A Thought on Private Investment

Fellow blogger Alex Uriarte has called our attention on the issue of the quality of investment. The focus of his posting is, understandably, on public investment as this is the variety that is currently fashionable in Latin America. Governments throughout the region have, in recent years, taken a more interventionist stance and have sought to replace the private sector as the motor and financier of investment, even in sectors like energy and transportation where the share of private participation had risen in the previous decade.

Take the case of MERCOSUR countries (Argentina, Uruguay, Paraguay, Venezuela and Brazil). This is a set of countries that was severely hit by series of negative shocks in the period 1998-2003, triggering among other things, a collapse in investment. Figure 1 makes two points: on the one hand total investment as a share of GDP has recovered since the collapse which bottomed in 2003, although it has not yet reach the pre-crises levels (right scale on the graph). On the other hand the recovery has come accompanied by a change in the composition, with a decrease in the share of private investment in the total (from 77% to 71%) and a corresponding increase in the share of public investment in the total (from 23% to 29%). These numbers are even more pronounced if we exclude Brazil, the only country of the group where the share of private investment has (slightly) increased since 1998.

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This phenomenon has many explanations. The current bonanza of public revenues in the region fostered by high commodity prices plus the cheap availability of credit has made it possible for governments to assume a more active role. Also, the “doing business” climate in the region is far from record highs and that hampers private investments (see world Bank’s “Doing Business” Report) leaving a perceivable vacuum that the governments are compelled to fill. One of the many adverse consequences of the wave of financial crises that spread throughout the region is that they sow the seeds for a growing anti-private sentiment, as “privatization”, “deregulation”, “competition” and the like, are concepts associated with the now unfairly demonized 1990’s.

The purpose of this posting is to bring the attention back to the issue of private investment. Yes, I know I might be old fashioned but I guess that some readers might have some sympathy for what I have to say. Indeed, ideally public and private investments should complement each other, so a focus on private investment might even be interesting to those that have converted to the faith of growing state interventionism.

I find the aforementioned patterns troublesome for at least a couple of reasons: (1) to the extent that public investment is financed through extraordinary revenues (i.e., booming commodity and oil prices plus very low interest rates), the question arises about what will happen if and when these sources of revenues fade-away. (2) The quality of public investment has historically been lower than private investment for the simple reason that the former is not always driven by efficiency standards. Thus, long run growth could be hurt by the current patterns.

For both of these reasons, I think the region would be well served if we focus our attention on how to make investment climate better so that new and better opportunities arise for everyone. In a next posting I will discuss the issue of the cost of financing for private firms in emerging markets.

5 Responses to "A Thought on Private Investment"

  1. Anonymous   July 25, 2007 at 11:37 am

    How much is the distinction between public and private investment relevant? Two issues on this: – Many of these Latin American countries need both private investment and more public infrastructures. – PPPs or Private Public Partnership can bridge the question of which type of investment is more important Also, why are investment rate still so low – lower than the pre-crisis period – in spite of higher growth, higher commodity prices, better terms of trade, and easier financial conditions as measured by spread and real rates? This is the main puzzle in Latin America.

  2. Vitoria Saddi   July 25, 2007 at 4:13 pm

    Eduardo, Do you think that private investment is driven by different factors than public investment? Should the government go back to grant incetives to private investment and leave the scene for the private sector? In this case, we would go back to discuss ‘industrial policy’ and which sectors the government should grant subsidies. Is that the point of your piece?  Overall great contribution.

  3. Nouriel   July 25, 2007 at 4:24 pm

    Eduardo, very good and interesting contribution. I would be curious to know why private investment has not recovered more: has “the cost of doing business” gotten worse in these countries in the last few years? If not, given the overall good global and regional growth climate one may have expected a stronger recovery of private investment than the one observed in the data. Or is it in part the return of “populism” in some countries in the region that explains in some measure this lack of private investment dynamics?

  4. Eduardo Cavallo   July 26, 2007 at 11:41 am

    Thank you for your comment.  Anonymous and Nouriel: I agree that it is a puzzle as to why investment is still so low despite the economic recovery and the exceptional external environment. My hypothesis is that it is because private investment has remained sluggish for the reasons that Nouriel speculates. On the issue of the complementarities between public and private investment and PPP’s, I agree. The problem arises when public funds are used to finance investments that could be carried out by the private sectors if the right incentives were set in place. This usually leads to waste resources.  Vitoria. I am not advocating for “picking winners” or active industrial policies. What I think is that in sectors where the regulatory framework can be put in place (i.e., energy) the results of private investment are typically better. The problem with some forms of public investment is that resource allocation is not usually driven by efficiency standards. And yes…I do think that the determinants of public and private investment are different as public investment is oftentimes driven by political motivations.

  5. Male Luppi   July 26, 2007 at 5:35 pm

    First: congrats Eduardo!! As to the reasons why private investment is still so low, I could add that in countries such as Argentina, where the 2001 crisis had a devastating effect on business in general, not only is there a crowding-out effect (whereby the public sector expands its borrowing to finance increased expenditure, for example in public works and social programs, therefore crowding out private companies from the lending market), but we should also consider that private companies have only been able to access short-term loans in the domstic market, paying high interest rates. To accompany the post-crisis growth in demand, the private sector invested working capital to increase supply, and production capacity is now reaching the limit in many sectors (in some sectors, 90%). In order to expand capacity and carry out much needed investments in infrastrucutre, the private sector is in desperate need of better access to long-term credit (10, 15 years) at acceptable rates. Another important matter to consider is “incentives” and “rules of the game”, but I am afarid that commenting on that would take up too much space….