• 14 Jun 21
  • Posted by Gurara, Daniel , Kpodar, Roland Kangni , Presbitero, Andrea F. , Tessema, Dawit

Public investment for growth: a country’s absorptive capacity is key

How can governments make use of public investment in infrastructure to promote growth without experiencing huge cost over-runs or a focus on prestige projects with limited social value? This column reports evidence that project unit costs increase when public investment levels are too high, especially during investment booms and when investment efficiency is low. These findings call for a gradual scaling-up of public investment consistent with a country’s absorptive capacity. Strengthening the institutions that manage public investment is critical to reap the greatest return from any additional dollar of infrastructure spending.

Public investment is critical to build and maintain physical infrastructure, to increase productivity, and to promote long-term economic growth. The case for public investment is even stronger now in the wake of the global pandemic. According to International Monetary Fund estimates, every 1% GDP increase in public investment could expand the GDP by 2.7%, creating jobs and supporting faster economic recovery from Covid-19.

But historical experience indicates that sharp accelerations in public investment have often fallen short of expectations. While there is evidence that public capital can indeed contribute to growth, especially in the case of infrastructure investment, analysis of past episodes suggests a certain degree of skepticism about the real effect of scaling up public investment on output growth.

For example, there is no dearth of anecdotes about bridges and roads to nowhere. A more systematic look at evidence on past public investment booms reveals that they ended with higher public debts and little or no long-run growth dividends. Consistent with this result and with the presence of absorptive capacity constraints, evidence based on project-level data shows that projects’ outcomes worsen in periods of public investment scaling-up.

The notion of absorptive capacity is related to technical capacity, waste and leakage of resources in the investment process – all of which affect project selection, management, and implementation constraints. Absorptive capacity embeds the idea of declining marginal returns, but also stresses the role that binding supply bottlenecks can have on rates of return on public investment in the short run, when the skills, institutions, and management required to reap the benefit of additional investment cannot be expanded.

Development practitioners consider technical skills, administrative and organizational capacity, government effectiveness, and the political environment as the main drivers of absorptive capacity.

While this body of research – as well as anecdotal evidence – suggests weak real economy effects of public investment booms, mostly because of a variety of inefficiencies related to public investment spending, not much is said about the actual mechanisms that can weaken the responsiveness of output to public investment during a boom.

In a recent study, we argue that one potential mechanism behind the limited economic returns of large public investment episodes could be rapid cost inflation – a situation in which project unit costs increase sharply because of rising marginal costs of public investment management. ​​As public investment programs grow, so does the marginal cost of managing them, because of the shortage of skills and tighter construction markets and supply constraints, among other factors.

Weaknesses in the institutional framework to manage public investment manifest themselves in payment delays to contractors, contract cancellations, and design changes and renegotiations. Project-level data across several continents show that cost over-runs are very common. Widely cited estimates, for example, report that 86% of projects have over-runs, with actual costs exceeding estimated costs by an average of 28%.

Figure 1 provides an example of a sharp acceleration of public investment in Vietnam, which led to a rapid expansion in the stock of infrastructure. The inefficiencies resulting from such surges in public investment can lead to critical weaknesses. A study of ​Vietnam’s infrastructure constraints​ notes that the ‘apparent inability of heavy investment to solve infrastructure constraints is explained by the fact that a disproportionate number of infrastructure projects, particularly those in the transport sector, are economically non-viable but approved under political pressure with inflated costs’.

Figure 1: Public investment surge episodes in Vietnam

Notes: The chart plots the sharp acceleration of public investment in Vietnam. Data are from the Investment and Capital Stock Dataset, published by the International Monetary Fund (2015, 2019​).

In addition, the broad set of technical and managerial resources required to implement several investment projects, which often cannot be expanded in the short run, could lead not only to cost inflation, but also to delays in project implementation and completion. For example, recent analysis shows that notwithstanding the prevalence of delays across countries (about 60% of projects are delayed by at least one year), delays are more pronounced in countries with weaker institutions and in periods of public investment scaling-up.

In our analysis, we zoom in on the relationship between public investment and the unit costs of road construction, using project-level data for more than 3,300 road construction projects undertaken in a large sample of countries. In this way, we can estimate the association between the size and speed of public investment scaling-up and the unit costs of roadworks.

We focus on road infrastructure as it is a key component of infrastructure spending, and it is critical to reducing trade costs and promoting development, structural transformation, and urbanization.

Three main results stand out:

First, there is a U-shaped relationship between public investment and project unit costs, with an inflection point close to 10% of GDP, suggesting rising marginal costs of governance associated with increasing public investment levels. This result holds after controlling for a wide range of project characteristics, geographical features, financing instruments, and other factors that may drive project costs.

Second, cost inflation kicks in at different public investment levels, depending on a country’s public investment efficiency – a proxy for the quality of public investment management. In particular, for low-efficiency countries, unit costs start increasing when public investment is above 7% of GDP, while for high-efficiency countries, this threshold is at 10% of GDP. These results are economically meaningful, given that over the period from 2013 to 2015, average public investment was above 7% of GDP in 32% of developing countries, and above 10% of GDP in 15% of developing countries.

Third, unit costs rise sharply during investment booms. For example, scaling up public investment from 8% to 15% of GDP is associated with a 38% increase in unit costs in low-efficiency countries vis-á-vis only a 3% increase in high-efficiency countries.

Our analysis points to the existence of a minimum efficient scale for public investment management. Investment portfolio mixes are particularly inefficient when investment programs are small. Such programs are likely to target portfolios dominated by ‘prestige projects’ with limited social value and comparatively higher unit costs.

As programs and investment portfolios expand, the mix and availability of projects is more balanced, including both affordable and sustainable projects. These changes are likely to lower unit costs. But as investment budgets expand further, the marginal cost of governance rises, as appraisal capacity does not grow at the same pace as the size, number and specificity of the projects.

The policy implications of these findings call for a gradual scaling-up of public investment consistent with a country’s absorptive capacity. Strengthening public investment management institutions is critical to reap the greatest return from any additional dollar of public infrastructure spending.

Reform priorities include implementing well-designed project selection and prioritization criteria, setting up a robust project appraisal process, improving the credibility of multi-year budgeting, developing an effective framework to manage the risks involved in public-private partnerships, strengthening project management, and ensuring that national and sector plans can effectively guide public investment decisions.

 

Authors:

Daniel Gurara is an Economist at the Strategy, Policy, and Review Department of the IMF. His research interest falls broadly under applied macro and microeconomics. 

Roland Kangni Kpodar is currently Deputy Division Chief in the Strategy, Policy and Review Department at the International Monetary Fund (IMF), Washington DC, USA. He is also Senior Fellow at the FERDI, Clermont-Ferrand, France.

Andrea F. Presbitero is an Economist at the IMF Research Department. Before joining the Fund, he was Assistant Professor at the Universita' Politecnica delle Marche (Italy) and served as a consultant for the World Bank, the Inter-American Development Bank, UNCTAD, and the IMF on a number of projects.

Dawit Tessema is an Economist at the IMF’s Strategy, Policy & Review Department. His work focuses on the macroeconomic implications of public investment scaling up. 

 

Authors’ note: The views expressed here are those of the authors and do not necessarily represent those of the institution with which they are affiliated.