Are public infrastructure investment and fiscal sustainability in Latin America incompatible?

Infraestructure - Transport - Water

Low and volatile public infrastructure investment is one of the most frequently-cited causes of slow output growth in many Latin American countries. Better roads, ports and railroads reduce transportation costs and increase the competitiveness of domestic firms. A stable and cost-effective provision of energy and telecommunications services also expands the production possibilities of firms. Furthermore, broad access to infrastructure services, from water and sanitation to transport infrastructure and telecommunications, also plays a key role in reducing income inequality and poverty. Latin America exhibits significant infrastructure gaps, due to decades of low and public investment. While during the 1980s, total infrastructure investment in the LAC-6 (i.e. Argentina, Brazil, Chile, Colombia, Mexico and Peru)1 averaged around 3.3% of GDP, total infrastructure investment between the years 2000-06 amounted to just 2.0% of GDP. These levels are far below those recommended by the literature.2 For example, the Commission on Growth and Development (2008) highlighted that in fast-growing Asia, public investment in infrastructure accounts for around 5.0% to 7.0% of GDP.

Source: Carranza et al. (2011), based on Calderón and Servén (2010), ECLAC and IMF databases

High financing costs due to weak fiscal sustainability, together with fragile institutions, have contributed significantly to low levels of infrastructure investment in Latin America. Improvements in fiscal balances achieved in the late 1980s and early 1990s came at the expense of sharp declines in public infrastructure investment (see Martner and Tromben, 2005; de Mello and Mulder, 2006; Lora, 2007; CAF, 2009). From the mid-1980s to the early-mid 1990s, the reduction of public deficits (cumulatively, 6.3 p.p. of GDP in the period 1987-1992 for LAC-6) was accompanied by a reduction in public infrastructure investment (-2.4 p.p. of GDP). Private investment did not offset this retrenchment in public investment (in the same period, private investment rose just 0.8 p.p.). Opaque procurement and concession processes, periodical re-negotiations of contracts, and inadequate regulatory frameworks explain in part this weak crowding-in effect in Latin America (see Guasch et al., 2007 for transport and water and Engel et al., 2003 for highways).

A closer look at investment rates vis-à-vis headline and cyclically-adjusted budget balances provides a more ambiguous message. In Carranza et al. (2011) we analyse episodes of sustained fiscal consolidations, defined as those in which the budget balance improved for two or more consecutive years. During these episodes, the contribution of infrastructure investment cuts to fiscal improvements is limited. For instance, only in the cases of Colombia 1999-2004 and Chile 2002-2005, and less so Peru 2000-2003, were reductions in public investment a significant part of the observed fiscal adjustment.3  

Source: Carranza et al. (2011), based on Calderón and Servén (2010), Daude et al. (2011), ECLAC and IMF databases

Still, closing the infrastructure gap remains a fiscal policy issue. In particular, the private provision of infrastructure often involves renegotiations of contracts and changes in contractual conditions that are contingent liabilities for the public sector. 

Fiscal exit strategies in many cases should incorporate a fiscal framework favourable to public infrastructure investment. Better fiscal frameworks may contribute to ease this public investment friendly fiscal consolidation. Priority should be given to generating more fiscal space in the long-run, beyond immediate cyclical considerations, rather than simply allowing for more discretionary fiscal space during economic slowdowns. The main institutional arrangements for fiscal policies and investment can be summarised as follows: golden rules - which set targets on the current balance and exclude capital expenditures -, accounting – excluding from the fiscal targets the operations of commercially-run public enterprises, and macro-fiscal rules - legislation forcing the accumulation of savings during the good times, in order to generate the fiscal space to maintain public investment during economic downturns. The first two arrangements share a potential problem, since they do not guarantee fiscal sustainability, even if they are perfectly defined (e.g. Ter-Minassian, 2011).

The Peruvian fiscal framework, which combines deficit and current expenditure ceilings, is an interesting case, as it was followed by a boom in public investment cum fiscal consolidation in the last five years.4 The 1999 Fiscal Prudency and Transparency Law introduced a series of numeric restrictions. Namely, a 1% limit on the deficit of the consolidated public sector (i.e. including Central Bank) and a 2% (plus inflation) ceiling on the growth rate of non-financial expenditures. In 2003 the latter limit was slightly relaxed, but additional restrictions were included for election years, and for regional and local governments. Key changes were included during 2006-2008, when a 3% limit to expenditure growth was applied to consumption expenditure (wages and expenditure in goods and services). This limit was then raised to 4% and included pensions. This meant that revenue booms could be devoted to boosting investment.

In the Peruvian case, fiscal rules have been effective in imposing discipline upon governments. However, they had to be fine-tuned along the years. Although the rules included escape clauses, investors found them credible and this was crucial for Peru’s successful economic performance during the last decade. 

Source: Carranza et al. (2011), based on data from the Peruvian Ministry of Finance and the Central Bank (BCRP)

To conclude

The fiscal consolidation strategies in Latin America should incorporate a fiscal framework favourable to public infrastructure investment. The case of Peru represents a good example for the region, as the establishment of a simple fiscal rule that combines deficit and current expenditure ceilings created fiscal space to boost public investment.

Our analysis focused on fiscal rules, but the effectiveness of fiscal consolidation could be improved by combining rules with better institutions (from fiscal councils to independent fiscal agencies) and budgetary procedures. Needless to say, higher infrastructure investment, thanks to more fiscal space, should be accompanied by better spending processes. 


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1Comparable statistics on infrastructure investment in Latin America are not available for a large group of countries. We focus on those for which data are available from the World Bank’s work on infrastructure in Latin America (Calderón and Servén, 2010): Argentina, Brazil, Chile, Colombia, Mexico and Peru (LAC-6, henceforth), which represent around 85% of Latin America’s GDP. This sample also covers a wide range of experiences regarding investment trends, both public and private, as well as budgetary frameworks and fiscal rules.
2There are significant differences within the region. In Argentina, Brazil and Mexico, public infrastructure investment fell around 2 p.p. of GDP, while private flows increased 1 p.p. in the best cases. Conversely, Colombia and especially Chile managed to compensate the reduction in public investment with an increase in private investment. Peru represents an extreme case with a collapse in total investment in the late 1980s. There is also heterogeneity across sectors. The general trends reflects the performance of electricity and ground transportation., while private investment in telecommunications has more than compensated the public sector’s retrenchment. Finally, public investment in the water sector has been fairly stable, with only marginal contributions from private initiatives.
3This weak relationship between fiscal performance and investment rates is also found analysing data for the whole period 1980-2006 (using both actual and cyclically-adjusted, according to Daude et al., 2011).
4In Carranza et al. (2011), we also take stock on the treatment of infrastructures in second-generation reforms of fiscal rules and frameworks in the LAC-6.

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