Public Investment and Fiscal Policy: Lessons from the Pilot Country Studies Gerd Schwartz Expenditure Policy Division Fiscal Affairs Department International Monetary Fund April 25, 2005

Outline of the Presentation  Overall Background  The Pilot Country Studies  Infrastructure Spending, Public Investment and Growth  Analytical Framework  Increasing Private Investment in Infrastructure  Increasing Public Investment in Infrastructure  Improving Investment Planning  Public-Private Partnerships (PPPs)  Background  Institutional Development  Limiting Fiscal Risk  Disclosing Fiscal Risk

Overall Background  Public investment had been in decline. Public investment as a share of GDP has declined over the last three decades in many countries, not only in Latin America.  Why? Neither causes nor consequences of this decline are fully understood.  Has private investment made up for the decline in public investment? The decline in public investment has only partially been offset by private investment. Infrastructure bottlenecks have emerged in some countries.  Why not just increase public investment? Some Latin American and European governments have argued that fiscal constraints should be relaxed to accommodate additional borrowing for infrastructure projects, as these productive assets will pay for themselves over time.

Overall Background  These various issues were initially addressed in 2004 in two IMF Board papers that proposed a new framework for looking at issues related to public investment. The papers:  analyzed options for accommodating in fiscal targets increased public investment in infrastructure, while safeguarding macroeconomic stability and debt sustainability;  discussed criteria under which the operations of commercially run public enterprises (PEs) could be excluded from the coverage of fiscal indicators and targets;  reviewed fiscal issues related to PPPs, specifically fiscal risks (that may result from guarantees and other contingent liabilities).

The Pilot Country Studies  The proposed new framework was recently applied in eight pilot countries that had volunteered to participate in the exercise: Brazil, Chile, Colombia, Ethiopia, Ghana, India, Jordan, and Peru.  The pilot studies covered the whole range of issues raised in the 2004 Board papers, except for the study on Chile, which focused on PPPs.  IMF missions were carried out in the second half of Most missions included World Bank staff, and, in the case of Latin American countries, also staff from the Inter- American Development Bank.

Infrastructure Spending, Public Investment and Growth What is the situation in the pilot countries?  Public infrastructure investment and rehabilitation needs appear sizeable in most pilot study countries, but they are difficult to quantify. The available approaches in the literature offer little guidance, also because they ignore financing constraints.  A better approach is to look at infrastructure bottlenecks, i.e., the most urgent investment needs. Such bottlenecks differ from country to country. In general, infrastructure bottlenecks seem most acute in the road transport sector, but they are also present in the ports, energy, telecommunications, and water and sanitation sectors.  In most of the pilot countries, there also appears to be a clear need to improve the quality and efficiency of public investment.

Infrastructure Spending, Public Investment and Growth What are causes and consequences of the decline in public investment? In general:  Causes: Probably many, including fiscal adjustment that has made policies more sustainable. However, public investment levels from years ago offer little guidance as to the resources needed to address today’s infrastructure bottlenecks and investment needs.  Consequences: Overall, the available literature finds mixed evidence on the relationship between public investment and growth. Still, sustained changes in public investment can be expected to affect economic growth over time.

Infrastructure Spending, Public Investment and Growth More specifically:  Causes—the decline of public investment may reflect different factors:  fiscal consolidation (fiscal accounts and macro-fiscal frameworks are now more sustainable than they were years ago);  a decline in public saving (e.g., through increased current spending);  the completion of major public infrastructure investments (major networks are in place now);  a stronger preference for a smaller public sector has gone hand-in-hand with an increase in the private sector’s ability to handle large investment projects.

Infrastructure Spending, Public Investment and Growth  Consequences—unclear!  The pilot studies were unable to determine to what extent growth may have been adversely affected by declining public investment (as compared to other important factors, like weak legal/institutional frameworks).  The pilot studies found evidence of other potential bottlenecks to growth, such as various institutional and regulatory impediments to private investment.  Conclusion: need to understand better both causes and consequences. More rigorous studies are needed.

Analytical Framework: Increasing Private Investment in Infrastructure Has private investment picked up? Yes, but not enough!  The pilot studies found that better and stronger legal and institutional frameworks generally coincide with higher levels of private investment.  Increasing private sector involvement in the provision of infrastructure requires a framework that helps private investment to flourish. Notwithstanding potentially high returns, the private sector may decide not to step in unless key policy decisions have been taken, and legal and institutional frameworks are securely in place.  Reduce private sector investment risks: Good regulations, application of the rule of law, property rights, and enforceable contracts are key elements for improving the investment climate and thereby fostering private investment and economic growth.

Analytical Framework: Increasing Public Investment in Infrastructure What can be done to boost public investment?  In any given country, the scope for sustained increases in public investment depends crucially on the prospects for macroeconomic and debt sustainability.  Policy options for significantly increasing spending on public infrastructure by relaxing overall fiscal balance targets are limited, particularly in countries with relatively high levels of public debt and significant vulnerabilities to macroeconomic shocks.  The pilot studies confirmed that, where this is the case, increases in public investment need to be accompanied by increases in public saving. This will require reprioritizing expenditure toward investment within a given expenditure envelope (i.e., by reducing current spending), and, where appropriate, mobilizing revenue.

Analytical Framework: Increasing Public Investment in Infrastructure  Governments seeking to increase public investment by more than public saving should take particular care to safeguard fiscal sustainability. In particular:  Increases in public investment should be consistent with a sustainable debt-to-GDP ratio and be focused on high- priority and high-return projects in bottleneck sectors.  Governments will need to have in place good procedures to evaluate, prioritize, and monitor investments. Cost- benefit analyses usually suggest that it is preferable first to invest in the rehabilitation and maintenance of existing infrastructure before starting new projects.  Recurrent O&M costs of completed infrastructure should be taken account in the decision-making process.  Complementarities between infrastructure and non- infrastructure investment need to be taken into account.

Analytical Framework: Increasing Public Investment in Infrastructure  The considerations above also underscore the need to continue to focus on comprehensive fiscal indicators (e.g., overall fiscal balance or primary balance).  Additional room for public infrastructure spending cannot be created by changes in fiscal accounting. Specifically, methodological changes to the measurement of fiscal targets or outcomes, and/or to exclude expenditures from the fiscal balance, cannot create room for additional spending while safeguarding macroeconomic stability and fiscal sustainability.  Still, a complementary focus on the current fiscal balance may help improve the quality of a country’s fiscal policy.

Analytical Framework: Improving Investment Planning  In most pilot countries there is significant scope to increase the efficiency and quality of public infrastructure spending:  Strengthen investment planning and project evaluation (e.g., CBA). Establish mechanisms to closely monitor projects under execution and evaluate them ex-post.  Even in countries with a long-standing tradition of public investment planning, inadequate priority is often given to the O&M, and rehabilitation of existing infrastructure.  “Bottom-up” sectoral planning approach should be accompanied by a strong oversight agency that screens and further prioritizes proposed projects.  In many (low-income) countries that have significant grant funds available, it is important to strengthen domestic mechanisms for investment planning.

PPPs: Background Are PPPs the answer to declining public investment?  To a limited extent. Well-structured and implemented PPPs offer prospects for sizeable efficiency gains. Overall, however, PPPs are a limited avenue to increase overall infrastructure investment.  But. It is important to ensure that PPPs are carried out for the right reasons rather than driven by desires to move expenditure off budget and debt off the government balance sheet.

PPPs: Institutional Development  Governments should give priority to strengthening the institutional framework related to PPPs, including the legal framework as well as their own analytical and managerial capacities:  The legal framework for handling PPPs needs to be strengthened so that it comprehensively covers all aspects of the PPP process.  The decision to opt for a PPP instead of a direct public investment has to be well informed, evaluating whether a given project is worthwhile economically & financially. Public sector comparators should be developed.  Governments also need to strengthen their capacities to manage PPPs (e.g., by setting up PPP units).

PPPs: Limiting Fiscal Risks Limiting fiscal risk from PPPs:  Limit what to use PPPs for. PPPs may not be ideal for all types of investment. Country experiences suggest that PPPs are best suited for economic infrastructure.  Do the math. Proper valuation is the key to assessing the fiscal risks posed by PPP-related (implicit or explicit) government guarantees. Monitor projects closely.  Distribute the burden. Risks should be borne by the party that can manage it best: construction & operating risk is typically borne by the private sector.  Tie your hands. Consider capping the overall size of obligations that governments can assume under PPPs.

 Disclose information on PPPs in budget documents and end-year financial reports and make complete signed PPP contracts publicly available. In particular, disclose:  A summary of key contract parameters;  Any preferential financing for PPPs from public sources.  How specific PPPs affect fiscal balances and public debt, incl. known future payments/receipts and expected contingent liabilities falling due, and take these into account for the purpose of DSA.  If PPP assets are accounted for in public or private sector balance sheets; indicate off-balance sheet items. PPPs: Disclosing Fiscal Risks