Basic Governmental Responsibilities

The most important step in ensuring the efficiency of public investment is choosing the appropriate mix of public and private investment in the first place. (The World Bank’s 1988 World Development Report discusses this general area in some detail.) Efficiency depends as much if not more on what the public sector chooses to do as on how well it does it. There is a wide spectrum of experience among countries with respect to public ownership, organization, and control of economic activities; some countries have minimal involvement in the direct provision of goods and services while the involvement of others is pervasive. As in most other aspects of life, there are trade-offs that are reconciled differently in different situations. Most would agree that public ownership and control involve a dilution of incentives to husband resources with care, resulting in welfare losses. Most also would agree that some economic activities, those that display inherent externalities, natural monopolies, or other types of market failures, cannot be left to the unfettered operation of market forces. The very existence of governments is a recognition that some activities are best handled as public undertakings. The challenge is to identify those activities and organize them in the most efficient way possible, fulfilling governmental responsibilities to create a favorable environment in which human welfare can flourish.

Public organization of various activities can be seen as a continuum, ranging from the least controversial type, which almost all would accept as governmental responsibilities, to the other extreme, which most would agree is better left to private initiative. At the beginning of the continuum would be basic defense services, maintenance of law and order, supply of justice, control of money, establishment of standards, funding of basic research, and collection and dissemination of basic statistics and information. A little further on, but still at the noncontroversial end, would be the governmental provision of social services—education, health, and poverty alleviation—often in conjunction with private organization of the same or similar services in the private sector. Basic physical infrastructure—roads, water supply, telecommunications, electricity, flood control, irrigation, and sanitation facilities—is almost everywhere subject at least to pervasive public control and often public ownership and investment.

These public responsibilities are perhaps the most basic undertaken by most developing countries. They should constitute the priorities for public investment. Where there are constraints to resource mobilization for public investment, these should become the core of investments to be protected in times of resource scarcity. Spending too little on basic government services while spending too much in areas that the private sector could have served is perhaps the biggest and most costly loss of efficiency in public investment.

World Bank staff have conducted research into the question of whether public investment is complementary or competitive to private sector investment (Chhibber and van Wijnbergen, 1988). On the macroeconomic level, public and private investment clearly compete for the same resources. Higher public investment requires either increased foreign borrowing or higher private sector net saving, requiring higher domestic interest rates. Either of these means of financing in a world of scarce resources means lower private sector investment. The question returns to which sector makes better use of the resources. Chhibber and van Wijnbergen show with quantitative analysis that in the case of Turkey public investment in infrastructural activities (broadly defined to include expenditures on health and education) is largely complementary with private investment; and public investment in noninfrastructural activities crowds out private investment and reduces overall rates of return to investment. Public investment of the right kind reduces the costs of private activities and creates the conditions for higher private sector profitability.

Public Sector Enterprises

Many developing countries have gone further along the public-private continuum to set up public sector enterprises (PSEs) to undertake a plethora of activities. Some Arab countries—Egypt, Algeria, and the People’s Democratic Republic of Yemen—developed public sectors that were dominant in most areas. In the more recent past, as a result of disappointing performance by PSEs, these three countries have started to move back from the extreme public sector end of the continuum by encouraging the private sector to take on more responsibilities, although a very large part of economic activity still remains under public control.

Ironically, many PSEs originally were set up to make governmental activities more efficient. That is, activities that were at first handled by government departments that were separable functions (for example, electricity or oil production, railways, hospitals) were spun off from the government itself to create a more businesslike environment. The idea was to protect these entities from political interference by separate budgets, cost accounting, cost recovery through pricing, rational employment policies, and management autonomy and accountability. The present-day problems of many of these PSEs attest to the difficulty of actually protecting these entities from political interference, despite the original intentions of doing so.

Often, countries expanded public ownership and control beyond those activities with strong externalities or natural monopolies to others that are elsewhere left to the private sector. Examples of these are production of steel, cement, and fertilizer, road transport, agricultural marketing, housing, health care, and commercial banking. The rationale used was some mixture of the following: appropriation of surplus, the size of the minimum investment required, the large impact of the produced items on consumers’ budgets, and the lack of private initiative. Comprehensive and ambitious development planning often led to the establishment of such PSEs, as it soon became obvious to planners that, left to its own resources, the (often incipient) private sector was not forthcoming in fulfilling the investment plans as formulated.

Experience with Public Sector Enterprises

The experience in developing countries with large-scale public investment in productive enterprises has not been an altogether happy one. While there are examples of efficient, financially viable, and flourishing PSEs, there are also many examples of the opposite. World Bank staff have often been requested to review the experience of public sector enterprises by the governments involved, such as a major study done recently on Egypt. World Bank research staff have distilled lessons from many such studies in papers that indicate a pattern of similar problems (World Development Report, 1988 and Shirley, 1989a).

Despite the desire to provide a businesslike environment for their operation, governments tend to saddle PSEs with mixed mandates, including not only financial targets but also social objectives that often conflict with the efficient operation of these entities. Governments find many reasons to control the output prices of PSEs—to protect vulnerable consumers, fight inflation, and maintain low input prices for other PSEs. Governments also seek to influence employment policies for social objectives such as general employment generation, placement of unemployed university graduates, establishment of minimum wages for the low-skilled, enforcement of maximum wages for managers and professionals for equity reasons, and appointment of senior managers on the basis of political patronage.

Because of these burdens of mixed mandates, governments often protect PSEs from competition as a way of creating rents from which the costs of the social burdens can be paid. PSEs are often protected from import competition through quota restrictions and high tariffs on outputs; and from domestic competition through restrictive licensing of domestic capacity (investment control), preferential access to (subsidized) inputs, and other rules rigged to benefit PSEs over the private sector. This protection holds two negative consequences for efficiency: the protection further weakens the economic efficiency of PSEs themselves beyond that introduced by the social burdens; it also introduces distortions into the entire domestic structure of production, weakening private firms as well.

Perhaps the ultimate protection from competition offered is the unwillingness of governments to allow PSEs to go out of business. Irrespective of ownership or motivation, some good ideas turn out badly in practice, and some originally viable undertakings become nonviable when circumstances change. Problems created when an investment turns sour disappear when the capital and labor are redeployed in other activities. These problems continue and escalate when governments refuse to allow the redeployment, either by continuing the operation of PSEs, or, sometimes, by converting failing private firms to public ones. The motivation is often the protection of employment of labor in these entities or the continued provision of goods and services for which no other private sector alternatives exist. More fundamentally, it protects labor and capital from the stress of adjustment to new employment at the cost of tying up these economic resources in inefficient firms. This unwillingness forces governments to protect sick PSEs further from competition, introducing further distortions, or direct subsidies in one way or another from the government budget.

Mixed mandates and protection from competition not only lead to economic inefficiency but also to financial distress, both for the PSEs and for the government. This financial distress shows up in the rising contribution of PSEs to overall public sector deficits, growing foreign indebtedness, interagency arrears in payments due, and increasing borrowing from the domestic banking system. When the scale of PSEs in the total economy is large, as it is in several Arab countries (Egypt, Algeria, and the People’s Democratic Republic of Yemen), financial distress in PSEs can lead to large macroeconomic imbalances in the economy as a whole—uncontrollable budget deficits, balance of payments deficits, and excessive growth of domestic credit. These imbalances tend to persist and grow as long as governments are unable to correct the root causes—inefficiencies in PSEs.

Reform of Public Sector Enterprises

The solution to this problem is inherent in the diagnosis: the best cure is prevention. Public investment should concentrate on those activities that are the core of governmental responsibilities, and scarce financial and administrative resources should be deployed to make these activities as efficient as possible. Those activities that can be should be left to the market to provide.

Where there is a legacy of a large public sector with inefficient and financially troublesome parts, restructuring of those parts is called for. The basic tools of public sector restructuring are divestiture, financial strengthening, and introduction of more market competition (Shirley, 1989b).

A growing number of countries with problematic PSEs have decided to divest public ownership or control, using a variety of mechanisms, none of them easy to implement. One is the straight-forward option of selling selected PSEs by negotiation or auction, often with some restructuring before or after the sale. Countries that have embarked on such a policy have found it no simple matter, as it is difficult to let go of the healthy ones and to sell the sick ones. Such a program requires careful preparation and determination. Another option is sale to employees. While this option has the advantages of divestiture and employee protection, it requires creative solutions to difficult financial and managerial problems. A third option that is not quite divestiture is to arrange private management contracts with suitable incentives for performance.

Countries that have initiated PSE divestiture programs have found that a change of ownership (or management) is not a complete solution. Where legacies of the burdens of mixed mandates remain and/or the economic environment is distorted by noncompetitive policies, changing ownership or management is only a partial solution. In some cases, the terms of sale of a PSE even worsen the situation, when governments agree to protect the PSE even further from competition as an incentive to complete the sale. In the long run, there is no escape from addressing the financial and competitive problems that caused the deterioration of the health of the PSE in the first place. The World Bank policy staff have embarked on a major research project to study the results of various divestiture programs in several countries.

When financial problems of PSEs are large and pervasive enough to create macroeconomic imbalances, the solutions involve changing the fundamental cost/price relations and instilling financial discipline. There is no creative financial engineering, such as conversion of debt to equity that will solve the problem for long, although such financial engineering is often needed as part of the rehabilitation of the PSEs that have fallen into a financial mess. It is even less useful simply to impose more stringent financial targets for PSEs by fiat without changing the rules under which they operate. The need is to rationalize pricing policies, limit subsidies, control borrowing, improve investment decisions, eliminate interagency arrears, improve financial reporting, and increase the financial accountability of managers.

The path to efficiency requires more than financial restructuring. With enough control over markets, governments could rig financial profitability in a highly distorted environment. This would send signals to managers to improve financial performance while wasting resources and reducing welfare. To increase economic productivity it is necessary to change the environment in ways that send economically correct signals. There is a growing consensus that the most important way to change the environment in pursuit of increased efficiency is to introduce more market competition, both at home and from abroad. Many governments with large public sectors surround PSEs with protection from domestic competition in the form of capacity licensing and cost-plus pricing rules, and from foreign competition by quota restrictions or prohibitive tariffs. These effectively remove all competition from the environment of PSEs and engender complacency in cost control, technical innovation, product quality, and the attitudes of both labor and management.

Changing this environment requires the removal of this cocoon of protection. A first step is to allow firms in the same industry to compete with each other on the basis of costs—by having each PSE face the same ex-factory price rather than calculating this price based on the cost of production of each PSE. A next step is to allow these firms to compete on the basis of price—allowing firms to set their own prices, which is tantamount to allowing the market to fix the price. Introducing competition from the domestic private sector means setting PSEs and private firms on the same basis with respect to both the freedom to invest and access to inputs, including credit and foreign exchange. A further step is to introduce competition from abroad by removing quota restrictions and reducing high tariff protection.

Removing the cocoon of protection is often painful, as it exposes some PSEs that have become inefficient and noncompetitive underneath the protection. Removal of cost-plus pricing rules and their replacement with unified output pricing often exposes PSEs with outdated, high-cost technology to competition with other PSEs in the same industry with newer, lower-cost plants. Setting prices at a level that covers the costs of the highest-cost producer means high prices, and setting them to cover the costs of the low-cost producer means other firms in the industry make financial losses. Exposing PSEs to domestic private sector firms often reveals the higher costs of PSEs owing to overmanning or lax management. Removing import protection exposes PSEs to the lowest-cost producers in the world. For these reasons, the removal of protection must be done gradually, along with carefully designed restructuring plans to avoid large-scale disruptions.

Timing

The timing of public investment is a crucial determinant of its efficiency. Investing too early or too late sharply reduces economic returns. Two independent studies by World Bank staff have found that economic returns to public investment depend heavily on its timing (Shah, 1988, and Chhibber and van Wijnbergen, 1988). The basic issue turns on whether the economy is pressing up against capacity constraints in areas of public responsibility. When excess capacity exists in basic infrastructure—often when a slow-down of economic activity occurs for macroeconomic reasons—then additional public investment yields low or negative returns. Also, when short-term resource imbalances cause an unusually high opportunity cost to public resources, limiting public investment only to those projects whose returns exceed the higher opportunity costs means a cut in the overall investment program. In fact, it is often public investment that gets cut when governments find themselves in a financial bind.

Cutting public investment when macroeconomic imbalances are large sometimes results in public investment that is too little too late from the point of view of the future growth of the economy. Some of the most important governmental responsibilities—basic infrastructure—require investments with long gestation periods. If these are cut when resources are out of balance, then, in a few years, after the economy resumes growth, it runs into infrastructural constraints (energy or transport) that could only have been avoided by earlier investment. This is a basic dilemma of development planning that can be reconciled only by setting and following clear priorities for public investment to ensure adequate funding for the most important activities.

Macroeconomic Consistency

World Bank staff, when they review public investment plans, often encounter overblown investment programs that have too many projects with too little funding for timely implementation. This results from a legacy of project proliferation owing to an inability by central ministries to prevent line ministries from initiating projects despite inadequate funding. Line ministries have learned that once started, no matter how small the initial funding, approved projects continue to be funded and eventually are completed. This situation leaves the public investment program overprogrammed and underfunded, with much of its scarce resources tied up in slow-moving projects with much delayed benefits. The same level of resources, concentrated so as to complete priority projects expeditiously, results in earlier benefits and raises the efficiency of the total investment program. When priorities are formulated, governments should be mindful of the future infrastructural needs of continued growth. Given the situation they often face when reviewing public investment plans—a large list of ongoing projects, scarce (and often overestimated) resources, and the need to protect investments in basic infrastructure—the World Bank often recommends creating a “core” public investment program whose funding should be protected for timely implementation, with other projects to be funded only if additional resources become available. This solution is clearly second best. The best would be to scale the whole investment program back to a level that can be implemented in a timely way with priority projects necessary to fulfill the most important public responsibilities.

Economic Evaluation of Project

Development literature places great emphasis on economic evaluation of individual projects as a primary means of ensuring economic efficiency of public investment plans. The World Bank also places great emphasis on project evaluation and has been instrumental in developing and spreading techniques to undertake such evaluations (Kavalsky, 1986, and Squire and van der Tak, 1975).

Economic evaluation of individual projects is actually the last step, in a long and complex process, whose usefulness is largely in confirming that an already formulated program of public investment meets minimum efficiency criteria. No country formulates its public investment plans by calculating economic rates of return for every conceivable project, ranking them high to low, and then approving from the top of the list as far down as resources allow. Even if tried, the information costs of such an approach would be impossibly high. In any case, governments do not try (Leff, 1985). The process of formulating a public investment program is subtle and involves both economic and noneconomic criteria.

Formulating an efficient public investment program requires several key components. First, someone needs to supply a vision of a development strategy. This is a highly intellectual element but indispensable if the actual program elements will be mutually supportive, a necessary requirement for efficiency. The strategy must be developed within a macroeconomic framework that relates investment, growth, and resources consistently and realistically, resulting in a resource envelope that defines the scale of the feasible investment program. Individual projects that exhaust the available resources must be prepared in the context of sectoral strategies and development programs designed to fulfill these strategies. Such strategies and programs are necessary to define which projects are worth preparing to the stage they can be rigorously evaluated. A rigorous evaluation, then, is the last stage. It is nevertheless quite an important stage. Quantitative project evaluation of its technical, financial, and economic characteristics is a check on the realism of all the assumptions that have gone into the project formulation.

Foreign Financing

Maintaining a close correspondence between the individual projects approved and the development strategy is an important element of efficiency. One threat to the coherency of a public investment program is the influence foreign financiers sometimes have on the individual investment decisions. While foreign sources usually want to help finance the high priority investments, they sometimes have agendas of their own that are not fully coordinated with the investment strategy of the government. Where foreign financing is small in relation to the total size of the public investment program, it usually is not difficult to find projects that mutually meet the priority development strategy of the government and the agenda of the lender, whereas where it is large, finding an identity of views is more difficult. Governments should take care that all projects, irrespective of their financing source, are fully integrated with the planning and budgeting of the public investment program and reflect the country’s development strategy. Any hidden costs of foreign financing, such as tied procurement, should be considered when deciding how to finance a project. Foreign-financed projects should avoid becoming enclaves with special treatment vis-à-vis the rest of the government.

Capital Versus Noncapital Expenditures

Although the topic of this paper was the efficiency of public investment, it should be noted that noncapital development expenditures are as important as capital ones. At least two issues with respect to noncapital development expenditures are important. One is the operation and maintenance costs associated with investment projects. The other is that in some sectors noncapital expenditures are considerably more important in development programs than capital expenditures.

Operation and maintenance requirements of investment projects create future burdens on the government budget and must be considered when formulating the investment program. For this reason, among others, ministries of finance should be involved in the planning and approval of public investment. By the same token, future operation and maintenance costs must be provided to ensure the realization of future benefits.

In sectors such as health, education, and agriculture, the most important development programs often require only modest capital expenditures, compared with their recurrent expenditure requirements. Government involvement in these sectors usually takes the form of provision of services, which is more staff intensive than capital intensive. For this reason, the World Bank has increasingly emphasized in its work the review of public expenditure programs rather than just public investment programs.

Macroeconomic Consistency

Egypt’s second Five-Year Plan modestly estimated the resources available for public investment during the period (LE 27.4 billion in 1986/87 prices), despite a highly ambitious GDP growth target (6 percent per annum). Bank staff supported the macroeconomic investment target but estimated that the cost of the investments proposed exceeded this target, owing to various elements of undercosting. The Bank recommended that the total program be scaled back somewhat while protecting the “core” investments needed to enable growth in the future. It pointed to projects in some sectors (for example, transport and land reclamation) where the economic returns looked low and the implementation capacity was constrained.

Timing

There were many timing issues in Egypt’s second plan. An important one concerned the rate of investment in electric power generation. The original power generation investment plan was based on an extrapolation of past trends that were unlikely to continue in the future because of slower GDP growth and the demand-dampening effects of the Government’s pricing policy. This meant that the original plan called for investment in capacity before it would have been needed. Once the plan included a consensus demand projection and a revised generation investment program, it was important to fund this program fully to ensure that the capacity needed to supply the projected demand would be available. Another timing issue concerned the development of natural gas. As natural gas should be developed as rapidly as possible in Egypt, the issue was simply to ensure that the natural gas development program was fully funded for maximum development. A third timing issue was in the transport sector, where the need for new roads was relatively modest compared with the pressing need to maintain roads and bridges.

Economic Evaluation of Projects

The economic evaluation of projects influenced the plan and the Bank’s recommendations in many instances. In an important sense, some view of the economic rate of return permeates the whole planning process and the Bank’s views of the plan. The view that the land reclamation program was too large was based on a view that some of the projects included in the program earned low or negative returns. On the other hand, the drainage program is expected to earn high returns and fully deserves its prominent place in the investment program. Similarly, the high returns from gas development motivate the recommendation to proceed quickly with its development. The industrial sector’s public investment plan contained many potential projects whose economic return was questioned, leading the Ministry of Planning to exclude them from the plan.

Foreign Financing

The Government of Egypt has established a Ministry of International Cooperation to coordinate the foreign aid financing of development projects. This ministry works closely with the Ministry of Planning to ensure that projects financed by such aid fit into the Government’s priorities. The Ministry of Planning has an established mechanism to deal in an orderly way with the additional aid that becomes available in the period after investment plans are made.

Capital Versus Noncapital Expenditures

Egypt’s second Five-Year Plan included many examples of development programs where the noncapital expenditures were more important than the capital ones. Many agricultural programs essential for the growth of productivity (such as research and extension) require salaries and facilities of a largely noncapital type. Most of the education and health expenditures are similarly non-capital in nature. Even in some typically capital-intensive sectors such as transport, the main need during the plan is for rehabilitation and periodic maintenance rather than new investment.