Chapter

CHAPTER 4. Policies, Institutions, and Growth in Sub-Saharan Africa

Author(s):
Kevin Carey, Sanjeev Gupta, and Catherine Pattillo
Published Date:
February 2006
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Some additional examination is warranted of selected policies that the growth acceleration analysis could not probe deeply. Although many countries’ fiscal policies have improved, they still face major challenges in maintaining low deficits, reforming public expenditure management to improve the productivity and efficiency of spending, and designing institutions that reduce the procyclicality of fiscal policy, particularly if they are resource intensive. Financial sector development has been identified as an important correlate of growth accelerations in the literature, but less is known about the link between financial development and growth in sub-Saharan Africa. The scope of the discussion below is limited and selective: it explores the consistency of sub-Saharan Africa data with some important predictions from the literature directly linking fiscal policy or financial development and growth. These areas, as well as institutions—which the growth acceleration analysis highlighted and recent literature suggests are fundamental for growth—are discussed.27 The coverage of policies is also selective: some of the most critical reforms now needed to improve sub-Saharan Africa growth prospects are microeconomic or related to governance—that is, improving the quality of public services, particularly in health and education; improving the private sector business climate; and expanding and upgrading the quality of infrastructure.

A. Fiscal Policy28

The literature suggests several propositions about the impact of fiscal policy on growth in low-income countries. First, recent papers have found that the channels through which fiscal policy affects growth in low-income countries are different from those in industrial countries, giving rise to a nonlinear effect of deficits on growth (Baldacci, Hilman, and Kojom 2004). One paper found a threshold of 2.5 percent of GDP (deficit including grants) at which further fiscal consolidation does not benefit growth.29 This threshold should be considered more of a range, as the relationships between deficits and growth will vary according to country specifics. Second, in general, fiscal consolidations that reduce reliance on domestic financing enhance growth.30 Third, the composition of fiscal spending affects growth (Gupta, Clements, and Inchauste, 2004). A higher share of spending on education and health benefits growth, but with a lag. However, this positive effect is reduced if governance is poor or macroeconomic policies are unsound (Baldacci and others, 2004).

Recent data support the hypothesis of a threshold in the growth-deficit link in sub-Saharan Africa. Although causality runs in both directions, a simple way to highlight the deficit-growth channel is to relate lagged changes in deficits to growth and conduct a separate analysis of the link between the direction of changes in the deficit and growth, depending on whether the country is above or below a particular deficit threshold. While clearly not definitive, the simple calculations in Appendix Table A14 support a stronger association between growth and deficit reduction when the deficit is above the 2.5 percent threshold. For high-deficit countries, average growth is higher when the deficit is reduced, whereas low-deficit countries show much smaller growth improvements. The difference in growth rate changes in the two groups is statistically significant.

Since the early 1990s, sub-Saharan Africa has seen an overall improvement in fiscal balances accompanied by a more prudent financing mix. Since the mid-1990s, growth has improved and deficits have declined. Since 2000, growth has moderated slightly, whereas deficits show further improvement, allowing countries to reduce the burden on domestic financing sources. Oil producers switched to making net repayments to both domestic and foreign sources, but the trend of relying less on domestic financing is more general. By 2004, on average, sub-Saharan Africa governments were making net repayments to domestic sources (Appendix Table A15).

Social Sector Spending

Since the mid-1980s, sub-Saharan Africa countries have increased their outlays on education and health care, with government spending on these increasing both as a ratio of GDP and as a share of total government spending (Figure 7).31 The only exception to this trend is oil-producing countries, where, since the late 1980s, both measures of social sector spending have been declining. In addition, sub-Saharan Africa data support the literature’s prediction that strong governance augments the effectiveness of social sector spending.32 Sub-Saharan African countries were ranked according to the quality of governance (World Bank CPIA data, average over the 1990s), level of social sector spending, and education and health outcomes (net enrollment in primary schools and under-5 child mortality in 2000).33 All seven countries that ranked in the top third of the distribution on both governance and education spending also ranked in the top third on education outcomes. Five of the eight countries that ranked in the top third on governance and health spending also ranked in the top third on health outcomes. In contrast, top outcome rankings were relatively few for countries ranking in the top third on only one of the governance or spending indicators.

Figure 7.Government Spending on Education and Health

(Percent of total spending)

Source: IMF, World Economic Outlook/Economic Trends in Africa database, 2004.

Infrastructure Spending

Declines in capital expenditures are a cause for concern. Since the mid-1980s, public investment in sub-Saharan Africa has declined modestly, both as a ratio of GDP and as a share of total spending. These declines partially reflect poor budget execution—persistently lower than programmed capital expenditures, which tend to be cut when there are fiscal overruns—and may also relate to shortfalls in foreign financing.

Higher allocations of public investment spending on infrastructure are likely to contribute to growth. Recently, high-profile efforts such as the UN Millennium Project (2005) have focused attention on the severe infrastructure shortage in Africa as a key obstacle to growth. However, results from studies on the impact of public investment on growth, both overall and for Africa in particular, do not give clear-cut results.34 Studies that have focused on infrastructure also have mixed results, but some have found a positive, significant contribution to output and growth. A recent panel study of more than 100 countries by Calderon and Servén (2004) found that an infrastructure index measuring telecommunications, power, and transport had a positive effect on growth. The index comprises data on the number of main telephone lines, an economy’s electricity-generating capacity, and the extent of the road network.

Sub-Saharan Africa benchmarks compared poorly with low-income countries in other developing country regions, based on the new data on infrastructure stocks and quality. In addition to infrastructure stocks, Calderon and Servén (2004) also compile an aggregate index of the quality of infrastructure services in the three subsectors. Compared with low-income countries in other regions,35 sub-Saharan Africa has the lowest value for the infrastructure stock index, and has experienced the slowest growth in the index since 1980–2000 (Figure 8). The infrastructure quality index has deteriorated slightly for sub-Saharan Africa, and South Asia is currently the only region where infrastructure quality ranks lower than that of sub-Saharan Africa.

Figure 8.Infrastructure Development in Low-Income Countries

Source: Calderon and Servén (2004).

Notes: Infrastructure stock uses data on number of main telephone lines per 1,000 workers, electricity generating capacity in MW per 1,000 workers, and length of the road network in kilometer per square kilometer of land area. Infrastructure quality uses three indicators: waiting time for telephone main lines, the percentage of transmission and distribution losses in electricity production, and the share of paved roads in total roads. The indices of infrastructure stock and quality are calculated based on the weights by which the log values of the indicators enter the first principal component analysis. The negative values reflect the log values of fractions.

The expected growth benefits of reaching the level of infrastructure development of Mauritius, the regional leader, vary across sub-Saharan Africa countries. Based on preferred estimates from Calderon and Servén (2004), payoffs are relatively low for countries like South Africa, whose current infrastructure stock is highly developed, and very large for countries like Niger, whose infrastructure is very limited (Appendix Table A16). Estimates suggest that Nigeria would experience the largest growth gain from improving its infrastructure quality to the level of the regional leader, consistent with its current poor quality of infrastructure services. But these expected large growth benefits would require infeasible growth in infrastructure stocks. For example, to reach the level of the regional leader, Ghana would need a 35-fold increase in the number of main telephone lines, a 5-fold increase in power generating capacity, and a 6-fold increase in the density of the road network. These calculations indicate that, according to this model’s specification, the growth effects of more reasonable increases in infrastructure are actually very modest.36

B. Financial Development37

The economies in sub-Saharan Africa with the best-developed financial sectors have experienced a higher per capita growth rate than the average, and the differential has widened since the financial liberalization of the 1990s. However, the development of financial markets, as measured by the ratio of liquid liabilities to GDP, has been slow and uneven.38 Differences in growth are wider if the oil producers, which experienced high growth but remained financially underdeveloped, are excluded (Figure 9). The weak financial development–growth link in the oil producers may help explain indications from the literature of a somewhat weaker relation between growth and financial development in Africa.39 Excluding oil producers, the economies that grew fastest over 1960–2003 also are those that are the most financially developed (Figure 9).

For financial development to stimulate growth, the policy environment must be favorable. In the early 1990s, the persistence of fiscal imbalances, which tend to crowd out credit flows to the private sector, may have weakened the effects of financial liberalization for some African countries (Reinhart and Tokatlidis, 2003). Substantial government ownership and interference in the banking sector may reduce the quality of banks’ decisions, lowering investment efficiency and growth. A crude segmentation of African countries into four categories depending on financial sector development and growth suggests that the growth-promoting effects of financial sector development may materialize only in conditions of macroeconomic stability (Appendix Table A17). Among the countries with relatively strong financial development indicators, those that grew faster achieved greater macroeconomic stability; that is, they had much lower budget deficits, including grants, and lower inflation. This supportive effect of macroeconomic stability for the financial development-growth nexus was even stronger during 1997–2003.

Figure 9.Financial Development of Countries Classified by Growth

(Percent)

Source: IMF World Economic Outlook database, 2004.

Note: The six oil-producing countries are classified separately. The remaining countries are classified by quartiles, according to real growth over 1960–2003.

C. Institutions40

Recent evidence in the literature suggests that institutions are the most important determinant of long-run growth. However, improving basic institutions—the laws, rules, and other practices that govern property rights; the freedom to do business; and the sanctity of contracts—can take a long time. In fact, because causation operates in both directions, spurring large improvements in basic institutions may be difficult without sustained growth.41 Policies also seem to play a role in fostering institutional development—for example, strengthening competition through trade openness, expanding the public’s access to information, increasing transparency, providing assistance in building institutional capacity, and creating external incentives, such as the peer pressure mechanisms to be used in the New Partnership for Africa’s Development (IMF, 2003).

The impact of institutional quality on growth is economically significant. In general, poor policies and institutions have explained a large share of the slow growth in Africa (Savvides, 1995; Easterly and Levine, 1997; Sachs and Warner, 1997; Collier and Gunning, 1999; Hernández-Catá, 2000). Studies have found that the annual growth in sub-Saharan Africa would increase by 1.7 percent if countries in the region adopted the world average quality of institutions (IMF, 2003). Moreover, extensive corruption within the political system and inefficient government bureaucracies are found to increase transaction costs and constrain the efficiency of resource allocation (Poirson, 1998; Leite and Weidmann, 1999; Keefer, 2004). Tax revenue to GDP ratios in sub-Saharan Africa would increase by 1.5 percent if corruption improved by one unit (for example, from 3 in Kenya, to 4 in Madagascar (Ghura, 1998).

The overall quality of both economic and political institutions in sub-Saharan Africa has been improving. However, for sub-Saharan Africa as a whole, while the improvement in political institutions continued throughout the 1990s, the strengthening of economic institutions plateaued in the late 1990s (Johnson and Subramanian, 2005). Fast-growing countries generally had better-quality institutions than slow-growing countries. Also, fast- and medium-growing countries have had more improvement in institutional quality than slow-growing countries (Figure 10). These observations have been confirmed by recent objective measures of countries’ economic institutions. In fast- and medium-growing countries, starting a business, registering property, enforcing contracts, and closing a business are less costly; urban and rural land property rights for investors and for the poor are more secure; and there are fewer land-related conflicts (Figure 11).42

While the quality of economic institutions is correlated with the quality of political institutions, the linkage between changes in political and economic institutions in sub-Saharan Africa is weak. Recent evidence shows that the quality of political institutions and the degree of political stability influence economic institutions, which, in turn, affect economic performance (Aron, 2000; Acemoglu, Johnson, and Robinson, 2001; Acemoglu and Robinson, 2005). In levels, measures of the economic and political institutions in sub-Saharan Africa tend to be strongly correlated; for example, there is a 30–50 percent difference in the index of security of property rights between countries in sub-Saharan Africa that have political freedom and those that do not, as measured by Freedom House. In the long run (1980–2000), however, Johnson and Subramanian (2005) show limited correlation between changes in political institutions (measured by the polity indicator) and changes in economic institutions (from ICRG).43 We confirm that this weak correlation is evident using a range of alternative indicators of political and economic institutions. Over time, the country level correlations rise from 1980 up to the early 1990s and then fall.

Figure 10.The Evolution of Economic and Political Institutions in Sub-Saharan Africa, 1984–2004

Source: International Country Risk Guide (ICRG)

Note: Fast, medium, and slow growers refer to 1960–2003 period.

Figure 11.Objective Measures of Economic Institutions in Sub-Saharan Africa, 2004

Sources: World Bank (1994) and World Bank database on land and property rights in Africa 2004; and Djankov and others (2002, 2003).

This weak correlation between changes in political institutions and economic institutions is not surprising given trends in these indicators beginning in the 1990s. Significant improvement has been registered in political indicators such as the Freedom House indices on political rights and civil liberties, the policy democracy index, and indices of the competitiveness of legislative and executive elections.44 As noted, however, region-wide, the ICRG indicator of economic institutions has stagnated since the second half of the 1990s.

The sizable number of resource-rich economies in sub-Saharan Africa is also a factor related to the weak correlation between changes in political and economic institutions. Resource-rich countries have seen some improvement in political institutions, but this increasing democratization has not been associated with improvements in economic governance. This is consistent with a recent paper’s evidence on the negative effects of democratization on growth in resource-rich countries.45 The authors also found that these adverse effects in resource-rich countries were reversed in political systems with intensified checks and balances, particularly freedom of the press.

The quality of economic institutions is also correlated with other structural characteristics of sub-Saharan Africa countries. On average, institutions in sub-Saharan Africa tend to be strongest in coastal countries, followed by resource-rich countries, and then landlocked countries.46 Institutions also tend to be weaker in oil-producing countries, in members of the CFA franc zone, and in conflict countries. Finally, institutional improvement is stronger in countries with on-track IMF programs than it is in both nonprogram countries and countries with off-track programs. While causality is difficult to determine, a recent paper finds that strong institutions improve IMF program implementation.47

27

Financial sector development and governance are key issues for sub-Saharan Africa. Forthcoming issues of the African REO will examine them in more detail.

28

This section draws on contributions prepared by Smita Wagh.

29

Gupta and others (2004). Adam and Bevan (2003b), using a smaller sample, including 11 African countries, estimated a threshold of 1.5 percent of GDP.

30

Gupta and others (2004b).

31

One should expect a significant time lag between increases in the scaling up of aid for social expenditures and their full effects on social indicators and growth. Baldacci and others (2004) find the highest positive effects of social expenditures in sub-Saharan Africa, because marginal returns are high given lower levels of social outlays.

32

See also Gupta, Davoodi, and Tiongson (2002) on the negative effect of corruption on social indicators.

33

Qualitatively, similar findings hold using the ICRG or Kaufmann, Kraay, and Zoido-Lobaton (1999) governance data.

34

yIMF (2005b) contains a summary of studies on public investment and growth.

35

Country classification follows World Bank and IMF (2005).

36

For sub-Saharan Africa, a one-standard-deviation increase in the index of infrastructure stocks (quality) in sub-Saharan Africa would raise the long-run growth rate by 2.7 (0.4) percentage points. But given the very wide range in the measured stocks, a one-standard-deviation increase is very large and implies increases in spending on infrastructure that are probably not feasible.

37

This section draws on contributions by Brieuc Montfort.

38

Since the 1990s, banking reforms have evolved: countries have eliminated harmful government interventions; addressed weak or distressed banks through restructuring, privatization, and strengthened regulation; reduced crowding out through fiscal adjustments; and adapted the regulatory environment to allow broader access to credit. Further reform in the last area remains a priority: addressing the key legal, regulatory, and institutional bottlenecks to access to banking services and credit, particularly for underserved groups.

39

In addition, Kpodar (2005) finds that the contribution of financial development to growth is weaker in sub-Saharan Africa than other developing countries. Kpodar shows that this weaker relationship is due to sub-Saharan Africa’s high level of ethnolinguistic fractionalization, large number of countries experiencing protracted banking crises, strongly concentrated banking sectors (suggesting limited competition), and heavy government intervention in the banking system.

40

This section draws on contributions prepared by Elena Duggar.

41

It is interesting to note, however, that of the very few countries that seem to have improved their institutions significantly before achieving high growth, two of these—Botswana and Mauritius—are in sub-Saharan Africa.

42

Zimbabwe is a prime example of a country where, in addition to political and economic policy problems, insecure land tenure and land-related conflicts have contributed to a severe downward spiral of growth.

43

Bates (2005) also suggests that democratization in sub-Saharan Africa in the 1990s may have made countries more prone to destabilizing political business cycles, because of, in part, the limited availability of information that citizens need in order to hold governments accountable.

44

From the Database on Political Institutions (see Beck and others, 2001).

45

Collier and Hoeffler (2005). The empirical work tests propositions of a simple model whereby politicians find it more effective to compete by providing private patronage than by providing public goods.

46

Different types of economic institutions might be particularly important for growth in different types of economies. For example, low corruption levels are critical for resource-intensive countries. Institutions that lower the cost of doing business, particularly for exporting manufacturers, are important for coastal countries, and weak rural property rights may be the key constraint for landlocked countries. These issues warrant further investigation.

47

Using data from a broad sample of IMF-supported programs, Nsouli, Atoian, and Mourmouras (2004) find that strong institutions lead to better program implementation. Their paper shows that program implementation also exerts an independent effect on macroeconomic outcomes, but not on growth.

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