Chapter

III Macroeconomic Environment and Factors Underlying Growth and Investment

Author(s):
Ahsan Mansur, and Edouard Maciejewski
Published Date:
May 1996
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Author(s)
Christopher McDermott

This section provides background information on how Jordan’s adjustment and reform programs and the resulting improved macroeconomic policy environment have influenced investment and growth in recent years. The basic indicators of the macroeconomic environment that are used to examine the potential effect of adjustment programs on investment and growth are the inflation rate, the fiscal balance, and the external current account balance. Movements in the terms of the trade, the inflow of workers’ remittances, and changes in the real exchange rate are basic indicators of external shocks affecting growth and investment.

The empirical analysis presented in this section and inferences from other empirical works suggest a number of conclusions. First, real GDP growth is attributable more to increases in physical capital than to increases in the labor force. Second, despite impressive growth performance, total factor productivity has declined in recent years because of the need to absorb into the economy some 300,000 Jordanians returning from abroad. Third, the most significant impact on real GDP growth has been achieved through fiscal policy; accordingly, the negative impact of the high fiscal deficits of the past has been declining with the progress made in reducing the deficit, despite falling foreign grants. Fourth, fiscal policy has affected real GDP growth primarily by slowing down the rate of capital accumulation by the private sector. Finally, the most important determinant of private investment in Jordan is the inflow of external financing in the form of workers’ remittances and transfers of savings.

Economic Developments During 1976–94

Boom of the 1970s

Between 1976 and 1980, real GDP rose by 9.5 percent a year, and investment averaged 35 percent of GDP (Table 3.1). During this period, domestic private sector investment was directed partly to residential housing construction and partly to the transportation and mineral-based processing sectors; such investments therefore had limited direct impact on the future growth potential of the economy. Jordan’s growth and investment depended heavily on external financing. Private construction activity was largely financed through workers’ remittances, while grants and loans from oil-exporting countries in the region accounted for a large part of the financing of Jordan’s public sector investment.

Table 3.1.Macroeconomic Performance
1976–801981–851986–901991–941976–94
Real GDP growth19.56.2–0.97.45.4
Gross fixed investment235.031.022.328.727.7
Inflation rate111.75.49.74.87.8
Fiscal balance2
Excluding grants–29.0–18.5–20.1–10.8–20.0
Including grants–12.4–8.5–12.8–6.0–10.1
Current account balance30.2–5.2–3.3–12.5–4.8
Terms of trade1
(1992 = 100)85.380.191.998.887.8
Real exchange rate1
(1992 = 100)171.4142.7117.399.9135.6
Sources: Department of Statistics, Government of Jordan; Central Bank of Jordan: and IMF staff estimates.

The indicators of macroeconomic policy describe a mixed situation during 1976–80: inflation averaged about 12 percent, and the fiscal deficit of the Central Government (excluding foreign grants) averaged 29 percent of GDP; however, the external current account—reflecting receipts of sizable foreign grants—remained virtually in balance. The large budget deficits were the result of the authorities’ efforts to improve public utilities and services, together with higher defense expenditure and subsidies for certain basic goods.

Economic Slowdown in the Early 1980s

By the early 1980s, the terms of trade had deteriorated, resulting in the subsequent deterioration in the external current account balance to a deficit of some 5 percent of GDP. Furthermore, as oil prices and related revenues started to decline, the level of external aid (primarily from regional oil-producing countries) dropped from about 17 percent of GDP to 10 percent of GDP, which in turn led to a reduction in public sector investment as a share of GDP from nearly 19 percent of GDP to less than 14 percent (Table 3.2). While public sector investment bore the brunt of the shock, private sector investment remained steady, at approximately 16 percent of GDP. The decline in investment and inflow of workers’ remittances adversely affected the economy, with real GDP growth falling to an average of 6 percent during 1981–85. The fiscal deficit (excluding foreign grants) declined by more than 10 percentage points, although at 18.5 percent of GDP by 1985 it remained very high; the reduction in the fiscal deficit was largely attributable to cuts in development expenditure. Inflation was contained to an average annual rate of 4 percent, reflecting the authorities’ policy of maintaining a stable nominal exchange rate and a moderation in the world rate of inflation.

Table 3.2.External Financing and Investment(In percent of GDP)
PeriodPrivate

Investment1
Workers’

Remittances
Central

Government

Capital

Expenditure
Central

Government

External

Aid
1976–8016.020.718.916.6
1981–8516.222.313.910.0
1986–907.114.215.37.3
1991–9316.316.313.14.8
1976–9413.718.515.49.9
Sources: Department of Statistics, Government of Jordan; Central Bank of Jordan; and IMF staff estimates.

Economic Crisis in the Late 1980s

In the second half of the 1980s, debt-service obligations and the fiscal imbalance increased sharply. Jordan’s debt service was some 45 percent of exports of goods and services in 1989, while the average fiscal deficit (excluding foreign grants) increased to 20 percent of GDP. Faced with growing budget deficits, the authorities resorted to borrowing from both domestic and foreign commercial banks. The monetization of the deficit led to higher inflation. Jordan’s economy also remained highly vulnerable to the unfavorable fluctuations in income in neighboring countries as a result of declining oil prices and associated revenues. The decline in workers’ remittances and grants and loans from neighboring oil-exporting countries led to a growing external imbalance and an associated rapid buildup of debt and debt service. By 1988, this external imbalance had reached unsustainable proportions. General financial instability in this period in turn led to bank failures and a reduction in private capital inflows. Reflecting this deteriorating macroeconomic environment, aggregate investment declined to some 22 percent of GDP, with private sector investment averaging only 7 percent of GDP. Real GDP declined steadily over 1986–90, with Jordan’s worst recession in recent history occurring in 1989 (Chart 3.1).

Chart 3.1.Real GDP Growth and Investment

(Percent changes)

Sources: Department of Statistics, Government of Jordan; and Central Bank of Jordan.

Economic Recovery, 1989–94

Since late 1988, interrupted only by the August 1990 regional crisis, Jordan has been implementing a medium-term structural adjustment program. Since 1991–92, the macroeconomic policy indicators have improved significantly. The inflation rate declined to 3.5 percent in 1994, and the average rate of inflation for 1989–94 was less than 5 percent. The fiscal deficit declined sharply, averaging about 11 percent of GDP during this period (Chart 3.2). Including foreign grants and the effect of external debt relief, central government operations on a cash basis were in surplus during most of the years. The improvement in macroeconomic indicators also led to a recovery in investment to about 29 percent of GDP, despite a significant decline in external official financing compared with earlier periods; and real GDP expanded by more than 7 percent a year. The strengthening of Jordan’s macroeconomic performance since late 1991 is attributable to three key factors: (1) the implementation of effective macroeconomic policies, such as restrained fiscal and monetary policy and prudent exchange rate management; (2) the regularization of external debt-service obligations, a prudent debt-management policy that contributed to a sharp reduction in the debt and debt-service ratios, and substantial external financial support from official bilateral and multilateral creditors; and (3) the effective absorption into the Jordanian economy of some 300,000 Jordanians from abroad (about 10 percent of the population and a higher proportion of the labor force), who also brought with them substantial savings and technical know-how to revitalize the private sector.

Chart 3.2.Real GDP Growth, Fiscal Balance, and the Current Account

(Percent changes)

Sources: Department of Statistics, Government of Jordan; and Central Bank of Jordan.

Factors Influencing Long-Term Growth

Recent developments in the growth literature have emphasized that economic conditions and implementation of appropriate public policies influence the rate of economic growth. Barro and Barro and Sala-i-Martin1 link growth to fiscal variables in their endogenous growth models, which were tested empirically by Cashin2 for member countries of the Organization for Economic Cooperation and Development (OECD). Fischer3 extends the notion that governments can influence growth by creating a stable macroeconomic framework, which can be created through macroeconomic policies that are conducive to growth.4 The key macroeconomic policies are considered to be monetary, fiscal, and exchange rate policies designed to keep inflation low and predictable, a stable and sustainable fiscal balance, appropriate real interest rates, a competitive and predictable real exchange rate, and a viable balance of payments. The signaling effect government management has on the private sector is one of the key mechanisms through which macroeconomic policies influence growth. To measure this signaling effect, Fischer recommends using basic indicators of macroeconomic policy, such as the inflation rate, the government fiscal balance, and the current account balance. In particular, Fischer used a regression analog of growth accounting to identify the channels through which macroeconomic variables affect economic growth; the idea behind this growth accounting framework is to measure the relationship between growth and several key macroeconomic variables. Growth can be attributed to changes in the supplies of factors of production (labor and capital) or to changes in total factor productivity (reflecting changes in the efficiency with which these factors are used).

Macroeconomic Stability and Growth

In examining the links between growth and indicators of macroeconomic stability, Fischer estimated several sets of panel regressions. All of the coefficients from the estimated equation of the growth rate of real GDP from 1961 to 1988 on a set of macroeconomic indicators and external shock indicators are significantly different from zero (Table 3.3). The results imply notably that (1) a country that has an inflation rate 100 percentage points higher than another will have a growth rate that is 3.9 percentage points lower; (2) a country with a fiscal balance that is in greater surplus or lower deficit by 1 percent of GDP will have a growth rate that is 0.23 percent larger; (3) a country with a higher black market exchange premium will grow slower than a country with a lower black market exchange premium, other things being equal; and (4) negative shocks in the terms of trade reduce growth. Overall, the results indicate that, when the measures of macroeconomic policies indicate stability, the prospects for growth are favorable.

Table 3.3.Summary of Estimated Panel Regression Coefficients from a Growth Accounting Framework
Regressors
Dependent

Variable
Inflation

rate
Fiscal

balance1
Changes in

the terms

of trade
Black market

exchange rate

premium
Real GDP growth–0.0390.2280.043–0.017
(–4.65)(–4.49)(–2.71)(–2.76)
Productivity growth–0.0180.1370.038–0.006
(–2.49)(–3.23)(–2.60)(–1.17)
Rate of capital accumulation–0.0370.0750.008–0.019
(–4.77)(–1.61)(–0.62)(–3.56)
Labor force growth–0.002–0.0070.00090.0003
(–1.14)(–0.53)(–0.29)(–0.22)
Source: Stanley Fischer, “The Role of Macroeconomic Factors in Growth,” Journal of Monetary Economics, Vol, 32 (December 1993), pp. 465–512.Note: Twenty-two countries are in the panel: Argentina, Chile, Colombia, Cote d’lvoire, Dominican Republic, Ecuador, Ghana, Greece, India, Indonesia. Jamaica, Kenya, Korea, Malawi, Mexico, Morocco, Pakistan, Paraguay, Thailand, Turkey, Venezuela, and Zambia. Figures in parentheses are t-statistics.

These findings are used to examine the effects of macroeconomic policies on Jordan’s growth performance during 1976–94 (Table 3.4). First, the negative impact of inflation on growth for Jordan is about a third of a percentage point a year during 1976–94. However, most of the impact came during 1976–80 and 1986–90. Had Jordan been able to maintain price stability in those two periods, the growth rates would have been nearly half a percentage point higher. However, even in the slump years, the restraining effect of inflation on growth is significantly less in Jordan than in the other countries in the sample. This reflects the fact that Jordan experienced relatively moderate rates of inflation over the entire period. Second, the changes in the terms of trade had a limited and mostly positive impact on Jordan’s growth performance.

Table 3.4.Impact of Macroeconomic Policy on Real GDP Growth(Percent change)
1976–801981–851986–901991–941976–94
Policy indicators
Fiscal balance
Excluding grants–6.61–4.22–4.58–2.46–4.56
Including grants–2.83–1.94–2.92–1.37–2.30
Inflation rate–0.46–0.21–0.38–0.19–0.30
Changes in terms of trade–0.490.160.250.440.38
Source: IMF staff estimates.Note: The impact on real GDP growth is calculated by multiplying the period mean of the policy indicator (see Table 3.1) by the relevant estimated coefficient in Table 3.3.

This analysis shows that the stance of fiscal policy represents the greatest impediment to Jordan’s growth performance. Over the entire period 1976—94, the fiscal deficit (including foreign grants) restrained growth by an average of over 2 percentage points a year. Had there been no foreign grants—which have been used largely to finance public investment—growth would have been reduced by nearly 5 percentage points. Jordan’s reliance on grants from oil-exporting countries in the region to finance public sector investment—a significant source of growth—diminished over the period. If the grants received during 1976–80 had not materialized, growth would have been reduced by an average of nearly 7 percentage points. However, if the grants received during 1991–94 had not materialized, growth would have been slower by an average of just over 2 percentage points.

Total Factor Productivity Residuals

The World Bank conducted a study of sustainable growth in Jordan that included an analysis of total factor productivity.5 The approach uses a production function to examine the relative contribution to growth of factors of production and productivity growth. The approach is a regression analog of growth accounting and allows for identification of the channels through which macroeconomic policies affect economic growth. Growth can arise through increased efficiency, which shows up as increased positive residuals in an estimated production function, or through increases in factors of production.

For this exercise, two specific types of production function have been specified and estimated. The first one is a standard Cobb-Douglas production function, in which output is a function of labor and physical capital, while the second also includes a measure of human capital—measured by school enrollment—as an additional factor of production. The restriction that the two factors’ shares in the Cobb-Douglas production function are equal and satisfy constant returns to scale cannot be rejected using a standard hypothesis test. Based on the extended production function, the estimated factor shares are 44 percent for physical capital, 23 percent for labor, and 33 percent for human capital. For the first type of production function, total factor productivity estimates,

Solow residuals = real GDP growth – 0.5 physical capital accumulation – 0.5 labor force growth;

and for the second set of production function, total factor productivity estimates,

Mankiw-Romer-Weil (MRW) residuals = real GDP growth - 0.44 physical capital accumulation - 0.23 labor force growth–0.33 human capital.

Both the Solow residuals and the MRW residuals show that total factor productivity declined over the period 1981–94, with the largest decline occurring during the period 1991–94 (Table 3.5). Estimates from the simple two-factor production function show that the growth component provided by extra labor is more than offset by the decline in total factor productivity, implying that increased output from a higher labor force was virtually offset by a loss of productivity. However, estimates from the three-factor production function, which allows decomposition between an increase in the quantity of labor and the quality of labor, show that for an increase in economic activity attributable to labor, about 50 percent can be attributed to an increase in quality. A striking feature of the results is that most of the growth in economic activity was generated by increases in physical capital. The manner in which macroeconomic policy affects investment and, thus, overall economic growth is examined below.

Table 3.5.Contributions to Economic Growth by Factors of Production(Period averages; percent change in real terms)
Growth Contribution of
PeriodGDPPhysical

capital
Labor

force
Human

capital
Solow

Residuals1
MRW

Residuals1
1976–809.56.51.31.7
1981–856.27.02.7–3.5
1986–90–0.90.30.3–1.5
1991–947.910.211.9–14.2
1976–945.45.53.2–3.3
1976–809.55.70.61.22.0
1981–856.26.11.31.2–2.4
1986–8725.03.11.10.9–0.1
1976–8727.45.41.01.2–0.2
Source: IMF staff estimates based on World Bank, Jordan: Consolidating Economic Adjustment.

Factors Influencing Investment

In view of the importance of physical capital investment in generating growth in Jordan, this subsection conducts a detailed time-series study of factors influencing private investment in Jordan. These factors include some of the policy indicators that were shown to be important determinants of growth in the previous subsection, as well as some specific variables found to be empirically important for private sector investment behavior in Jordan.

Methodology and Data

The analysis is based on empirical estimates of a private investment function for Jordan during 1977–94. Private investment is specified to be a function of (1) private external inflows measured by workers’ remittances; (2) a public investment financing constraint measured by the excess of central government capital expenditure over the Central Government’s available external financing; (3) a fiscal policy indicator, measured by the fiscal deficit excluding foreign grants; (4) an indicator of the sustainability of financial policies measured by gross official reserves; and (5) an indicator of macroeconomic uncertainty, measured by changes in the real exchange rate. The rationale for using external inflows, a government financing constraint, crowding-out effects, and uncertainty over policies and macroeconomic conditions as key factors influencing investment in Jordan is as follows.

First, in many countries an important element in investment decisions is the availability of credit for financing the investment. However, for Jordan, investment financing mainly took the form of external inflows of private capital—particularly through the transfers of workers’ remittances and savings. Accordingly, private investment in Jordan fluctuated with the flows of workers’ remittances, which in turn depended heavily on movements in oil prices in the region’s oil-exporting countries.

Second, the possibility that public investment and fiscal policy may in general crowd out private investment—as discussed in Easterly, Rodriguez, and Schmidt-Hebbel6—arises from government preferential access to credit at administered interest rates; or increasing lending rates resulting from a higher absorption of funds by the public sector; or lower private rates of return because of competition between the Government and the private sector for investment opportunities. In Jordan, such potential crowding out is represented by the excess of central government capital outlays over available external financing.

Third, uncertainty about policy and the general macroeconomic environment gives investors the incentive to wait until the uncertainty has been removed before committing themselves to an irreversible decision. Uncertainty is not a measurable entity, but it is assumed that investors use some indicators to gauge its level. In the case of Jordan, two such indicators are likely to be the level of gross official reserves and the real exchange rate.

The data used to estimate the private investment equation are all annual time series covering 1977—94, making a total of only 18 observations. Accordingly, while this econometric exercise provides some interesting information, any conclusions derived from it are tentative and should be considered with caution, given the low degree of freedom afforded by the small sample available.7

Empirical Observations

The estimates suggest a very strong relationship between the availability of remittance income and private sector investment. The marginal propensity to invest from workers’ remittances is estimated to be 0.85 and is statistically highly significant (Table 3.6). This finding shows the importance of external financing for Jordan: when the flow of remittances dries up—as happened in the late 1980s and early 1990s—private investment is constrained and growth is inhibited.

Table 3.6.Estimates of Private Investment Equation, 1977–94

(Dependent variable: private investment/GDP)1

Independent

Variables
Coefficient

Estimate
Standard

Errors2
t-statistic
Constant4.163.341.25
Workers’ remittances/GDP0.850.233.64
Government financing constraint3–0.810.18–4.49
Official reserves (in months of imports)1.940.533.68
Real exchange rate (percent change)–0.230.10–2.25
Fiscal balance/GDP40.500.124.22
Summary and diagnostic statistics5
Number of observations18.00
R squared0.71
Durbin-Watson statistic1.38
Breusch-Godfrey Test for AR(I) errors61.77(0.18)
Breusch-Pagan Test for heteroscedasticity6
From workers1 remittances4.91(0.03)
From government financing constraint1.18(0.28)
EngleTest for ARCH errors61.11(0.29)
Sources: IMF staff estimates based on data provided by the Central Bank of Jordan and the Department of Statistics. Government of Jordan.

An equally strong but inverse relationship was found between private investment and the excess of public investment over available foreign grants. The estimated coefficient on this variable was–0.81, nearly equal but of opposite sign to the estimated coefficient on workers’ remittances. Furthermore, an F-test of whether the estimated coefficients of the overall financing flows (workers’ remittances plus the financing constraint) sum to zero is also statistically acceptable. The coefficient estimates and tests show that there is an exact one-to-one correspondence of public to private investment. Virtually all Jordanian investment is financed through external sources. If the Government invests more than its own internal public savings, then it must use financing that would have been available to the private sector. The size of the financing constraint means that the cost of public investment is the forgone opportunity in the private sector and that this cost will be fully reflected.

The estimated coefficients on gross official reserves and the real exchange rate show that these indicators of uncertainty provide a strong signal to investors about the health of the economy, and this in turn has a large impact on investment decisions. The estimated coefficient on official reserves is 1.94 and is statistically highly significant. The implication is that an improved reserves position would clearly enhance the country’s prospects for private investment. The estimated coefficient on the real exchange rate is–0.23 and is significantly different from zero. The implication is that a devaluation is considered a sign of a weak economy and thus deters private investment, while maintaining real exchange rate stability would encourage confidence and thus investment. These results indicate that Jordan’s continued vulnerability to external shocks and the related perception of uncertainty in the macroeconomic environment tend to discourage domestic investment.

The estimated coefficient on the fiscal balance is 0.5 and is highly significant. The parameter estimate shows that there is a large crowding-out effect and that large fiscal deficits are the most important indicator of macroeconomic policy performance. A lack of fiscal discipline has been a major impediment to private investment in Jordan in the past. These findings are consistent with the strategy underpinning the emphasis on fiscal adjustment and the gross official reserve buildup in Jordan’s recent structural adjustment programs.

Concluding Observations

The empirical analysis presented above shows that there is a strong relationship between the macroeconomic environment and growth in Jordan. The basic indicators of the macroeconomic environment are found to be the inflation rate, the fiscal balance, and the external current account balance, with the fiscal balance having the greatest influence on real GDP growth. Furthermore, real GDP growth is attributable more to increases in physical capital than to increases in the labor force, highlighting the role of savings in achieving higher growth. An analysis of private investment shows that the inflow of external financing in the form of workers’ remittances and transfers of savings is the most important channel for private investment in Jordan. Fiscal deficits have adversely affected growth by crowding out private investment. In this sense, Jordan’s remarkable fiscal adjustment in recent years is the single most important macroeconomic policy instrument that has favorably influenced its investment and growth performance. Fiscal policy seems to have worked through two channels: the crowding-out effect on investment and thus growth; and the effect of signaling whether or not the Government is in control of the economy. Overall, the empirical analysis highlights the importance of sustained fiscal and external adjustments in creating a stable macroeconomic environment and in fostering growth and investment and the importance of large transfers of workers’ savings in easing the adjustment process.

R.J. Barro, “Government Spending in a Simple Model of Endogenous Growth,” Journal of Political Economy, Vol. 98 (October 1990), pp. S103–25; and R.J. Barro and X. Sala-i-Martin, “Public Finance in Models of Economic Growth,” Review of Economic Studies, Vol. 59 (October 1992), pp. 645–61.

Paul Cashin, “Government Spending, Taxes, and Economic Growth,” Staff Papers, International Monetary Fund, Vol. 42 (June 1995), pp. 237–69.

Stanley Fischer, “Development, Macroeconomics, and Growth,” NBER Macroeconomics Annual, 1991 (Cambridge, Massachusetts: National Bureau of Economic Research, 1991), pp. 329–64; and Stanley Fischer, “The Role of Macroeconomic Factors in Growth,” Journal of Monetary Economics, Vol. 32 (December 1993), pp. 485–512.

Other public policies conducive to growth include the enactment and enforcement of private properly rights through the legal system and the maintenance of national security.

Jordan: Consolidating Economic Adjustment and Establishing the Base for Sustainable Growth, Report No. 12645–JO (Washington: World Bank, 1994).

William R. Easterly, Carlos A. Rodriguez, and Klaus Schmidt-Hebbel, eds., Public Sector Deficits and Macroeconomic Performance (New York: Oxford University Press, 1994).

All the series entering the investment equation were expressed in scaled form (as a ratio of GDP or imports) or in rates of change to obtain a meaningful economic interpretation free of spurious correlations caused by unrelated trends in the data. Because a battery of diagnostic tests indicated the possible presence of heteroscedasticity, all standard errors are calculated using a heteroscedasticity-consistent variance-covariance matrix estimator. The diagnostic procedures do not indicate any other problems in the estimation, and the estimated model explains 71 percent of the movements in private investment.

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