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The role of public investment in socialand economic development

Public Investment:

Vital for Growth and Renewal, but should it

be a Countercyclical Instrument?

United NationsNew York and Geneva, 2009

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Preface

This document serves as background paper for the High-Level Seminar on theRole of Public Investment in Social and Economic Development, 1314 July 2009 in Riode Janeiro, Brazil. The seminar was organized by UNCTAD and the Braziliangovernment in response to a request by the President of Brazil, H.E. Mr. Luiz Incio Lulada Silva, made on the occasion of the Twelfth Ministerial Session of the United NationsConference on Trade and Development, held in Accra in April 2008.

The background paper was prepared by the Centennial Group, a strategicadvisory firm based in Washington, DC, for UNCTAD under the direction of James Zhan,Director of the UNCTAD Division on Investment and Enterprise (DIAE). Guidance andbackstopping were also provided by Joerg Weber and Mike Pfister.

Geneva, July 2009

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Contents

Preface............................................................................................................................................. 2

I.Whatistheroleofpublicinvestment? ........................................................................................ 4

Definingpublicinvestment ............................................................................................................. 4

Thepayofffrompublicinvestment................................................................................................ 6

Criteriaforpublicinvestment ....................................................................................................... 10

Recognizingthepolicytradeoffswithotherpublicprogrammes................................................ 11

II.Meetingthechallengeofpublicinvestmentfinancing............................................................. 12

TheGoldenRule:isitsufficienttoensureadequateinvestmentspending? ............................ 13

Publicinvestmentbysubnationalgovernments ........................................................................... 15

Institutionalapproaches

to

strengthen

the

public

investment

decision

process ......................... 16

Drawingintheprivatesectorthroughpublicprivatepartnerships............................................. 17

ChinaandIndia:sourcesofinfrastructurefinancing .................................................................... 20

III.Challengesinusingpublicinvestmentasacountercyclicalpolicyinstrument........................ 22

IV.Concludingthoughts ................................................................................................................ 26

Tables

Table 1. Estimated requirements for Infrastructure spending in coming years ............................... 9

Boxes

Box 1. United States: components of the American Recovery and Reinvestment Act of 2009 (in

billions of dollars)........................................................................................................................... 23

Box 2. Characteristics of public infrastructural investments observed in recent fiscal stimulus

packages ....................................................................................................................................... 24

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Public Investment: Vital for Growth and Renewal, but Should it be a

Countercyclical Weapon?

The last decade has seen a resurgence ofattention paid to the role of publicinvestment. Whether because of the desireto learn from the investment-fueled highgrowth in Asia, respond to the expectedrapid pace of urbanization and itsassociated infrastructure needs, takeadvantage of technological change intelecommunications and energy or reduce acountrys carbon footprint, governments atall levels of development have recognizedthe need to bolster public investment levels.This attention has engendered efforts to findthe necessary budgetary resources, andwhere this has proven infeasible, led toinnovative approaches for collaborating withthe private sector, particularly in thefinancing and implementation of publicinfrastructure investments. The recentfinancial crisis has further intensified thefocus on public investment as a potentialcountercyclical policy tool, both to create

jobs and lay the foundation for renewed andsustained growth.

This paper will emphasize the important rolethat public investment can play in comingyears for realizing government policy goalsfor growth, poverty reduction and climatechange mitigation as well as for respondingto forthcoming demographic trends,particularly intensified urbanization. It willunderscore the financing challenge posedby budgetary constraints and the need forcontinued efforts to develop fair risk-sharingmechanisms that foster collaboration oninfrastructure investments with the privatesector while still limiting the governmentscontingent financial risk exposure. It willexplore both the potential and the limitationsof public investment as a countercyclicalfiscal policy tool in the current crisis. The

paper will conclude by laying out severalissues for discussion.

I. What is the role of public investment?

Defining public investment

What types of expenditure can becharacterized as public investment? This is

less obvious than might appear at firstglance. In principle, the normal distinctionbetween capital and current outlays wouldapply, with the former relating to anyexpenditure whose productive life extendsinto the future. Thus, much publicinvestment takes the form of infrastructuraloutlays for road and rail networks, ports,bridges, energy-generating plants,telecommunications structures, water andsanitation networks, government buildings which can have a productive life of severaldecades. Such outlays range from small,one-off, limited infrastructural projects thatcan be implemented within a year to morecomplex projects that take place overdecades so-called mega projects (theBoston Big Dig, the Netherlands dikeschemes, Heathrow Terminal 5, theChunnel, etc.). As in the private sector,governments may invest in machinery andequipment computers, laboratoryequipment, even textbooks whose lifespan is much shorter.

But other types of outlays, some of a morecurrent form, can also contribute to capitalformation. Notably, government spendingon education and health contributes not onlyto an individuals human capital but also tothat of society, with benefits that can extendfor a lifetime. Here the capital good is lesstangible than a building or a piece of

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equipment. While governments traditionallyclassify spending on education and healthas current expenditure (and thus not a formof public investment), the policy implicationsof this treatment are often contentious,particularly when governments seek to

justify borrowing only for public investment.Equally tricky is whether to include spendingon maintenance in the definition of publicinvestment. While governments often treatmaintenance as a form of current outlay,periodic maintenance and rehabilitationprojects should be treated as capitaloutlays, since the absence of maintenancecan reduce the productive life of aninfrastructural asset, often substantially.1

While any capital outlay of a government

would be defined as public investment innormal budgetary classification terms, thisapproach sidesteps a number of importantconceptual issues. First, from a normativepublic finance perspective, the reason thatgovernments spend on public assets isbecause some form of market failure ispresent that either leads to inefficientprovision by the private sector or entailsexcess rents to a private producer.Specifically, the asset gives off externalities,positive or negative, or the asset is a public

good, whose services are subject tonon-rivalness in consumption or where it isdifficult to exclude potential consumers. Orthere are economies of scale involved, suchthat a natural monopoly situation would beentailed, justifying either public provision orregulation of a private monopoly. Manykinds of infrastructural networks are subjectto such natural monopoly conditions.

Moreover, the public sectors role in publicinvestment is not limited to its own

1 The distinction is typically made as between routine,periodic and rehabilitation maintenance, with routinemaintenance intended to ensure the smooth functioning ofthe asset during the course of a year, periodic maintenanceas critical in preventing premature deterioration of the assetand rehabilitation maintenance being even more critical toensure the design life of an asset. Often, one refers toO&M (operations and maintenance) where operationaloutlays refer to the complementary current outlays for wagesand other materials necessary to realize the output potentialof a capital good.

budgetary spending. A simple focus ongovernment outlays may yield too narrow apicture of the level of public investmentsand more importantly, an overly restrictedperspective on the potential role played bygovernments with regard to the provision of

public infrastructure. Most obviously, whenthe government collaborates in a publicprivate partnership (PPP), most outlays willnormally be made by private sector entities.Yet the purpose of these outlays would beto provide goods or services for which thereis justified public involvement. And thegovernments role in relation to the PPParrangement in terms of monitoring,regulation, risk bearing and ultimatelypurchaser of the asset (long in the futureperhaps, but part of the PPP contractual

terms) will still remain prominent.Similarly, in cases where the private sectorinvests in the production of goodscharacterized by natural monopolyconditions, government regulatoryinvolvement is called for. In other spheres ofprivate investment, a government regulatoryor planning role may also be fundamental inorder to take account of public policyobjectives (in the case of externalities),though such investments would still berecognized as private.

The challenge of classifying publicinvestment is rendered even more complexin the context of privatization efforts, wherethe sale of a government asset is classified,in budgetary terms, as a negativeinvestment, though in fact the transactionsimply represents a reclassification ofownership.2The complexities of measuringpublic investment and the changes in thedefinitions that have occurred over time hasled the Organization for Economic

Cooperation and Development (OECD), in

2 This raises the further issue that government budgetary

accounts or balance sheets rarely measure the extent ofdepreciation of the public capital stock. As a result, one canhave a negative investment arising from privatization, but nomeasure of the decline in capital arising from depreciation.Such accounting practices contribute to the undervaluationof spending on periodic and rehabilitative maintenance,which would reduce the extent of depreciation of the publiccapital stock if it were so measured.

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its recent effort to analyze the linkagebetween public investment and growth, torely on indicators of physical stock ratherthan measures of the financial value ofpublic investment or the net value of itscapital stock. Rather than being misled by a

narrow budgetary classification, what isimportant to recognize are the ways inwhich governments have a responsibility inthe creation of capital goods and their needto intervene, particularly when market failureleads to underspending on goods vital forthe realization of public policy objectives.

The pay-off from public investment

There is a curious disjuncture between the

econometrics literature that seeks tomeasure the quantitative impact of publicinvestment on growth and the large policyand planning literature that estimates thesize of infrastructural gaps and the amountof public investment needed in differentsectors within the foreseeable future. Whilethe former provides a somewhat ambiguousmessage on the impact of public investmenton growth, there is little ambiguity in thepicture painted by the latter on the need fora dramatic increase in infrastructure to close

existing gaps in service provision(particularly in low income countries) and todeal with the multiple policy challenges ofthe future.

After years of quiescence, the debate on theimpact of public infrastructure investment ongrowth was reinvigorated by Aschauer(1989), who used econometrics to supportthe productivity of non-military public capitalinvestments in the United States. Indeed heexplained the post-1970 decline in United

States productivity growth as aconsequence of the decline in publicinvestment. Gramlich, in a 1994 surveyarticle, noted that the subsequent blizzard ofpapers on the topic failed to yield conclusiveresults confirming Aschauers results. Butthis did not quell interest either in the role ofpublic investment or in the challenge ofempirically assessing its impact. By the late

1990s, the strong growth of Asianeconomies coupled with their high publicinvestment rates led to a debate in Latin

America as to whether its relatively lowerinvestment rate could explain its weakergrowth performance.

What does the econometrics literature nowsay? Drawing on recent surveys of theliterature (e.g. IMF, 2004; Scandizzo andSanguinetti, 2009), the evidence seems tobe mixed on the impact of aggregate publicinvestment rates broadly defined ongrowth, with some studies finding littlerelationship between public investmentrates and per capita gross domestic product(GDP) growth. This is not surprising for anumber of reasons. An important part of

public investment outlays support the broadfunctions of government (provision of socialservices, redistribution, maintenance of lawand order, administration), which onlyindirectly feed into the factors influencingproductivity growth. Much public investmentis of a lumpy nature, focused oninfrastructure that has its impact onproductivity only over a long period of time.Moreover, as already noted, the data onpublic investment has numerousdeficiencies, excluding the contribution of

spending on education and health, andoverstating the level of investment (by virtueof ignoring any measure of the depreciationof public capital).

Yet when the focus is more narrowly placedon infrastructure investments or onindicators of the stock of infrastructureassets, the evidence becomes morenuanced. Caldern and Servn (2004), in aWorld Bank study, found significant positivecontributions from public investments in

telecommunications, transport and power,with the estimated marginal productivity ofthese assets significantly exceeding that ofnon-infrastructural capital. In a similar vein,Caldern et al. (2003) suggest that cutbacksin infrastructure spending reduced long-termgrowth by about 3 percentage points a yearin Argentina, the Plurinational State of

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Bolivia and Brazil and by 12 percentagepoints a year in Chile, Mexico and Peru.

Sutherland et al. (2009), in a study onnetwork infrastructure investments in theOECD, sought to gauge whether

infrastructural investment has an effect onoutput over and above those from simplyadding to the productive capital stock. Theynote that:

infrastructure can have additional effectsthrough a number of different channels,such as by facilitating the division oflabor, competition in markets, thediffusion of technology and the adoptionof new organizational practices orthrough providing access to larger

markets, new resources and intermediateproducts. (p. 13)

Their cross-sectional estimates suggestsignificant non-linearities, with therelationship between infrastructure andgrowth changing with the level ofinfrastructure. Initialinvestments exhibit onlysmall marginal effects on growth, but moresubstantial positive effects are observedwhen an infrastructural network iselaborated in a sector. However beyond

that, subsequent investments that only addto a network tend to have a smalleradditional pay-off in terms of growth.Indeed, for some countries, investmentseven had a negative effect.3 The energyand telecommunications sectors particularlyexhibit these non-linear effects. ButSutherland et al. also emphasize that theseresults are by no means universal, with both

3 To give a sense of the differences, for electricitygeneration, the effects are significantly positive for mostcountries, but for Australia, Ireland, New Zealand andRepublic of Korea, there is evidence of negative spilloversfrom additional investment. For roads, positive coefficientsare found for New Zealand and the United Kingdom butnegative ones for France, Greece, Netherlands and Spain.For telecommunications, additional fixed mainlineinvestmentwould have negative externalities for Australia, Iceland, NewZealand and the United Kingdom and positive ones inAustria, Greece, Italy, Mexico, Norway and Spain, but thesecoefficients are reversed when an alternative measure ofinfrastructure (total subscriptions, including mobiletelecommunications) is used.

positive and negative effects found indifferent countries, reflecting principally thepre-existing level of infrastructuralavailability. This implies that whileinfrastructural investment may have beenprofitable in the past for these OECD

countries, future new investments may notbe as profitable. But equally valid, forcountries where there are substantial gapsin infrastructure, there are considerablereturns that can be anticipated from theelaboration of an infrastructural network.

Other recent studies by Scandizzo andSanguinetti (2009) as well as Roland-Hurst(2006) also emphasize the positive impacton trade flows from public infrastructuralinvestments in transport, airports and port

facilities. By reducing trade and transportmargins and lowering the cost of marketparticipation in a relatively non-discriminatory manner, infrastructuralinvestments can promote regional tradeexpansion. They underscore that theseeffects on transport cost margins havebecome particularly important as countrieshave sought to reduce tariff and non-tariffbarriers. This type of effect is only one of abroader set of ways in which publicinfrastructural investments can create

synergies with private investments. Byproviding key infrastructure, privateinvestments that were previouslyuneconomic become profitable, as energyand water availability are no longercharacterized by shortages, communicationchannels are raised to global standards andtransport time becomes comparable tocompetitor countries. In terms of attractingforeign investments, infrastructure narrowsthe set of issues that deter consideration ofa country as a potential market for

investment.

Scandizzo and Sanguinetti also underscoreanother important effect of publicinfrastructural investment, namely its impacton the quality of life of households,particularly in low income and emergingmarket countries. Provision of water andsanitation services for underserved

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communities positively affects the healthand time availability of households.Provision of electricity has multiple potentialpositive effects access to information, thepossibility of heating water and keepingfood cold and extending the number of

hours dedicated to productive activities.Better roads enable households to accesspotential jobs, education and healthservices more efficiently.

In a recent paper, Ter-Minassian et al.(2008) emphasize the mediating contextualfactors that appear to explain why theempirical literature finds the impact of publicinfrastructural investments positive in somecountries and negative in others. Theseinclude: (a) how the investment is financed,

specifically whether the governments modeof financing ends up crowding out privateinvestment; (b) the availability ofcomplementary inputs, in particular thequality of human capital (citing studies thatsuggest that infrastructure investment hasits largest impact when combined withother forms of productive publicexpenditure, such as effective educationand health spending (p. 6.)); (c) the qualityof project evaluation, selection andmanagement, the absence of which can

significantly lower the cost-effectiveness ofinfrastructure projects; and (d) theregulatory and operational frameworkwithin which such infrastructural servicesare provided. This last point is echoed bySutherland et al, who emphasize theimportance of the policy framework within acountry, in terms of whether it encourage[s]an efficient level, allocation and quality ofinfrastructure investment (p. 18). Thisincludes the approach to assessing thesocial profitability of an investment, the

regulatory framework and the incentives itprovides for competition within a sector andthe balance between public and privateinvestments in public infrastructure.

Looking to the future, the evidence on theneed for public infrastructure investmentappears almost overwhelming. Indicators ofinfrastructure availability in many countries

reveal obvious and enormous gaps. Theyhighlight the number of households withoutaccess to clean water and basic sanitationservices, the number of days whenshortages in electricity or water are present,the frequency of intense road congestion,

the excessive time required to bring goodsto port or to unload them and theinadequacy of a countrys per capitaelectrical generating capacity. Others revealthe sharp differences in infrastructureavailability between urban and rural areasor the increasing logistical costsexperienced by enterprises.

Even more compelling, consideration ofdemographic trends as well as obviouslong-run policy challenges on the agenda of

many governments underscore the need togo beyond simply closing existinginfrastructural gaps. Recent United Nationsprojections highlight the dramaticurbanization that will occur in the nextseveral decades, particularly in Asia and

Africa (United Nations, 2007). In Asia alone,there will be 500 million new entrants tourban areas in the next 20 years. This willnecessitate substantial investments inpublic infrastructure, both to provide basicuniversal services (water, sanitation, roads

and power) as well as the infrastructurenecessary to facilitate and incentivizeprivate sector investments for job creation(Heller, 2009).

Pressures to address climate changemitigation, adapt to ongoing climate changedevelopments (particularly sea level riseand changing precipitation patterns) andtransform the energy generation sector withtechnologies that reduce carbon emissionswill all require substantial investments in

new infrastructure. Reduced wateravailability will necessitate investments toharness potential water sources, both torespond to demands in growing urban areasand to service industry and agriculture.Emerging innovative technologies willundoubtedly require new investments if theyare to be adopted. And last, but not least, torealize the Millennium Development Goals,

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governments will need to invest to closeexisting gaps and respond to the additionaldemands of a rising population, particularlyin Asia and sub-Saharan Africa.

The implied requirements for public

investment are large and can be illustratedby the forecasts of, inter alia, the AsianDevelopment Bank (ADB), the NewPartnership for Africa (NEPAD), OECD andthe World Bank as well as concerned non-governmental organizations (NGOs) (table1). Focusing just on industrial countries and

some of the larger emerging marketcountries, the OECD estimates thatinvestments of almost $3 trillion per year willbe needed in five sectors. The ADBestimates that Asia alone will need almost$1 trillion in annual investments over the

next decade. Yet most studies suggest thatcurrent investment spending is barely halfthe amount required, and that on their own,neither governments nor the private sectorcan finance the required essentialinvestments in infrastructure (Kuroda et al.,2006).

Table 1. Estimated requirements for inf rastructure spending in coming years

Asian Development Bank (Kuroda et al.,

2006)East Asia $700 billion per year for the next 10 yearsSouth Asia $88 billion per year for the next 10 years

European Union: Western Europe:transport (Gil and Beckman, 2009)

$600 billion between now and 2020 fortransport

Estache (2006): Africa $40 billion annually for investment andoperations and maintenance

NEPAD (2002) $64 billion annuallyOECD (2007): estimates for OECDcountries and some larger developingcountries (such as Brazil, China and India)

$70 trillion between 20052007 and 2030for surface transportation (roads, rail andurban public transport), water,telecommunications, electricitytransmission, distribution and generationand other energy-related infrastructure

World Water Council (Gil and Beckman,2009)

Developing and transitional countries willrequire $80 billion annually to producewater security in the next 25 years

International Energy Agency (Gil andBeckman, 2009)

$20.7 trillion would be required today if allgovernments simultaneously decided toenact over 1,400 policies to secure energysupplies due to decades ofunderinvestment in energy infrastructure

Economist(2008) $22 trillion in projected investments overthe next 10 years in emerging economies.

There are three important takeaways fromthis discussion. First, public investmentscan have an important positive impact ongrowth, trade and household welfare.Second, the need for high quality publicinvestment is overwhelming as one

confronts existing infrastructural gaps andfuture policy challenges. But third, and notless important, there is ample evidence thatthe returns from such investments are notalways as high as desired and that there isa considerable pay-off to having an

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appropriate policy framework to ensureadequate productivity. In part, the rate ofreturn may simply relate to whether aninvestment breaks new ground in thecreation of an infrastructural network ormerely adds marginally to an existing

network. More important factors foremerging market and low income countriesinclude whether the financing modalities forpublic investments are compatible withfostering private sector investment as wellas ensuring macroeconomic stability;whether the public sector is able toeffectively evaluate, implement and manageits public capital stock; whether there isprovision of critical complementary publicservices (particularly in education andhealth); and whether the government is

fostering good and transparent governanceand the rule of law.

One final point not raised heretofore mustalso be mentioned. The need for publicinvestment will occur at all levels ofgovernment. Much of the neededinvestment, particularly for infrastructure,relates to priorities that must be addressedat the municipal or regional levels. For manycountries with a fiscal federal structure,local, municipal, state or provincial

authorities must thus address thechallenges of financing and management.

Criteria for public investment

With fiscal constraints binding and thedesirability of private sector financingnonetheless tempered by the need forcaution on the amount of risk ultimatelyborne by government, sound criteria areneeded for appraising the profitability of

public investments. This is not a newproblem. For almost a half-century, the artand techniques of social costbenefit andcost-effectiveness analysis have becomehighly developed and well understood (see(Little and Mirrlees, 1974; Belli et al., 1998).Too often, the problem observed is a lack ofcapacity by governments to undertake suchassessments and the difficulties of

developing reasonable measures of socialbenefits and costs of the social discountrate.

The complexities of analysis have beenfurther increased by three important

developments. First, while costbenefittechniques are well suited for small discreteprojects, they may be inadequate for largeinfrastructural projects with networkcharacteristics or for mega projects, whoseimplementation may span many years.Mega projects in particular require moreelaborate analysis, with investments infront-end strategizing to reduce uncertainty,including risk management, scope and taskdefinition, and contingency planning (Giland Beckman (2009), p. 19). Second, the

use of PPPs requires additional dimensionsof analysis in order to assess the locus ofrisk-bearing in the contractual arrangementfor the various types of risks to which aproject is exposed. Third, costbenefitanalyses focus on the net present value ofthe output derived from a project. Butgovernments typically have other objectives

poverty reduction or social inclusion,enhanced energy efficiency, reducedcarbon emission, fostering environmentalsustainability, gender promotion, industrial

upgrading, moving to a new level oftechnological sophistication, spurringentrepreneurship and these benefits areless easily quantified, including using acostbenefit approach.

These complexities have led to theelaboration of additional methods forassessing the viability and value of largeinvestment projects. One involvesdetermining whether an investment canremove critical bottlenecks in an

infrastructural network. For mega projects,Flyvbjerg et al. (2009) suggest furtheranalytical strategies. One involves theconstruction of alternative possiblescenarios that a project might experience interms of economic, environmental,demographic or technologicaldevelopments. These could be contrasted

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with the counterfactual situation in which theproject is not undertaken.

Another encourages the use of an outsideview of the problem, with a focus less on thespecific details of the project at hand and

more on a broad reference class of similarprojects. The objective is to get anindependent perspective on what is realisticin terms of the time frame for the project, itscost and its potential productivity.4 Such aview can abstract from the biases orpredispositions that inevitably areassociated with a specific project, wherethere is an inevitable tendency to see eachproject as unique. They also suggest thatin the course of any costbenefit analysis,an optimism bias uplift should be

incorporated. This constitutes anempirically based adjustment to a projectscosts for different percentiles of costoverruns, on the basis of the project type(p. 183). Finally, they argue for theestablishment of a risk register that wouldlist the risks likely to affect the delivery andoperation of the proposed infrastructure andwould clarify who owns the identified risk.

Particular care is also needed with regard tobasic project design for mega projects. For

these larger projects, since they will beimplemented over time, there is a highpossibility that unexpected needs as well asunanticipated technological change mayoccur. These would have to be incorporatedin the design as the projects areimplemented. This implies the need forflexibility in infrastructure design with upfrontprovision or allowance for some evolution inresponse to external changes.

4 Flyvbjerg et al. (2009) provide a useful discussion of thereasons project assessments for mega projects often provehighly optimistic. They note that a characteristic of megaprojects is that managers pursue initiatives that are unlikelyto come in on budget or on time, or to ever deliver theexpected returns. These biases are often the result of theinside view in forecasting: decision makers have a strongtendency to consider problems as unique and thus focus onthe particulars of the case at hand when generatingsolutions (pp. 172173).

Together, the challenge of thesecomplexities underscores the importance tobe attached to establishing dedicatedinstitutional units for project analysis andassessment and network design andmanagement. At the centre, linked to the

Ministry of Finance, there is a need for adedicated agency responsible fordeveloping guidelines for project evaluationand assessment that can be applied to anyproject above a given size. This agencywould also play a pivotal role in providingguidance to central budget authorities as towhether sectoral project proposals meetcertain threshold criteria in terms of thestandards for assessment and of socialprofitability. It would be desirable toestablish similar units at the sectoral and

municipal and state government levels.These units should be expected to assessand judge projects according to thenationally set technical guidelines. As wewill discuss in section II, when a project is tobe undertaken in the context of a PPP,additional guidelines and assessmentswould be needed to ensure not only thedesirability of the project but also totransparently guarantee disclosure of theextent of risk transfer to the centralgovernment. Particularly if a regional or

municipal project entails significantborrowing, there may be a role for thecentral government to review the projectappraisal (recognizing that the centralgovernments involvement would beprincipally shaped by the particulars of thefiscal federal relationships of a country andthe degree of autonomy provided to localgovernments in accessing funds fromcapital markets).

Recognizing the policy trade-offs withother public programmes

A final concern when considering theappropriate amount of governmentinvestment is to avoid the implicit bias thatmay arise against spending on forms ofpublic investment that are more orientedtowards human capital. Social profitability

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assessments of investments in humancapital, particularly in education and health,are far more difficult than for physical capitalprojects. The pay-off in growth is likely to bemuch further into the future and the variousbenefits of these programmes are less

easily captured in simple quantitative terms.

The difficulties in the trade-off betweenspending on human and physical capitalemerges clearly in some low incomecountries, where the needs in both spheresare enormous. For low income countries,the gains from investment in primaryeducation are well understood from manystudies. Equally, lack of investments inprimary health care may preclude achievingthe decline in infant and maternal mortality

rates necessary to create incentives forhouseholds to opt for a smaller family sizeand thus foster a demographic transition. Asan example, Ethiopia desperately needsmore physical infrastructure to harness itswater resources, develop its road network,provide clean water and sanitation andprovide even minimal electricity ortelecommunications services to its ruralpopulation. But its social indicators in thespheres of education and health are verylow (pupilteacher ratios exceeding 100;

population to physician ratios of 50,000) andthere would be a high social and economicpay-off to investment in these sectors.

But even in some emerging marketcountries, a failure to invest sufficiently andwell in human capital particularly in thetertiary education sector can createimportant bottlenecks that can prevent acountry from sustaining a rapid growth rate.Taking India as an example, many policyanalysts have expressed concern that there

is insufficient capacity at the highereducation level to enable a breakthrough inother sectors outside the leading edgetechnology sector.

This is not an argument for putting anunambiguous premium on investments inthe social sector, e.g. for the realization ofthe Millennium Development Goals, at the

expense of reduced infrastructuralspending. The opportunity cost of foregoingspending on infrastructure can be quite highand may deter private capital investmentsand retard the economic growth so essentialfor realizing increased employment and

income growth among the poorest groups.The important point to make is thatpolicymakers certainly need to besufficiently sensitized to the fact thatphysical and human capital investmentsboth have important pay-offs. Simplisticadherence to budgetary rules (as discussedbelow) or pressures for infrastructureinvestment should not undercut essentialspending in the social sectors that can meetimportant human needs and contribute tosustainable long-run growth.

II. Meeting the challenge of publicinvestment financing

Virtually all governments in industrial,emerging market and low income countries

face the challenge of finding the fiscalspace (the available budgetary resources)to finance needed public investments(Heller, 2005). The obvious sources of fiscal

space raising taxes, cutbacks inunproductive or lower priority expenditures,user charges, privatization revenues anddomestic borrowing should be exploitedas a government seeks to raise itsinvestment ratio. This paper will not explorethe various issues associated with themobilization of fiscal space for publicinvestment through the former twochannels. The remaining sources of fiscalspace will be touched upon in the course ofthis section.

In general, rare is the government whosebudgetary position is strong enough tofinance its public investment needs from taxand non-tax revenue sources withoutborrowing. Since most capital projects arelong-lived and benefit future generations aswell as the present, there is a soundeconomic basis for governments to finance

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a substantial portion of their investmentprogramme in this way. But there areobvious limits. Incurring debt to financeinfrastructure investment is reasonable forthe private sector, which expects to directlyreceive the benefits from investments in the

form of a future stream of income or value.In contrast, governments invest on the basisof social profitability criteria to achieve manyother non-monetary benefits and cannotcount on these benefits being translated intohigher tax receipts sufficient to cover thecost of a projects debt service orassociated operations and maintenance.

Even when projects have a high pay-off inincreased output, in low income andemerging market economies, poor tax

compliance and limited tax handles mayprevent a government from generating therevenues needed to pay for it. This impliesthat governments need to be sensitive as towhether their overall fiscal position, and inparticular their debt levels, can besustainably financed over the long term.Particularly for emerging market countriesthat borrow on global capital markets,allowing the governments debt to GDP ratioto rise above 4050 per cet is likely to raisea red flag with creditors and potentially lead

to an increase in the sovereign risk premiumattached to government borrowing. Lowincome countries of course may benefitfrom aid flows in the form of grants andconditional lending, enabling them to runoverall budget deficits (exclusive of grants)to finance significant public investments. Butdebt sustainability concerns apply evenmore strongly in these countries(recognizing that the criteria for assessingsustainability in these countries needs totake account of the degree of

concessionality in the terms ofgovernments debt). And even low incomecountries with large amounts of aid need toworry about fiscal sustainability, since ahigh rate of public investments willultimately require funding for futureoperations and maintenance outlays.

Confronted with the fiscal space challenge,several policy questions will be discussedbelow. First, what budgetary rules or criteriashould guide decisions on the appropriatesize of the overall investment budget?Second, how should central governments

ensure that subnational governments arefiscally responsible in financing theirinvestment programmes? Third, what arethe necessary institutional correlatesassociated with relying on such budgetaryrules, and can we identify best practicesamong countries that are worthconsideration by other countries? Fourth,what policy issues should be considered inrelying on the private sector to financepublic investment spending? Finally, arethere lessons for other low income and

emerging market countries that can belearned from Chinas strategy for financingits high level of public investment?

The Golden Rule : is it sufficient toensure adequate investment spending?

One approach to budgeting for investmentis to pursue the so-called Golden Rule,which ensures that government borrowing isonly for investment purposes and that

current expenditures do not exceed currentrevenues. A governments capital outlayswould then be financed by any surplus onthe budgetary current account i.e.government savings as well as from publicdebt. Implicit in the Golden Rule is therecognition that public investments createassets and thus should not be treated thesame as consumption outlays. In effect,using the Golden Rule ensures that anyincrease in debt on the public sectorsbalance sheet is at least matched by an

increase in assets.5

Four concerns are often expressed aboutthe Golden Rule as an approach to fosteringpublic investment and maintaining fiscal and

5Some recognition would also need to be paid to ensuring

that the increase in debt does not significantly exceed thenet increase in public assets, after taking account ofdepreciation in the public sectors stock of assets.

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debt sustainability. First, the rule itself doesnot offer guidance as to how muchborrowing for investment is appropriate andconsistent with macroeconomic stability anddebt sustainability. Thus, in the UnitedKingdom at least, the Golden Rule has been

supplemented by the SustainableInvestment Rule or Debt Rule, which setsa limit on the ratio of outstanding public debtto GDP in order to ensure continued fiscalsustainability. More generally, the literatureon debt sustainability suggests that theappropriate ceiling for public debt wouldneed to take account of the expected realinterest rate, real growth rate and theabsorptive capacity of the domestic capitalmarket and risk perceptions of externalcreditors. Ultimately then, it is the latter rule

that provides the binding ceiling on theamount of public investment to beimplemented in any given period.

But some critics (particularly theInternational Monetary Fund IMF) worrythat the Sustainable Investment Rulecorollary to the Golden Rule will receiveinadequate attention or will be fudged in itsapplication, creating potential pressures onfiscal or debt sustainability.6 The problemarises because when an economy is

buoyant, there may be a tendency to accepta high investment rate financed by debt,with relaxed standards concerning theassessment of investment decisions. Thepotential is then for a government to allowits debt ratio to increase to levels whichprove vulnerable in an economic downturn.Thus, the Golden Rule may contribute tovolatility in capital investment spendingrates. Ironically, this issue may now bearising in the wake of the significant debtrelief efforts for highly indebted poor

countries at the beginning of this decade,which reduced their public debt ratios torelatively low levels. Since the sustainabilityrule is not likely to be a constraint on

6 This criticism has even been leveled against the United

Kingdom, when some felt that optimistic growth forecastswere used to support higher levels of government borrowingand public investment while maintaining consistency with theSustainable Investment Rule.

borrowing at low debt ratios, one can readilyunderstand that the combination ofpressures for increased public investmentand low debt levels would encourageborrowing for investment. This accentuatesthe importance of undertaking adequate

assessments as to the social profitability ofpublic investments.

Second, by itself, the Golden Rule does notensure that borrowing will only financeprojects with an adequate social andeconomic rate of return. Certainly in thepast in many countries, decisions on publicinvestment have been made in a non-transparent way and the institutionalcapacity for sound project assessment hasproven lacking. Political pressures and

creative accounting have unreasonablyjustified low productivity investments, withadverse medium- to long-termconsequences for the governments debtsustainability. The literature on publicinvestments is not short of papersemphasizing public investments that wentwrong badly conceived projects, projectsundertaken less for their productivepurposes and more for political orcountercyclical reasons (Japansinfrastructure programme in the 1990s

comes to mind) and of course the so-calledwhite elephant projects, where rentseeking and external interests led to thefinancing of projects that yielded little return.Flyvgbjerg et al. (2009) have writtenextensively on the tendency of megaprojects to take far longer to implement,cost far more than originally planned andyield lower gains than designed. Thisconcern is not only an issue in low incomecountries but in emerging markets and evenindustrial countries. Togo and Wood (2006),

in their analysis of the United KingdomsGolden Rule, emphasize that a robust setof budgetary control and capital appraisalprocesses need to be established to ensureinvestment projects are efficient and takeinto account value for moneyconsiderations and to ensure thatincentives are in place to improve

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management of existing capital assets (p.89).

Transparent accounting and reportingpractices for public investment funds couldfoster confidence among taxpayers,

governmental units that provide funds andrecipients. Accrual-based budgeting andaccounting enhances the understanding ofsources of funding and commitments,thereby reducing risks of overspending.Under the auspices of the InternationalFederation of Accountants, the InternationalPublic Sector Accounting Standards Boardhas been issuing accounting standards thatfacilitate accrual-based accounting andreporting.

A third concern about the Golden Rule isthat it may give rise to some degree ofprocyclicality in public investment, since inboom periods, current revenues areparticularly buoyant and it is easier to run acurrent budget surplus. Moreover withstrong growth, higher borrowing rates arenot likely to raise the public debt ratiosignificantly. But in lean times, the currentbudgetary account may yield either nosurplus or even be in deficit, forcingdisproportionate cutbacks in public

investment. Certainly, when faced with theneed for fiscal adjustment, governments findit easier to delay or postpone capitalprojects rather than to lay off workers or cutfunding for basic operational expenses. Insuch situations, maintenance outlays arealso likely to be deferred, contributing tohigher than appropriate depreciation ofpublic assets as well as reducedproductivity of public infrastructure.Institutionally, the Golden Rule, if rigorouslyenforced, may prove an obstacle to using

public investments as a countercyclicalpolicy instrument in a recession. This ledScandizzo and Sanguinetti (2009) to arguefor relaxing the Golden Rule in the case of acrisis, allowing exceptions for thoseexpenditures associated with infrastructurefor public investments involved in projectswith private financing (so long as abuses ofsuch exceptions can be prevented, e.g.

passing off current expenditure asinvestment).

Finally, and as discussed above, a GoldenRule approach to incentivize current savingsin the budget for investment implies limits

on current expenditures. As notedpreviously, this creates a bias againstcurrent expenditures necessary for theoperation and maintenance of public assetsor for the creation of human capital.Treating only investment outlays as assetson the public sectors balance sheet maylead to an imbalance in terms ofinvestments on physical as opposed tohuman capital formation.

Thus, the challenge faced in deciding on the

appropriate level of investments is in part amatter of macroeconomics and the settingof overall fiscal policy targets. But in manyrespects it is more a matter of ensuring thatgovernments have a strong capacity formaking sound decisions on individualinvestment projects and on the overallinvestment portfolio.

Public investment by subnationalgovernments

A final issue in the financing of publicinvestment, particularly infrastructure,relates to the role of states andmunicipalities. In most emerging marketsand certainly low income countries, theneeds for urban infrastructure are greatfrom the perspective of providing basicuniversal services and critical in terms ofproviding the infrastructural servicesnecessary for attracting private investment.Yet most urban areas lack a sufficient

revenue base to finance these investments.While provinces or states may haveindependent sources of tax revenue(income or sales taxes or shared taxbases), most are in a similar position andthus rely on four principal sources of fiscalspace: grants from the central government,local borrowing, user fees and private sectorfinancing (direct investment or PPPs).

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Space does not allow a detailedconsideration of these issues but severalpoints need to be emphasized here.

First, while recognizing the importance oflocal autonomy, the central government

must have some role in ensuring fiscalsolvency by subnational governments andsome stake in ensuring that largeinvestment projects are assessed andmanaged rigorously (Ahmad et al., 2005;Ter-Minassian, 2005). This role derives inpart from the typically large financing roleplayed by intergovernmental grants (e.g.special purpose grants) from the centralgovernment. But it also is related to thecentral governments exposure to the riskthat it may be forced to bail out a bankrupt

subnational government entity. Second,moral hazard considerations arise withregard to both issues and the centralgovernment needs to ensure that theincentives of a subnational government areto be fiscally prudent and that it does notborrow or spend on unproductive projects.Third, countries differ in the approach takento ensure the fiscal solvency of subnationalgovernments in a federal system. Relianceon market discipline or cooperativearrangements, which can work in industrial

country settings, may be impractical in othercountries. Fiscal rules numerical rules(limits on debt, deficit ceilings, ceilings onspending, the Golden Rule) oradministrative or procedural rules (pre-authorization of debt issuance, limits onexternal borrowing) may be more thenorm in low income and emerging marketcountries, but with challenges still faced inenforcement and sanctions. Limits onsubnational government borrowing areparticularly necessary in situations where an

subnational government has limited sourcesof local revenue to service any new debt. Insome countries, borrowing is centralizedwith on-lending to subnational governments.Finally, as noted earlier, central governmentefforts to ensure a standardized projectassessment system are warranted as wellas a strengthened institutional capacity tomanage PPP contracts and projects.

Institutional approaches to strengthenthe public investment decision process

The above discussion has highlighted boththe importance of public investments beingevaluated according to best practicetechniques, and the value of an institutionalmechanism to facilitate such an evaluationprocess and to limit the excessive intrusionof political economy factors into theinvestment decision process.

In the current environment, the institutionalmechanism must be further reinforced toensure that the implementation of aninvestment is carried out according to the

project design and is able to be adapted inthe context of unforeseen factors in aneconomically sensible way. This alsorequires the development of appropriatestandards of good governance andtransparency in the procurement policiesassociated with public investment. Goodproject design can be rendered less cost-effective if procurement decisions provepolitically motivated or subject to rentseeking. Even after the investment hasbeen put in place, realizing productive

public or privately financed publicinfrastructure projects will require a capacityboth to manage operations andmaintenance and to enact and enforceregulatory measures that facilitate or mimiccompetitive markets, set price caps forinfrastructural services and implementefficient user fee policies (Sutherland et al.,2009).

The United Kingdom and Australia bothprovide good examples of new approaches

that seek to depoliticize and strengthen theproject assessment, decision,implementation and managementprocesses. In late 2008, the UnitedKingdom passed legislation that establisheda new Infrastructure Planning Commission(IPC) with the aim of fast-trackinginfrastructural schemes of nationalimportance. Each national ministry (in areas

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such as energy, aviation, road and railtransport, and water and sanitation) wasexpected to set out a national policystatement detailing its nationalinfrastructural priorities. The decisionwhether to go ahead with a project would

then be taken independently by the IPC,operating within a framework established byministers.

Australia moved to depoliticize both theassessment and the decision processes forpublic investment. It establishedInfrastructure Australia, whose principalfunction was to assess infrastructurepriorities independently of the originatinginfrastructural ministries and stategovernments. The goal was to obtain a

clearer picture of which projects yielded thegreatest value for money in relation tonational infrastructural priorities.7 Costbenefit analysis was to be used, projectrisks assessed and the potentiality forleveraging private sector financingconsidered. In relation to the latter,Infrastructure Australia was expected toreview and provide advice on measures toimprove harmonization of policy andregulatory regimes that facilitateinfrastructural development as well as to

identify barriers or disincentives toinvestments in nationally significantinfrastructure (Infrastructure Australiawebsite). It was also expected to carry outregular audits on the condition of existinginfrastructure, clarifying where there werecritical infrastructural bottlenecks andformulating a prioritized list of projectsworthy of consideration for investment. Amajor cities unit was also established in theoffice of the infrastructure coordinator forthe consideration of urban infrastructural

needs.

Decisions on the proposed infrastructuralinvestment programme of Infrastructure

Australia were then to be made by the

7 Infrastructure Australia is reported to have expressedconcern about the varying quality of the costbenefitanalyses carried out by states (Australian, 2009).

Council of Australian Governments, takinginto account revenue availability fromcentral government budgetary surpluses,available savings built up in the FuturesFund and borrowing prospects, with acentral government body, the Building

Australia Fund (BAF), drawing on theseresources for the financing of nationalinfrastructural projects. The BAF wasmodeled on Norways GovernmentPetroleum Fund and was established in2008 to utilize budgetary surpluses for thepurpose of infrastructural investment, withmore independence in terms of the timing ofexpenditures (Martin, 2008). In the absenceof sufficient financial resources in the BAFand with limits on the proposed borrowingprogramme, the government would be

expected to explore the potential role for theprivate sector.

Thus, four key elements of the Australiaapproach are: the establishment of a bodyseparate from state governments andministries to provide an independentassessment of projects value for money;the establishment of a shelf of priorityprojects for implementation, subject tofinancing availability; the provision of anational perspective on infrastructural

priorities; and the ability of InfrastructureAustralia to overcome any tendency ofspending ministries to consider only alimited set of investment options(Sutherland et al., 2009).

Drawing in the private sector throughpublicprivate partnerships

Fiscal space limitations and debtsustainability considerations have led

governments to assess the potential role forprivate sector financing for some of therecognized public infrastructural investmentneeds of the future. PPPs in particular havebecome a prominent modality for workingwith the private sector in the constructionand operation of public infrastructureprojects, with substantial experience gainedover the last decade in Latin America

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(particularly Chile and Mexico), theCaribbean, South Africa, and South andSoutheast Asia. And while the currentrecession has proven a speed bump togovernments in accessing such financing, itis likely that over time, private financing

sources will once again be available andinterested in partnering with governmentson public infrastructural projects.

Four important points need to berecognized. First, there are some areas ofpublic infrastructural spending where theprivate sector may be willing to invest andprovide services without the need for a PPP(e.g. in the telecommunications sector).There are also sectors where a publicenterprise has been privatized, e.g. in the

water sector, and where the private sectorfirm has taken over the delivery of services.The challenge in such situations is typicallyfor the government to ensure that the samepublic policy factors that originally motivatedpublic sector investment and provision, e.g.equity factors, natural monopoly conditionsor externalities, are taken into account in theway in which the private sector producesand delivers services. Here thegovernments task is to ensure that a clearand well-designed regulatory structure is in

place, perhaps including a pricing policy.

Second, private financing in the form of aPPP entails both opportunities and risks to agovernment, and management of theserisks is essential if there is to be a genuinesharing of both the gains and the associatedrisks between the public and privatesectors. Third, PPPs are not suitable for allpublic investment projects and as withprivatized utilities, successful reliance onPPPs requires substantial government

involvement in their monitoring, evaluationand regulation throughout the contractperiod. Fourth, because private sectorfinancing cannot necessarily be relied upon(as the current global financial crisis hasillustrated), governments should intensifytheir efforts to mobilize fiscal space and to

prioritize what public investment projectsshould be implemented.8

Typically, in the words of an IMF study(2004), PPPs entail the private sectorsupply[ing] infrastructural assets and

services that have traditionally beenprovided by the public sector, often withgovernment as main purchaser. The role ofthe private sector can be in the design,building, financing and operation of thescheme, with many PPPs in advancedcountries involving all of these elements.Governments have used PPPs for thebuilding and operation of hospitals, schools,prisons, roads and water supply, and wastemanagement facilities, though experiencesuggests that PPPs operate more

effectively for economic rather than forsocial infrastructure projects (Akitoby et al.,2007). Usually, a PPP entails for an asset tobe transferred to the government at lessthan its true residual value when theoperating contract ends. Often the privatesector can work with government tocollateralize the project income stream for aconcession (e.g. toll revenue) using thecollateral as the basis for the issuance ofsecurities to the financial markets, thustapping private sources of finance.

What makes a PPP attractive to agovernment is the ability to harness thepotential of the private sector to constructand operate a facility with greater efficiencythan would be the case for the public sector,with such efficiency gains offsetting thepresumably higher borrowing or equity costsassociated with private as opposed togovernment borrowing. Such efficiencygains are particularly relevant when theprivate sector can bundle the construction

and operating phases of a project, thusallowing for internalization of cost-reducing

8To illustrate this contention, the Wall Street Journal(2009)recently reported that Indias infrastructure investmentprogramme is struggling to find private investors needed toparticipate in expanding roads, ports airports and power.They report that many capital market firms find debt-heavyinfrastructure projects too risky, with the highway authority,for example, putting out poorly conceived projects that weresaid to be unbankable.

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incentives (Scandizzo and Sanguinetti,2009). At the same time, by substituting theprivate sector for public provision, thegovernment can also save scarce publicfunds and relieve strained budgets.

While PPPs can thus ease financialconstraints on infrastructural investments,they can also be used, inappropriately, tobypass spending controls and move publicinvestments off budget and debt off thegovernments balance sheet. This couldleave governments bearing most of the risksinvolved and facing large fiscal costs overthe medium to long term. This underscoresthat a key challenge for governmentsentering into PPP arrangements is toensure that there is an appropriate

distribution of risks between the public andprivate sectors.

Experience also suggests that for a PPP towork effectively and to be an appropriateapproach, several key prerequisites shouldbe satisfied: the quality of services shouldbe contractible; there should be competitionor incentive-based regulation; as noted,there should be an appropriate distributionof risks; the institutional framework shouldbe characterized by political commitment,

good governance and clear supportinglegislation (including with regard to pricing);and there should be a transparentprocedure for the award of performanceincentives and the enforcement of sanctionsthroughout the concession period. Finally,the government needs to have a capacity,both in the finance and sector ministries, toeffectively appraise and prioritize publicinfrastructure projects; design PPPs;evaluate affordability, value for money andrisk transfer; correctly select those projects

that are appropriate to undertake as PPPs;draft and scrutinize contracts; monitor,manage and regulate ongoing projects; andundertake periodic performance evaluations(see Sutherland et al., 2009; Scandizzo andSanguinetti, 2009; IMF, 2004; Ter-Minassian et al., 2008; and Tchakarov,2007). This extensive list of prerequisiteshighlights the value of moving at a

deliberate pace in developing a reliance onPPPs for public investment.

In terms of negotiating the distribution ofrisk, some are appropriately borne by theprivate partner those associated with the

construction or the operation of the projectin particular. Others, such as political andregulatory risk, clearly inhere in thegovernment. Still others such as marketdemand risk, some supply-side risks (thecost of foreign exchange, some factor costrisks) may be influenced by governmentbut are not fully under its control. How suchrisks are shared is an obviously importantand sensitive aspect in the negotiation of aPPP with a private partner, since it will bearon the size of the contingent risks to which a

government is exposed. Inevitably as well,for any project that is likely to extend for adecade or more, there will be a need forsome flexibility and renegotiation of theoriginal terms, as the underlying assumedmarket conditions can change enough torender the original assumptions irrelevant.In the context of mega projects, Flyvbjerg etal. (2009) suggest that two important waysof limiting risk are to ensure that theproposing and the approving institutionsshare financial responsibility for a mega

project, and that private financersparticipate in financing the project with theirown capital at risk.

Governments entering into PPPs also needto be aware, from the experience of manycountries, that contracts often need to berenegotiated. Tchakarov (2007) notes thatin Latin America and the Caribbean, over 30per cent of PPPs were renegotiated(particularly in transportation and waterprojects), often within the first two to three

years of the award of a PPP. Key factorsforcing renegotiation have included the fixedterm nature of concession contracts, thechallenges posed by demand risk, poordecisions at the design stage, governmentacceptance of aggressive bidding orchanges in the rules of the game by thegovernment after the contract award.Tchakarov also notes that an improper

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regulatory framework and poor regulatoryoversight [can] increase the chances ofconflict, rent capture by operators, oropportunistic behavior by government.

In sum, private sector financing offers

important opportunities for governments toaugment fiscal space for infrastructure, butsuccessful exploitation of this sourcerequires important capacity-building withingovernments to ensure both fiscal savingsand efficiency gains relative to publicprovision.

China and India: sources ofinfrastructure financing

Over the last decade, China hasdramatically expanded its infrastructuralinvestment programme (reaching 14 percent of GDP by 2008) (Lall et al., 2008).Indeed, in the recent financial crisis, Chinahas increased its infrastructural spending byas much as 3 per cent of GDP, far morethan other countries. The obvious questionis how these investible resources have beenmobilized (particularly since the spendinghas not been associated with a dramaticexpansion of Chinas overall government

deficit).9

There are several key features to Chinasapproach. First, like other countries, Chinahas sold public property throughprivatization initiatives and used the receiptsto finance new investment, with provincesand municipalities leasing, on a long-termbasis, publicly owned land. Given theabsence of privately owned land since the1949 revolution, this resource of the statehas proven a fertile source for financing

infrastructural investments, with foreignenterprises being a significant source ofknow-how.10

9 This discussion is largely drawn from a recent AsianDevelopment Bank paper by Lall et al. (2008).10

While this approach has proven very effective, there arepresumably limits to the extent to which this is feasible, onceone has leased much of the most attractive land within urbanand suburban areas. Distributional concerns could also be

Second, much infrastructural financing hasderived from three important sources:corporatized enterprises owned orcontrolled by a province or municipality;subnational government agencies; and

state-owned commercial banks linked with amunicipality or province. This has exploitedanother key feature of Chinas developmentstrategy, which is to allow a high level ofretained earnings in state-ownedenterprises, with little dividend remittancesto the central government.11 Similarly, withlittle alternative options for investments,household savings have largely beenchanneled into either the banking orinsurance systems and these financialinstitutions have largely utilized their excess

reserves for loans to either state-ownedenterprises or provinces and municipalities.Decentralized fiscal authorities have thusbeen able to draw on enterprises for equityfinancing and state banks for loans inrelation to infrastructural investments. Alsoworth emphasizing is the relatively low rateof return earned by enterprises and banks,as well as the suppliers of infrastructuralservices, at least relative to what might havebeen expected if such loans or equityfinancing had been sought from private

domestic or foreign sectors.

A final important source of financing hasderived from extrabudgetary fundscontrolled by municipalities and provinces.Unlike many developing countries, Chinahas relied on earmarked user fees to coverthe cost of operations and maintenance,with these revenues earmarked toextrabudgetary funds. Some capitalsubsidies have been provided by the centralgovernment budget but these have been

limited.

raised, since presumably compensation for the land that hasbeen taken from its previous occupants has most likely beensignificantly less than the lease revenues obtained.11Another form of government investment for the publicbenefit is through state-owned enterprises. Often,governments establish enterprises that provide the publicwith essential goods and services. Transparency andaccountability are essential for state-owned enterprises.

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In sum, more than half (54 per cent) ofChinas infrastructural projects have beenfinanced by equity investments from localgovernments, state-owned enterprises andforeign and other investors; a third from

loans from domestic banks; and only 16 percent derived from grant funding (orallocations from the consolidatedgovernment budget). Of equity financing,only 2 per cent has been derived fromforeign direct investments and 6 per centfrom third party equity funding (Lall et al.,2008).

Third, an important characteristic of Chinasapproach has been the unique role of theNational Development and Reform

Commission (NDRC) [which] combinestop-down guidance with a troubleshooting,coordination and clearing house function,which has greatly enhanced executioncapacity, especially in dealing with inter-

jurisdictional and inter-ministerialcoordination (Lall et al., 2008, p.2).

It is useful to contrast this approach withthat of India. User fees in India are muchlower than in China and do not cover alloperations and maintenance costs, so that

government subsidies are needed to coverthese costs. Indian municipalities and stateshave also been less able to draw on stateenterprises for equity financing ofinfrastructural investments. While financialmarkets in India are also repressed, withstate banks limited in their potential lendingrates, they are also more involved in lendingto private and state enterprises, so thisavenue of public infrastructural financinghas proven more limited. Thus, budgetarycontributions constitute a much larger share

of infrastructural financing in India,subjecting these grants much more to fiscalspace constraints. Lall et al. (2008) alsonote that there is no equivalent in India ofthe funding source that is localgovernments extrabudgetary revenuesdeployed as equity in infrastructure projectsin [China] (p. 27). Neither has India beenable to monetize land holdings for

infrastructural investments. India has alsosought to rely on greater privateparticipation in infrastructure development,thus necessitating the need for regulatorybodies to address the challenges that arisewith PPPs. Also in contrast to China, India

has had difficulties in its coordination amongrelevant agencies involved in infrastructuralinvestments, leading to executive gridlockand shortfalls and delays in implementation.Lall et al. (2008) note that there are manyreasons cited for the shortfall from delaysdue to land acquisition and environmentclearances, equipment availability, pipelineof projects not being ready but in reality, itcomes back to the issue of inadequateplanning and coordination (p. 32).

What is important to emphasize aboutChinas approach has been the extent towhich fiscal space for public infrastructuralinvestment has exploited the use ofprivatization receipts and user charges. Forthe latter, the distributional and equitychallenges for most low income countries ofrelying on user fees to cover capital andoperations and maintenance costs are notto be minimized, particularly for sensitiveservices such as water. This problem isfurther exacerbated when administrative

collection capacity is weak. Efficiencyissues also consistently arise in the case ofnatural monopolies. But Chinas approach isinstructive in that important fiscal space hasbeen derived from this source, at least foroperations and maintenance and capitalservice costs, if not for the initial investmentoutlay. Chinas ability to exploit itsownership of land is also not easilyreplicated in most countries. But certainlycountries may need to explore whetherthere is scope for intensified privatization.

This is particularly relevant when there isjustification for state involvement in a sectoror the possibility for using eminent domainfor the purpose of infrastructuralinvestments.

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III. Challenges in using public investmentas a countercyclical policy instrument

The current financial downturn and thestimulus packages adopted by a number ofindustrial and emerging market economieshave rekindled interest in the potential rolethat public investment can play amongcountercyclical fiscal tools. Several OECDand emerging market countries notably

Australia, Canada, China, Germany,Mexico, Poland and the United States have incorporated public investments intotheir stimulus programmes in varyingdegrees, with Australia and China being themost prominent (reaching almost 3 per centof GDP). Most investment programmes areless than 1 per cent. Box 1 provides details

on the composition of the United Statesfiscal stimulus package. Box 2 illustrates thekinds of investments supported by thedifferent countries.

In principle, public investments have severalpotential advantages as a means to supportaggregate demand. They potentially have arelatively high Keynesian multiplier (possiblyas high as 2), particularly if largely labourintensive and not heavily reliant on imports(Solow, 2005). They can target industries

most affected by a recession, notably theconstruction and durable goods sectors.They can be utilized flexibly, particularly inlow income countries, as public workschemes can bolster employment,especially in rural areas. Finally, they cando double duty, contributing not only to

immediate aggregate demand support butalso to the creation of infrastructure thatsupports longer-term growth prospects.

But several problems are associated withusing public investments for countercyclical

policy. Examining these problems highlightsthe prerequisites for such investments beingused successfully. First, the response to thepresent crisis suggests that most countriesdo not have a shelf of shovel-readyprojects (Kuroda et al., 2006) of the kindthat, in the words of the OECD (2009), areaimed at stated policy goals and advancedenough in planning to be implementedquickly and effectively. With the exceptionof durable goods purchases (ambulances,police cars, school buses, fire engines,

laboratory equipment) and possibly assetrehabilitation projects (periodic roadmaintenance or road rehabilitation),infrastructure investments take time todesign and evaluate before substantialexpenditures can get underway. This isparticularly true for investment projects thatbreak new ground in terms of technologiesor infrastructural networks. Legislative lagscan further delay the implementation of aninfrastructural investment programme.Bottlenecks in the construction sector or in

the capacity of ministries to spend may alsocontribute to significant implementation lags(Eskesen, 2009). Again, the OECD (2009b)notes a period of crisis does not lend itselfto complex investment projects whichtypically require careful and lengthyplanning (p.4). This is a fortiori even morethe case for mega projects.

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Box 1. United States: components of the American Recovery and ReinvestmentAct of 2009 (in b il lions of dol lars)

Tax relief $288Individuals (237)Companies (51)

Health care $147o/w Health information technology (19)

Health research and NIH construction (10)

Education $91

Aid to low income workers, reti red,unemployed and Social Securi ty recipients $82

Infrastructure investment $81o/w Core investment (road, railways,

sewers, bridges, other transportation) (51)Government facilities and vehicle fleet (30)

Supplemental investment $15o/w Broadband and internet access (7)

Energy $61o/w Electricity smart grid (11)

For state and local governmentinvestment in energy efficiency (6)

Renewable energy (6)

Housing $13

Scientific research $9

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Other $18

TOTAL $805Percentage for publ ic investment 20%As share of 2009 pro jected GDP 1.1%

Box 2. Characteristics of public infrastructural investments observed in recentfiscal stimulus packages

Canada: investment in roads, bridges and public transport, green infrastructure, as wellas in knowledge and health infrastructure, investment in social housing and support forhome renovationChina: rural infrastructure, water, electricity, transportation, the environmentGermany: for infrastructure, mostly education, hospitals, transport and informationtechnologyIndia:infrastructure projects in rural areasIndonesia: infrastructure, mainly roadsJapan:subsidy to municipalities to repair and make quakeproof public facilities

Mexico: rebuilding of nations infrastructurePoland: stimulating investment in telecommunications infrastructure, renewable energyUnited States: large infrastructure investment (roads, public transit, high speed rail,smart electricity grid and broadband; modernize classrooms, labs and libraries; fosteringrenewable energy production investments)

Source:OECD (2009b).

Even with regard to maintenance andrehabilitation spending, surprisingly fewcountries, states or municipalities haveasset registries that clarify the condition of

assets or specify the schedules for whensubstantial maintenance or rehabilitationinvestments are needed and which could beused for accelerating spending in thecontext of a recession. Even if suchregistries were available, there would still belimits as to how many investments could bequickly accelerated in a recessionarysituation. Logistical issues would limit the

number of roads that could be shut down atany one time or the number of schools forwhich it would be practical to placestudentsin a temporary classroom situation.12

In the absence of a shelf of projects,spending on many desirable projects isunlikely until well after the onset of the

12 The United Kingdoms Building Schools for the Future

project was announced in 2002 but did not incur significantexpenditures until 2006 because of the logistical challengesof selecting sites, relocating students and agreeing andfinalizing contracts.

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recession. One interesting example thatpredates the current crisis is the UnitedKingdom, which undertook several yearsago to increase its public investment levelsby 1 per cent of GDP. The evidencesuggests that it took almost four years to

raise the public investment ratio by thisamount. In fact, most major investmentprojects took about three to four yearsbefore major new expenditures wereincurred.13 In the current crisis situation,even Germany, for which infrastructuralinvestments are not a major part of thefiscal stimulus package, has experiencedserious delays in project spending. If acountry were confronted with a sustainedand deep trough in demand, this spendinglag would not be a problem, though the

demand effects of the investment might beslow in coming. But if the recession is notlikely to last for more than a year, thelikelihood is that countercyclically inspiredinvestments might have a procyclical effect,stimulating aggregate demand just when itis already surging in the context of arecovery. Empirical studies of fiscal policyconfirm such a procyclical effect (Kraay andServn, 2008), with fiscal expansionincreasing output volatility rather thanreducing it. Indeed such policies have been

found to undermine long-run growth.Additionally, once fiscal expansionarypolicies are put into play, it may be difficultto reverse them when times improve,threatening long-run fiscal sustainability.

Further of concern, in the absence of a well-evaluated list of shovel-ready projects, thereis a high risk that badly designed projectswould be implemented in a crisis. Japansexperience with infrastructural investmentsin the 1990s often illustrates this point.

Many low income countries particularly lackadequate oversight institutions or thecapacity to appraise new projects. Whilequick implementation of public works

13Another illustration relates to the London 2012 Olympics.

Here the government had, as early as 2005, developed aproposed scheme of construction in the process of makingits successful bid for the games, yet construction work didnot seriously begin until 2009.

projects may provide a temporary boost todemand, the aggregate demand effects maynot be very different from that of othermeasures to stimulate private demand. Ifpoorly conceived, the contribution of suchprojects to long-run growth is likely to be

low.

This is not to argue that new infrastructuralinvestments are not needed or that theycould not contribute importantly in the wayssuggested in section II to responding tolooming policy challenges and sustaininggrowth. The issue is simply the lead timethat is required to develop a detailed, well-designed and well-evaluated shelf ofprojects that can be put out to tender andbegin implementation at the time of a

recession.

A further difficulty with the use of publicinvestment as a countercyclical fiscalweapon is that often countries enter a crisiswith a fiscal position that is alreadyoverleveraged. When public debt to GDPratios are already high, using fiscal policylevers for further stimulus may prove lessthan effective, with fiscal multipliers lowbecause of Ricardian effects arising fromprecautionary savings.

What makes Australia and China unusual inthis regard is that both have developed sucha shelf of projects and both have enteredthe current crisis with quite strong fiscalpositions in terms of low outstanding publicdebt. In the case of China, this reflects adevelopment strategy that has pivotedaround a high savings and investment rateover the last decade or so. As a result, therehave been periods when spending oninvestments had to be contained in order to

prevent an overheated economy. Thus,when the current slowdown struck, manymunicipalities and provincial governmentsalready had a backlog of projects that hadbeen held back and which were ready to beimplemented (though one could raisequestions as to whether all the projects onthe shelf were socially profitable). In thecase of Australia, Infrastructure Australia

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was established before the signs of a crisiswere evident, motivated not by thepossibility of a recession but by therecognition of a need to develop a nationalstrategy for infrastructure investment. Thisleft Australia fortuitously well positioned,

during the current downturn, to movequickly on a number of projects that hadalready been evaluated and prioritized.

There is a message of course implied by theAustralian and Chinese cases, which is thatthere is a contingency value in developing apipeline of shovel-ready, well-evaluated andprioritized infrastructure investments. In theevent of a future recession, such aprogramme would facilitate (thoughobviously not guarantee) a more

premeditated, well-considered perspectiveon infrastructural priorities, though even insuch cases, there would most likely be timelags before implementation is feasible.

IV. Concluding thoughts

There can be little doubt that most countriesin the world face enormous challenges interms of the need for public investment,

starting with a large agenda forinfrastructure but also for addressing majordeficiencies in the availability of socialservices and for developing the humancapital resources required to meet thecomplex challenges of this century.Prioritizing public investment decisions willnever be easy, because the trade-offsbetween physical and human capitalformation, as well as between the interestsof present and future generations, cannotbe easily quantified or calibrated. Neither

will the factors that have limited publicinvestment in the past be any less binding inthe future. For most countries, fiscal spaceconstraints will continue to make it difficultto finance much of the required investment,underscoring the importance of efforts tomobilize additional fiscal resources in theform of additional tax revenues andrationalized expenditure programmes.

Macroeconomic stability and fiscalsustainability must remain importantconcerns in shaping decisions on the size ofa governments overall investmentprogramme. Added to these considerationsis the recognition that in times of economic

downturn, public investment can play animportant countercyclical role.

In terms of the challenge of prioritization,one must watch out for a bias againstspending on vital social services. Wehighlighted earlier the important trade-offsbetween soft and hard infrastructure, and inparticular, the bottlenecks to rapid andsustainable growth that can arise from ascarcity of high quality human capital orfrom a neglect of basic social services in

health and education. While difficult, gettingthe right balance is not impossible. A goodstarting point for thinking about prioritiesbetween physical and social capital areanalyses that highlight domestic and foreigninvestors perceptions of what the keybottlenecks to investment are. Equally, it isimportant to stand back from arguments thatsimply establish norms or targets for socialspending. Rather, analysts should seek toclarify and try and understand what theplausible linkages are between investments

in social capital and development, takingaccount of the timing of potential returns.

The potential importance of publicinvestment as a tool for countercyclicalfiscal policy has once again beenrecognized in the current crisis. But thatrecognition has come too late for mostcountries in terms of using the tool verysubstantially in the near term. Whatapproaches are available to governments inaddressing the obstacles of the absence of

shovel-ready projects and the limits in fiscalspace? For the former, an obvious startingpoint is the development of an asset registryof government infrastructure that specifiesan appropriate schedule for maintenanceand rehabilitation. Such a registry would notonly help guide ongoing governmentspending on maintenance of publicinfrastructural assets but would also be

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available for an accelerated programme ofrehabilitation and maintenance when thereis a need for an active countercyclicalpolicy. Next in priority would be forgovernments to adopt the Australian andChinese approaches and move proactively

to develop a portfolio of appraised,acceptable and prioritized infrastructureprojects, with a categorization of thoseprojects that can be implemented relativelyquickly. The Australian initiative also is amodel of how governments can develop apublic investment programme that isresponsive to the challenge of enhancinggrowth. Third, achieving clarity on when theprocurement of locally produced machineryand equipment would be desirable can beanother axis for providing some

countercyclical stimulus. Finally, and notnecessarily as productive, someconsideration could be given to labour-intensive public works schemes, similar tothose adopted by India in recent years, thatmight provide a form of social safety net forunderemployed low income workers.

Concerning fiscal space, the obvioussolution in a recession for providingcountercyclical stimulus is initiall