were Intertek (goods from North and South America); Bureau veritas (for goods from continental Europe and Africa) and Cotecna (for goods from the United Kingdom, Asia and South Pacific). Quite a large array of products apart from the imposition of value limitations are however are, exempted from the PSI program. Thus, the program has not been successful in eliminating trade faking. 2.8 POLITICAL AND MACRO ECONOMIC DEVELOPMENTS IN NIGERIA A study of capital flight is incomplete without a preliminary examination of the structure of the Nigerian economy and its political history. Ordinarily Nigeria was an agrarian society, with agriculture accounting for at least 65% of the GDP. The contribution of the sector, gradually declined due to the emergence of crude petroleum in 1970 when Nigeria became a member of OPEC. Thereafter, oil became the mainstay of the economy (Onwiodukit, 2001).
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The oil boom of the early 1970s had a pervasive effect on the growth and development of the economy. It suddenly became the dominant sector of the economy accounting for more than 90% of exports and main source of revenue. However, the oil revenue witnessed growth overtime and the growth was absorbed mainly by public sector spending particularly on transportation, social services, education etc. but considering their long run financial implications and efficiency with which the projects where price increases secured the resource needed to accommodate the supply in nontraded goods but they depressed the non-oil traded goods sectors. Nigeria borrowed significantly during this period to procure foreign goods. In 1978, economic problems start to manifest but a second oil-boom in 1979 brought about confidence that oil proceeds could be a sound basis for planning and sustaining public sector consumption and investment. The second oil-boom coincides with the civilian government (second republic). The increase in oil revenue gave the government impetus to increase public expenditure and real income declined. Then, the government was forced to
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run deficit budget and finance this by borrowing. Also, the value of exchange rate began to appreciate and this placed export at a disadvantage position. The distorted exchange rate prevented the government from allocating resources efficiently to purchase import. Based on this, government established several measures and stringent trade control in the economy, stabilization heat of 1982. Besides, public investment was cut noticeably and petroleum products prices and tarrifs were raised. In spite of these stringent measures, the economy reached a crises point in 1983/84 when oil earning declined drastically. To fill the domestic savings gap in order to execute development projects, government continue to borrow heavily and the external debt was mounting, this put unnecessary pressure on BOP position. Nigerias indebtedness impeded her access to foreign capital and short term trade arrears amounts to the point at which foreign banks held back on confirming letters of credit. Due to her unwillingness to devalue naira, donors refuse to roll over short term debt or fresh capital. This persisted until
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the military seized power in 1983 (Adedipe, 04). The military government strengthened the strict measure of 1982, then imposed wage freeze on public sector employees, enforced the redundancy of a vast number of civil servants and introduced users fee in education and health sectors. Yet, there measures made little impact on budget deficit. As the deficit in budget was manifested by capacity under utilization widespread closure of plants. Decline in imports and exports was accompanied by a significant rise in domestic price levels, inflation rate escalated, domestic savings and investment fell drastically, private investment also fell coupled with the reluctancy of the donors to release fresh debt, it became difficult to accumulate capital (GCF) which is a major ingredient in developmental process. Meanwhile, government could not reach an agreement with the Bretton Woods institution on several issues including devaluation of the naira and import liberalization. Thus, a significant difference emerged between Nigeria government and its creditors. Later, the Babangida
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administration emerged in 1998 without proper accommodation of the multilateral lending institutions, the prospect for more credit was bleak. This led to the adoption of SAP. This programme brought some far-reaching reforms on the Nigerian economy, such as devaluation of exchange rate, liberalization of interests rates, imports and exports, commercialization and privatization of several public enterprises and so on. Suddenly, there were reverse in the old trend as GDP starts to witness growth, but inflation rates worsens. Interest rates reforms did not yield the desired result due to frequent policy changing. In the era of high inflation rate, the real rate of interest became negative. From 1985,the interest rate, direct foreign investment and foreign exchange had been liberalized of AFEM. The 1997 monetary and banking policies adopted in the fed budget as well as entire financial system restructuring as well as the fiscal surplus achieved in the last two years (1999) appear to seemingly approximate the precondition for preventing capital flight. Thus, the need to sustain and improve the seemingly enabling environment in order to consolidate growth reduce
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external debt through restructuring programmes in agreeable to the Bretton wood institutions that could illicit favourable disposition by our donor nations in ensuring debt reduction for Nigeria cannot be overemphasized. \ 2.9 DEFINITIONS AND MEASUREMENT ISSUES There are various definitions of capital flight. The use of the term capital flight arouses strong emotions in some quarters. Some analysts view capital flight as a symptom of a sick society while others view capital flight as the cause of heavily indebted countries in ability to recover from their present debt problems. Capital flight is regarded by others as a pejorative description of natural, economically rational response to the portfolio choices that have confronted wealthy residents of some debtor countries in recent years Clessard and Williamson, 1987 p. 202). The controversy surrounding the term is due partly to the lack of a precise and universally accepted definition for it in economic theory and partly becauseof the way the term is used between developed and developing
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countries. It is usual amongst some economists to refer to capital outflow from developed countries as foreign investments while the same activity when undertaken by the residents of the developing countries is referred to as capital flight. One of the distinctions that is often made, however, is that exchange rate control regimes existing in many developing countries. One of the reasons for this dichotomy is the belief that the investors from developed countries are responding to better opportunities abroad. The investors from the developing countries on the other hand are said to be escaping the high risks which they perceive at home. This interpretation makes it very obvious why a lot of economist are ill-at-ease with the definition of capital flight. In general, it is believed that the investors from all countries whether developed or developing will base their investments decisions on the relative returns and risks of such investments at home and abroad. There are possibly a number of valid reasons why capital flows from developing countries should be labeled as capital flight. The first is the
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general presumption in economics that capital should flow towards capitalscarce countries. There is scarcity of capital in developing countries. Any flows in the opposite direction, that is, from developing to developed countries as mentioned in the introduction are not only unusual but abnormal. The second reason is related to a policy issue. What is important is the extent to which those assets held abroad could be utilized at home to reduce the level of external indebtedness and relieve the inherent liquidity problems brought about by debt service obligations (Pastor 1990). In distinguishing between capital flight and normal capital flows, two broad approaches are taken in the literature. The first is an identification of specific episodes (or countries) that are characterized by abnormally adverse economic conditions for investment and consider all estimates of the acquisition of external claims that are not reported to the domestic authorities (Chang and Cumby, 1987); (Dodey, 1998). On the other hand, capital flight can be considered as those capital outflows which are in excess

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of normal flows. One problem with this definition lies in what constitutes normal capital outflows in this content (Anthony and Hallett, 1990). These various difficulties essentially lie at the heart of the varying definitions and computation methodologies in which have been employed to quantify the capital flight phenomenon (Anthony and Hallett, 1990). Thus, the possibility of multiple definitional terms is one of the quandaries in this area in a sense and yet perhaps one of the strong points. One cannot but therefore agree with Chang and Gumby (1991) that there exists more than one viable definition of capital flight and the appropriate choice will depend on the policy question most pertinent capital flight and the so called normal capital flows. Since illegal transactions are not reported, it is therefore not only difficult, but almost impossible to measure it as a component of capital flight. capital flight is capital that flees (IngoWalter, 1987; Kindleberger; 1987). Alternatively, capital flows in response to economic or political crisis are capital flight (Husted and Melvin, 1990).

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Normal capital flows on the other hand, refer to flows that correspond to ordinary portfolio diversification of domestic residents. According to Cuddington (1986), capital flight refers to short terms private capital outflows. It involves hot money that responds to political or financial crisis, heavier taxes, a prospective tightening of capital or a major devaluation of domestic currency arising from high misalignment of the currency. In the Morgan Guaranty Trust Company (1986 p. 13), an expansive definition is adopted. Capital flight is the reported and unreported acquisition of foreign assets by the non-bank private sector and elements of the public sector. In order to clarify our thoughts on capital flows presented in table 1 is a taxonomy of factors explaining international capital flows. This table is adopted from Lessard and Williamson (1987). The upper left quadrant of the table identifies various factors based on differences in economic returns across countries. In the upper right quadrant are those additional factors that deal with the two-way flows normal portfolio diversification. Most of the
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theoretical and empirical studies of capital flight place emphasis on the lower left and right quadrants. The factors emphasized are those that create a wedge between economic and financial returns regardless of whether they operate a cross the board or asymmetrically among residents or nonresidents (Lessard and Williamson, 1987 p. 217). Table 1: Taxonomy of Factors Explaining International Capital Flows One-way flows Economic risk and -Natural resources endowments returns -Terms of Trade -Technologies changes -Demographic shifts Two-way flows -Differences in absolute riskness of economics -Low correlation of risky outcome across country

- General economic management -Differences in investor risk preferences Financial risk and -Taxes (deviation from world -Differences in tones and returns, relative to levels) economic -inflation -default on their incidence between resident and non-residents government -Differences in nature and
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obligations -Devaluation -Financial repression -Taxes on

incidence of country risk -Asymmetric of guarantees financial -Different interest ceiling for residents and nonapplication

intermediation

-Political instability, potential residents confiscation -different access to foreign exchange claims Adapted from: Lessard and Willams on (1987) p.216 denomination

From the above table and analysis therein, normal capital outflows are the ones that take place in order to maximize economic returns and opportunities between countries. Normal portfolio diversification takes place on the basis of differentials in economic returns. Capital flight on the other

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hand as seen from this analysis is that subset of capital outflows that are propelled by source country policies (Lessard and Willamson (1987, p.217). 2.9.1 THE MECHANISMS OF CAPITAL FLIGHT The conduits for capital flight are not only many but varied, Ajayi (1992). A very suitable description of some of the conduits and various forms as they take place is described best by Glyll and Koenig (1984 pp. 109). It comes in first bottom suitcases or in electronic funds transfers from private banking services that caters to high net worth individuals. Thus, there are a number of channels through which capital flight can take place in Nigeria and these are briefly discussed as follows. Firstly, it can take place through precious metals and collectibles including works of arts, local currency is converted into gold, silver or other precious metals, stones, jewelry and similar assets that cannot only be moved abroad but also retain their value. The sales of value of these items are usually high in foreign currency. Secondly, transfer of money in form of
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capital flight can take place through cash or monetary instruments. These are usually in the form of either foreign or domestic currency. In the early 1970s studies about Nigeria currency were being carried out of the country and being exchanged in big centers like London and New York, Ajayi (1992). Another method of transferring money abroad is through black market itself. This is a thriving source of transferring funds abroad. Through this method, the amount of money transferred is difficult to estimate. Fourth method is through the banks transfer from a local affiliate of foreign owned banks to a designated recipient abroad. This amount of money can be exchanged at the market rate where no constraints or restrictions are in place. Transfer can still possible in the face of exchange controls but possibly at a less favourable rate. The fifth vehicle through which money can be transferred abroad from domestic country is false invoicing of trade undertaken. Substantial amount of money can arise from the systematic faking of imports and exports. For capital flight to occur in this case exporters will engage in underinvoicing while importers overinvoicing, in
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the process foreign exchange gain is derived by both and this is outside the control of the foreign exchange authorities.

2.9.2 CAUSES OF CAPITAL FLIGHT The causes of capital flight are many. These various causes can be grouped under relative risks, exchange rate misalignment, financial sector constraints and/or repressions, fiscal deficits and external incentives (Khan, 1989) and disbursement of new loans to LDCs (Cuddingtom, 1987). These are no doubt economic causes of capital flight. There are, however, other non-economic causes which though important are often ignored. These include the corruption of political leaders and extraordinary access to government funds. Some of these factors are now discussed.

2.9.2.1

RISKS

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In decision making process, the wealth holder looks at the various risks confronting him. There are certain inherent characteristics of developing countries which make risks attached to investments larger than those of developed countries. An increase in risk in a rational expectation setting would tend to increase the outflow of private capital from the domestic economy into foreign countries where investment are less risky. Thus, domestic investors will prefer to transfer funds and hold foreign assets. 2.9.2.2 EXCHANGE RATE MISALIGNMENT

The importance of this variable has amply been demonstrated in several empirical analysis including the studies by Dornbusch (1985), Cuddington (1986), Lessard and Williamson (1987) and pastor (1989, 1990). The real exchange rate plays a significant role in the direction and magnitude of capital flight from highly-indebted developing countries. Under normal circumstances, if a currency appreciation is expected, domestic wealth owners would shift out of domestic assets into foreign
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assets. In general, it is difficult to measure precisely exchange rate expectations. It is safe, however, to assume that if a currency is overvalued, economic agents would expect the currency to be devalued in the future. Holding firm to this expectation would cause residents to avoid the potential capital loss by converting into foreign claims. 2.9.2.3 FINANCIAL SECTOR CONSTRAINTS

This can also lead to capital flight. It is well known that narrowness of the capital and money market is a feature of developing economies. Financial markets in these countries provide only a limited variety of financial instrument in which wealth can be held. There is also in many developing countries the lack of full or credible deposit insurance on assets that are held in the domestic banking sector. This deficiency is, however, being increasingly remedied by many developing countries. Additionally, there are extensive controls on interest rates and on other aspects of financial market behaviour in developing countries. Government policies in the financial sector have resulted in normal interest
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rates that are far below the rates on comparable foreign financial instruments. In most cases, the real rates of return on domestic financial assets are negative. 2.9.3 EFFECTS OF CAPITAL FLIGHT As observed from various studies in capital flight, it deserves serious attention for many reasons. Oloyede (2002 pp163) classified the effects into both short term and long term. i) The short term effects: A sudden increase in the outflow of capital can have destabilizing effects on domestic reserve position. ii) Long term effects: a. A reduction in available resource to financial domestic investment, leading to a decline in the rate of capital formation and adversely affecting the countries growth rate. b. Reduction in government ability to tax all the income of its residents

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c. Increase in the need to borrow from abroad thereby increasing the foreign debt burden. Other effects of capital flight are: It might have pronounced regressive effects on the distribution of wealth. The individuals who engage in capital flight generally are members of the sub-continents economic and political elites who take advantage of their privileged position to acquire and siphoned funds abroad. Both the acquisition and transfer of funds often involves legally questionable practices including the falsification of trade documents (Trade misinvoicing). Also capital flight causes a diversion of scare resources away from domestic investment and other productive activities. In recent decades, African economies have achieved significantly low investment levels than other developed countries (international financial corp, 1998; Ndikuma, 2000). These low level of domestic investments are attributable in part to the apparent scarcity of domestic saving, weak and shallow financial systems and high country risks due to the unstable macro-economic ad political
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conditions. Thus, capital flight is both the cause and symptom of this weak investment performance. Furthermore, the outflow of capital can cause a shortage of liquidity in the economy and thereby create a short fall in the amount of funds that are needed for the importation of equipment which are needed for development. Accorind to Lessard and Williamson (1987 pp52) capital flight leads to a net loss in the total resources which are available to an economy for the purpose of investments and growth. Therefore, the pace of growth and development in the economy is retarded from what it would have otherwise been. 2.10 CAPITAL FLIGHT: THE NIGERIAN EXPERIENCE. HOW NIGERIA LOSES N960bn ANNUALLY TO CAPITAL FLIGHT IN THE OIL SECTOR Nigerias economy loses about N960bn ($8billion) annually to nonimplementation of local content by oil companies operating in the country, thus leading to lost opportunities for able-bodied Nigerians.

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Oil experts at the just concluded local content workshop in Abuja disclosed that with an estimate annual spending of about N1.2trillion ($10billion) going into the Nigerian oil and gas industry annually, only about 20percent or N240billion ($2billion) of that amount is domiciled in Nigeria. About $8billion of this amount goes out of the economy in things that could ordinarily be done locally. And with proven oil reserved of about 35billion barrels and 187trilliion standard cubic feet of gas (Sc fg) Nigeria is termed in some quarters as a gas province with a drop of oil. It is therefore, no surprise that Nigeria has the biggest investment in natural liquefied Gas (NLG) in the world. But, that has made little impact on the countrys Gross Domestic Product (GDP). This is because most of the engineering, technical, supplies, insurance, shipping and other skilled aspect of the business is either done abroad or carried out in-country by expatriates and their firms. Apart from creating thousands of jobs through direct and indirect engagements of Nigerians, if Nigeria acquires the capacity to carry out these
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jobs, a value chain in economic activities would lead to more properity. It is with this in mind that the federal government initiated the Nigerian content initiative. The target of government is to meet 45percent of the local content of the production of oil and gas by 2006 and 70percent by 2010 by which time, apart from employment, the same proportion of investment an sundry economic activities will be domesticated. To show its resolve, the presidency, six years ago directed the Nigerian national petroleum corporation (NNPC) to put in place a comprehensive and workable Nigerian content realization strategy in the industry. The NNPC created a Nigerian content division (NCD), but its effectiveness is still a matter of controversy in the industry. Insurance an shipping companies are at a loss that almost all the insurance businesses and oil liftings are carried out by foreign firms with little or no inputs from Nigerians. Also, the national assembly is on the last stage of passing the Nigerian content bill, if the utterances of some members of the assembly is anything to go by. The bill, when passed will lead to the
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establishment of the Nigerian content development agency to be run by the Nigerian content management board that will oversee the running and affairs of the Nigerian content policy. But, that is for the future. Meanwhile, as the NNPC and other related arms of government are busy applauding themselves and ascribing high scores over their contribution to the realization of the Nigerian content dream, some indigenous experts have ridiculed their claims. For example, the petroleum technology association of Nigeria (PETAN), an association of Nigerian indigenous technical oil field service companies in the upstream and downstream sectors of the oil industry, has come short of laughing off such claims. Contrary to claims by government that Nigeria has now attained 45percent Nigerian content, PETAN, said even by 2010, Nigeria would not attain 30percent of local content if things stand the way they are today. PETAN which employs about 20,000 Nigerians also said the crisis in the Niger Delta would persist unless government mandates oil firms to broaden indigenous participation in oil jobs, establish decent educational
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facilities, build infrastructure and improve on the wellbeing of host communities. Chairman of PETAN, Mr. Shawley Coker, said multinational oil companies were trying to stiffen the conditions for getting oil contracts and employments opportunities to the extent that the present local content in the industry is just about 15percent and not the figure flaunted by government officials. On contracts, he said since the issue of Nigerian content came to therefore, multinational oil firms had come up with frustrating terms before engaging Nigerian servicing companies.

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CHAPTER THREE 3.0 3.1 RESEARCH METHODOLOGY INTRODUCTION The primary objective of this research work as stated in chapter one of this study, is to investigate the effect of capital flight on Nigeria economic development using an error correction mechanism (ECM) technique. In order to effectively realize the objective of the study, relevant factors or variable will be used to measure the time series characteristics of the variables in the model where Gross Domestic Product (GDP) denote the dependent variable while index capital flight (ICF), Gross capital formation (GCF), External reserves (ER) denotes independent variables. The significance of methodology in any research study cannot be under-estimated because it guides the data collection process. According to Oloyede (2002 pp.2) research is a step-by-step procedure for obtaining reliable findings about existing problems through organize and systematic

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collection, analysis and interpretation of data with the aim of making significant contribution to already known body of knowledge. In a nutshell, this section deals with the specific model to be used in arriving at the index of capital flight, the estimation technique to be employed in the analysis, the restatement of hypothesis to be tested and the data sources and collection procedure. The estimation techniques encompass the unit root test, co-integrating test and the error correction model. 3.2 RESTATEMENT OF HYPOTHESIS This research work shall involve the formulation of hypothesis to be tested hereafter. We shall make use of the null hypothesis and alternative hypothesis. The aim of this study is to measure the effect of capital flight on Nigerias economic development. This study would attempt to do this by testing the following hypothesis. H0: H1: 3.3 Capital flight has no significant effect on gross domestic product. Capital flight has significant effect on gross domestic product. ECONOMIC APROIRI CRITERIA
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These are determined by the principles of economic theory and refer to the sign and size of the parameters of economic relationship. In this study, index of capital flight is expected to have a negative sign because increase in the capital flight will reduce gross domestic product that is, dGDP < 0 dICF an

while gross capital formation is expected to be positive because an increase in the GCF will have a positive effect on gross domestic product.

dGDP >0 dGCF

Also, external reserve is expected to be positive because an increase in the external reserve will have a positive effect on gross domestic product. dGDP >O
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dER 3.4 MODEL SPECIFICATION GDP = F (ICF, GCF, ER,U)..(i) Where, GDP = Gross Domestic Production ICF = Index of capital flight GCF = Gross capital formation ER = External reserves U = Error term F = Functional relationship among variables specified in the model. Specifying the model in explicit by log-linearizing it becomes Log(GDP)=X0+X1LOG(ICF)+X2LOG(GCF)+X3LOG(ER)+U.(ii) WHERE, LOG= Natural Logarithm X0= Intercept of the relationship in the model X1= Coefficient of the Index of Capital Flight
80

X2= Coefficient of Gross Capital Formation X3= Coefficient of External Reserves.

Specifying the model in a time series form: Log(GDP)=X0+X1LOG(ICF)+X2LOG(GCF)+X3LOG(ER)+U. (iii) The specification of the model in a general ECM (Error Correction Mechanism) gives thus: DLog(GDP)=X0+nEi=0X1LOG(ICF)t-1+
=0 n

Ei

=0

X2LOG(GCF)t-1+

Ei

X3LOG(ER) t-1+ nEi =0ECM t-1 + E t .(iv)

Where : t-1=Meaning the variables were lagged by one period

n

E i=0ECM t-1= Error Correction Term

E t= White Noise Residual. Once Co-integration is established along side its extent and form, the next step is to develop an over-parametized autoregressive distribute (ADL)
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model (ECM1)and a Parsimonious Error Correction Model (ECM2) that incorporates long-run equilibrium relationship and the short-run dynamics 3.5 ESTIMATION TECHIQUE The recently developed co-integration analysis and the Error correction mechanism (ECM) techniques shall be used for estimation of the parameters of the model specified earlier on. The co-integrating analytical technique will be used to analyze in this study. This involves the use of unit root test, co-integration test and error correction model. As stated earlier, the test of hypothesis for each parameter will be conducted using the standard error test. The Johansen co-integration test will also be employed in testing for co-integration among the variables while Augment Dickey Fuller test (ADF) is used for determining the stationary in the variable series.

3.5.1 CO-INTEGRATION ANALYSIS

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The concept of co-integration relates to the existence of a long-run equilibrium relation to which an economic system converges overtime and equilibrium relationship among the set of non-stationary variable influencing it implies that their stochastic trends must be linked. It is necessary to assess whether the services in a time series data are stationary or not. The reason is that regression of a non-stationary series on another non-stationary series leads to what is known as spurious regression. Thus, implicit in the co-integration theory is that, there exists a linear combination of these non-stationary variable that is stationary. If two series are non-stationary but their linear combination is, the two series are said to be co-integrated series that are co-integrated move together in the long run at same rate. In other words, they obey an equilibrium relationship in the long run (Davidson and Macknnon, 1993). In this study, we will test for the stationarity of the variable through the Augment Dickey Fuller (ADF) unit root test. 3.5.2 UNIT ROOT TEST
83

This is the first step in co-integration analysis and it is the standard approach to investigate the stationarity of a time series. This test is relevant because of the statistical test of the parameter resulting from spurious regression, sequel to regression of a non-stationary series on another nonstationary series may be biased and inconsistent (Engle and Yoo, 1987). 3.5.3 CO-INTEGRATION MODEL Having established stationary of the variables then we proceed to investigate whether or not there is such a relationship labeled co-integration among the variable. This is sequeal to the fact that, although economic variables may not be stationary individually, a mechanism could still exist that prevents some of the variables from diverging significantly from one another. The number of co-integration equation which is know as cointegration rank can be decided through the Johanson tests. The hypothesis of the (H0) is that there is no-integrating vector or there is one co-integration
84

TEST

AND

ERROR CORRECTION

vector. This implies that the variables in the model have no equilibrium condition that keeps them in proportion to one another in the long run. To this hypothesis, compare the likelihood ratio in each of the row of the upper table of the output of the Johnanson co-integration test to their corresponding critical values. If the likelihood ratio is greater than the critical value, then reject the null hypothesis and accept the alternative hypothesis of the existence of co-integration and vice-versa. The issues of error correction model (ECM) series when the various statistical tests performed supports the existence of co-integrating relationship between the dependent variable and any (or a combination) of its explanatory variables. The first error correction model (ECM1) known as the over paramelized ECM involves lagging of variable in the regression equation. However, parsimonious error correction model (ECM) is simply to introduce dynamism into the model. The selection of this final vector error correction model (ECM0 should be based on economic as well
85

as statistic criteria of evaluation put differently, only the variables that are statistically significant are reported in ECM2. 3.6 NATURE AND SOURCES OF DATA For the purpose of this study, the data used is entirely secondary as obtained from the Central Bank of Nigeria (CBN), Federal Office of Statistics (FOS) and other sources of already processed data that are relevant to the study.

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CHAPTER FOUR 4.0 ESTIMATION AND ANALYSIS OF DATA AND INTEPRETATION OF RESULTS 4.1 INTRODUCTION This chapter deals with presentation of data gathered for the purpose of this study, presentation and analysis of the co-integration result 4.2 DATA PRESENTATION GDP 5205.1 6570.7 7208.3 10990.7 18298.3 20957 26656.3 31520.3 34540.1 41947.7 46632.3 47619.7 49069.3 53107.4 59622.5 ICF 121.6 319.6 248.3 192.6 48.3 475.4 46.3 197.6 331.8 289.9 467 137.8 1624.9 556.7 534.8
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YEAR 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984

GCF 38941.775 4750.15 203064.72 27244.85 7922.25 50198 81078 9420.6 9386.3 9094.5 10841.2 12215 10922 3135 5417

ER 104.6 132.3 191.6 241 3112.5 3380.1 3057.6 2521 1249.1 3043.2 5445.6 2424.8 1026.5 781.7 1143.8

1985 67908.6 1986 69147 1987 105222.9 1988 139085.3 1989 216797.5 1990 267550 1991 312139.8 1992 532613.8 1993 683869.8 1994 889863.2 1995 1933211.6 1996 2702719.1 1997 2801972.6 1998 2708430.9 1999 3194023.6 2000 4537640 2001 4685912.2 2002 5403006.8 2003 6947819.9 2004 11411066.9 2005 14610881.5 2006 18564594.73 2007 19675476.23

329.7 2499.6 680 1345.6 439.4 464.3 1808 8269.2 32994.4 3907.2 48677 2731 5731 24078.9 1779.1 3347 3377 8206 13056.1 19908.7 25881.3 41470.8 43676.1

65578 7386 10663.1 12383.7 18414.2 3062.6 35423.9 58640.3 80078.1 85021.4 111476.3 172105.7 205553.2 192984.4 175785.8 268894.5 371897.9 438114.9 429230 433672.45 431451.23 433117.145 432284.1875

1641.1 3587.4 4643.3 3272.7 13457.1 34963.1 44249.6 13992.5 67245.6 30445.9 40333.2 174309.9 262198.5 226702.4 546873.1 1090148 1181652 1013514 1065093 2478620 3835433 5617317 5726375

SOURCE: The sources of this data is secondary from the publications of: 1. Central Bank of Nigeria (CBN) Statistical Bulletin. 2. Federal Office of Statistics (FOS) Annual Reports .
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Annual time series data for the period between 1970 and 2006 were used for this study. We start the empirical analysis by examining the characterization so as to know whether a trend is present or not. A trend variable is necessary in the Augmented Dickey-Fuller unit root test if trends are present in the series. 4.3 UNIT ROOT TEST The unit root test is carried out to know if the data of the variables are stationarity with respect to time. The unit root or stationary test for each variable in the model is carried our using hypothesis. The hypothesis are: H0: Xt ..1(1) H1: Xt . 1(0) Decision Rule If the Augmented Dickey-Fuller test statistics is greater than the Mackinnon critical value (in absolute value), the null hypothesis (H0) that Xt does not contain a unit root is rejected and the alternative hypothesis (H1) is accepted and meaning that Xt is stationary is accepted and vice-versa.
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In the literature, most time series are non-stationary at level and using non-stationary variables in the model might lead to a spurious regression result(Granger and Newbold,1977). The first or second differenced terms of most variables will usually be stationary (Remand tham, 1992). All the variables are tested at levels, first and second differences for stationary using the Argumented Dickey-Fuller (ADF) tests. All the variables are stationary at their respective second differences. The table(s) below (the unit root table) shows the result of the stationarity test for all variables used. The stationary level is considered after comparing the ADF value against the Mackinon Critical Value at 5% level. The result of the ADF unit root test, which can be found in the appendix and are summarized in table 4.2, 4.3 and 4.4 below. TABLE 4.2 RESULT OF STATIONARITY TEST AT LEVEL Variables ADF test Mackinnon No of time Remark

statistic value critical value difference

90

GDP ICF GCF ER ECM Sources:

@5% 3.96596 -2.948404 1(0) Non-stationary -1.036021 -2.948404 1(0) Non-stationary 0.290599 -2.948404 1(0) Non-stationary 3.260222 -2.948404 1(0) Non-stationary -4.535505 -2.948404 1(0) Stationary Extracted from computer output (See appendix)

From the table above, the absolute values of Mackinnon critical values at 5% are greater than that of the ADF test statistic values in all the variables. This means that the null hypothesis of the presence of a unit root at one percent is accepted. Since there is non-stationarity of the variables at level difference of the time series variables, there is need to carry out the test at first difference to see if there will be stationary of the variables. The first difference is reported as following table 4.3 RESULT OF STATIONARITY TEST AT FIRST DIFFERENCE Variables ADF test Mackinnon No of time Remark

statistic value critical value difference @1%

91

GDP ICF GCF ER Source:

0.290523 -2.951125 1(1) Non-stationary -6.638374 -2.951125 1(1) Stationary -5.781224 -2.951125 1(1) Stationary 0.003477 -2.951125 1(1) Non-stationary Extracted from the computer output (See appendix)

The unit root test analysis above shows that the dependent variable (GDP) and External Reserves (ER) are non-stationary while some of the independent variable (GCF and ICF), are stationary at first difference. The result shows that ADF test statistics of GDP and ER are less than that of its MacKinnon critical value, but, this is not so for GCF and ICF as a result, there is the need to carry out further test of second difference for GDP and ER. This is shown below: TABLE 4.4 RESULT OF STATIONARITY TEST AT SECOND DIFFERENCE Variables ADF test Mackinnon No of time Remark

statistic value critical value difference GDP ER -4.413200 -4.119319 @1% -2.954021 -2.954021
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1(2) 1(2)

Stationary Stationary

ICF GCF Source:

-12.61177 -2.954021 1(2) Stationary -8.970314 -2.954021 1(2) Stationary Extracted from computer output (See appendix)

The table above shows that the variables (GDP and ER) are stationary at their second difference. That is, ADF test statistic values of the variables are greater or higher than the Mackinnon critical values which means, the variable are stationary after the second difference. Table 4.5 SUMMARY OF THE ORDER OF STATIONARITY VARIABLE ORDER ICF GCF GDP ER STATIONARITY 1(1) 1(1) 1(2) 1(2) OF

Table 4.6 below shows the result of the ADF test equation on each of the variables with their different level of stationarity and lagged period. Also shown is their corresponding co-efficient of multiple determination (R2). The
93

variables in each of the multiple are regressed together expressing one as dependent variable (i.e GDP) and others as independent variables. The test of significance was also conducted for each of the equation. TABLE 4.6 THE ADF TEST EQUATION Variables D(GDP(1),2) D(GDP(1),3) C D(ICF(-1) D(ICF(1),2) C
94

Co-efficient Standard -1.285777 0.048750 149264.9 Error 0.291348 0.196205 124738.5

t-statistic Probability 4.41320 0 0.24846 7 value 0.0001 0.8055 0.2408

R2 0.6084

-2.168550 0.311439 2038.064

0.326651 0.179253 1874.363

1.196622 0.0000 6.63874 4 1.737422 0.0922 0.2853

0.8336

1.08733 D(GCF(-1) D(GCF(1),2) C -1.355292 0.131879 11101.17 0.234430 0.146772 8679.261 7 5.78122 4 0.89852 8 1.27904 D(ER(-1) D(ER(1),2) C -1.055294 0.109384 56456.42 0.256182 0.187389 5097.46 5 0.0003 0.4680 0.0000 0.3758 0.2104 0.6933

4.119319 0.5638 0.58372 3 1.10760 0.2768

Source: 4.4

9 extracted from computer output (See appendix)

CO-INTEGRATION TEST

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Given, the above multi variables case, the test for co-integration was performed using Johansen maximum likelihood estimation approach. Under this approach, trace test statistics was used on testing whether a long run relationship exist among the variables. If this test establishes that at least one co-integrating vector exist among the variables under investigation, then a long term equilibrium relationship exists between them. TABLE 4.7 RESULTS OF JOHANSEN CO-INTERGRATION TEST ON THE SPECIFIED MODEL Hypothesized no of (ECs) Elgen value Trace Statistics Likelihood ratio Non ** 0.648396 64.18367 47.21 At most 1* 0.427287 27.59991 29.68 At most 2 0.199836 8.091966 15.41 At most 3 0.008226 0.289098 3.76 The co-integration equation is specified below
96

5% or value

critical 1% value

critical

54.46 35.65 20.04 6.65

dGDPt= -49.45dICFt -9.639840dGCFt -4.111052dERt *(**) denotes rejection of hypothesis at 5% significance level. Trace (LR) test indicates one co-integrating equation at both 5% and 1% significance level. The result in table 4.7 shows the existence of co integration or long run relationship among the growth of GDP, index of capital flight (ICF) , Gross capital formation and external reserve (ER). The condition for cointegration among the variables is that the critical value at 5% must be less than the likelihood ratio considering the table, the critical value at 5% is less than the likelihood ratio at none hypothesized (i.e. the first column). Hence, the hypothesis of non-co integration has been rejected at 5% significance level. 4.5 ERROR CORRECTION MEHANISM Having established the long run relationship among the variables through the use of Johansen co-integration test, the next step is to switch to the short run model with the error correction the unit root test was also
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conducted on the error correction mechanism model with its ADF test statistics at -4.535505 and 5% critical value at -2.948404 at level difference with R2 of 0.68. This shows that the error correction model is stationary at level difference. An over parameterized error correction model is estimated by setting the lag length long enough in order to ensure that the dynamics of the model have not been constrained by a too short lag length. Table 4.8 below presents us the over-parameterized error correction of the model.

TABLE 4.8 OVER PARAMETERIZED MODEL Variables d(GDP(-1),2) d(ICF,2) d(ICF(-1),2) d(GCF,2) d(GCF(-1),2) d(ER,2) Co-efficient -0.119014 -7.646534 1.471856 2.175970 0.423608 2.548199 Standard Error 0.109943 2.278173 2.195169 0.663471 0.496417 0.154793
98

t-statistic -1.082501 -3.356432 0.670498 3.279676 0.853330 16.46202

Probability 0.2890 0.0024 0.5085 0.0030 0.4013 0.0000

d(ER(-1),2) ECM (-1) R2 = 0.93

-0.100643 -.614563

0.322268 0.126542

-0.312294 -4.856572

0.7573 0.0000

Adjusted R2 = 0.91 Durbin Watson statistic = 2.086 The table above shows the over parameterized error correction of capital flight and Nigerias economic development. The result shows that the error correction mechanism model is in conformity with the a priori expectation. Also the R2 is 0.93 or 93% with Durbin-Watson statistic of 2.086. However, for the sake of simplicity there is need to simplify the model into a more interpretable and certainly more parsimonious model. The standard error is employed as a guide to this reduction exercise. All in the standard error values of the parameters of model is an indication of model parsimony. The result of the parsimonious model is reported in the table below: TABLE 4.9
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PARSIMONIOUS MODEL Variables Co-efficient d(ICF,2) -7.313022 d(GCF,2) 1.649559 d(ER,2) 2.522510 ECM (-1) -0.681589 2 R = 0.8996 =0.90 Adjusted R2 = 0.8899 Durbin Watson statistic = 1.877 F statistics = 106.43056 (See appendix) The result of the parsimonious error correction model is drawn from the over-parameterized model and if considered and explained only those variables certified significant from the over parameterized model. 4.6 INTERPRETATION OF RESULTS From the parsimonious model result above, it can be seen that the coefficient of external reserve and Gross capital formation as well as their lagged values are positive in conformation with the a priori expectation. This means that there is a positive relationship between the gross domestic
100

Standard error 1.574439 0.475139 0.150093 0.095303

t-statistic -4.644843 3.471736 16.80637 -7.151796

Probability 0.0001 0.0015 0.0000 0.0000

product, external reserves and gross capital formation. Thus, with the coefficient of external reserve and gross capital formation at 2.5225 and 1.6496 respectively. This implies that a unit increase in both external reserves and gross capital formation will increase gross domestic product by 2.5225 and 1.6496. The co-efficient of index of capital flight is negative in conformation with the apriori expectation. This means that there is a negative relationship between the index of capital flight and GDP. The co-efficient of the index of capital flight -49.45176, a unit rise in index of capital flight will lead to a fall in gross domestic product by 49.45176 . Furthermore, the error correction model (ECM) otherwise known as the speed of adjustment is significant with the appropriate sign i.e negative sign in conformity with the a priori expectation. This implies that the present value of gross domestic product (GDP) adjust rapidly to changes in external reserves, gross capital formation and index of capital flight. The large value of the error correction variable given as 68% indicates a feed back of that
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value from the previous period disequilibrium of the present level of gross domestic product in the determination of the causuality between the past level of GDP and the present and past levels of external reserve, gross capital formation and index of capital flight. The co-efficient determination (R2) shows the percentage of total variation in the dependent variable explained by the independent variables. The coefficient of determination (R2) from the model stands at 0.8996 i.e 90%. This means that over 90% of the variation in the present state of gross domestic product is being explained by the variation in past values of GDP and the present and past values of external reserve, gross capital formation and index of capital flight, while about 10% of the variation in the present value of gross domestic product is being explained by the stochastic error term or a counted for by the disturbance variable. Thus, the depth and magnitude of the percentage of gross domestic product (GDP). The standard error test is carried out for the significance of the parameters. The standard error test measures the statistical reliability or
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significance of the co-efficient estimates. It is carried out by comparing standard error value of a parameter and the co-efficient of the parameter divided by 2. Test for ICF Co-efficient = 7.313022 and standard error = 1.574439 SE > < 1.57443 coefficient 2 < 7.313022 2 1.57443 < 03.656511 Since the standard error is less than that the coefficient then the ICF is statistically significant. Test for GCF SE > < 0.475139 coefficient 2 < 1.649559
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2 0.475139 < 0.8247795 Since the standard error is less than that the coefficient then the GCF is statistically significant. Test for ER SE > < 0.150093 coefficient 2 < 2.522510 2 0.150093 < 1.261255 Since the standard error is less than that the coefficient then the ER is statistically significant.

Test for ECM SE > < coefficient 2

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0.095303

< 0.681589 2

0.095303 < 0.3407945 The ECM is significant From the above standard error test, it can be seen that all the variables in the model are statistically significant. The statistical significance of the independent variable means that the null hypothesis is rejected while the alternative hypothesis is accepted, implying that there is a relationship between the dependent and independent variables. This means that index of capital flight, gross capital formation and external reserve are statistically reliable and significant in explaining variations in the gross domestic product. This is how the variables influence or affect the gross domestic product. The F-test shows the overall or aggregate significance of the model. The aim is to find out whether all the explanatory variables put together do

105

actually have any significant influence on the dependent variable. It is carried out by comparing the F-cal culated (F*) and F-tabulated (Ft) F* = R2/K-1 (1-R2)/(N-K) Where N = simple size K = No of parameters F* = 763.0678 This follows an F-distribution value with K-1 and N-K degree of freedom at 95 percent confidence level. Therefore, with V1 = K-1 (i.e 4-1 =3) V2 = N-K (i.e 37-4 =33) FT 0.05= 7.44 763.0678 >7.44 Since the F-calculated is greater than the F-tabulated we reject the null hypothesis and accept the alternative hypothesis. This shows the overall significance of the model. That is, the result shows that all the explanatory
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variables that is external reserve, gross capital formation and index of capital flight are significant in influencing or explaining variations in the growth rate of the gross domestic product. The Durbin-Watson test is to be carried out to test for serial correction of resideuals in the model. Hypothesis is set up as: H0:d* = 0 (No autocorrelation) H1:d* = 0 (there is autocorrelation)

No autocorrelation Or +ve
autocorrelation

Inconclusive region dL dU 1.31 1.66

Acceptance region
2

Inconclusive region 4-dU 2.34 4-dL 2.69

-ve autocorrelation Time

107

dL 1-08

dU 1.66

4-dU 2.34

4-dL 2.92

Note: CR = Critical value dL = Durbin Watson @ lower case du= Durbin Watson @ upper case To test for autocorrelation at 5% significant level, D.w state = 2.094861 From the graph, since d* (i.e 1.877584) falls between du <d* <4-du, then H0 is accepted and H1 is rejected. Therefore, there is no auto correlation in the model. 4.7 SUMMARY OF FINDINGS The analysis shows that there exists positive relationship between the gross domestic product, external reserve and gross capital formation. The co-efficient of index of capital flight is negative and this conforms with the aprior expectation. Thus with the co-efficient of external reserve and gross capital formation at 2.522510 and 1.649559 respectively, this implies that a unit

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increase in both external reserve and gross capital formation will increase gross domestic product by 2.522510 and 1.649559. In order to determine the goodness of the model, the co-efficient of determination (R2) is considered. The R2 is 0.899593 i.e 90%. This means that over 90% of the variation in the present state of gross domestic product is being explained by the variation in past values of gross domestic product and the present and past value of external reserve, gross capital formation and index of capital flight, while about 10% of the variation in the present value of GDP is being explained by the stochastic error term or accounted for by the disturbance variable. The empirical investigation shows that external reserve, gross capital formation and index of capital flight and their lagged values are statistically significant and reliable in explaining variations in the gross domestic product.

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4.8

IMPLICATIONS OF FINDINGS This study does not pretend to consider exhaustively all the potential

factors determining economic growth and development with regards to capital flight. However, the models developed and the estimation techniques employed in this study are intended to reveal how capital flight has been able to affect the gross domestic product (GDP) and gross capital formation (GCF) since capital flight is detrimental to development of any economy as also revealed by the empirical results of this study which is consistent with the findings of Ajayi (1992) and Onwiodukit (2007). Though Ajayi (1992) did not employ co-integrating analytical technique to estimate his data, the a prior expectation still holds. Thus, this study has contributed to the existing body of knowledge by employing short run dynamics of ECM which bridge the gap between the short run disequilibrium and the long-run equilibrium in estimating the observed time series data.

110

Furthermore, anymore increase in the laxity of supervision of the central bank of Nigeria (CBN) and national drug law enforcement agency (NDLEA) will further worsen Nigerias growth rate with regards to the moving out of funds from the domestic economy. On the whole, the research revealed that the current level of index of capital flight (ICE) does not only explain or account for the current level of GDP and GCF but also the previous level of index of capital flight 9ICE) should be reckoned with in order to account adequately for the current level of GDP and GCF. They have been identified as two most important measure of growth, both the GDP and GCF should therefore steadily increase with a corresponding mass reduction in the level of capital flight that fled to achieve sustainable development in Nigeria.

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CHAPTER FIVE SUMMARY, CONCLUSION AND RECOMMENDATION 5.1 SUMMARY This study addressed the issues relating to capital flight and the major objective being to determine its effect on the Nigerian economic development for the period 1970-2006. the economic growth indicators used in this study are the grows domestic product (GDP) and gross capital formation (GCF) while the important variables explaining capital flight from Nigeria include mounting external debt, external reserves, inflation, depleting foreign exchange reserves, comparative growth rate of the economy among others. As indicated in the introductory part of this study, the phenomenon of capital flight from developing countries received considerable attention in economic literature beginning from the mid-1980s. A number of country specific case studies and cross country studies have examined the magnitude
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of capital flight, its course and its effects. On this note the outflows of capitals from Nigerian economy deserves serious attention for several reasons. First, capital flight constitutes a diversion of scarce resources away from the domestic investment and other productive activities. Secondly, it is likely to have pronounced regressive effect on the distribution of wealth. The third reason for the greater attention to the Nigerian capital flight like most sub-Saharan African countries is that is remains is the grip of severe external debt crises, which has the potential to dampen economic growth. In achieving the objective of this study, the co-integrating analytical technique is used to determine the effect of capital flight on the time series of GDP and GCF in Nigeria. The specific model used to estimate capital flight is the Residual Approach, the World Bank Version (1985) and Erber (1986) version. The simple regression and error correction model (ECM) results revealed that capital flight has significant negative effect on the Nigerian Economic development as the co-efficient of GDP and GCF in the ordinary least square (OLS) vis--vis the co-efficient of the same variables
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in the dynamic model was found to be negative which is consistent with our expected result. This situation in Nigeria context could be attributed to unstable macro economic environment which forces investors to respond positively to external incentives, debt overhang and its burden of interest payment also influences the outflows of domestic resources as this makes the government of domestic economic to lose credit worthiness both internally and externally. In addition, political instability is also attributed to the negative impact of capital flight on the Nigerian economic growth and development.] The result is therefore consistent and accords with our a priori expectation that capital flight is detrimental to the economic development of any nation. 5.2 CONCLUSION A number of conclusions can be drawn from this study. The first is that there is no generally accepted definition of capital flight, hence the use of several concepts in this study. Secondly, a significant proportion of
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capital flight can be estimated from recorded data in the BOPS and debt statistics. The implication is that, the reliability of the measure is dependent on the accuracy of the items in the BOP statistics and debt data. Significant amount of capital flight in relation to external debt took place over the years covered by this study. Trade faking has been discovered as an important vehicle of effecting capital flight. Thirdly, domestic macro economic policy distortion is the culprit in the capital flight episode. Of significances in the area of policy errors are lack of opportunities for profitable investments within the domestic economy. The attractive incentives offered by the foreign sector cannot be left out. Lastly, the present level of the economy cannot only be explained or judged by the current level of capital flight but also the previous level of capital that fled the economy as evident by our findings in this study. On this note, policy-makers and the relevant authorities should pay more attention than ever to the issue of capital flight in order to stem its counter productive effects on economic growth. To conclude following
115

Ajayi (1992), capital flight constitutes a diversion of domestic savings away from the domestic investment and it retards the pace of growth and development in the economy from what it would have otherwise been. However, this study may not have exhausted all the ramifications of the concept of capital flight in relation to economic growth and development but it constitutes a fair representation of thinking in the literature. Therefore, this study forms a basis for further research. 5.3 RECOMMENDATIONS Nigeria has been identified as a sleeping giant with a lot of potentials to develop based on her natural endowment but the massive fled of capital in terms of human and material resources has retarded the pace of its growth and development. Meanwhile economic growth is known to provide opportunities for profitable investments. If investment opportunities are enhanced profitability will be ensured in the domestic money would be less difficult.

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From our analysis the policy issues that can be drawn are very clear. There is the need for the maintenance of sound domestic macro economic policy. The various aspects are hereby discussed. There is a lot to be said on imposition of controls on the movement of capital to foreign countries by appropriate authorities, Oks and Gajdeczka, (2004). In addition it is necessary to ensure that the exchange rate is not appreciated by high domestic inflation. We also recommend that fiscal discipline should be given priority so that deficit as a proportion of the gross domestic product is kept in check because this is crucial to the maintenance of macro economic stability. Appropriate interest rate policy is also germane as there is the need to ensure a positive real interest rate. The rates should be high enough to attract funds but not too high to stifle investment initiatives. In addition, an integrated and unified tariff structure would be useful, as it will reduce the rewards for trade faking. The issue of the existence of and how to deal with corruption is certainly more difficult to prescribe. It is part of the general problem of
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capital flight, one can only say that there is a need or change of attitude on the part of those who public office and have access to foreign funds directly or through the contracts, which they awarded. This attitudinal changes involves a serious commitment to honest government. Therefore, we recommend that they place their public duties ahead of their personal gain, by so doing the economy will experience a boost as enough funds will be available to execute development project such as power generation and opening of new vibrant sectors. Of paramount importance is the provision of enabling environment for business to thrive. It is more important to make the domestic economy more attractive for the investors by creating a wider menu of domestic financial assets on which domestic capital can be invested at a rate not lower to rate on comparable foreign financial instruments. If the policy package discussed are pursued rightly and with consistency it should be possible and there is every reason to hope for the

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repatriation of capital flight or at worse eradication of further flight of capital.

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