FISCAL POLICY AND PRIVATE INVESTMENT IN AFRICA A TEST OF THE CROWDING-OUT HYPOTHESIS

ABSTRACT

This  study  probes  the  effectiveness  of  fiscal  spending  in  the  context  of  crowding  out/in hypothesis  for Sub-Saharan  Africa,  using  annual  panel  data  for the  period  2000 –  2011 obtained from the World Bank online data bank for forty six countries in the region. The data set were included in the model based on review of past studies and taken mainly as a ratio to GDP to minimize the problem of heteroscedasticity. The fixed effects model was applied based on  the  specification  tests.  The  panel  output  indicates  that  private  investment  is positively responsive  to  fiscal  policy  measures-  though  minimally,  hence  increases  in  government spending  are  found  to  crowd  in  private   investment  in  all  the  countries  selected  both individually  and on the average.  Variables like real exchange  rate and value of total debt servicing as a ratio of GDP have positive significant effect on private investment in the region. While the value of total external debt as ratios of GDP and real interest rate have significant negative effect on private investment. The study also finds that real per capita income growth has positive significant effect on private investment with random effects model only, whereas domestic  credit  to  the  private  sector  appeared  insignificant  and  negative.  Other  macro variables  such  as inflation,  real per capita  GDP and real per capita  income  growth,  are statistically insignificant  in affecting  the behaviour of private investment  in the  region. The study  therefore  recommends,  among  other  things,  a  strengthened  proactive  regional  fiscal policy agenda – with no room for half measures- aimed at stimulating private investment as well as ensuring a stable, predictable and healthy macroeconomic environment. Also, efficient and  effective  public-private  strategies  will  reduce  information  asymmetries  between  both sectors on investment related policies and pave the way, all other things being equal, for the much desired economic transformation of the sub-region.

CHAPTER ONE INTRODUCTION

The economic problems of third world countries are not, in their totality, uniform. But their basic characteristics  transcend  the boundaries  of individual countries (Ray, 1983). These  problems according to Jhingan (2005) are the problems of a fundamental disequilibrium of the economy, with the attendant  features of stilted  economic  growth, an adverse  balance  of payment,  low capital formation, unequal distribution of income, price level instability, severe unemployment among  others.  The African  continent  is worst  hit by  underdevelopment,  while  Sub-Saharan Africa is generally described as the poorest region of the world; one that is getting poorer in the face of sustained growth and significant improvement of living standards in the rest of the world (Todaro and Smith, 2006; Bayraktar and Fofack, 2007). Virtually all countries in the region have been  confronted  with  deep-rooted  developmental  constraints:  rapid  population  growth,  low physical and human capital development, and inadequate infrastructure. These and other similar economic  problems have constituted major impediments to private sector development and to their economies in general. In addition, ethnic conflicts, political instability, and adverse security conditions have aggravated the economic performance of several countries in the region. These all have been putting huge obstacles to the capital formation in the subcontinent- one of the very crucial factors of production for the progress of economies (Chhibber and Dailami, 1990; Sima

2007)

Private  investment  is  essential  for  ensuring  economic  growth,  sustainable  development  and poverty reduction. It increases the productive capacity of an economy, drives job creation, brings innovation and new technologies, and boosts growth. Private investment plays an important role in  developing  nations  for  the  same  reason  that  it  does  in  industrial  countries:  investment determines the rate of accumulations of physical capital and is thus an important factor in the growth of productive capacity (Agenor and Montiel ,1996). However, the amount of physical capital in general and private investment in particular falls short of development needs in these countries  especially  African  nations.  Several  studies,  such  as  Mlambo  & Oshikoya  (2001), Anyanwu (2006),Bayraktar  & Fofack (2007), Douglas and Quentin (2007) and Bakare (2011) show that the contributions to growth of physical capital and total factor productivity in Sub- Saharan Africa (SSA) have been low and have declined over time.

In economic  growth  literature,  neoclassical  growth models  such as Solow (1956)  and  Swan (1956) postulate that economic policies do not affect steady state economic growth,  although they can affect the level of output or its growth rate when the economy is in transition from one steady state to another; while in endogenous growth models some fiscal policy instruments are harmful for growth while others are not (Barro, 1990; Lucas 1990). However, these days it is believed that macroeconomic policies may affect economic growth either directly through their effect on the accumulation of factors of production, namely capital, or indirectly through their impact on the efficiency with which factors of production are used. Macroeconomic  stability (reflected in low and stable inflation, sustainable budget deficits, and appropriate exchange rates) sends important signals to the  private sector about the direction of economic policies and the credibility of the  authorities  regarding their commitment  to manage  the economy efficiently. Such stability, by facilitating long-term planning and investment decisions, encourages savings and private capital accumulation (Ghura & Hadjimichael, 1995).

Specifically,  endogenous  growth  models  have shown  that  fiscal  policy can  have  significant effects on economic growth in the long run. For example, in a model that  assumes constant returns to scale with respect to government inputs and private capital combined but diminishing returns with respect to private capital alone, Barro (1989 and 1990) has shown that high levels of government  taxation  distort savings decisions,  which  in turn lower  economic  growth  in the steady state.  Fiscal  policy can  foster  growth  and  human  development  through  a number  of different  channels.  These  channels  include  the  macroeconomic  (for  example,  through  the influence  of  the  public  investment,  as  a  catalyst,  on  private  investment)  as  well  as  the microeconomic (through its influence on the efficiency of resource use) channels.

Since 1980s, extensive efforts have been directed at generating economic recovery in  Africa through the Structural Adjustment Program (SAP) and other similar programmes. However, little (or only recently) attention has been given to the need to promote private investment, although investment is essential in any country for a number of economic reasons (Arin, 2004).  Policy makers have not tended to give much practical attention to the link between private investment and socio-economic  progress (Atukeren, 2010). The  Structural Adjustment Programme of the World Bank (WB) and the International Monetary Fund (IMF), aiming to address the problem of poverty and declining  private  investment,  emphasize  the need  to reduce government  budget deficits;  Hermes  and Lensink,  (2001)  stressed  that  these  bodies assume  that  reducing  fiscal

deficits  is  beneficial  for  the  long-run  growth  process,  no  matter  how  such  a  reduction  is achieved.

Fig 1.1 Sub-Saharan Africa Government Final Consumption Expenditure Annual % Growth

The investigation on the effectiveness of fiscal spending in Africa is essential in the  decision making process. This is because government spending has been on the increase since the turn of the millennium, especially during the peak of the global economic crisis which witnessed the region increase expenditure from 5.47% in 2008 to 23.29% in 2010 while the developed world were battling with public spending cuts (see fig 1.1) and most governments in the continent have been running a budget deficit for more than a decade (Motlaleng, Nangula and Moffat, 2011). According to the WB and the IMF, reducing the role of the government would reduce barriers to the economic endeavours and ginger private initiative and intervention. Despite these efforts, the continent’s poor economic performance has been persistent due to, among others things, the low levels of private  investment  as the  share of GDP in the subcontinent  (Alfredo, 2006; Udah,

2010). This opens a door for suspicion of those policies formulated by these two organizations. However, there is a need to emphasize that the aim of this study is not to  attest whether the public policies designed by the WB and/ or the IMF, particularly for the developing world, such as  the  SSA  region,  are  correct  or  not.  Rather,  the  study  will  focus  on  investigating  the effectiveness of fiscal policy measures in enhancing the performance of private investment in the region.

The association between public investment spending and private investment is a controversy in the  realms  of  macroeconomics  and  public  policy  making  that  has  strong  implications  for determining the government policy to promote economic growth (Kollamparambil and Nicolaou,

2011). On the one hand, increased government  involvement  in the economy (mainly through expenditure  activities)  might distort the economic  and political environment  of  business  and discourage or crowd-out private sector investment. On the other hand,  government protective and productive investments in physical, legal, and human capital infrastructure might crowd-in

private sector investments (Atukeren, 2010). It is thus vital to establish whether efforts  being made by the governments of African nations, with regard to their investment contributions, are thwarting or fostering the private sector’s incentive to invest.  Ascertaining such a relationship between these two key elements is imperative for economic growth-oriented public policy in the region.

1.2      Statement of the Problem

Private investment is a powerful catalyst for innovation, economic growth and poverty reduction (Todaro and Smith, 2006). Chhibber and Dailami (1990), Oshikoya (1994), Ndikumana (2005) and Bakare (2011) particularly stress that the importance of private domestic investment to the growth and development  strategy of developing  countries  is  emerging  with particular  clarity from the convergence of two strands of empirical concerns. One is the evidence that in almost all these countries, domestic investment has borne the brunt of the aggregate demand contraction associated with the process of external adjustment. The second, which derives partly from the first, is the growing agreement on  the desirability of increasing private sector’s share in total capital formation through increased reliance on market forces and incentives.

In addition to its documented  contribution to growth, private investment in the case of Africa deserves  serious  attention  for  three  additional  reasons.  First,  sustained  increase  in  private investment serves as a visible proof of the private sector’s confidence in public policy both in the sense that policy is heading in the right direction and that policy reforms are deemed sustainable in the long run (Ndikumana, 2005) Achieving the growth rates needed to alleviate poverty and raise  employment  will  require  active  participation  of  private  investors.  Second,  sustained increase in private investment is a sign of efficiency of public investment especially in reducing the costs of private investment, thus raising profitability (Motlaleng, Nangula and Moffat, 2011). Third, sustained improvement  in private investment serves as a medium for attracting foreign direct  investment  as  it  is  an  indicator  of  high  returns  to  investment  and  declining  risk  of investment in the country (Caballero and Krishnamurthy, 2004).

However, attention given to promote domestic investment in Africa is rather below par relative to other regions of the world (United Nations Economic  Commission  for Africa  1995; IMF,

2009).   The rate of return on both capital and labour and the overall productivity of the Sub- Saharan  African  economies  remain  low  because  of a variety  of distortions  and  institutional deficiencies (Sima, 2007). The problems according to Udah (2010) and Jecheche (2011) include obstacles to international trade, overvalued exchange rate, poor infrastructure, bad governance &

corruption,  insufficient  competition  & monopolistic  structures  in many of the sectors.  It  has always been argued, in one way or another, that all of these problems are related to the policies formulated in these countries.

Anyone concerned about SSA’s dismal growth performance over the past three decades cannot help  noticing  that private  investment,  too, was significantly  lower  as well; such  that Africa invested 9.6% of GDP while the ratio of other regions was above 15.6% (Devarajan, Easterly and  Pack,  2001).  During  the  late  1970s  and  1980s,  many  African  countries  experienced  a profound  slowdown in economic growth. Oshikoya (1994)  adduced that a widely recognised reason  was  that  gross  private  investment  fell  substantially  in Africa  during  the  period  and remained severely depressed for the rest of the decade across the region. He further stated that the proportion of total private investment to GDP fell from 20.8% per year during 1973 – 80 to

16.1% per year during 1980 – 89. In some African countries, private investment has fallen to less than 10% of GDP – a level that is insufficient even to replace depreciated capital (OECD, 2006). Much more investment  is needed  in the continent  in order to achieve  significant  success  in meeting the millennium development goals, the minimum private  investment needed to attain this is estimated at between 25% – 30% of GDP (IMF, 2009; Atukeren, 2010).

The impact of government spending on private spending constitutes one of the central issues in empirical  and policy debates  (which Africa  is not left out).  Empirical  evidence  reveals  that investments  of  the  public  sector  exert  mixed  effects  on  the  private  sector,  such  that  the relationship  between  the  two  types  of  investments  is  either  complementary or  substitutive. Literature  from  previous  studies  offer  inconsistent   conclusions  on  the  impact  of  public investment on private investment in developing economies, with some studies suggesting that public   investment   stimulates   private    investment   (Jecheche   (2011),   Atukeren   (2010), Kollamparambil   and  Nicolaou   (2010),   Hermes  and  Lensink  (2001),  Ndikumana  (2005), Bogunjoko  (1998),  Ghura  and  Godwin  (2000),  Alfredo  (2005)  and Motlaleng,  Nangula  and Moffat (2011)) and others suggesting that public investment crowds out private investment (for example Martin and Wasom (1992), Anyanwu (1997), Badawi (2000), Muyambiri et al (2010), Fan and  Saurkar (2007), Everhart and Mariusz (2001), Devarajan, Easterly and Pack (2001), and Ogbole, Amadi and Essi (2011)). The literature on the impact of public investment in developing economies  thus  gives  conflicting  results  on whether  it  complements  or  crowds  out  private investment.

In addition, most studies mentioned are country specific, covering individual countries in Africa ((Jecheche (2011), Kollamparambil and Nicolaou (2010), Ndikumana (2005), Bogunjoko (1998), Motlaleng, Nangula and Moffat (2011), Martin and Wasom (1992), Anyanwu (1997), Badawi (2000), Muyambiri et al (2010)). While others conducted  inter-regional studies of developing countries  collectively  (for  instance;  Chhibber  and  Dailami  (1990),  Fan and  Saurkar  (2007), Everhart and Mariusz (2001), Ghura and Godwin (2000), Alfredo (2005), Hermes and Lensink (2001) and Atukeren (2010). This gives room for new research contribution that studies the case of Sub-Saharan Africa strictly as it available studies looked at Africa as whole (see; Oshikoya, (1994) Devarajan, Easterly and Pack (2001) and Fosu, Getachew and Ziesemer (2012)).

Obviously,  empirically studies on public – private investment  nexus devoted to  Sub-Saharan Africa is still scanty.  The methodologies adopted in the aforementioned works are either cross- section or time-series in nature, with the exception of Bousrih and harrabi (2006), Ghura and Godwin (2000),  Everhart  and Mariusz  (2001) and Fan and Saurkar  (2007).  However,  cross- section studies cannot satisfactorily control for country-specific  effects and time series studies does not satisfactorily  control for time-specific  effects.  Apart from this, several studies were concerned with either investigating the relationship between public expenditure and growth with investment playing a secondary role.

This work will attempt to fill the above identified gaps by focusing on the Sub-Saharan Africa region and give attention to the heterogeneity of the countries in the sub- continent. It will aspire to contribute to empirical literature on the effect of fiscal policy, proxied by public investment, on the performance  of private investment  in the region using panel  data. In so doing, it will incorporate  other  previously  identified  factors  of  interest  in  order  to  indicate  the  relative importance  of the fiscal policy variable  in explaining the  behaviour  of private investment  in SSA.  Moreover,  the  mixed  results  of  previous  studies  on  private  investment  behaviour  in developing countries in general and the dearth of research output that captures the entire SSA as a unit in particular, provides a rationale  for new research contributions. This study will try to show how private investment  responds to public policies, among other things, particularly to fiscal policy changes in the sub-continent.

1.3      Research Questions

To be able to accomplish the task at hand, the study will address the following questions:

i.   Does public spending crowd-out private investment in SSA?

ii.  What  is  the  extent  to  which  macroeconomic  variables  like  inflation,  interest  rate, exchange rate, external debt and GDP growth rate affect private investment in the region?

1.4      Objectives of the study

The broad objective of this work is to examine the fiscal policy effects on private investment in Sub- Saharan African countries. In doing so, it aspires to contribute to empirical literature on the effect of fiscal policy, proxied by public spending, on the performance of private investment in the region.

In particular, the study seeks to:

I.     Ascertain if public investment crowds-out private investment in SSA.

II.      Assess the extent to which macroeconomic variables like inflation, interest rate, exchange rate, external debt and GDP growth rate affect private investment in the region.

1.5      Research Hypothesis

Based on the objectives of the study, the following null hypotheses are proposed: Ho1:     Public investment crowds-out private investment in SSA.

Ho2:     Macroeconomic variables like inflation, interest rate, exchange rate, external debt and

GDP growth rate do not significantly affect private investment in the region.

1.6      Policy Relevance of the Study

The work will be helpful in showing how country specific factors are significantly important in fiscal policy formulation to enhance private investment and hence economic progress in the sub- continent. The results to be obtained from this analysis will therefore contribute to the literature on the effects of public investments on private investment by shedding light on the dynamics between the public – private sector interactions,  understanding this relationship  would enable governments in the region to formulate policies most suited to improve private investment and much desired economic transformation. Also, since private investment decisions are influenced by a couple of  factors – including  government  spending-  the work will serve as a resource material to the private sector and aid  understanding of government fiscal actions, which in turn will determine their response to policy reforms.

Moreover, the study will also contribute to the existing literature by extending the works  of others on fiscal policy devices-  for enhancing private investment  in SSA by applying  panel econometric models. This would give policy makers in developing countries a clue  for better policy formulation, because identifying the most significant determinants of private investment

and indicating those that fall within the domain of the public policy choices will help improve effectiveness of reform measures taken by government bodies.

The work will also shed light on the relative importance of fiscal policy measures in enhancing private investment by explicitly modelling the effects of public investment and some other macro variables on private investment. This shows the alternative measures that the government bodies may take in order to accelerate the performance of private investment in the region.

1.7      Scope of the Study

The study is a macro level analysis which will involve both cross-sectional and time elements, thus the econometric analysis of private investment is to be based on a panel of 46 Sub-Saharan African countries (out of 48 countries in the region) for the period 2000 – 2011 based on the available dataset. The choice of Sub-Saharan Africa is informed by the fact that it is considered the most backward economic region of the world. The countries include

S/N	COUNTRY
1	Angola
2	Benin
3	Botswana
4	Burkina Faso
5	Burundi
6	Cameroon
7	Cape Verde
8	Central African Republic
9	Chad
10	Comoros
11	Congo, Dem. Rep.
12	Congo, Rep.
13	Cote d’Ivoire
14	Equatorial Guinea
15	Eritrea
16	Ethiopia
17	Gabon
18	Gambia, The
19	Ghana
20	Guinea
21	Guinea-Bissau
22	Kenya
23	Lesotho
24	Liberia
25	Madagascar
26	Malawi
27	Mali
28	Mauritania

29	Mauritius
30	Mozambique
31	Namibia
32	Niger
33	Nigeria
34	Rwanda
35	Sao Tome and Principe
36	Senegal
37	Seychelles
38	Sierra Leone
39	South Africa
40	Sudan
41	Swaziland
42	Tanzania
43	Togo
44	Uganda
45	Zambia
46	Zimbabwe

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