Public Investment in Developing Countries: Blessing or Curse?

 

 

 

In a previous blog one of us made the point that the increase in the share of public investment in total investment that happened in some countries in recent years could be growth deterring. The concern was (and is) the potential crowding-out effects of public investment on private investment and its negative consequences for productivity and growth.

 

The point is controversial because it is well known that the Latin American and the Caribbean region has a severe infrastructure deficit (see a great analysis on this issue by Gonzalez, Guasch and Serebrisky). Furthermore, it is well-known that public investment may have positive externalities, and thus the optimal provision of these public goods would not be achievable through the private sector decisions.

 

On normative grounds there is no clear reason why the source of total investment levels should matter. However, if there are more inefficiencies or distortions associated to the process of public investment than that of private investment, then the difference could indeed matter. It is well known that governments in many developing countries lean towards inefficient public investment or “costly prestige” public works programs (Robinson and Torvik, 2005).[2]

 

In a recent paper we test the empirical linkages between public and private investments using a consistent data set for a large sample of developing countries over almost three decades. We find a strong and robust crowding out effect, both across regions and over time.

 

We go one step further by providing evidence of the country’s characteristics that help to break-up this negative relationship. These characteristics are related to aspects of institutional quality and the access to credit and markets. Not surprisingly, these are often the main focus of the conditionality set by development banks to finance public works.

This conditionality is oftentimes criticized on the basis that it interfears with national domestic affairs. The results reported in this paper suggest that this criticism has to be qualified. In absence of the conditionality there is no guarantee that the loans would not aggravate the crowding out effect.

Public investments should ideally be focused on increasing productivity and competitiveness, searching the areas where externalities and spillover effects are significant and social returns are the highest.

 

The most important concern when it comes to infrastructure investment is project selection. Selecting projects with the greatest impact is critical; thus, it is crucial that countries set up institutions capable of doing adequate planning, cost-benefit analysis and ongoing monitoring and evaluation.

 

If, instead, the focus in on quantity rather than in quality, then it is more likely that higher levels of public investment end up having undesirable collateral effects, namely, crowding out private investment with little or even negative productivity gains for the economy. Our results seem to suggest that, on average, increases in public investment do tend to crowd out private investment.


  

(1)The views expressed are those of the authors and should not be attributed to the Inter-American Development Bank.

(2)Robinson, James and Ragnar Torvik (2005) “White Elephants”, Journal of Public Economics 89, 197 – 210.

One Response to "Public Investment in Developing Countries: Blessing or Curse?"

  1. Rachel   July 2, 2008 at 9:26 am

    Where does public/private partnership investment fit in. Is it an example of public funds crowding out private funds? Or in some cases could government involvement provide a platform for other investmentI recognize that, as you suggest, formal and informal institutions matter a lot. The results of research like yours provide potentially interesting cross-regional lessons given that globally we seem to be seeing a rise of public-led investment in emerging markets, particularly in my view in Asia, Russia and the Middle eastgreat post