2 Investment and Growth

Amer Bisat; El-Erian Mohamed; El-Gamal Mahmoud; Francesco P Mongelli

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Author: Amer Bisat¹, El-Erian Mohamed, El-Gamal Mahmoud, and Mr. Francesco P Mongelli

¹ 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund

Language:: English

Keywords:: BOOK; country; Mena; MENA country; liberalization; trade; investment performance; investment responsiveness; investment experience of Mena country; investment response; investment decision; Structural reforms; Private investment; Public investment spending; Foreign direct investment; Asia and Pacific; East Asia; Western Hemisphere; Middle East

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Abstract

How to achieve a better economic growth is the major economic policy challenge facing the countries of MENA. Sustained high growth is needed to improve living standards, reduce unemployment, and provide jobs for the growing labor force. During the 1970s and early 1980s, favorable developments in MENA’s external environment stimulated growth. This was no longer the case in the mid-to-late 1980s and early 1990s and the region’s per capita income stagnated and fell short of that achieved by developing countries as a group. Looking forward, the external environment is expected to remain broadly neutral with significant downside risk, particularly related to developments in the international oil market. Sustained economic growth will therefore depend primarily on domestic policy efforts.

Improving the investment performance—in both human and physical assets—is an important determinant of the MENA region’s ability to grow. While there are important differences among countries in the region, investment levels for the region as a whole have been low—both in absolute terms and relative to other developing country regions. The composition of investment has remained heavily tilted toward the public sector, consistent with the dominant role that the government has tended to play historically in a number of countries. Investment activity has also been heavily dependent on external influences, particularly fluctuations in international oil prices. These factors have also contributed to low inflows of foreign direct and portfolio investment to most MENA countries, as have conflicts in the region. However, recent efforts to improve the investment environment in MENA countries indicate policymakers’ awareness of the importance of enhancing capital formation and human resource development.

Developments in Growth and Investment

Growth

The current emphasis in MENA on growth and investment has much to do with policymakers’ desire to reverse the disappointing economic performance of recent years. After sustaining an average annual real growth rate of nearly 5 percent in the 1970s and the first half of the 1980s, the region’s growth nearly halved and lagged behind population growth rates. As a result, per capita income in 1995 is estimated to have been 4 percentage points below its level a decade earlier (Chart 1). In comparison, during the same period (1985—95) the per capita income of developing countries as a group rose by 40 percent and that of the fastgrowing countries of East Asia by 80 percent.

Growth varied significantly among MENA countries. In the energy exporting economies, the large international oil price increases in 1973 and 1979—80 provided important stimuli to growth. Many other countries in the region experienced positive spillover effects, principally as a result of worker remittance flows and receipt of financial assistance. They were also positively affected by international developments, including high demand for labor in European countries and the availability of official development assistance. Earlier growth in these countries also reflected heavy investments by the public sector, typically in import-substitution activities.

Growth in most MENA countries in the 1970s was concentrated in the industrial (including energy) sector. In the oil economies, it was associated with the rapid growth in the extractive and related sectors; in MENA’s non-oil economies, growth was in large part promoted by import-substituting manufacturing activities—the latter often at the expense of the agricultural sector.

Since the early 1980s, the real price of oil has fallen sharply. The spillover effects from the oil economies to the non-oil economies worked in a contractionary manner at a time when labor demand subsided in the region’s major external markets. Concurrently, the returns from the earlier investment surge also declined rapidly, which left many MENA non-oil economies with a problem of an aging capital stock.

Looking forward, most analysts agree that on the basis of current prospects MENA’s external environment will not provide a major stimulus to growth (El-Erian, 1996). Notwithstanding the recent surge in international oil prices, the outlook for prices is subdued, with significant downside risks. The high unemployment in European countries is likely to limit demand for labor from the MENA region. Finally, the outlook for official bilateral assistance is uncertain as donors and creditors face their own budget consolidation issues. For these reasons, the region’s growth stimulus will need to come from appropriate domestic policies. Indeed, the main challenge facing the regions’ authorities today is to implement policies aiming at spurring growth and, more generally, raising living standards. The crucial step in meeting this challenge is to increase both the level and efficiency of the region’s capital.

Investment

MENA’s investment performance has also weakened in recent years. Specifically, after growing sharply in the 1970s and early 1980s, gross investment (that is, without taking depreciation into account) as a percent of GDP has hovered just above 20 percent—a level that is lower than the average for developing countries (over 24 percent in 1995) and sharply lower than the ratios prevailing in the fast-growing Asia region (nearly 30 percent) (Chart 2).

As with growth, investment behavior within the region varied considerably. Governments in the oil economies channeled surpluses from oil exports into capital-intensive projects in infrastructure, basic social services, and, over time, industrial activities. In the ensuing recession, investment expenditures in the oil countries were badly hit: investment expenditures in 1995 were nearly 6 percentage points of GDP below their peak in the early 1980s. This pattern was even sharper in the non-oil countries. In these countries, a period of high investment (mostly by the public sector) ended in the early 1980s and was followed by a period in which the rate of capital accumulation fell by more than 10 percentage points of GDP between 1982 and 1995. Investment rates in both regions have recently converged, with both oil and non-oil economies currently spending one fifth of their output on investment.

Investment has been low in the last decade…

Public sector investment has continued to dominate fixed capital formation in the MENA region. It accounts for approximately half of total investments at present—the highest share among developing countries and one that international experience suggests is suboptimal. As a ratio to GDP, public investments in the MENA region are among the highest in the world. After reaching a peak of more than 16 percent in 1982, the ratio of public investment to GDP declined to about 10 percent in 1995 (compared with about 6 percent in developing countries as a whole). While public investments in Asia are somewhat higher (ranging between 7 percent and 8 percent), they tend to be concentrated mostly in basic social services and the development of human resources.

… with modest private sector participation…

Private sector investment expenditures in the MENA countries (at about 10 percent of GDP since the early 1990s) remain lower than the average for developing countries (at about 17—18 percent over the last few years) and considerably below the average in the Asia region (at about 21—22 percent during the last few years). However, the ratio of private sector investment to GDP in the MENA region had edged upward in the first half of the 1990s, although the increase is accounted for by a small number of countries.

Consistent with low levels of private sector investment, the region has attracted only modest amounts of foreign direct investment, a significant share of which was concentrated in the energy sector. Since the mid-1980s, the ratio of foreign direct investment to GDP in the MENA region has ranged between 0.5 percent and 0.75 percent of GDP—rates that are significantly below those in fast-growing developing countries. In comparison, the Asian region has for many years attracted foreign direct investment flows equivalent to more than 1 percent of GDP a year, while in the Western Hemisphere region, the pattern is more recent but no less evident. In terms of selected countries, foreign direct investment in Malaysia reached a peak at 9 percent of GDP in 1992 and remained at 6 percent in 1995.

By international standards, the level of investments in MENA has been modest and well below the aspiration of policymakers. Its efficiency also appears to have been low. The incremental capital-output ratio (that is, the value of investment needed to produce one unit of output) in the MENA region has become much higher than that in other regions. It is more worrisome, perhaps, that the trend in this indicator has deteriorated, which confirms the findings of a number of sector-specific studies.

… and a decline in efficiency

Low capital efficiency in the region is to some extent associated with the pattern of large public capital expenditures eventually exhibiting low return. In fact, most MENA governments provide infrastructure services to households in quantities analogous to, or even higher than, those in countries with similar incomes. However, the quality of such services has tended to be low. In addition, MENA countries devote a larger share of their national income to education than any other region in the world; however, the greater emphasis on higher education (as opposed to basic education or vocational training) and the deteriorating quality of education have resulted in low rates of completion of studies, high unemployment among graduates, and low and falling labor productivity.

Investment Determination: Some General Considerations

Why Is Investment Important?

In its most comprehensive coverage, investment includes the accumulation of physical capital—such as buildings, equipment, and inventories—as well as human and other intangible forms of capital. While it typically accounts for a relatively small portion of GDP, economists and policymakers place heavy emphasis on investment expenditure. Why? At least three reasons may be cited.

Since physical and human capital represent the critical input in the production process, investment constitutes an important engine of growth and employment.
Investment spending is also the means through which advanced technologies—central to the growth process—are incorporated into an economy.
Since investment spending tends to be the most volatile portion of aggregate demand (often accounting for a significant portion of changes in real output), understanding its behavior is important for explaining business cycles.

What Are the Main Determinants of the Investment Decision?

Theoretical models of investment behavior are usually based on a fairly simple notion: firms respond to changing economic developments by deciding whether and to what extent to modify their existing capital stock—the “investment response.” The movement from the “current” to the “optimal” level of capital (that is, the investment decision) depends on a number of factors:

Interest rates and taxes that affect the cost of the investment outlay, its opportunity cost, and its profitability over time.
Quantity factors that affect the demand for the products to be produced by the investment project.
Exogenous factors such as technology shocks.

When Is Investment More Efficient?

Investment reacts positively to demand, low cost of funds, and an enabling environment

A rich body of theoretical and empirical literature has shown that the mere accumulation of additional units of physical capital is not sufficient to ensure sustainable economic growth. Investment in physical capital is more effective when associated with strong “enabling” factors. These include

A stable macroeconomy (Box 1).
A regulatory environment that enhances the return to, and the effectiveness of, private and public investments. This requires structural reforms in the real, external, and financial sectors.
A social service policy that emphasizes basic health and education.
A strong institutional base.

Empirical Investigation of Investment Behavior in MENA

MENA countries as a group face the challenge of increasing both the level and efficiency of their investment outlays, with a view to achieving faster and more sustainable growth. This section provides an investigation of investment behavior in the MENA countries over the period 1980—94, based on an empirical exercise carried out by Bisat and others (1996). A consideration of investment behavior in MENA countries leads to the identification of three broad country groupings:

Investment in Group I countries (the Islamic Republic of Iran, Kuwait, Lebanon, Mauritania, Oman, Somalia, and the Republic of Yemen) was slow to respond to changing economic conditions. In addition, countries in this group tended to devote relatively less of their output to capital accumulation.
Although Group II countries (Bahrain, Libya, Morocco, Qatar, Saudi Arabia, Sudan, the Syrian Arab Republic, and the United Arab Emirates) also showed a relatively slow speed of investment response to changing economic conditions, they exhibited a better capital-output ratio and a less rapidly decaying stock of capital.
Relative to the other two sets of countries, Group III countries (Algeria, Egypt, Israel, Jordan, and Tunisia) were characterized by a rapid investment response to changing conditions, a much more favorable capital-output ratio, and fairly robust capital stock.

Box 1

Macroeconomic Stability and Investment Behavior

Macroeconomic instability inhibits private investment through a variety of channels.

Inflation, especially at very high and variable levels, distorts relative prices, creates uncertainty, and contributes to inefficiencies in the allocation of resources. Empirical studies have shown that countries with high and variable inflation rates invest (and grow) less rapidly than countries with low inflation.

Macroeconomic instability often results from unsustainable management of government finances. This usually translates into high financing needs by the government and can crowd out private investment. In addition, in the face of large government financing needs, countries sometimes channel credit administratively, which adds to the risks of resource misallocations. Experience suggests that preferential access to (cheap) credit is usually provided to large inefficient enterprises; smaller and more dynamic firms are usually rationed out.

Public investments play an important role in private sector investment decisions. The literature distinguishes between complementary” public investments (that is, those that “crowd in” private investments by rendering them more profitable—such as infrastructure and education); and “competitive” public investments (that is, those that “crowd out” private investments—such as public enterprises in the manufacturing sectors). The challenge for policymakers is to strike the right balance. While too low a level of “complementary” public investments is sub optimal, too high a level is also inefficient insofar as it would need to be financed through higher taxes on the private sector. In addition, while there is no a priori reason to believe that competitive public investments are less efficient than the equivalent private sector undertaking, there is considerable empirical evidence pointing to the higher inefficiency among public enterprises.

Another channel through which macroeconomic variables affect investment decisions relates to uncertainty and policy credibility. Investments are long-term decisions that require a minimum level of forecasting clarity; firms are reluctant to invest in an environment in which the stance of future policies is unclear or is not credible.

What do these differences mean? First, looking at the stock of capital, a higher level of capital stock means that a country has in the past devoted a larger share of its output to capital accumulation. Such a country is better poised to generate higher levels of output in the future. However, a high level of capital, in and of itself, is not sufficient to generate higher output. How the capital is used (that is, its efficiency) is at least as important. Second, with regard to investment responsiveness, a high degree of responsiveness is not necessarily a “good” outcome. It would depend on how well the economy performed during a particular period.

Virtuous cycles of high growth and high investment

An economy experiencing a combination of significant output growth and high degree of investment responsiveness is likely to have directed a large portion of its output toward the production of capital goods (as opposed to consumption). A virtuous cycle is attainable when high growth and high investment reinforce each other. On the other hand, high growth coupled with low investment responsiveness would indicate that the economy has directed what is often an externally induced growth-push toward consumption rather than investment, implying a forfeiting of future growth prospects for the sake of present consumption. Finally, an outcome where output growth is low (or negative) while investment responsiveness is high indicates that the economy has attempted to maintain a constant level of consumption at the expense of investment. This may lead to a negative-growth, low-investment scenario where, as growth falls, investment declines and, in turn, future growth suffers.

Nearly all of the countries in the Group I have experienced significant and disruptive armed conflicts over part of the period covered. Consequently, most countries in this group exhibited a pattern of poor investment and growth performance during the period of hostilities, followed by growth in real investment and output after the end of hostilities. In fact, removing the years of hostilities from the sample period would have placed some of Group I countries (for instance, Lebanon) in a high-growth, high-investment scenario. Looking ahead, the end to these conflicts in most of these countries may be expected to improve the investment responsiveness. However, the experience of other countries from within and outside the region suggests that this may be a necessary but not sufficient condition. There is also a need for domestic policy adaptations, as discussed in the following section.

Group II is dominated by economies with limited—albeit growing—economic diversification. The group’s slow investment responsiveness suggests that structural factors played an important role. It is worth noting, in particular, the extreme vulnerability of the economies in this group to fluctuations in international prices and weather. For example, many Group II countries failed to raise correspondingly their investment rates following positive exogenous shocks (for instance, higher oil prices) and instead opted for larger relative increases in their consumption levels. Similarly, some of the countries in the group reacted initially to negative developments (falling oil prices for Qatar and Saudi Arabia and droughts for Morocco and Sudan) by reducing investment expenditures.

Group III countries had the highest investment responsiveness in the sample of MENA countries. However, some of these countries—for example, Algeria and Egypt (since the mid-1980s)—experienced low growth initially, and, as a result, subsequently cut down on their real investment. This, in turn, given the effect of investment on future growth, tended to perpetuate continued economic stagnation and required a significant policy response to restore the momentum toward a high-growth, high-investment path. To varying degrees, the remaining countries in Group III exhibited more favorable results, including a combination of substantial growth in both output and investment—for example, as occurred in Tunisia starting in 1989 and in Israel starting in 1990; Jordan had a similar turnaround in 1992.

Policy Implications

The disappointing investment performance for the region as a whole and the distinctions among country grouping discussed above underscore the challenge facing policymakers in the MENA region: to implement a set of policies that would move the economies into a virtuous cycle of higher investment and higher growth. The central question then becomes what policies are needed to facilitate such a movement.

Policies needed to sustain a virtuous cycle

Four key factors appear to be crucial for improving MENA’s investment performance: maintaining stable macroeconomic conditions; accelerating structural reforms; investing effectively in the social sectors; and strengthening the institutional base. The continued improvement in the overall sociopolitical regional environment that would result from progress in establishing a just, durable, and comprehensive peace in the region—and the concurrent reduction in country risk—would facilitate the process.

Macroeconomic Factors

Macroeconomic instability has been shown to undermine investment. It is encouraging that significant progress has been made in MENA countries in recent years to reduce financial instability (see El-Erian and others, 1996; and Shafik and others, 1995). Inflation rates have fallen, and international reserve losses have been either contained or reversed. These developments primarily reflect the progress that has been made in reducing fiscal deficits.

Budget consolidation will improve the macroeconomic environment

Within the MENA, countries demonstrating a faster investment response, together with a sustained growth in output, have recorded better overall macroeconomic results compared with the other countries. Their inflation rates, while still high by industrial country standards, have declined faster, and their current account deficits (relative to GDP) have been lower. Behind these factors is a more pronounced adjustment in fiscal imbalances.

The macroeconomic challenge is far from over, however. The region’s fiscal balance remains vulnerable to prospects for oil prices. In addition, several of the countries are negotiating or have concluded Association Agreements with the European Union, the free trade component of which will lead to reduced receipts from tariff and other trade taxation.

The required continuation of the budget consolidation effort will entail further fiscal reform. While the extent of the challenge varies from country to country, most would benefit from a broadening of the base of taxation on income and consumption and in a rationalization of spending (including a shift away from nonproductive outlays and toward investment in basic social services).

The pursuit of an appropriate monetary policy also has an important role to play in improving the mobilization and allocation of resources in favor of private sector growth and in helping to maintain a stable, noninflationary macroeconomic environment that is conducive to foreign and domestic investment.

Structural Reforms

Structural reforms and deregulation—in the real sector, in external trade, and in the financial sector—are also key to supporting efforts to improve MENA’s investment performance.

Real sector and external trade. By enhancing the return to private sector investment activities, deregulation and other structural reforms facilitate the transition to a higher-growth path. In the case of the GCC countries, where the government accounts for a considerable portion of aggregate demand spending and employment, reforms will also dampen the contractionary impact of fiscal restraint on non-oil activities (Sassanpour, 1996; and Chalk and others, forthcoming). In the GCC countries, the main issues are the reform of the labor markets, privatization and deregulation, and relaxing further the limits on foreign investment participation.

The non-GCC countries are faced with the need for trade liberalization, in addition to the challenges of deregulation and privatization. These countries stand out internationally in terms of high statutory tariff rates and widespread nontariff barriers. As a result, the region remains weakly integrated in the global economy through trade, with adverse spillover effects on foreign investment linkages.

It is now widely accepted that greater openness strengthens the sustainability of a high growth path (Sachs and Warner, 1995). In addition to the well-known (static and dynamic) gains, greater openness promotes domestic competition, contributes to capital accumulation that is more inclined to more efficient tradable activities, and provides for a faster upgrading of the capital stock.

In this context, it is not surprising that the “virtuous cycle” MENA economies exhibiting a faster investment response and higher growth are relatively more integrated in the global economy. Their ratio of total trade to GDP is larger than that of many other countries in the region; moreover, they either have already achieved low average tariff rates or are committing (in the context of regional or international agreements) to schedules of declining tariffs. These countries have also been more successful in attracting foreign direct and portfolio investments.

Financial sector reform is needed to mobilize savings

In view of these considerations, it is encouraging that structural reforms have picked up in the MENA region. Privatizations have intensified in both oil exporting and non-oil economies and have been accompanied by steps aimed at regulatory reform, including the opening up of certain sectors previously reserved for the public sector. A trend toward greater trade liberalization in non-GCC countries (for instance, in Egypt, Jordan, Morocco, and Tunisia) is also evident. For many countries in the region, the Association Agreements with the European Union have the potential to serve as a stepping stone to move toward greater multilateral liberalization (Nsouli and others, 1996; and Havrylyshyn, forthcoming).

Financial sector. A well-functioning system of financial intermediation can both facilitate the implementation of structural reforms and enhance the return from such reforms. Such a system increases the mobilization of savings from domestic and foreign sources and contributes to a more efficient allocation of loanable funds. In this context, a number of MENA countries have recently implemented financial sector reforms, both in the banking sector and in capital markets (Bisat, 1996).

As MENA countries press ahead with reform, early emphasis will continue to be placed on competition-enhancing measures and the removal of administrative restrictions—thereby further reducing market segmentation and oligopolistic market structures—as well as improving the legal and regulatory frameworks. Such measures are necessary because financial markets and monetary policy face difficult constraints if a large group of financial institutions have sizable nonperforming loans and face persistent cash flow problems. Although a number of MENA countries have adopted strict prudential and supervision standards, others may need to do more in this regard. In addition, while the de jure adoption of regulations and legal provisions is essential, MENA countries would also need to ensure strong institutional capacity for proper enforcement of these regulations.

Financial reform tends to cause substantial changes in the behavior of monetary aggregates—those would need to be carefully integrated into financial policies or else risk macroeconomic instability. Capital markets would need to evolve in conjunction with indirect monetary policy instruments, and would be invigorated by, as well as facilitate the acceleration of, the privatization process.

Raise the efficiency of social sector spending

Social Sectors

The experience of the high-investment, rapidly growing East Asian countries illustrates the importance of investing in people, as do the numerous studies on the return to education and health spending (World Bank, 1993 and 1994). The returns from investing in primary health and primary and secondary education are particularly high, as these are important determinants of factor productivity. Similarly, investing in female education has also been shown to have high returns in contributing to better family health and lower population growth. Emphasis on these factors complements the effectiveness of social safety nets needed to protect the most vulnerable groups of the population, particularly during the transition period.

MENA countries as a group spend more public resources on education and health in terms of GDP than any other developing country region (Shafik, 1994). Yet the outcome in terms of human resource development has been disappointing because of (1) composition issues (for example, too large a share is devoted to higher education compared with primary education); (2) weak delivery systems; and (3) inadequate incentives to maximize the returns from investments in human capital (mainly labor market distortions).

The challenge for the MENA countries therefore is not only to maintain a high level of spending on social sectors, but also to improve the return from a given dollar of investment in the region. Going back to the earlier quantitative analysis of investment performance in MENA, policymakers can draw comfort from the strong link between investment in human capital and the investment responsiveness. In particular, evidence points to a strong relationship between the individual country’s investment responsiveness, on the one hand, and the rate of illiteracy among school age children, the extent of school enrollment, and the pupil-teacher ratio, on the other hand.

Institutions

There is now no doubt that institutions matter a great deal—whether in the process of economic development or in maintaining a continued strong economic and financial position. Accordingly, progress on the macroeconomic and structural reform fronts will need to be accompanied by a further strengthening of institutional mechanisms.

Institutional mechanisms need to be strengthened

International experience points to a number of important criteria when implementing institutional reform. First, the process should be consistent with the more general regulatory reform being pursued in the economies of the region. This includes the need to strengthen agencies responsible for enforcing antitrust, property rights, and prudential regulations. Second, it is essential to have improved coordination between the various economic and financial authorities with an eye to strengthening the monitoring of economic developments within an overall macroeconomic framework. Third, institutions should be commercially oriented and their activities transparent, predictable, and sheltered—to the extent possible—from the political process. Finally, attention should be paid to the timely dissemination to markets (both domestic and international) of economic and financial information to help prevent market failures arising from incomplete information.

Regional institutions—existing and new ones—and regional initiatives will also play an important role. In this regard, much attention is being devoted these days to the Association Agreements with the European Union and the establishment of a new Middle East Development Bank. As noted earlier, the former can serve as a catalyst for reform and can provide an anchor for the economies of the region—albeit with risks that need to be minimized. The latter offers a channel for improving policy coordination in the region and supporting welfare-enhancing regional projects.

Concluding Remarks

MENA policymakers have rightly identified growth as the economic policy priority. Sustained high growth constitutes a necessary condition for reducing unemployment, generating jobs for the increasing number of entrants into the labor force, and improving citizens’ welfare.

To meet the growth challenge, MENA must improve its investment performance—by investing more and increasing the return from a given dollar of investment spending. Unlike past development strategies, the process must be led by the private sector with the public sector playing a supportive role in providing an enabling environment, addressing market failures, and investing in basic social sectors and key infrastructure.

Theory and empirical evidence demonstrate that factors that stimulate higher domestic investment also result in larger foreign direct investment and, more generally, in a better ability to benefit from the changes in regional and international environments. The investment experience of MENA countries provides further support for the findings of the literature. The experience differs within MENA countries. Economies facing severe conflicts and dislocation have tended to invest little and possessed an unresponsive investment function. The end of hostilities in most such countries should serve as an opportunity for the governments to implement policies necessary for improving investment responsiveness. At the other extreme, some MENA economies are already on a virtuous path, having acquired a track record of economic growth that is coupled with a responsive investment function, thus promising sustainable high growth. In between the two extremes lie most of the MENA countries that need to increase the share of their output devoted to investment and its efficiency.

Growth should be private sector driven

MENA countries’ investment performance is positively linked to strengthening macroeconomic balances, implementing structural reforms, emphasizing the social sectors, and strengthening institutions. With timely policy actions on these fronts, MENA can look forward to higher and more efficient investment, thereby strengthening the basis for rapid and sustained economic development.

Abstract