Proceedings of Nigeria’s Economic Development Conference (NEDCO) 2016

CAPITAL FLIGHT AND MONEY SUPPLY IN NIGERIA

Kolawole Ebire
Department of Business Administration, Ahmadu Bello University, Zaria

ABSTRACT
The effectiveness of monetary policy in achieving macroeconomic objectives in Nigeria have
been constrained by several factors among them is the prevalence of capital flight in Nigeria.
This study examines the effect of capital flight on the money supply in Nigeria with data
from 1981-2014. The World Bank residual method was used to estimate capital flight for
Nigeria and the broad money supply was used. The data were subjected to stationarity test
and the variables were found to be stationary at first difference. Johansen test of co-
integration was used to test the long-run relationship and it was found that there was no co-
integration. Unrestricted vector autoregressive model (VAR) was used to test the short-run
relationship between the variables. The residuals of the regression result were subjected to the
various diagnostic tests. The findings indicated that capital flight positively and significantly
affects money supply. This implies that capital flight over the years has undermined the
central bank ability to effectively pursue its monetary policy targets in order to achieve
desired objectives. Therefore, the study recommends that capital flight should be considered
in formulating and implementing monetary policy in order to ensure that it does not
undermine the effectiveness of the monetary policy.

INTRODUCTION
The importance of money in an economy has made policy makers and other relevant
stakeholders toaccord special recognition to the conduct of monetary policy. The Central
Bankof Nigeria (CBN) is the institution that is responsible for the conduct of monetary policy
in Nigeria. Monetary policy as defined by the CBN, is a deliberate action of the monetary
authorities to influence the quantity, cost and availability of money credit in order to achieve
desired macroeconomic objectives of internal and external balances.The action here involves
changing money supply and/or interest rates with the aim of managing the quantity of money
in the economy.
In formulating monetary policy, the monetary authorities usually set targets, which
are strategies used to achieve specified objectives (CBN, 2011a).There are different strategies
used by central banks in the conduct of monetary policy and these strategies affect the
operating, intermediate and ultimate targets through different channels. According to CBN,
one of such strategies is monetary targeting. Here, the CBN regulates the money supply in
order to achieve specified monetary policy objectives.

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from Multidimensional Perspectives

According to CBN (2011b), The need to regulate money supply is based on the

knowledge that there is a relatively stable relationship between the quantity of money supply

and economic activity and that if the supply of money is not limited to what it is required to

support, it will result in undesirable effects such as inflation or deflation, exchange rate

volatility, shortage in money supply, etc. Monetary policy in Nigeria has relied more on

indirect transmission mechanisms which according to Agu (2007) results to complexity of

monetary targeting as well as decision to choose between which target to adopt, which is a

major concern for monetary authorities as well as inadequate information on the nature and

size of impact of the target on key macroeconomic aggregates. Several factors may

undermine the effectiveness of monetary policy targets in achieving its goals/objectives. One

of such factors that could undermine the effectiveness of monetary policy targets in achieving

its goal is capital flight.

Generally, capital flight is referred to as, the movement of cash and investment out
of a country to a place that is believed to be safe. Over the years, capital flight has taken
center stage and the attention of researchers in developing nations including Nigeria. The
increased attention to capital flight amongst other reasons is due to the volume of capital
taken out of these developing countries and the impact these capital could have on domestic
economy. According to Adetiloye (2011) capital flight has become an issue in recent times in
the Nigerian financial environment such that three national dailies (The Guardian, Daily
Vanguard and The Sun) ran editorials on it between April 11th and 20th 2010. Ndikumana,
Boyce and Ndiaye (2014), reported that between 1970-2010, a cumulative amount of capital
flight for 39 African countries sum up to US $1.3trillion out of which Nigeria contributed
about US $311.4 billion. In another report by Global Financial Integrity (GFI) a Washington
DC based research and advocacy organization, stated that Nigeria comes first among the
African countries that have suffered from massive outflows of illegal funds between 1970-
2004. GFI (2010) reported that Nigeria lost $165 billion, nearly 19 percent of the total $854
billion outflows from Africa, to the developed economies. Massa (2014) noted that the net
Official Development Assistance (ODA) from members of the Development Assistance
Committee (DAC) of the Organization for Economic Cooperation and Development (OECD)

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to developing countries was about US $129 billion in 2010, representing only about 11% to
15% of the wealth that left poor countries through capital flight, this invariably means that
such assistance fund is insignificant compared to the volume of fund that leaves developing
nations.
Unfortunately, these monetary policy targets could be distorted in a financially
globalized world where capital move freely and can be easily siphoned away from an
economy without corresponding inflow. Fofack and Ndikumana (2014), noted that overtime,
agents acquire the skills and establish networks that enable them to evade regulatory scrutiny
and smuggle capital abroad with impunity.
As a result of these challenges, it therefore becomes pertinent to study the effect of
capital flight on money supply in Nigeria. Given that Nigeria has been experiencing
continuous increase in capital flight, and have been reported to have suffered more capital
flight than any other country in Africa. It is against this background that this study examines
the extent to which capital flight have undermine the effectiveness of money supply in
achieving its objectives in Nigeria. The main objective of this paper is to therefore, examine
the effect of capital flight on money supply in Nigeria.

Statement of Hypothesis
In line with the objective of this study, the following hypotheses are formulated:
H0: Capital flight has not significantly affected money supply in Nigeria
HA: Capital flight has significantly affected money supply in Nigeria

The paper is therefore organized into five sections. After the introduction is Section
2 that dwells on the literature review, Section 3 explains the methodology of the study,
Section 4 discusses the findings while, Section 5 is the conclusion and policy
recommendations.

LITERATURE REVIEW
This section reviews relevant literatures on capital flight and money supply and
theory that underpins the study.

Concept of Capital flight

A lot of controversies surround this phenomenon called capital flight, reasons being
that there has been controversies among researchers as to what constitute capital flight, and

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 Conference Theme: Nigeria’s Economic Challenges since Independence: Issues and Prospects
from Multidimensional Perspectives

also because the term is also viewed differently by developed and developing economies.
Cuddington (1986) in his study quoted a Sao Paulo economist Stephen Charles Kanitz, who
asked a question: Why is it that when an American puts money abroad it is called "Foreign
Investment" and when an Argentinian does the same it is called "Capital Flight"? Why is it
that when an American company puts 30 percent of its equity abroad it is called ―Strategic
Diversification" and when a Bolivian businessman puts only 4 percent abroad it is called
"Lack of Confidence"?Capital flight can also be viewed from legal and illegal point.
However, illegal transactions (fraud, money laundering, stolen funds, scam, etc) are not
recorded and as such its precise figure cannot be ascertained. On the other hand, legal capital
flight are legitimate wealth acquired and transferred abroad for different reasons (Adetiloye,
2011).
The World Bank (1985) study on capital flight defined it as, the sum of gross capital
outflows and the current account deficit less increases in official foreign reserves. This
definition sees capital flight as a change in debt plus net foreign and direct investment minus
current account deficit plus change in reserves. Khan and Nadeem (1985), took a different
approach and defined capital flight as gross private short-term capital outflows plus net error
and omissions in the country‘s balance of payment accounts. This definition sees capital
flight as cross border bank deposit by residence of depositor. However, this definition was
corroborated by Cuddington (1986) who defined capital flight as short-term speculative
outflows. In other words, capital flights are short term external assets by the non-bank private
sector plus the error and omissions in the balance of payment. This definition views capital
flight as ‗hot money flows‘ i.e., funds that respond quickly to changes in expected returns or
to changes in risk. These funds seek highest level of return at a given level of risk and return
very quickly to the country as soon as the economic conditions improve. Another definition
of capital flight is one given by Dooley (1986). He defined capital flight as capital outflows
motivated by the desire of residents to obtain financial assets and earnings on those assets
which remains outside the control of the domestic authorities. This study however, adopts the
definition by World Bank.

Measurement of Capital Flight

There are various measures of capital flight, according to Okoli (2008) they
includes: The residual method, Hot money measures, Mirror stock statistics, Dooley Method,
Trade Misinvoicing. However, this study adopts the World bank residual method. According

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to Lawanson (2007), the residual method appears to give a rather straight forward calculation
of capital flight, which may be responsible for being the most widely accepted and applied
method. This method used by World Bank, (1986); Morgan Guaranty Trust, (1986); Pastor,
(1989 and 1990), are often referred to as the ‗sources and uses‘ of fund approach, the broad
measure or indirect approach to measuring capital flight. The residual method according to
Lawanson, (2007), not only considers all private capital outflows as capital flight, it also
compares the sources and uses of such capital flows. This method suggests that for the non-
existence of capital flight, the sources must be equal to the uses of capital inflows. The
components of capital flight in this method include: the net increase in External Debt (EXD)
and the net inflow of Direct Foreign Investment (DFI) as sources which are compared with
the Current Account deficits (CA) and addition to foreign reserve (RES) as uses. Thus,
according to Pastor, (1990), capital flight is defined as the change in adjusted debt stock, plus
foreign direct investment, minus current account plus changes in reserve.

CFit = ΔDEBTit + FDIit - (CAit + ΔRESit)

Where CF is capital flight
ΔDEBT is the change in the stock of external debt outstanding
DFI is net direct foreign investment,
CA is thecurrent account deficit, and
ΔRES is net additions to the stock of foreign reserves.

According to Adetiloye, (2011), the total capital flight experienced by the country is
estimated and approximately capitalised to know the total capital lost to the country. Negative
values are capital net flows or capital reversal while positive values are capital flight.
Ndikumana& Boyce (2012) noted that only a fraction of the ‗leakages‘ revealed by this
calculation can be attributed tostatistical errors. They further explained that much of the
unrecorded flows resultsfrom illicit transactions, pursued for a variety of motives including
moneylaundering, tax evasion and tax avoidance which have been exacerbated by the
increasing complexity of financial transactions resultingfrom globalization, the increasing
sophistication of operations of multinationalcorporations with multiple domiciles across the
globe, and the expansion ofthe offshore interface between illicit and licit economies.

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from Multidimensional Perspectives

Empirical Studies
According to Fofack and Ndikumana (2014), the relationship between capital flight
and monetary policy may run either ways, that is, the outcomes of monetary policy affect
economic agents‘ investment and saving decisions, which may indirectly affect capital flight.
They further explained that, capital flight in turn has implications for the effectiveness of
monetary policy and affects the degrees of manoeuvre of monetary policy authorities in their
attempt to influence economic activity.Unsal (2011), in his study pointed out that there are
doubts that monetary policy is sufficient to guard against the risks of financial instability
caused by capital flight. On the other hand, Fofack and Ndikumana (2014) noted that capital
flight depletes resources in the domestic financial system i.e, it constitutes leakages in
aggregate money supply and the stock of reserves.
Bruno and Shin (2012) examined capital flows and the risk taking channel of
monetary policy by establishing the relationship between low interests maintained by
advanced economy central banks and credit booms in emerging economies using the Vector
Auto Regression (VAR) analysis found that expectations of lower short term rates dampens
measured risks and stimulates cross-border banking sector capital flows.
Sen (2010), examined the relationship between monetary policy, capital flows and
the exchange rate in India for the period 1990-2009. He observed that the use of monetary
policy in India has been constrained by a loose fiscal policy and capital flows. Using money
supply, exchange rate and GDP, his findings revealed that capital inflows have the potential
to cause a Dutch Disease-type situation and the authorities should keep a lid on capital flows,
allowing only the most urgent inflows from a growth standpoint which would help promote
competitive edge in manufacturing as well as promoting labour-intensive industry and help
mitigate the massive poverty levels. The methodological limitation of this study is that, there
was no evidence of stationarity test, serial correlation, heteroskedasticity and normality test.
Kinuthia (2015), examined that causality between capital flight and monetary policy
and the mechanisms in Kenya for the period of 1970-2010. Vector Error Correction Model
(VECM) was used to analyse the data. The study found out that there exists a link between
capital flight and monetary policy.
Ulke and Berument (2014), assessed the effects of tight monetary policy on
economic performance under different levels of capital flows with an empirical evidence
from Turkey from 1990-2013. They found out that the effectiveness of monetary policy
decreases for interest rate and also decreases for exchange rate and prices if capital flows are

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high. The methodological limitation of this study is that, there was no evidence of stationarity
test, autocorrelation, heteroskedasticity and normality test.

Theoretical Framework
One common theory that has been used in capital flight studies (Pastor, 1990;
Onodugo, Kalu, Anowor&Ukweni, 2014) is the Investment Diversion Theory.This theory of
Capital Flight postulates that due to the macroeconomic and political uncertainties in
developing countries, and the simultaneous existence of better investment opportunities in
advanced countries, like high foreign interest rates, wide array of financial instruments,
political and economic stability, favourable tax climate and secrecy of accounts, some corrupt
leaders and bureaucrats usually siphon scarce capital resources from their countries to
advanced countries. They do this either to earn higher returns, safe guard their investment
from instability, diversify their assets, or to enjoy confidentiality. These funds are, therefore,
not available for investment at home, thereby widening the savings gap, constraining
aggregate investment and limping economic growth. The investment diversion theory is
adopted in this study because it provides one of the well-known negative consequences of
capital flight in the countries.

RESEARCH METHODOLOGY
This section discusses the research design, sources of data collection, analysis
technique as well as model specification.

Research Design
The study adopts an ex-post facto research design. This is because an independent
variable has already occurred and an investigator starts with the observation of the dependent
variable then studies the independent variable inretrospect for possible relationship and
effects on the dependent variable. In this case, ex-post facto research design will provide a
basis for understanding the effects of capital flight and money supply.

Sources of Data Collection

The study used secondary data which are times series and quantitative in nature. The
data were sourced from CBN data base.

Data Analysis and Techniques

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from Multidimensional Perspectives

The technique employed for this study is parametric statistical technique since the
research uses quantitative data. Hence, the hypothesis will be tested with the use of the
Ordinary Least Square (OLS). The OLS method is an econometric technique that is used to
estimate the parameters of the linear regression technique model, because the OLS properties
are known as the Best Linear Unbiased and Efficient estimator (BLUE). Its objective is to
minimize the error term with the view of finding the model or regression equation that
explain the data.

Model Specification
To capture the relationship between capital flight and monetary policy targets in
Nigeria, the empirical model that accommodates the capital flight and money supply is
specified, which is drawn from reviewed literatures and theories. The model of capital flight
was adopted from World Bank residual measure of capital flight as used by Adetiloye (2011).
The mathematical expression below that was earlier stated will be vital for our study. That is:

CFit = ΔDEBTit + DFIit - (CAit +ΔRESit)

Where CF is capital flight
ΔDEBTit is the change in the stock of external debt outstanding
DFI is net direct foreign investment,
CA is thecurrent account deficit, and
ΔRES is net additions to the stock of foreign reserves.

Model I
LogMS = f(LogCF)
i.e. LogMS = β0 + β1LogCFt + ε…………………………………………………(1)

where;
MS is broad money supply
where, β0 and β1are the coefficient
ε is the stochastic error term

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TABLE 3.1 Variables and their Measurement

S/N VARIABLE NATURE OF MEASUREMENT
VARIABLE
1. Capital Flight Independent variable Estimated using the world bank residual
method which is measured as ΔDEBTit is the
change in the stock of external debt outstanding
plus
net direct foreign investment (DFIit), minus
thecurrent account deficit (CAit), plus
net additions to the stock of foreign reserves
(ΔRESit)
2. Money Supply Dependent variable Measured as the annual broad money supply
Source: Authors compilation (2016)

Data Analysis and Interpretation

Before estimating the regression, the variables were subjected to various diagnostic
test. Below are the various test conducted:

Test of Data Stationarity

Before estimating the equation, the variables were subjected to stationary tests of
time series in order to avoid the problem of spurious regression. If the data series is
differenced and it is found that it is stationary, then they can be integrated to the order of one
or greater, otherwise, a non-stationary series exists. The unit roots test was evaluated using
Augmented Dickey-Fuller (1981) and Phillip-Perron for all the variables in this study.

Table 1 Augmented Dickey Fuller Statistics of the Variables

Variables ADF PP

Levels 1st Difference Levels 1st Difference Order of

integration
LOGCF -2.159917 -7.389386 -2.256541 -8.644483* I(1)

LOGMS 0.123898 -3.730850 * 0.027269 -3.730850* I(1)

Note: * indicates significance at 1% level
Source: Author‘s Eviews 8.0 output, 2016

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from Multidimensional Perspectives

Table 1 shows the summary results obtained from the stationarity test conducted on
the variables. It can be seen from the table that the variables are found to be stationary and
integrated in the order I(1) as evidence by the significance of their respective test statistics.
Hence, a long-run relationship exists between the variables. Therefore, co-integration test will
be carried out to ascertain their long-run relationship.

Co-integration Test
Given that the variables are I(1), we proceed to implement the Engle-Granger
Residual Co-integration procedure as shown in table 2

Table 2: Johansen Co-integration Test

Hypothesized Trace 0.05
No. of CE(s) Eigenvalue Statistic Critical Value Prob.**
None 0.336687 14.23841 15.49471 0.0766
At most 1 0.033856 1.102141 3.841466 0.2938
Trace test indicates no cointegration at the 0.05 level
* denotes rejection of the hypothesis at the 0.05 level
**MacKinnon-Haug-Michelis (1999) p-values

From the above, it can be seen that the trace statistics is less than the critical value
and also, the probability value is more than 5% level of significance. This implies that there is
no co-integration or long-run relationship among the variables at none and also at most 1.
Therefore, we proceed to run an unrestricted VAR.

Table: Vector Autoregressive Model

Variables Coefficients Std. error t-statistics Prob.

Logms 0.392996 0.158522 2.479127 0.0190

Source: Authors Computation (2016)

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Econometric result of the model adopted is presented in table 3. The vector

autoregressive model of logms is statistically significant at the current year (-1) as the
probability of the t-ratio (2.479127) is less than the critical value of 5%. This implies that
capital flight affects money supply that is, as capital flight increases, money supply is
increased to thereby altering desired objectives of the monetary authorities.
Investigating the overall significance of the model, the value of F-statistics is 83.89
and the probability associated with it is (0.000) which is less than 0.05 at 5% level of
significance. This means that there exists statistical significance between capital flight and
money supply. R-square is 0.8483, implying that the coefficient of determination (R2) is
statistically significant at 84.83% which adjudge the model as accurate and highly fitted. The
adjusted R-square indicates that about 83.82% variation in the endogenous variable can be
explained by the exogenous variables.
This result is in line with Fofack and Ndikumana (2014) findings, that capital flight
is a leakage in aggregate money supply and as such weakens monetary policy transmission.

Serial Correlation Test

The residuals of the regression equation were tested for serial correlation using the
Breusch-Godfrey serial correlation LM test. The null hypotheses were tested which stated
that, there is no serial correlation. This was necessary because, serialcorrelation in the
residuals will lead to incorrect estimates of the standard errors, and invalidstatistical inference
for the coefficients of the equation. From our analysis, the presence of serial correlation was
corrected in the model by the introduction of the first-order autoregressive {AR(1)} to our
model. However, after the introduction we could not find reasons to reject our null
hypotheses. Hence, the null hypotheses were accept for all model which states that there is no
serial correlation.

Heteroskedasticity Test
One of the statistical assumptions of OLS is that the error terms for all observations
have a common variance (homoscedastic).On the contrary, varying variance errors are said to
be heteroskedastic. The heteroskedasticity was tested in the residuals of the estimations using
the Autoregressive Conditional Heteroskedasticity (ARCH) test developed by Engle (1982).
Ignoring the ARCH effect on the residuals of time series may result in the loss of efficiency
of the estimators. The null hypotheses are stated as, there is no heteroskedasticity. From our

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NEDCO, JUNE 6-8, 2016. FEDERAL UNIVERSITY DUTSINMA, KATSINA STATE
 Conference Theme: Nigeria’s Economic Challenges since Independence: Issues and Prospects
from Multidimensional Perspectives

analysis, there was no heteroskedasticity. Hence, we could not find reasons to reject the null
hypothesis because they were insignificant at 1%, 5% and 10%.

CONCLUSION AND RECOMMENDATION

The objective of this study is to examine the effect of capital flight on money supply
in Nigeria from 1981- 2014. From the results obtained from the econometric analysis of the
data, the study therefore, concludes that capital flight has positively and significantly affected
money supply in Nigeria. Due to increased capital flight in the Nigerian economy over the
years, monetary policy transmission is weakened as a result of such leakages and as such
more money has to be supplied to make up for the such leakages. This is in line with Fofack
and Ndikumana (2014) study.
Based on this findings, the following recommendations are made:
Firstly, capital flight should be considered in formulating and implementing
monetary policy in order to ensure that it does not undermine the effectiveness of the
monetary policy.
Secondly, measures such as fiscal and monetary policies should be put in place to
checkmate capital flight out of Nigeria.

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from Multidimensional Perspectives

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