By Daniel Makina, University of South Africa
“Cecily, you will read your Political Economy in my absence. The chapter on the Fall of the Rupee you may omit. It is somewhat too sensational”, Oscar Wilde from his work, The Importance of Being Earnest
Economic theory states that capital should flow from rich developed countries to developing countries because developing countries are labour-abundant and capital-scarce relative to rich developed countries. Under the assumptions of the standard two-factor neoclassical growth model, this suggests that the marginal product of capital should be higher in developing countries than in rich developed countries. This standard arbitrage story would suggest that capital should flow from where its returns are relatively low to where they are relatively high – that is, from rich developed to poor developing countries. Yet, this is observed not to be happening to a significant extent. Indeed, according to the IMF Balancer of Payments, World Bank and IMF staff calculations, global cross-border capital flows to developing countries have slowed down markedly especially after the global financial crisis. Little capital is flowing from rich developed countries to developing countries for reasons ranging from real or perceived high risk to lack of adequate knowledge about investment opportunities. More capital continues to flow from rich-to-rich countries. This behaviour has created a puzzle that defies theory. The puzzle has become known as the Lucas Paradox after a seminal paper by Robert Lucas in 1990 that discussed the controversy surrounding the non-migration of capital to developing countries.
There are two broad explanations for the Lucas Paradox. One explanation is that the limited amount of capital received by poor developing countries is attributed to differences in fundamentals that affect the production structure of the economy, such as technological differences, unfavourable endowments of human, public, and institutional capital. The second explanation focuses on international capital market imperfections. It is argued that although the expected returns on investment could be high in poor developing countries, capital does not flow there because of the high level of uncertainty associated with those higher expected returns.
Enter Geopolitical Risks
The COVID-19 pandemic heightened US-China tensions when supply chain disruptions led to increased inflation in the Western world. The idea of friendly re-shoring (developing supply chains from friendly countries) became a strategy so as not to entirely rely on Chinese supply chains. The Russian invasion of Ukraine in February 2022 exacerbated geopolitical tensions as nations became divided between those against invasion of a sovereign state and those sympathetic to Russia’s cause. The IMF observes that geopolitical tensions as measured by the divergence in countries’ voting behaviour in the United Nations General Assembly, can play a big role in cross-border portfolio and bank allocation. Its latest IMF reports observe incipient geopolitical risk. Research by its staffers finds that foreign direct investment and portfolio investment flows into markets seen as “geopolitically distant” from the US and Europe may already be taking strain as global geopolitical tensions rise. Furthermore, it is noted that increased tensions are associated with reduced cross-border allocation of investment.
In a world in which the US and Europe are talking “on-shoring”, “friend-shoring” and “near-shoring” to shift supply chains to countries seen as friendly, emerging and developing countries may have to work very hard to attract capital if they are found to be on the wrong side as proxied by the UN General Assembly voting.
In the face of tensions between the US and China and the Russia’s invasion of Ukraine, the IMF’s latest World Economic Outlook shows how global fragmentation is reshaping the geography of foreign direct investment. Generally, the IMF observes that FDI flows have slowed down in recent years and are increasingly concentrated among “geopolitically aligned” countries, especially in strategic sectors. “Several emerging market and developing economies are highly vulnerable to FDI relocation given their reliance on FDI from geopolitically distant countries,” says the report. “Firms and policymakers are increasingly looking at strategies for moving production processes to trusted countries with aligned political preferences to make supply chains less vulnerable to geopolitical tensions.”
Indeed, the IMF study finds early evidence of financial fragmentation, with the shift in FDI very much noticeable, and Sub-Saharan Africa is observed as one of the regions losing out. Investing countries are observed to be allocating a smaller share of FDI to countries with less agreement on foreign policy issues as well as a smaller share of cross-border portfolio investment and bank credit.
Regarding portfolio flows, the IMF’s recent Financial Stability Report finds geopolitical tensions among major economies determining cross-border capital allocation. It is observed that portfolio investment is also being routed away from countries seen as “geopolitically distant”, though to a lesser extent than FDI. It is observed that geopolitical tensions, proxied by the divergence in the foreign policy orientation of investing and recipient countries, significantly affect cross-border portfolio allocation. Some investors are starting to use divergent voting behaviour at the UN as a proxy for who is on which side. This is becoming more apparent on issues regarding US-China tensions and on the Russia-Ukraine war. Financial fragmentation has the potential to increase the volatility of capital flows in emerging and developing economies thereby limiting their financial deepening and development as well as weakening their capacity to absorb shocks, the IMF observes.
South Africa gets entangled in the geopolitical spiderweb
Either voluntarily or sheepishly, South Africa entered the geopolitical spiderweb by first mistakenly believing that by abstaining in the UN General Assembly voting on the Russia-Ukraine issue, it would be viewed as non-aligned. This is despite its continued hobnobbing with the sanctioned aggressor in the conflict in the form allowing it use of its military naval bases and airfields, among others. It should be noted that idea of non-alignment is a relic of the almost defunct Non-Aligned Movement (NAM) although there are signs of efforts to revive it, perhaps using BRICS which unfortunately has China, a world power, as one of its members. During the Second World War the term nearer the notion of non-alignment was neutrality. Switzerland was famously known of being neutral and as a result it became a financial haven of bounty from dictators around the world.
On 11 May 2023 South Africa’s tenuous non-alignment position was publicly unveiled when the US Ambassador to South Africa in a press statement said that arms had been shipped from a naval base in South Africa to Russia via the sanctioned Russian ship – Lady R – which “does not suggest …. the actions of a non-aligned country.” On another contentious issue, the US Ambassador said: “We expressed as well our serious concerns for the timing of the joint naval exercises that SA participated in with Russia and China in SA waters that coincided with the anniversary of the Russian invasion of Ukraine.” Furthermore, the Ambassador insinuated that the ANC Resolution on International Relations at its last Party Conference in December 2022 that “US-led expansionist military strategies” were resulting in “Western imperialist dominance over Eastern Europe” implied the US provoked the war between Russia and Ukraine. It is unusual that party issues from ANC conference resolution was clothed together with the Government issues because, in true democracies, party resolutions are normally viewed as rantings of madding crowds (just accommodated to satisfy populist elements) and are not considered government policy.
Nevertheless, following the US Ambassador’s press statement South African financial markets got unnerved. As expected, the currency market reacted spontaneously on the day. The rand fell to its lowest since 2020 to over R19 to the US dollar, with options pricing showing an 80 percent chance that it would hit R20 by June. However, it should be noted that one characteristic of the rand is that it trades far more freely and hence it can be more volatile than other emerging markets currencies simply on account bad news. In 2022 the Bank for International Settlements (BIS) ranked the rand as the 18th most traded currency in the world ahead of bigger emerging economies such Brazil, Poland, and Thailand.
Similarly, both the bond and equity markets tanked by not less than 1 percent on the day the Russian arms debacle went public. The reaction by South African markets is consistent with empirical studies that have found that an increase in geopolitical risks is associated with a decrease in stock returns and increased market volatility. For South Africa geopolitical risks are being added to the already slowing economy due to load-shedding, failing SOEs, greylisting and portfolio outflows.
Geopolitical risks could be considered a modern explanation of Lucas Paradox, that is, a reason for non-migration of capital to developing countries. Indeed, an increase in geopolitical tensions with major trading partners can cause a sudden reversal of cross-border capital flows. This effect is observed to be more pronounced for emerging and developing economies than it is observed in advanced economies. Going forward, in a financially fragmenting world, the global flow of capital will largely be determined by geopolitical factors. Developing countries on the wrong side of the new bipolar world will be denied capital despite even after having addressed their unfavourable endowments of human, public, and institutional capital. Therefore, it is in the interest of affected countries to make utmost efforts to strengthen engagement and dialogue to diplomatically resolve geopolitical tensions and prevent economic and financial fragmentation.
 Jung, Seungho, Jongmin Lee, and Seohyun Lee. 2021. “The Impact of Geopolitical Risk on Stock Returns: Evidence from Inter-Korea Geopolitics.” IMF Working Paper 2021/251, International Monetary Fund, Washington, DC