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K4D Helpdesk Report;382

The Public Investment Gap: the Need for External Finance to Increase Public Investment

Published on 2 August 2018

Public investments are an important tool for economic growth and development. For sub-Saharan Africa, the issue of optimal level of public investment is under-researched. Public investment trends show that during the booming years of the 2000s public investment went up in all developing countries and emerging markets. Public investment in Low-Income Countries (LICs) and Lower Middle-Income Countries (LMICs) is higher as a percent of GDP than in other emerging markets and advanced economies and has followed a general upward trend since 2000, first surging before the global financial crisis and then picking up again until 2015. This trend after the global financial crisis was mainly the result of high export commodity prices, advancing in particular countries that depend heavily on these exports for their public finance. However, with the recent fall in commodity and fuel prices, the literature shows that now only the more diversified and frontier economies particularly in LMICs are able to remain their public investment levels. The gap between public savings and public investment is growing rapidly in developing countries, contributing to higher government debt-to-GDP ratios. Budget deficits have gone up, interest rates have risen, and local currency depreciation has increased the burden of external debt.

Despite the recent struggles to raise public investment in LICs and LMICs, there is a call from the international community and national governments for additional public finance to invest in sustainable development. Additional finance is needed for job creation, the transition to a green economy, climate change mitigation, sustainable and inclusive food systems, access for all to education, energy and health care. Recent calculations on investment gaps relate to the Sustainable Development Goals (SDGs). The literature references an annual US$1.4 trillion investment gap for LMICs and LICs (US$2.5 trillion worldwide). A large part (40%) could be financed through increased private investment (e.g. foreign direct investments). The remaining public investment needs are particularly high and unmanageable for LICs, as it is 27% of GDP, while for LMICs it is 5.5% of GDP. The literature further references in what sectors public investment is needed. For example, to help vulnerable countries deal with the consequences of climate change, between US$140 billion and US$300 billion per year will be needed to 2030, and US$280 billion to US$500 billion per year to 2050. Furthermore, public investment needs are the highest for education, energy infrastructure and transport infrastructure. Private investments are estimated for power installations and transport infrastructure, however, they are concentrated in LMICs and will ignore road infrastructure and access to energy in rural areas. In sectors with high private investment rates, like ICTs and telecommunications, public investment is still necessary to stimulate infrastructure in remote areas and for updating policy frameworks for the use of new technologies. Public investment in policies will give the private sector better opportunities to invest in innovation. The health sector is a good example of where investment needs are very well assessed and money mobilised to finance investment needs and improve efficiency.

Public investment needs can be financed in multiple ways. There are three main measures that governments can take. Firstly, governments can increase tax revenues (it is estimated that developing countries can gain 9% of GDP through reforming tax systems and tax collection). Secondly, improving public investment management is necessary to increase efficiency and impact (the average developing country loses about 30% of the value of its investment to inefficiencies in its public investment processes). Thirdly, Public Private Partnerships (PPPs), which can reduce risks for private investors, could – if well managed – improve quality and quantity of public investment. However, the literature shows that PPPs are mainly used in emerging markets and less in LMICs and LICs. Furthermore, PPPs are concentrated in energy (power) and transport (airports and ports). Overall, if developing countries succeed in these three measures this would mean that most LMICs could provide in their own public investment needs. However, LICs still rely on additional external public finance flows.

Therefore, additional external finance, in particular in LICs and some LMICs, is still necessary. Multilateral aid (through multilateral developments banks) is unlikely to increase significantly, however, they play an important role in aid assistance and capacity building on public investment management. Bilateral aid flows are not expected to increase significantly in the coming years, and more ODA money is used for loans instead for grants, particularly for LMICs (and other MICs). Also some LMICs (e.g. Senegal and Ethiopia) recently have accessed international financial bond markets, as a consequence increasing their debt levels significantly.

The literature shows that governments now have a wide range of new finance tools available, in the form of innovations for resource mobilisation and resource delivery. This results in more complexity and planning for public investment projects to find the right financial tools. Governments can act in three ways. “Additional” finance provides more money for development, generating a distinctly new flow of funds. “Efficient” financial mechanisms add value by reducing risks and improving financial characteristics of a program rather than raising new funds. “Effective” mechanisms are designed to increase purchasing power of available funds by incorporating incentive structures that enhance accountability and ownership. Many current initiatives combine these attributes.

Cite this publication

Quak, E. (2018). The public investment gap: the need for external finance to increase public investment. K4D Helpdesk Report no. 382. Brighton, UK: Institute of Development Studies

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published by
IDS
authors
Quak, Evert-jan
language
English

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