Understanding how various factors influence investment decisions is important in choosing policies that can sustain and promote private investment. Some evidence from 23 developing countries
The behavior of private investment activity, a key factor underlying economic growth in developing countries, has long been of interest to economists and policymakers. But, to date, empirical research in this area has been limited, largely because information on private investment in developing countries has been scarce or unreliable. The recent assembly of data on private and public sector investment rates (the ratios of private investment and public investment to GDP, respectively) by the World Bank Group (see “Private Investment Rebounds in Developing Countries,” by Andrea Madarassy, Finance & Development, June 1990), however, has given researchers a rich data base with which to conduct empirical analysis. With this information, it is now possible to explore a number of hypotheses that help explain the behavior of private investment rates in developing countries.
This article offers one such examination, based on an analysis of private investment rates for 23 countries (see box) over 1975’87. The results of this study, though preliminary, may help to identify more fundamental relationships between private sector investment and macroeconomic variables in these countries that can then be used to develop an appropriate structural model of investment behavior in developing economies.
What affects private investment?
Private investment rates in developing countries have varied significantly over time, and from one country to another (see chart). Although relatively stable until 1980, private investment in a number of these countries fell sharply following the rise in international interest rates in 1981 and the onset of the debt crisis in 1982, only to recover slightly toward the end of the decade. A number of factors help explain these variations.
• real per capita growth rate. There is general agreement among economists that a country’s growth rate would have a positive impact on private investment. A higher growth rate would increase private investment activity if the relationship between the level of real output and the desired capital stock is relatively fixed.
• real interest rate. There are competing views about the effect of real interest rates on private investment. A high level of real interest rates raises the real cost of capital, and therefore dampens the level of private investment. But there is another side. Poorly developed financial markets in these countries and inadequate access to foreign financing for most private projects implies that private investment is constrained largely by domestic savings. These, in theory, are expected to respond positively to higher real interest rates. For this reason, private investment could, on balance, be positively related to real interest rates in developing countries.
• level of per capita income. Economists have argued that per capita income levels should be positively related to private investment activity, because higher income countries are better able to devote resources to saving.
• public investment rate. As with the real interest rate, the impact of the public investment rate (i.e., the ratio of public investment expenditure to GDP) on private investment activity is uncertain. On the one hand, public investment activity may be complementary to and thus support private investment. This is particularly likely where public investment involves mainly spending for basic infrastructure (such as schools, transportation systems, water, and sewage facilities). Projects in these areas tend to raise the expected rate of return on private investment and thus encourage higher private investment rates. On the other hand, public sector investment may dampen private investment activity to the extent that it substitutes for private projects. This may occur where the investment involves mainly projects for public sector enterprises whose products compete with those of the private sector. High public investment rates may also “crowd out” private investment activity when heavy spending for public sector capital projects leads to high interest rates, severe credit rationing, or a heavier current or future tax burden. Whether public investment activity on balance has a positive or negative impact on private investment rates is thus an empirical question.
Average levels of private investment in 23 developing countries, 1975-87
Source: “Private investment in Developing Countries: An Empirical Analysis,” by Greene and Villanueva, IMF Staff Papers (forthcoming).
The countries in this study are: Argentina, Bolivia, Brazil, Chile, Colombia, Costa Rica, Ecuador, Guatemala, India, Kenya, the Republic of Korea, Mexico, Pakistan, Peru, the Philippines, Singapore, Sri Lanka, Thailand, Tunisia, Turkey, Uruguay, Venezuela, and Zimbabwe.
• domestic inflation rate. High rates of inflation adversely affect private investment activity by increasing the riskiness of longer-term investment projects, reducing the average maturity of commercial loans, and distorting the information conveyed by prices in the economy. In addition, high inflation rates are often considered a sign of macroeconomic instability and the inability of government to control macroeconomic policy, both of which contribute to an adverse investment climate.
• external debt burden. Measured by its debt-service payments ratio and the ratio of external debt to GDP, the external debt burden can have a powerful negative effect on a country’s private investment rate. A higher debt-service payments ratio means that fewer resources are available for domestic use, including private investment, and hence should have a direct adverse impact on private investment rates. A high ratio of external debt to GDP, which indicates that the country has a large debt “overhang,” may also discourage private investment. This is because a significant portion of the future returns from investment must be used to repay current debt obligations acting as a tax on, and thus a disincentive to, investment (see “The Effect of External Debt on Investment,” by Eduardo Borensztein, Finance & Development, September 1989). Moreover, if substantial external debt leads to difficulties in meeting debt-service obligations, relations with external creditors may suffer, thus reducing the amount of trade financing a country can obtain. This in turn may make it more difficult or costly to finance private investment, because imports represent a major component of investment projects in developing countries.
• noneconomic factors. Besides the above economic variables, there are also other factors, such as political stability and investor confidence, that play an important role in investment behavior. But, not surprisingly, these are hard to quantify, particularly in developing countries. For the same reason, no attempt was made to include specific measures of a country’s tax and regulatory environment in the analysis.
How can one verify the influence of the preceding factors on private investment rates? One simple way is to compare a country’s average private investment rate with its average levels for the different variables. The resulting figures, averaged for countries in the sample with above- and below-average rates of private investment, appear in Table 1. As shown, the 11 countries with the highest average rates of private investment exhibited lower negative real interest rates, higher real growth rates, higher public sector investment rates, much lower inflation rates, and higher per capita GDP levels. These countries also revealed somewhat lower debt-service ratios, although they had slightly higher ratios of total external debt to GDP. Much the same results follow from comparing average private investment rates for countries with above- and below-average levels of each of the explanatory factors. The one exception is for public investment rates, where countries with below-average public investment rates had higher private investment rates.
|High private investment countries1||Low private investment countries2|
|Private investment rate||15.4||9.1|
|Real per capita GDP growth rate||2.1||0.9|
|Real deposit interest rate||-0.9||-5.7|
|Per capita GDP level (in US dollars)||1,818.5||1,083.5|
|Public investment rate||9.8||8.3|
|Domestic inflation rate||24.7||61.1|
|External debt to GDP ratio||41.4||38.2|
Countries with the 11 highest average private investment rates.
Countries with the 12 lowest average private investment rates.
Countries with the 11 highest average private investment rates.
Countries with the 12 lowest average private investment rates.
Another, more careful, method of analysis is to employ multivariate statistical analysis. This allows the impact of each variable to be estimated more accurately, by holding constant the effects of other possible explanatory variables. For this purpose, econometric equations for the private investment rates in the sample were estimated, allowing each year’s data for each country to be considered as a separate observation. Different equations were estimated for the entire 1975-87 period and for the subperiods 1975-81 and 1982-87, to determine the impact of the post-1981 debt crisis on the results. In estimating these equations, steps were taken to reduce the bias that could arise because the private investment rate can also affect a number of its potential determinants, such as the growth rate.
Despite the omission of noneconomic factors, the equations explained more than 80 percent of the observed variation in private investment rates in the sample. In addition, every variable except the public investment rate proved highly significant in explaining movements in private investment rates. Except for the public investment rate during the 1975-81 subperiod, coefficients for every other variable were significant at the 95 percent confidence level or better. The change in the real effective exchange rate, a measure of relative currency valuation, had no significant effect on private investment rates in their study. As shown in Table 2, the real interest rate, the domestic inflation rate, and the two indicators of external debt burdens all had negative effects on private investment rates, while the real growth rate, public investment rate, and level of per capita GDP were positively related to private investment rates. Thus, for this sample of countries, the adverse effect of higher interest rates on the cost of capital outweighed any positive impact of higher interest rates in mobilizing private domestic savings for financing investment. Conversely, public investment appeared on balance to support, rather than compete with, private investment activity.
|Real per capita GDP growth rate||Positive|
|Real deposit interest rate||Negative|
|Per capita GDP level||Positive|
|Public investment rate||Positive|
|Domestic inflation rate||Negative|
|Debt-service payments ratio||Negative|
|External debt to GDP ratio||Negative|
The effects of these variables also differed between the years before and after the onset of the debt crisis in 1982. In particular, the impact of the real interest rate, domestic inflation rate, per capita GDP level, debt service payments ratio, and to a lesser extent, the public investment rate appeared greater during 1975-81, while the external debt stock to GDP ratio had a greater impact during 1982-87. The differing effects of the two external debt variables during the two time periods may reflect the change in overall debt position of most developing countries during the 1980s. Before 1982, most countries remained current on their external debt-service obligations, so the actual debt-service payments ratio would have been the major debt variable affecting private investment activity. After 1981, when many developing countries experienced a sharp increase in average debt levels and rescheduling and arrears became more common, a country’s debt “overhang” and its difficulty in securing foreign trade financing—both of which are measured by its ratio of external debt to GDP—became more important.
The analysis also indicates that certain variables had more impact than others on private investment rates for the countries in the sample. Overall, the real interest rate, the per capita income level, the domestic inflation rate, and debt-service ratio during 1975-81, and the external debt to GDP ratio during 1982-87 had significantly greater impact than the other variables, while the public investment rate had less impact. This last finding is not surprising given the ambiguity of the predicted effect of public investment rates on private investment activity and the recognition that in many developing countries, public investment activity involves both important infrastructure projects and projects that perform essentially private functions.
Lessons from the study
Although this study provides strong support for the role of certain economic variables as determinants of private investment activity in developing countries, the precise ways in which these variables affect private investment rates remain to be determined. Doing so would require a detailed structural analysis of private investment in developing countries. It would also be more worthwhile to explore the various links among saving, private investment, and economic growth in developing countries. Such an analysis could provide better information about how to promote savings and private investment, and thereby increase economic growth, in developing countries.
Nevertheless, the results of this study serve to identify the kinds of economic policies that can promote and sustain private investment in developing countries: a macro-economic policy that encourages price stability; a cautious approach to external borrowing; and a reallocation of public expenditure toward investment projects supportive of private sector activity. These policies may also encourage private investment by promoting economic growth and, in conjunction with effective financial sector policies, avoid the emergence of high real interest rates that deter all but high-risk investment projects. In short, the same policies that help countries overcome economic imbalances are also likely to promote private investment. This points out the close relationship between adjustment and growth, and suggests that all countries can benefit from pursuing sound and consistent macroeconomic and structural policies.
For a more detailed analysis on this topic by the authors, see “Private Investment in Developing Countries: An Empirical Analysis,” IMF Staff Papers, forthcoming, March 1991, Vol. 38, No. 1.
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