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Macro Research for Development: An IMF-DFID Collaboration

Topic 2: Public Investment, Growth, and Debt Sustainability

Last Updated: November 11, 2014

IMF economists, Rafael Portillo (left) and Felipe Zanna (photo: IMF)

IMF economists, Rafael Portillo (left) and Felipe Zanna (photo: IMF)

Many low-income countries (LICs) are working to deliver on an ambitious promise to scale up public investment to meet huge needs in infrastructure, energy, and other critical sectors.

With aid assistance stagnating, authorities are turning to non-concessional loans, which can bridge financing gaps but can also threaten macroeconomic stability and create heavy repayment burdens. To assess these risks, the World Bank and the IMF together created the Debt Sustainability Framework (DSF), an instrument for guiding LIC's borrowing decisions and reducing the chances of excessive debt accumulation. Although the framework is widely used, it has been criticized for a number of reasons. The Bank and the IMF have responded to some of these criticisms, for example, by proposing greater use of models such as that described below to better capture investment-growth linkages (see Revisiting the Debt Sustainability Framework for Low-Income Countries).

A Model-Based DSA (The DIG Model)

Recently Buffie et al. (2012) have put forward a dynamic LIC-specific macroeconomic model, the DIG model, which complements the IMF-World Bank DSF by addressing the following two criticisms: 


 the DSF lacks a consistent analytic framework, which makes it difficult to systematically incorporate and assess the relationship between public investment and growth; and 

(2) the existing DSF does not take into account the possibility of authorities making fiscal adjustments in reaction to rising debt levels.

To correct for these shortcomings, Buffie et al. develop an internally consistent model with productive sectors that use public capital as an input, different borrowing schemes (external concessional, external commercial, and domestic) and various fiscal rules that react to debt paths.

The authors conclude that an increase in infrastructure investment can produce striking benefits for the real economy in the long run because of output expansion and revenue gains. They note, however, that even highly productive investments may require long-run tax increases to finance recurrent costs of sustaining new public capital, because much of the benefit goes to the private sector and average tax rates are low. Even these positive results are contingent upon the country's structural conditions. Public investment inefficiencies and absorptive capacity constraints for example, can imply that the increases in private capital and GDP that result from increased public investment may be disappointing.

Public Investment Efficiency and Debt Sustainability

Simulations of the calibrated model show how lowering efficiency of public investment can translate into less effective capital, lower GDP, lower fiscal revenues and potentially unsustainable debt dynamics when countries contract external commercial debt.

Even if the long-run outcome is promising, transition problems can be formidable, especially when concessional borrowing does not fully cover the cost of the ambitious public investment plans, resulting in a substantial fiscal gap. Buffie et al. analyze the medium-term risks and trade-offs associated with different financing schemes:

(1) unconstrained tax and spending adjustments combined with concessional loans only; 

(2) smooth tax adjustment supplemented with concessional and external commercial borrowing; and

(3) smooth tax adjustment supplemented with concessional and domestic borrowing.

Covering the fiscal gap with tax increases or government spending cuts requires sharp macroeconomic adjustments, crowding out private investment and consumption and delaying the growth benefits of public investment. Covering the gap with domestic borrowing is not helpful either: higher domestic rates increase the financing challenge and private investment and consumption are still crowded out. Supplementing with external commercial borrowing, on the other hand, can smooth these difficult adjustments, reconciling the scaling up with feasibility constraints on increases in tax rates or spending cuts. But borrowing in external commercial terms may be also risky. With poor execution (e.g., low public investment efficiency), sluggish fiscal policy reactions, or persistent negative exogenous shocks (e.g., terms-of-trade shocks or natural disasters), this strategy can easily lead to unsustainable public debt dynamics (see figure above).

The confluence of ambitious, front-loaded investment programs and weak structural conditions (such as low returns to public capital and poor execution of investments) make the fiscal adjustment more challenging and the risks greater.

Box 1. IMF-WB DSF Nuts and Bolts

Under the DSF, debt sustainability analyses (DSAs) are conducted regularly. They consist of:

  • a baseline set of 20-year projections for borrowing, GDP growth, exports, and other key macroeconomic variables that underpin an analysis of key debt ratios as well as the vulnerability assessment to external and policy shocks—baseline and stress tests
  • an assessment of the risk of debt distress over the 20 year period, based on indicative debt burden thresholds that depend on the quality of the country's policies and institutions; and
  • recommendations for a borrowing (and lending) strategy that limits the risk of debt distress.

Source: The Joint World Bank–IMF Debt Sustainability Framework for LICs

As a complement to the IMF-World Bank DSF, this fully articulated, dynamic macroeconomic model developed by Buffie et al. provides a sophisticated debt sustainability analysis for LICs. This model enables country authorities, IMF country teams, and others to build a wide variety of logically consistent scenarios for public investment surges and other shocks. Its application in particular cases requires a number of country-specific assumptions. Many of these, such as the share of imports in consumption, can be based on available data. Others such as the rate of return to future public investments are more speculative. However, the use of the model should allow country teams and policymakers to understand better the implications of various assumptions and should drive demand for and eventually generate better information.

Next Step: Application

We have completed numerous applications of this model (see box below). Recent examples include:

1. Ghana: 2013 Article IV Consultation

The DIG model has been applied to Ghana. Assuming a gradual improvement of investment efficiency and user fees of a magnitude attainable over the medium term, the debt ratios of the baseline and an alternative ambitious investment scenario could be reduced to about 40 and 50 percent of GDP, respectively. The model illustrates how a successful scaling up of public investment would require both fiscal consolidation and improved investment efficiency.

2. Rwanda

The Rwandan authorities have ambitious investment scaling-up goals in the face of declining grant aid, and the team assessed the possibilities for further scaling-up without sacrificing debt sustainability. The paper recommends a moderate scaling-up to continue lessening dependence on foreign aid.

3. Senegal

Senegal's fiscal deficit and public debt have been on the rise in recent years owing partly to an ailing and inefficient oil-based energy sector. Using a two-sector, open-economy, dynamic general equilibrium model, this application investigates the effects of varying fiscal policy instruments one at a time and of policy packages that increase public investment in energy and infrastructure in scenarios with varying degrees of debt finance and with different types of supporting fiscal adjustment.

Looking Forward

The team is currently working with the Czech consulting firm OGR on extending the model to systematically incorporate uncertainty about parameters and shocks. The new framework will allow the user to provide ranges, rather than specific estimates, for key parameters such as maximum tax rates and the return to public capital. The user may also provide estimates of the risk of various shocks such as productivity growth and terms-of-trade shock. The model can then help assess how these uncertainties interact and ultimately determine the risk of unsustainable debt. Applications and dissemination of the DIG model are expected to be facilitated by a friendly and publicly available front-end that will be soon finalized and released.
Finally, the team is also doing empirical work on public investment booms as well as on quantifying absorptive capacity constraints that could help enrich the applications of the model.

Applications to LICs
Country Status

Afghanistan

Completed

Burkina Faso

Completed

Cape Verde

Completed

CEMAC

Completed

Côte d'Ivoire

Completed

Ethiopia

Completed

Ghana

Completed

Liberia

Completed

Rwanda

Completed

Senegal

Completed

Togo

Completed

Yemen

Completed

Benin

Ongoing

Guinea

Ongoing

Lesotho 

Ongoing

Nicaragua

Ongoing

Vanuatu

Ongoing

Collaboration

  • Felipe Zanna and other Fund Staff, in collaboration with Professor Edward Buffie (Indiana University) extended the model developed in Buffie et al. (the DIG model) to make it applicable to Ethiopia. The new model features an energy sector and a banking sector.
  • A working paper by Professors Christopher Adam and David Bevan titled “Public Investment, Public Finance, and Growth: The Impact of Distortionary Taxation, Recurrent Costs, and Incomplete Appropriability” was released in May, 2014. This paper builds on the DIG model and explores the macroeconomic implications of this recurrent cost problem and its resolution in a context that recognizes that taxation is distortionary.
  • Salifou Issoufou, Mouhamadou Bamba Diop and Kalidou Thiaw (Direction des Previsions et des Etudes Economiques, DPEE) and Professor Edward Buffie (Indiana University) introduced an electricity sector and more fiscal instruments in the model and applied it to Senegal
  • Andrew Warner, in a recent working paper, looks at episodes of large public investment drives and tests whether economic growth was higher after those episodes. He also compares boom countries with those that never had such episodes. On average, the econometric evidence shows only a weak positive association between investment spending during booms and growth and little evidence of long-term positive impacts. Case studies indicate that governments have been plagued by poor analytics at the time investment projects were chosen, incentive problems, and interest-group infested investment choices.
  • Five staff members from the Liberian Ministry of Finance, including the Chief Economist, attended a workshop on debt sustainability modeling held in Washington, DC in August, 2013. The authorities produced a policy note and discussed the possibility of modifying the DIG model to capture some specificities of the Liberian economy so that they can use it as a tool to inform policy analysis.

Papers

Working Papers

Article IV Consultations

Selected Issues Papers

Published Papers