How does public investment affect private investment?

Selim Raihan

The importance of investment in economic growth is well acknowledged both in theory and empirical literature. No country has been able to accelerate economic growth without significantly increasing the investment-GDP ratio. However, there are disagreements among economists and policy-makers about the composition of investment, i.e. the share of private and public investment in total investment. Two views dominate in this regard. One view argues that public investment has a crowding out effect on private investment. That means, with the rise in the public investment the private investment may fall. In contrast, the other view argues that public investment can be complementary to private investment. Thus, the rise in the public investment can be conducive to the rise in private investment. The inconclusive nature of the results of the empirical literature is, however, also driven by the differences in the methodology used in these studies in different country contexts.

The data on public investment share in GDP is available for 91 countries. Figure 1 presents the average percentage share of public investment in GDP for those 91 countries for the years during 2013-2017. With a share of 20.77%, Republic of Congo is at the top of this list, while with a share of 0.98%, Sudan is at the bottom of the list. The top ten countries with the high shares include Republic of Congo, Iraq, Rwanda, Equatorial Guinea, Venezuela, Ethiopia, Timor-Leste, Djibouti, Burkina Faso, and Mozambique. In contrast, the bottom 10 countries include Sudan, Yemen, Lebanon, Guatemala, Russia, El Salvador, Armenia, Serbia, Philippines, and Croatia. Among the five South Asian countries, Bhutan has the highest share (10.86%), followed by Bangladesh (6.82%), Nepal (5.78%), Pakistan (3.74%), and India (3.6%).

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While looking at the pattern of the cross-country differences of the share of public investment in GDP and GDP growth rate, as plotted in Figure 1, it appears that in the recent years (2013-2017), 19 countries exhibit having shares of public-investment in GDP of 5% or more as well as GDP growth rate of 5% or more. Among these countries, 10 are from sub-Saharan Africa, two from Latin America, two from South Asia (Bangladesh and Bhutan), and two from Southeast Asia (Malaysia and Myanmar). If we consider the 6% GDP growth rate as the cut-off mark with public investment share in GDP of 5% or more, there are only eight countries (Rwanda, Ethiopia, Djibouti, Lao PDR, Myanmar, Guinea, Bangladesh, and Cote d’Ivoire). This suggests that the association between public investment share in GDP and GDP growth rate is not straightforward.

Furthermore, the scatter-plot between the ratios of public investment to GDP and private investment to GDP (Figure 2) suggests that there are two different trends as far as the association between the public and private investments in a cross-country context is concerned. For the countries with public investment to GDP ratio of less than 7%, there seems to be a positive association between the ratios of public investment to GDP and private investment to GDP. However, for the countries with excessive public investment to GDP ratio (more than 7%), there seems to be a negative association between public and private investment.

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The aforementioned analysis underscores the need for a discussion on some critical factors which are important to make public investment conducive for private investment. While it is true that public investment is the main channel for the formation of public capital stock, an adequate level of public capital can have a positive impact on economic growth depending on the capacity and nature of public capital to attract or crowd-in private capital. The crowd-in effect can only occur when public investment furnaces such a public capital stock that increases the rate of return of private capital.

One of the critical channels through which public investment may play a role in increasing the rate of return of private capital is infrastructure development. The importance of infrastructure originates from the fact that it provides key intermediate consumption items in the production process for almost all activities in the economy. Therefore, an adequate supply of infrastructure through public investment has the potential to crowd-in private investment. However, when it comes to infrastructure development through public investment, there are two important issues which need to be in order to ensure the crowd-in effect of private investment.

First, not only the quantity but also the quality of the infrastructure is equally important. In many developing countries, due to institutional deficiencies, infrastructural projects suffer from huge cost and time over-run, which can discourage private investment. The high cost of infrastructural projects and uncertainty in the timely delivery of such projects may reduce the rate of return of private investment.

Second, while several supply-side constraints related to weak infrastructure can restrict potential private investments in new and emerging sectors, some of these constraints are broadly ‘general’ in nature and some are critically ‘sector-specific’. Interconnection and complementarities between general and sector-specific infrastructures are key elements for increasing service efficiency, supporting the adoption of innovative technologies, and the promotion of private investment in those sectors. However, there is a tendency in the developing countries to excessively emphasize on the broad general infrastructure, i.e., the enhanced supply of electricity, improvement in roads, improvement in port facilities, etc. that the development of critical sector-specific infrastructure is largely overlooked. Embarking on developing broad general infrastructure are relatively easy, whereas solving sector-specific infrastructure problems involves identifying priorities in the policy-making process and addressing a number of political economic issues. However, failure to deal with sector-specific infrastructure problems leads to a scenario where a large number of potential growth-enhancing sectors may fail to enjoy the benefit from the improvement in broad general infrastructure. This can discourage private investment.

Dr. Selim Raihan. Email: selim.raihan@gmail.com

First published at the Thinking Aloud on 1 November 2018

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How does improvement in infrastructure affect economic growth?

Selim Raihan and Sunera Saba Khan

Infrastructure plays a decisive role in stimulating long-run economic growth. An increase in the level of infrastructure stock directly helps in reducing poverty and accelerating productivity. Infrastructure also contributes to the development process through the provision of intermediate consumption items for production as well as final consumption services for households. It contributes to growth through generating new jobs, creating cohesive spillover benefits and attracting further investments through crowding in effects. Empirical studies also corroborate the relationship between different infrastructural indicators and growth.

In the present article, we have constructed an Infrastructure Index to observe the growth-infrastructure nexuses from a broader perspective. With a view to observing nexus we have constructed the Infrastructure Index for 133 countries over the period between 1990 and 2012 using four indicators namely Electric Power Consumption (per kWh per capita), Energy Use (kg of oil equivalent per capita), Fixed Broad Internet Subscribers (per 100 people) and Mobile Cellular Subscriptions (per 100 people). The indicators are selected based on the availability of data and importance. We have obtained the data of these selected indicators from the World Development Indicators (WDI) of the World Bank. In order to assign weight to each indicator to construct the Infrastructure Index we have applied the Principal Component Analysis (PCA) method as it enables to derive the weight for each variable associated with each principal component and its associated variance explained. In doing so, firstly, we have used normalized values of variables followed by the extraction of factors. Secondly, the Eigen values of the factors, which help to determine the significance of principal components, have been used to determine the factors that will be retained. Thirdly, the variables have been assigned weights, which have been calculated by multiplying factor loadings of the principal components with their corresponding Eigen values. And, finally, the index has been constructed using those weights. The constructed Infrastructure Index ranges from 0 to 100 where 0 depicts the worst case and 100 depicts the perfect case. The PCA suggests that the weights for electric power, energy use, internet use, and mobile subscriptions were 29.9%, 37.6%, 16.3% and 16.2% respectively in 1990; 30.1%, 36.5%, 15.8% and 17.6% respectively in 2000; and 31.4%, 33.8%, 19.4% and 15.4% respectively in 2010.

Table 1

Table 2

Table 3

Tables 1, 2 and 3 depict the top 10 and bottom 10 countries in terms of the Infrastructure Index for the years of 1990, 2000, and 2010 respectively. Norway ranked at the top in 1990 while Iceland ranked at the top in both 2000 and 2010. Among the 133 countries considered, Bangladesh ranked the lowest invariably in both 1990 and 2000 whereas, Ethiopia ranked the lowest in 2010. The ranking of the South Asian countries (Table 4) shows that Pakistan ranked 110th in 1990, the highest among the five South Asian countries; while Sri Lanka ranked 108th and 103rd respectively in the following two consecutive decades, the highest among the five South Asian countries. It should be noted that the South Asian countries’ rank as some of the bottom most countries clearly indicate dissatisfactory performance in their infrastructure development. This poor performance clearly depicts that the region has huge electricity shortages and very low energy use, which together takes into account more than 60% weight of the Infrastructure Index.

Table 4

In order to explore the association between infrastructure and economic growth we have run a series of fixed effect panel regressions where Infrastructure Index and its sub-components are treated as infrastructure capital. We have followed the production function approach in the cross-county growth regressions where aggregate output Y at time t is produced using other capital, infrastructure capital and labor. Our data covers the time period between 1990 and 2011 and we have a balanced panel data set. We have chosen a long panel over other models as infrastructure is expected to have a long-term effect on growth. Output is measured as real GDP at constant 2005 national prices (in million 2005 US$), other capital is measured as capital stock at constant 2005 national prices (in million 2005 US$), and labor is measured as the number of persons engaged (in millions). The data of real GDP, capital stock and labor is obtained from the Penn World Table 8.1. We have taken natural logarithm for all variables except the infrastructure variables.

We have carried out five individual sets of fixed effect regressions. The first set of regressions included real GDP, the Infrastructure Index, capital stock, and labor. The result shows strong, statistically significant and positive relationship of labor, capital stock, and Infrastructure Index with real GDP: a 10% increase in labor supply increases real GDP by 3.5%; a 10% increase in capital stock increases real GDP by 6.2% while a 10 unit increase in the Infrastructure Index raises real GDP by 1%. Analogous to the first set of regressions, in all of the successive regressions, after controlling for capital stock and labor, we find a highly significant influence of sub-components of Infrastructure Index over real GDP growth. It is observed that, a 10 unit increase in the electric power consumption raises real GDP by 1.3%; a 10 unit increase in the energy use raises real GDP by 1.7%; a 10 unit increase in the fixed broad internet subscribers brings about 1.6% increase in real GDP; and finally, a 10 unit increase in the mobile cellular subscriptions boosts real GDP by 1.6%.

Furthermore, to capture the regional differences between ‘South Asia’ (SA) and ‘East and South-East Asia’ (ESEA) with regard to impact of infrastructure over growth performances we have carried out regressions using a least squares dummy variable model (LSDV). It is observed that in the case of South Asia a 10 unit increase in Infrastructure Index results in a 3.1% rise in their real GDP, whereas, a 10 unit increase in Infrastructure Index results in a 1.2% increase in real GDP in ESEA. A reason for such difference in the size of the coefficients may be due to the differences in the level of development of infrastructure between SA and ESEA. As SA is well behind ESEA in terms of infrastructure development, improvements in infrastructure will bring about a larger positive effect on growth in SA than in ESEA.

The aforementioned analysis points to the fact that improvements in infrastructure significantly contributes to economic growth, and therefore, investment in infrastructure is an essential pre-requisite pediment. Hence, to opt for the ‘inclusive growth’ agenda, supply side bottlenecks should be addressed promptly. Priorities should be given to the development of infrastructures that can create highly adhesive ‘crowding in’ effect for private sector investment.

Published at the Thinking Aloud on 1 February, 2016

Published at The Financial Express on 1 March, 2016

 

 

How to tackle ‘entitlement failure’ in infrastructure?

In the discourse on infrastructure and economic growth the dominant area of discussion is on the quantity and quality of infrastructure and how countries differ in these respects. While most of the countries emphasize a lot on investing in raising the quantity (and quality) of infrastructure, there is a fundamental concern whether rising supply of infrastructure ensures the access to infrastructure. This problem is manifested through the fact that due to a variety of reasons enhanced supply of infrastructure may not solve the problem of ‘entitlement failure’ in terms of effective access to infrastructure, as the people/sectors in dire need of improved infrastructure may not have the access even with an increased supply.

There appears to be a consensus among researchers and policy makers that infrastructure is a key contributing factor to economic growth. The importance of infrastructure for economic development originates from the fact that it provides both final consumption services to households and key intermediate consumption items in the production process. The deficiency of some of the most basic infrastructure services is an important dimension of poverty; and therefore, increasing level of infrastructure stock has a direct bearing on poverty reduction. Furthermore, while it is generally accepted that economic diversification is a necessary condition for a sustained and long term growth of the economy and job creation, infrastructure development is a prerequisite for economic diversification.

What is the significance of economic diversification as far as ‘inclusive growth’ is concerned?  If inclusive growth is defined as the inclusiveness in economic opportunities, economic diversification can help attain inclusive growth. However, several supply-side constraints related to weak infrastructure can restrict economic diversification. Some of these constraints are broadly ‘general’ in nature and some are critically ‘sector-specific’. Interconnection and complementarities between general and sector-specific infrastructures are key elements for increasing service efficiency, supporting the adoption of innovative technologies, promotion of economic diversification and supporting inclusive growth.

“Yet, policymakers in the developing countries are so inclined to improvement in the broad general infrastructure, i.e., enhanced supply of electricity, improvement in roads, improvement in port facilities, etc. that the developments of critical sector-specific infrastructure are largely overlooked.”

Yet, policymakers in the developing countries are so inclined to improvement in the broad general infrastructure, i.e., enhanced supply of electricity, improvement in roads, improvement in port facilities, etc. that the developments of critical sector-specific infrastructure are largely overlooked. Embarking on developing broad general infrastructure are relatively easy, whereas solving sector-specific infrastructure problems involves identifying priorities in the policy making process and addressing a number of political economic issues. Failure to deal with sector-specific infrastructure problems leads to a scenario where a large number of potential inclusive-growth enhancing sectors fail to enjoy the benefit from the improvement in broad general infrastructure, and thus end up with ‘entitlement failure’.

One such example is the leather industry in Bangladesh which accounts for around one billion US$ in exports and which has huge potentials in generating employment and growth by increasing export of higher value added products. However, this sector has not yet reached its full potential primarily due to operating constraints stemming from its production base in Hazaribagh of Dhaka city where there are minimal waste management systems and inadequate industrial layout planning. The Hazaribagh-centric tannery industry is now legally bound to relocate all the factories to a new environmentally compliant tannery estate (under construction) on the outskirts of Dhaka city. However, such relocation has been stuck for many years with unresolved decisions on cost sharing of various components of the new industrial estate. Yet, there is no denying the fact that unless this relocation is effectively done, the leather sector will continue to suffer from ‘entitlement failure’ despite significant improvements in broad general infrastructure.

“..the major critical factor behind the failure to address sector-specific infrastructure problems is the inability of the political system to deliver a political consensus around strategic plans for such sector-specific infrastructure and stable policy frameworks to support their implementation.”

Factors responsible for such entitlement failure include the lack of resources to undertake sector-specific infrastructure development, lack of reliable data to determine finance and manpower requirements of projects, lack of infrastructure development framework that adequately delineate links between general and sector specific infrastructure requirements, inadequate planning, inadequate supporting institutions, and unstable political environments. However, on top of all these, the major critical factor behind the failure to address sector-specific infrastructure problems is the inability of the political system to deliver a political consensus around strategic plans for such sector-specific infrastructure and stable policy frameworks to support their implementation.

How to deal with this entitlement failure? A major part of the sector-specific infrastructure problems needs to be solved through public investment. The priorities in the industrial and related policies need to be realigned to the country’s long term economic growth strategy in the changing world economy. There is a need for generating political capital for such realignment. However, the task of developing such infrastructure facilities cannot be left to the government alone. It is binding on policy makers to come forward with strategies and mechanisms to encourage private sector participation in such sector-specific infrastructure developments. Such mechanisms should not only provide strategies that are rarely implemented, but practical ways of turning them into tangible projects through the provision of adequate finance.

Published at the Thinking Aloud on 1 February 2016

Published at The Daily Star on 3 February 2016