Its importance, and how it is affected by public policy
Mario I. Blejer and Mohsin S. Khan
It is well established that private investment plays a crucial role both in long-term development and in the design of short-term stabilization programs in the developing countries. In this context, what factors influence the rate of domestic private investment and how it responds to changes in government policies are questions of considerable importance. For example, would a tightening of monetary policy result in a fall in private capital formation and thereby lower the rate of growth? How do private and government investment interact in developing countries, and specifically what impact would an increase in public sector capital expenditures have on private investment? Any meaningful analysis of growth has to deal with the investment issue and thus must take questions of this nature into account. Similarly, identifying the effects of stabilization policies on, say, the current account balance, the level of output, and employment, also requires an understanding of how private investment is likely to respond to the implementation of public policies.
While the behavior of private investment in industrial countries has been studied extensively and there now exists a fairly large body of literature on both its theoretical and empirical aspects, there is as yet surprisingly little systematic evidence on the subject for developing countries. This reflects a variety of reasons, both analytical and practical. Due to a number of institutional and structural factors, such as the absence of well-developed financial markets, the relatively larger role of the government in capital formation, distortions created by foreign exchange constraints and other market imperfections, the assumptions underlying the standard investment models are typically not satisfied in most developing countries. Furthermore, even if the standard neoclassical approach could be directly adapted to developing countries, severe data constraints arise when attempting to apply it empirically. For example, reliable data on variables such as capital stock, labor force, and wages generally do not exist for most developing countries, and in the absence of information on real financing rates (debt and equity), it is quite difficult to calculate the appropriate cost of capital.
Apart from problems of modeling and measurement, there are also serious conceptual difficulties in defining private investment in economies where autonomous state enterprises play a relatively important role; whether these should be classified as part of the public or the private sector is offer unclear. If parastatals should be treated as part of the public sector, as in most cases they perhaps ought to be, obtaining the necessary data again becomes an issue. In addition, it may be possible that the foreign and domestic sources of private investment will not be equally affected by the same set of variables. Typically, however, one has to consider that the main determinants of both types of private investment are similar and discuss these together. This is also done for practical reasons, since information about the sources of private investment is not widely and consistently available for developing countries.
It is probably fair to assume that this range of problems has tended to inhibit the study of private investment in the developing world, important though it may be. This article makes an initial attempt to shed some light on this fundamental economic variable.
To gain some insight into the relative importance of private investment, basic data on investment were assembled for a group of 24 developing countries for 1971–79. A summary of this data, specifically the average ratios of total investment to GDP and the corresponding ratios for the private and public sector components, is presented in the accompanying table. The total investment ratio varied considerably across the sample countries—ranging from a low of 12 percent for Haiti to a high of nearly 36 percent for Singapore. The average value of the investment-income ratio was about 22 percent for the 24 countries as a group, but significant deviations are apparent. Therefore, it would be erroneous to attempt to generalize from the investment pattern in a single country, or even the patterns in a few countries, to the group of developing countries as a whole.
There appeared to be some relationship between the average investment-income ratio and the level of development, although this relationship was not very rigid (Chart 1). For example, countries with a high average per capita income (defined as nominal GDP in U.S. dollars deflated by population), such as Argentina, Singapore, and Venezuela, also had among the highest average investment-income ratios. At the other end of the spectrum, the lower-income developing countries—Haiti, Sri Lanka, and Bolivia—had a relatively smaller average ratio of investment to income. However, there were a number of important exceptions, so that it would be incautious to conclude either that a higher investment-income ratio necessarily led to an increased level of economic development, or conversely, that a higher per capita income resulted in more investment.
Chart 1Investment-income ratio and per capita income, 1971–79
Source: IMF data.
The relation between investment and the growth of real income has been documented in a large number of studies, and some confirmation of this is provided by the scatter diagram in Chart 2. The observations do indeed indicate that countries with higher investment income ratios also, in general, experienced higher average levels of growth. However, the relationship was by no means exact or uniform, reflecting that variables not considered here, such as the growth of the labor force, and productivity and technological changes, were also important factors in the growth process. Nevertheless, the simple scatter diagram does provide support for the premise that higher rates of investment are typically associated with higher growth rates.
Chart 2Investment-income ratio and growth of real income, 1971–79
Source: IMF data.
The variation across countries in the shares of private investment in total investment was even larger than for the total investment ratio. Between 1971 and 1979, private investment (defined for most countries to exclude the principal state enterprises and autonomous institutions) represented over 75 percent of total gross investment in some countries—Barbados, Brazil, Colombia, Guatemala, Korea, Singapore, Thailand, and Trinidad and Tobago—while it was less than 50 percent in Bolivia, Chile, and Haiti. Any generalization here, too, would obviously be quite hazardous, since the relative proportion of the private sector in total capital formation represents myriad factors, the most important of which are probably political preferences of the country toward state and private investment. Nevertheless there seemed to be a loose association between the total investment-income ratio and the share of private investment in total investment (Chart 3). This relationship leads to the first of two straightforward empirical propositions regarding private investment that emerge from the data in the table.
Countries with a high share of private investment in total investment also tend to have a higher ratio of total investment to income
Chart 3Ratios of private Investment to total Investment and total Investment to income, 1971–79
Source: IMF data.
This proposition reflects the fact that countries where the private sector has been allowed to take on a larger role in the investment process have managed to raise the overall level of savings, and therefore total investment. It also suggests an interaction between private and public investment and, therefore, throws some light on the issue of “crowding out.” In broad terms, public sector investment can crowd out private investment if it utilizes scarce physical and financial resources that would otherwise be available to the private sector, or if it produces marketable output that competes directly or indirectly with private output. Furthermore, the financing of public sector investment—whether through taxes, issuance of debt, or inflation—will reduce the real resources of the private sector and depress its investment activity. If there is perfect substitutability between private and public investment, there should be no relationship between the private investment component and the total investment-income ratio, since any change in private investment would be offset by movements in public investment, and vice versa. It is clear from Chart 3, however, that substitutability between private and public sector investment was by no means perfect.
|Trinidad and Tobago||24.4||5.3||19.1|
Includes general government, and principal autonomous institutions and nonfinancial state enterprises.
Total investment less public.
Includes general government, and principal autonomous institutions and nonfinancial state enterprises.
Total investment less public.
The evidence on the relationship between total investment and growth, together with the first proposition, yields the second proposition:
Countries with higher shares of private investment in total investment also tend to have higher growth rates
Chart 4 is a scatter diagram of the average ratio of private investment to total investment against the average rate of growth of real GDP. Again, the observations show that the countries with the highest average ratios of private to total investment also experienced the highest average growth rates. There are, of course, certain exceptions, such as Trinidad and Tobago and perhaps Argentina, where a much higher average growth rate might have been expected on the basis of the average private investment ratio, but, as mentioned previously, there are a whole host of variables that affect economic growth aside from investment (private or total) and that are not taken into account in this simplified exercise.
Chart 4Ratio of private investment to total investment and real growth, 1971–79
Source: IMF data.
A more rigorous approach
To provide more systematic evidence on the factors presumed to affect the rate of private investment, empirical tests were conducted for the 24 countries in the sample. The model of private investment underlying the empirical analysis drew essentially on theoretical approaches suggested in the literature, adapted to incorporate some of the institutional and structural characteristics of developing countries. The main modification, in terms of the formulation of the model, was to postulate that the response of private investment to the gap between the desired and the actual levels of the private capital stock varied systematically with identifiable economic factors that influenced the ability of private investors to carry out their projects. (Although these factors also affect the process in industrial countries, they are of particular importance in developing countries where relative price variations are assumed to play a lesser role.) In addition to the effects of changes in real output (generally presumed to have a positive effect on private investment via the standard acceleration relationship), the factors specifically identified as affecting the level of investment were (1) cyclical conditions in the economy; (2) the availability of financing; and (3) the level of public sector investment.
The theoretical effects of cyclical factors on private investment tend to be somewhat ambiguous. During the expansionary phase of the cycle when demand conditions are buoyant, private investors can be expected to respond rapidly to changes in desired investment. However, the reaction of investment could turn out to be smaller if actual output is above capacity, because the additional strain on available resources would lead to an increase in input prices; in situations of excess capacity, by contrast, investment could respond more rapidly. The problem is further complicated if business expectations are brought into the picture. For example, if current output is abnormally high, investors may expect it to grow at below-average rates in the future stages of the cycle and reduce their current investment and vice versa. Finally, the cyclical response may itself involve lags arising from the difficulties in changing ongoing investment rapidly according to variations in demand, and thus private investment may not appear to be affected in the short run by variations in cyclical conditions.
The effect of the availability of financing on private investment is less ambiguous. A clear consensus has emerged in recent years that, in contrast to the case in industrial countries, one of the major constraints on investment in developing countries is the availability of financial resources (i.e., financial savings) rather than the costs of borrowing. The rates of return on investment in these countries tend to be typically quite high, while real interest rates on loanable funds are kept low by governments for a variety of reasons. (For a more detailed discussion of this issue, see “The importance of interest rates in developing economies” by Anthony Lanyi and Rüşdü Saracoglu, in the June 1983 issue of Finance & Development.) In such circumstances, the total amount of financing is limited and since the price mechanism is not allowed to operate smoothly, it is legitimate to conclude that shortages will emerge and the private investor will be restricted by the level of available bank financing—particularly since in developing countries there are limited possibilities for firms to issue shares and obtain equity financing. Any effect exerted by the rate of interest on private investment is not direct within this rationing framework, but occurs essentially via the channel of financial savings.
The rudimentary nature of capital markets in developing countries limits the financing of private investment to the use of retained profits, bank credit, and foreign borrowing. As is the case of internal finance, an increase in real credit to the private sector will encourage real private investment, and by rolling over bank loans the maturity of the debt can be lengthened significantly. The effects of foreign financing—whether in the form of direct or portfolio investment—are broadly similar to the effects of variations in bank credit; both tend to increase investment since they expand the pool of financial savings.
As control of total bank credit generally represents the main instrument of monetary policy in developing countries, the authorities can, by varying the composition of credit between the public and private sectors, affect the ability of private investors to achieve their desired level of investment, and the speed with which they reach it. Monetary policy can thus have a direct influence on the rate of private investment. Similarly, private investment can also be influenced by interest rate and exchange rate policies that cause changes in private capital flows that augment or reduce available financial resources.
Finally, although it is a well-accepted proposition that in developing countries private and public investment are related, and this was shown to be broadly true for the 24 sample countries, there is considerable uncertainty as to whether, on balance, public sector investment raises or discourages private investment. The issue obviously hinges to a large extent on the type of public investment, since there are some forms that substitute for private investment, while others may increase it. For example, government investment in infrastructure and the provision of public goods is likely to be complementary to private investment. It enhances the profitability of private investment and raises the productivity of capital; in addition, it can increase the demand for private output through increased demand for inputs and ancillary services, and augment the total amount of resources available to the private sector by expanding aggregate output and savings. The overall effect of public on private investment will thus depend on how far the effects of such infrastructural investment offset the crowding-out effect that could arise from other types of public investment which compete directly or indirectly with the private sector.
There is, therefore, no a priori reason to believe that in the aggregate the public and private components of total investment will substitute for or complement each other. Assuming that the possibility of financial crowding out can be taken into account by increasing credit to the private sector and by private capital flows when public sector investment is increased, the specific concern here is with its real aspects. It is these real effects that allow for a direct role for government policy in capital formation and growth.
The results of the empirical tests conducted for the 24 sample countries indicated that these factors were able to explain the movements in private investment surprisingly well. While the role of the cyclical factors was somewhat uncertain, there did appear to be a strong effect on private investment exerted by changes in real output. A direct and statistically significant link was also found between government policy variables and private capital formation. By and large the results met standard econometric levels of confidence. (The model used in the empirical test, as well as the complete results and a discussion of the statistical methodology, is provided in M.I. Blejer and M.S. Khan, “Government Policy and Private Investment in Developing Countries,” available from the authors.)
Specifically, the results provided clear evidence that private investment in developing countries was constrained by the availability of financing; monetary policy can, therefore, by altering the flow of credit to the private sector, influence the level of private investment. Furthermore, there was a quantitatively important role for public sector investment in the process of private capital formation. However, as postulated above, the effect did appear to depend on the specific nature of public investment. Meaningful results were obtained only when an empirical distinction was made between long-term, or infra-structural, investment, which had a positive effect on private capital formation, and short-term public investment, which tended to crowd it out. In the absence of such a distinction, the overall effect of government investment was practically nonexistent—a result that runs counter to even the most casual observation of the capital formation process in developing countries.
The policy implications of the exercise are themselves quite straightforward. A contractionary monetary policy, which is a typical element of a stabilization program, would be expected to have adverse effects on private investment and consequently lead to a reduction in growth, unless the authorities ensure that the flow of real credit to the private sector for investment purposes is not curtailed. In general, when the public sector uses more domestic financial resources, it would tend to crowd out private investors. By the same token, if the total supply of foreign financing to an individual developing country is limited, as is normally the case, larger public sector borrowing from abroad would leave less available for the private sector. While this latter type of crowding out may be less significant in relation to domestic financial crowding out, nevertheless the government has to be conscious of this possibility. The flow of foreign capital is also likely to be affected by inappropriate exchange rate and interest rate policies, and these policies may have equally harmful effects on private investment.
The effects of a contractionary fiscal stance are, on the other hand, not that obvious. If the policy takes the form of a cut in real public sector investment that is not related to infrastructure, then there may be an increase in private investment as the physical resources, such as capital and labor, released by the government can be utilized by the private sector. This beneficial effect, however, can be offset if there is a reduction in infrastructural investment that, in turn, has a negative impact on private capital formation. As a general principle, the country authorities should, if at all possible, try not to cut investments that are directly related to the development of infrastructure. The difficulty with this recommendation is, of course, that there are problems with defining such types of investment, and perhaps more important, the government may not have the necessary leeway in selecting the components of public investment to reduce in the midst of a stabilization program.