Board of Governors of the Federal Reserve System
International Finance Discussion Papers
Effects of Financial Autarky and Integration: The Case of the South Africa
NOTE: International Finance Discussion Papers are preliminary materials circulated to stimulate
discussion and critical comment. References in publications to International Finance Discussion Papers
(other than an acknowledgment that the writer has had access to unpublished material) should be cleared
with the author or authors. Recent IFDPs are available on the Web at www.federalreserve.gov/pubs/ifdp/.
This paper can be downloaded without charge from Social Science Research Network electronic library at
Effects of Financial Autarky and Integration: The Case of the
South Africa Embargo
The economic embargo imposed on South Africa between 1985 and 1993 brought the country
closer to financial isolation. This paper interprets the imposition and removal of the embargo as
financial autarky and financial integration ‘natural experiments’, and studies the effects on the
economy. The aggregate data indicate a decrease in the levels and growth rates of investment,
capital, and output during the embargo period relative to the pre-embargo and post-embargo
periods. To further rationalize the findings in the aggregate data, we calibrate a neoclassical
growth model to the South African economy. During the transition to steady-state, we model the
embargo by limiting the country’s ability to borrow for a period corresponding to the duration of
the embargo. The derived dynamics for investment, capital, and output support the view of a
positive (negative) link between financial integration (isolation) and economic growth.
Keywords: International Finance, Embargo, Autarky, Financial integration, Financial isolation,
JEL classifications: F3; F41; E13; O4; O11; O16
* Mailing address: Division of International Finance, Board of Governors of Federal Reserve System,
Mail Stop 24, Washington DC 20551, USA; email: firstname.lastname@example.org. Tel.: (202)-452-2609;
fax: (202)-736-5638. The author thanks Linda Tesar for encouragement and constructive feedback,
Matthew Shapiro, Miles Kimball, and Herman Kamil for helpful comments and discussions. I am
indebted to David Gale at the South Africa Trade and Industrial Policy Strategies for providing access to
some of the data, and to David Lam for funding a data set used to explore earlier versions of the study. I
am also grateful to Dale Henderson, Sylvain LeDuc, David Bowman, Sanjay Chugh, Luis-Felipe Zanna,
and to seminar participants at the Board of Governors of the Federal Reserve System for helpful
comments, and to Jon Faust for detailed constructive feedback. Work on this project started while I was a
graduate student in the Department of Economics and a Research Associate at the Institute for Social
Research at the University of Michigan. The views expressed in the paper are those of the author and do
not necessarily reflect those of the Board of Governors or the Federal Reserve System.
Between 1985 and 1993 the world imposed economic sanctions on South Africa to put pressure
on its apartheid regime (a political system that granted di¤erent rights to citizens based on race).
At that time, foreign investors withdrew their capital from the country and stopped making new
investments in and loans to South Africa. As a result, net capital in‡ows declined drastically. In
this paper, we exploit the unique reversion toward …nancial autarky during the embargo period and
reintegration into the world economy in the post-embargo period to study the economic bene…ts of
…nancial integration for an emerging economy.
Until recently, it seemed obvious that …nancial integration yields important economic bene…ts
for emerging economies. The conventional view of …nancial integration suggests that when countries
are integrated, capital ‡ows from capital-abundant to capital-scarce countries to achieve a more
e¢ cient allocation of global savings. The in‡ow of capital speeds up capital formation, and increases
economic growth and welfare in the recipient country (see e.g. Obstfeld, 1994; Fischer, 1998;
Eichengreen and Mussa, 1998).1
The …nancial crises that devastated the emerging economies of Asia and Latin America in the
mid to late 1990s following the liberalization of their capital accounts challenged the conventional
view on the economic e¤ect of …nancial integration, and prompted a renewed research interest in the
subject.2 Since then, several empirical studies have assessed the economic e¤ect of capital account
liberalizations with mixed resulting evidence. (see Edison et al., 2003 for a survey). Part of the
challenge to resolve this issue can be traced to the di¢ culty in measuring …nancial integration as
noted in Edison et al. (2002). The literature uses four broad measures.
The …rst measure is based on the International Monetary Fund’s (IMF) Annual Report on
Exchange Arrangements and Exchange Restrictions (AREAER). It constructs a binary zero-one
indicator for whether the country maintains restrictions on foreign exchanges. When averaged over
a period, the constructed indicator measures the fraction of time when the country maintained
an open capital account. Rodrick (1998) uses such a measure as an independent variable in a
panel regression of one hundred countries. He …nds no evidence that capital account liberalization
increases investment or economic growth.
The second measure, proposed by Quinn (1997), aims to improve upon the …rst measure by
capturing the intensity of the restrictions. It departs from the binary coding and assigns numerical
values based on detailed information in the AREAER. The resulting 0-14 measure attempts to
provide a more informative measure by capturing the extent of the countries’…nancial integration.
In contrast to …ndings in Rodrick (1998), he …nds a positive relationship between capital account
liberalization and economic growth.
1 Additional references on positive e¤ect of …nancial integration include Henry (2000a,b), Bekaert et al. (2001),
and Summers (2000).
2 See for example Stiglitz, 2000 and Bagwhati, 1998 for arguments against the conventional view of a positive e¤ect
of …nancial liberalization.
The third set of measures is based on the ‡ow of capital or the stock of foreign liabilities to Gross
Domestic Product (GDP) ratios. Based on these measures, the higher the capital ‡ows between a
country and the rest of the world, or the higher the country’s stock of foreign liabilities as a share
of GDP, the more …nancially integrated the country is. Using this measure, Kraay (1998) …nds
some positive relationship between …nancial integration and economic growth, while Edison et al.
(2002) …nds no signi…cant relationship.
The last measure is based on o¢ cial dates of stock market liberalizations. This approach,
used in Henry (2003) and Bekaert et al. (2001), considers that the countries are more …nancially
integrated after they open their stock markets to foreign investors. Both authors …nd a positive
signi…cant relationship between the liberalization of stock markets and growth in investment and
output. (see Edison et al., 2002 for a detailed survey on various measures).
In this study, the …nancial isolation is the imposition of the embargo, and the …nancial in-
tegration is the removal of the embargo. The experiment, therefore, circumvents the challenges
of measuring …nancial integration. A related and often mentioned reservation about some of the
previous measures of …nancial integration is the endogeneity of the integration measure itself. Fi-
nancial integration, it is argued, is a process that does not occur in isolation. It is usually induced
by contemporaneous or prospective changes to the economy. In this case, the direction of causality
between integration to economic performance is not obvious.
In this study, we posit that the isolation and reintegration due to the imposition and removal
of the embargo, can be interpreted as events less subject to the endogeneity encountered in some of
the previous studies. The decision by the world to impose an economic embargo on South Africa
was not related to the country’s economic performance, but to the desire to change its political
regime. Similarly, the decision to remove the embargo followed a host of political reforms that
dismantled the apartheid regime. The reforms were instituted under a new and more moderate
prime minister following the resignation of his predecessor for unexpected health problems.
The study further contributes to the literature by analyzing the bene…ts of …nancial integration
through the lenses of the adverse e¤ects of …nancial isolation. A corollary of the view that greater
…nancial integration yields economic bene…ts is that …nancial isolation should adversely a¤ect the
economy. Since South Africa was integrated prior to the economic embargo and reintegrated into
the world …nancial markets after the embargo period, we can analyze both the negative e¤ects of
…nancial isolation as well as the positive e¤ects of …nancial integration.
There are, however, potential challenges to using this embargo event study which make it
di¢ cult to isolate the e¤ect of the …nancial isolation. First, the sanctions against South Africa
included an embargo on trade, and the e¤ects of the embargo on the economy could have resulted
from the trade sanctions, and not necessarily from the …nancial isolation. Second, domestic policy
changes induced by the sanctions, if any, could have been the cause of any distortions to the
economy during the embargo period. Third, the embargo took place in an environment of political
instability. The risk stemming from the instability could have adversely a¤ected the economy
during the embargo period. Last, possible shocks to the global economy during the embargo period
could have also a¤ected the South African economy irrespective of the …nancial isolation. Despite
these potential limitations, which we address later in the study, the South Africa embargo o¤ers a
unique alternative experiment not explored in the literature to analyze the economic importance
of …nancial integration (isolation) for an emerging economy.
The study begins in section 2 with a documentation of the embargo event and the …nancial
isolation. In section 3, we analyze the e¤ect of the embargo on investment, capital, and output
using time series data of the South Africa economy. According to the integration hypothesis, the
growth rates and levels for these variables should decrease during the embargo period compared to
the pre-embargo and post-embargo years. The data support these predictions.
During the embargo period, average growth rates fell from 0.2 percent to -2.6 percent for
investment, from 3.5 to 1.3 percent for capital per worker, and from 2.2 to 0.8 percent for output
per worker. After the embargo, the average growth rates for investment, and capital and output per
worker increased to 5.0 percent, 2.0 percent, and 3.7 percent, respectively. The statistics further
indicate that the levels of investment, capital, and output fell by 25.6 percent, 12.5 percent, and 9.5
percent during the embargo period compared to the levels that would have prevailed if the variables
had maintained the pre-embargo average growth rates. In the post-embargo period, the levels of
investment, capital, and output rose 37.3 percent, 2.2 percent, and 8.4 percent above the levels that
would have prevailed if the variables had continued to grow at the embargo period average growth
To further rationalize the observations of a positive (negative) e¤ect of …nancial integration
(isolation) on economic performance, we present in section 4, a small open economy neoclassical
growth model calibrated to the South African economy. During the transition to steady-state,
we model the embargo event by limiting the country’s ability to borrow, and by imposing a tax
on output to capture the disinvestment during the embargo period. The resulting dynamics for
investment, capital, and output con…rm the observations of a positive (negative) link between
…nancial integration (isolation) and economic growth. In section 5, we address the challenges,
noted earlier, with using the South Africa embargo experiment, and conclude in section 6.
The South Africa Embargo
In 1948, the Nationalist party assumed power in South Africa and passed legislations that instituted
the apartheid system; a system under which citizens from di¤erent racial groups had di¤erent
rights. The institution of the apartheid system prompted a worldwide condemnation and marked
the beginning of sanctions against the country. The United Nations (U.N.) and several countries
imposed various forms of sanctions on South Africa to end the apartheid regime. However, the
economic sanctions did not intensify until 1985, and they continued until the apartheid regime was
dismantled around 1993. In the remainder of the study, the period 1985-1993 is considered the
embargo period. The choice of these dates is guided by historical accounts of the embargo and
by the changes in economic variables such as foreign liabilities, net capital ‡ows, and the current
To assess the e¤ect of the embargo on foreign investment and trade in South Africa, the next
sections document some anecdotal evidence of the disinvestment, and present data obtained from
the South Africa Reserve Bank on net capital in‡ows (Figure 1), foreign liabilities (Figures 2 and
3) and the current account (Figure 4).
Foreign Investment prior to the Embargo
Prior to the 1985 economic sanctions, South Africa had an open capital account and foreigners
invested in the country. The following statistics document the magnitude and composition of foreign
liabilities (Foreign Direct Investment, Portfolio investment, and Loans) in the period leading up to
the 1985 embargo.
Between 1970 and 1985, net capital in‡ows and total foreign liabilities as percentages of GDP
averaged 2.2 percent and 53 percent, respectively (see Figures 1 and 2). Figure 4 indicates that
current account was mostly in de…cit (except in 1977-1980), averaging over 2 percent of GDP.
Figure 3 presents the composition of the liabilities. On average, 45 percent of the total liabilities
were in Foreign Direct Investment (FDI), followed by loans (40 percent). Portfolio investments
made up the remaining 15 percent; two-thirds of which were held in equity.
By 1985, total foreign liabilities as a percentage of GDP had increased from 53 percent to
nearly 70 percent (the public sector held 37 percent of the liabilities, and the banking and non-
banking sectors held the remaining 63 percent), and the composition changed. The share of FDI
and portfolio investments declined to 25 percent and 13 percent, respectively. The share of loans,
on the other hand, increased from 40 percent of total liabilities to over 60 percent; 70 percent of
which was due to mature within a year. The shift in liabilities from FDI and portfolio to debt
re‡ected, perhaps, foreign investors’ desire to reduce their risk exposure in South Africa (in light
of the prevailing fragile political situation), forcing the country to rely on loans rather than on
FDI and equity capital to ful…ll its investment needs. The government had, reportedly, facilitated
foreign borrowing by reassuring foreign banks and by stabilizing the indebtedness through gold
swaps, or by borrowing from the IMF.
Foreign Investment during the Embargo
In September 1984, the ruling party in South Africa instituted a new constitution that estab-
lished separate parliamentary chambers for Indian and colored representatives, and continued to
exclude Blacks. The new constitution signaled an uncompromising position on the apartheid issue,
and sparked widespread protests and riots. The unrest resulted in an intensi…cation of economic
sanctions and marked the beginning of the disinvestment period.
Several foreign companies operating in South Africa decided to disinvest and/or stop making
new investments or reinvestments of earnings in the country. For example, of the approximately
350-400 United States (U.S.) companies with direct investment in South Africa in January 1984,
the Investor Responsibility Research Center estimated that seven withdrew in 1984 and 39 in 1985.
During 1986 the pace quickened. Forty companies left and thirteen announced their intention of
leaving. By June 1987, 39 additional …rms had left or announced their intention of leaving. By
mid-1988, only 136 U.S. companies reportedly remained in the country (Lipton 1998, 64; Baker
In addition to private companies, several countries and some U.S. states passed laws forbidding
investment of municipal or state funds in companies operating in South Africa. In 1986, California
announced a gradual disinvestment of its $11 billion held in companies with ties to South Africa.
By the end of 1988, 23 states, 19 counties, and 79 cities had adopted various economic measures to
distance themselves from South Africa. (Chettle 1982, 106-08; New York Times, 28 October 1984,
A18; Los Angeles Times, 25 December 1984, A1; Lipton 1988, 23-24; Baker 61). In 1985, France
also banned new investment in or loans to South Africa.
Foreign banks joined in on the sanctions. In the …rst half of 1985, U.S. banks reportedly
withdrew $1 billion. In the Fall of 1986, Barclays Bank (the largest British investor in the country)
disinvested as well. Other British banks, that had lent South Africa more than $3 billion in debt
due to mature in 1987, were also unwilling to make new loans to the country (Washington Post, 1
September 1985, A1).3
As a result of the economic sanctions, the U.S. General Accounting O¢ ce (GAO) estimated
that $10.8 billion ‡owed out of South Africa from January 1985 through June 1989, including $3.7
billion in loan repayments to banks, $7.1 billion in other debt repayments and capital ‡ight (GAO
1990, 12, 17). Similarly, Trust Bank (a South Africa commercial bank) calculated that the country
had forgone nearly $14 billion in loans and direct investments between 1985 and 1990 in comparison
to what loans and direct investments would have been had money ‡own in at the rate that had
prevailed before 1985 (The Economist, 10 February 1990, 69). The IMF estimated that South
Africa had forgone $8 billion in foreign investment between 1985 and 1991, which amounted to 3
percent of the 1985-1991 period cumulative GDP.
Figures 1-4 document the e¤ect of the embargo on net capital in‡ows, foreign liabilities, and the
current account. Net capital in‡ows reversed to net out‡ows of approximately 2 percent of GDP per
year. The current account reversed from an average of 2 percent of GDP de…cit prior to the embargo
to a 2.4 percent surplus during the embargo period. Foreign liabilities as a percentage of GDP fell
from 53 percent prior to 1985, to 44 percent during the embargo period. The composition of the
liabilities shifted from loans to portfolio investment, most likely, re‡ecting a 1987 debt renegotiation
agreement that allowed foreign investors to convert loans into equity.
Foreign Investment after the Embargo
In 1989, the Prime minister su¤ered a stroke, and resigned unexpectedly. His successor initiated
a series of reforms in the early 1990s that resulted in the abolishment of the apartheid system.
Accordingly, the international community began to lift the sanctions. In 1992, the European Com-
mission lifted its sanctions against South Africa. The United States, Norway, and India followed
in 1993. In 1994, the remaining United Nations sanctions were removed.
With the removal of the economic sanctions and the reintegration of South Africa in the global
economy, foreign investment in the country resumed. For example, the World Bank announced
$1 billion worth of development projects for South Africa in 1993. The South Africa Reserve
Bank estimated that capital ‡ows switched from large out‡ows prior to 1994 to net in‡ows of
approximately 2.6 billion rands ($730 million) in 1994, and to 16.6 billion rands ($4.6 billion) in
1995 (Wesso, 2001). The share of foreign portfolio investment in the JSE increased from 6 percent
in 1985 to approximately 15 percent in 1994. At the end of 1995, South Africa had the largest
weight in the International Finance Corporation’s (IFC) global emerging market index (15 percent)
and investible emerging market index (27 percent).
Figures 1-4 document the e¤ect of the removal of the embargo on net capital in‡ows, foreign
liabilities, and the current account. Capital ‡ows reversed again from net out‡ows during the
embargo period to net in‡ows of approximately 2 percent of GDP per year between 1994 and 2001.
During the same period, the current account also reversed from a surplus during the embargo period
to a 1 percent per year de…cit. The e¤ect of the post embargo in‡ows is also re‡ected in the stock
of foreign liabilities. Total liabilities as a percentage of GDP increased from its 1985-1993 average
of 40 percent to 63 percent between 1994 and 2001, exceeding the pre-1985 average of 53 percent.
In summary, consistent with historical accounts on the disinvesment, net capital ‡ows which
were positive prior to the embargo, reversed to net out‡ows during the embargo period, and the
amount of foreign liabilities declined signi…cantly. Re‡ecting, in part, the disinvestment, the current
account reversed from a de…cit to a surplus. When the sanctions were lifted, foreign investment
returned to South Africa. Net capital ‡ows switched from net out‡ows during the embargo to net
in‡ows. The stock of foreign liabilities increased signi…cantly in the post embargo period, and the
current account reversed back to a de…cit. Both the historical accounts of the disinvestment and
the data on foreign investment support a reduction of foreign investment in South Africa between
1985 and 1993 reverting the country to quasi-autarky. The following section analyzes the e¤ect, if
any, of the …nancial isolation on …xed investment, capital, and output.
Economic E¤ect of the Embargo
We plot in …gures 5 through 7, annual …xed investment, and capital and output per worker for
South Africa from 1970 to 2001. The vertical bars denote the 1985-1993 embargo period. The
…gures indicate that during the embargo period, the growth rates of investment, capital and output
per worker decreased in comparison to the pre-embargo and post-embargo periods growth rates.
Table 1 compares the growth rates of investment, capital, and output before, during, and after
the embargo. The results indicate that average growth rate of investment fell during the embargo
period to -2.6 percent from 0.2 percent in the eight years prior to the embargo, and increased to 5.0
percent between 1994 and 2001. The average growth rate for capital also fell during the embargo
period to 1.3 percent from 3.5 percent in the eight years prior to the embargo, and increased to
2.0 percent in the post-embargo period. Similarly, the average growth rate of output fell from 2.2
percent prior to the embargo to 0.8 during the embargo period, and increased to 3.7 percent after
To measure the investment, capital, and output loss due to the embargo, we plot also, in …gures
5 through 7, the paths assuming the variables maintained their eight-year pre-embargo period
average growth rates during the embargo period (upper dotted lines between 1985 and 1993). To
measure the investment, capital, and output gains due to the removal of the embargo, we also plot
in …gures 5 through 7, the paths assuming the variables maintained their eight-year embargo period
average growth rates (lower dotted lines between 1994 and 2001). To quantify the losses (gains),
we compare, also in Table 1, the levels of investment, capital, and output to those that would have
prevailed if the variables had maintained the pre-embargo (embargo) period average growth rates.
Results indicate that the average level of investment fell by 25.6 percent during the embargo
period compared to the level that would have prevailed if investment had grown at its pre-embargo
growth rate. For capital and output, the corresponding declines in average levels were 12.5 and
9.5 percent, respectively. After the embargo, the levels of investment, output and capital increased
37.3 percent, 2.2 percent, and 8.4 percent from the levels that would have prevailed if the variables
had grown at the embargo period average growth rates.
In summary, the descriptive statistics of investment, capital, and output suggest that the em-
bargo adversely a¤ected the economy, and that the economy bene…ted from the removal of the
embargo. To further rationalize these …ndings, the next section presents a neoclassical growth
model calibrated to the South Africa economy to capture the e¤ects of the embargo.
A Theoretical Growth Model
The theoretical framework is a simple neoclassical growth model in the context of a small open
economy with perfect capital mobility and capital adjustment costs. The adjustment costs are
introduced to avoid instantaneous convergence to steady-state. A central planner makes all the
production, consumption, and investment decisions. The agents in the economy are in…nitely lived.
There are no uncertainties, except that the imposition and removal of embargo are unexpected,
and there is no government. Markets are competitive, and the production technology has constant
returns to scale.
The model further assumes that population and labor (supplied inelastically) are identical.
Labor grows at a constant rate so that labor at a time t is given by Lt = L0ent:Technology At
evolves at a constant rate g; and At = A0egt. Zero subscripts denote the initial value of the economic
variable, e.g. X(0) = X0: Let A0 = 1 and L0 = 1: The e¤ective unit of labor at a time t is given
by Lt = e(n+g)t: All lower case variables are expressed in e¤ective units of labor; e.g., xt =
In absence of the embargo, the economy accumulates capital using savings of its residents, and by
attracting foreign capital. Since the country is open and small, the interest rate is set exogenously
at the world rate. The social planner has perfect foresight and determines each period’s allocation
by maximizing the welfare subject to the budget constraint:
M ax Ut = Z 1e ( n)tu ctegt dt
t = ct + (rw
g) dt + it 1 +
kt = it
Where u ( ) is the utility function, ct, dt, kt, yt, and it denote consumption, the stock of foreign
debt, capital stock, output, and investment in e¤ective units of labor, respectively. rw is the world
interest rate. It is costly to adjust capital.
( ) is the adjustment cost function. Parameters ,
represent the rate of depreciation, the utility discount rate, and the share of capital in
output production, respectively.
Equation (1) is the resource ‡ow constraint. The change in the net foreign debt is the excess
spending (consumption, investment, transfers) over production net of capital adjustment costs.
Equation (2) states that capital accumulates through investment net of depreciation. Further,
assume a constant relative risk aversion (CRRA) utility function of the following form: U (c) = c1