International Seminar on Strengthening Public Investment and Managing Fiscal Risks from Public-Private Partnerships

Budapest, HungaryMarch 7–8, 2007

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Challenges for Public Investment in New EU Member States

Filip Keereman*

Head of Unit – Czech Republic, Poland, Romania and Slovakia

International Seminar on Strengthening Public Investment and Managing Fiscal Risks from Public-Private Partnerships

Budapest, 7 March 2007

EUROPEAN COMMISSIONDIRECTORATE GENERAL ECONOMIC AND FINANCIAL AFFAIRSEconomies of the Member States

* prepared with the help of Anton Jevcak

2

Outline• Relevant economic theory – main implications

• The need to upgrade infrastructure and enhance catching-up

• Public investment in the EU budgetary surveillance framework

• Public investment in new MS and relation to private investment and EU transfers

• Conclusions

3

Public investment – definitionNational Account Statistics– investment (GFCG) - defined as expenditure on

fixed assets –– tangible or intangible assets to be used in production process for more than a year: roads, buildings, computer software…

−> excludes investment in human capital and knowledge creation – wages paid to teachers and researchers = current expenditure

– net investment - taking into account depreciation −more correct measure of public investment−> result of estimation methods −> limited reliability −> gross GFCF commonly used

4

Public investment – definition

National Account Statistics

– public = general government – includes central and local authorities −> excludes investments by publicly-owned enterprises classified outside the GG sector −> offers room for circumventing budgetary rules

5

Growth theorySolow (exogenous) growth model− declining marginal productivity of capital

−> the capital/output ratio converges to some steady-state level −> saving/investment rate has no impact on long-term growth

Endogenous growth models− Investment in human capital and R&D −> potential

for increasing/constant marginal productivity −> higher investment rates can lead to higher long-term growth

6

Rationale for public investment

1. Public goods – partially non-rival and non-excludable goods −> under-supplied by the private sector – basic research, transport infrastructure, legal system…

2. Positive externalities - social rates of return exceed private ones

3. Asymmetric information problems – missing markets for capital or insurance

4. Presence of increasing returns/network externalities−> imperfect competition (natural monopolies)

−> under-supply by the private sector

7

Problems associated with public investment

1. Lack of information by policy-makers2. Political economy considerations –

disproportionate impact of small, clearly identifiable groups/corruption (higher in new MS)

3. Expenditure competition – over-supply of public investment in an effort to attract private capital (Fuest, 1995 and Bayindir-Upmann, 1998 )

8

Empirical evidence

• Seminal paper – Aschauer (1989) – strong positive impact of public investment on US aggregate output

−> subsequent research – majority of studies find a positive impact of public investment on output, productivity or growth

−> but, it is often not strong, sometimes it is insignificant and in some case negative

9

Outline• Relevant economic theory – main implications

• The need to upgrade infrastructure and enhance catching-up

• Public investment in the EU budgetary surveillance framework

• Public investment in new MS and relation to private investment and EU transfers

• Conclusions

10

Public capital stock lower in new MS

New members states have less roads and of a lower quality, especially in Poland and Romania

Road infrastructure in 2002

0.0

0.5

1.0

1.5

2.0

2.5

EU15

EU12 HU CZ

CY LT PL EE SI SK RO

BG

Roads (km per square km)Share of motorways (%)

11

Costs of compliance with the EU acquis

• The costs of the environmental acquis estimated at around EUR 80 billion – 110 billion, or around 18 – 24% of 2003 GDP of the new Member States (European Commission, 2003).

• The costs of compliance with the transport acquis estimated at around EUR 100 billion, or around 22% of 2003 GDP (Van Miert, 2003).

• However, estimated benefits of the environment acquis far outweigh the costs (World Bank, 2002).

12

Total investment

Total GFCF on average higher in new membersstates – but there is large dispersion

Total GFCF (2001-05 average)

20.7 20.1 21.3 21.6

26.1 26.3 26.729.7

22.8

18.0 18.7 18.822.6

23.8

0

5

10

15

20

25

30EU

15

EU12 CY

MT

PL BG LT RO HU SI LV SK CZ

EE

% GDP

13

Composition of total GFCF

New member states seem to invest in more productive assets (distribution stable over time) but no stable pattern across all countries

GFCF by asset type

AVERAGES 96-05 01-05 96-05 01-05 96-05 01-05 96-05 01-05 96-05 01-05EU15 20.6 20.7 5.4 4.9 5.0 5.3 6.0 6.2 2.2 2.1EU12 22.8 22.8 7.9 7.4 3.4 3.5 9.0 8.9 2.3 2.5Bulgaria 16.9 20.1 NA NA NA NA NA NA NA NACzech Republic 27.9 26.7 9.8 8.7 3.2 3.0 10.6 9.8 3.1 3.6Estonia 28.3 29.7 9.3 9.0 2.9 3.4 12.1 12.4 3.5 4.3Cyprus 18.2 18.0 4.7 4.5 6.4 6.5 5.8 5.7 1.2 1.2Latvia 23.6 26.1 8.6 8.2 2.2 2.2 8.1 9.9 3.2 3.8Lithuania 21.5 21.3 6.8 6.6 1.8 1.8 10.2 10.1 1.9 2.0Hungary 22.7 22.6 8.3 7.4 4.4 4.8 7.3 7.1 1.9 2.0Malta 20.8 18.7 7.3 6.5 3.8 3.9 7.1 6.8 1.2 0.3Poland 20.8 18.8 6.7 5.6 2.7 2.8 9.0 8.0 2.0 1.8Romania 20.4 21.6 6.9 6.9 9.1 9.6 2.5 3.2Slovenia 24.0 23.8 8.2 8.0 3.5 3.3 9.1 9.3 2.1 2.2Slovakia 28.7 26.3 10.5 9.6 3.0 3.2 10.3 8.6 3.1 3.2

Transport EquipmentTotal Metal Products And Machinery

Construction Work: Housing

Construction Work: Other Constructions

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Public investment

Public GFCF also on average higher in new members states but there is again large dispersion

GFCF by General Government (2001-05 average)

2.83.3

1.6

2.7

3.5

2.9 3.03.3 3.3 3.4

3.9 3.9 4.24.4

0.00.51.01.52.02.53.03.54.04.55.0

EU15

EU12 LV SK RO LT CY SI PL BG EE HU

MT

CZ

% GDP Local GovernmentCentral Government

15

Public expenditure on education

Public expenditure on education on average higher in old member states

5.0

3.3

4.1 4.2 4.3 4.55.1 5.2

6.0 6.25.75.75.6

5.4

0

1

2

3

4

5

6

7EU

15

EU12 RO

BG CZ

SK MT

HU PL LV EE LT SI CY

Public expenditure on education (1999-2003 average)

% GDP

16

Public expenditure on R&D

Public expenditure on R&D also on average higher in old member states: all new MS below EU15 average; variation between 0.2% (MT) and 0.5% (CZ)

Public expenditure on R&D (2001-05 average)

0.62

0.36

0.18 0.19 0.20

0.280.33

0.37 0.380.44

0.480.51 0.53

0.16

0.00.10.20.30.40.50.60.7

EU15

EU12 MT

RO LV CY

SK BG PL EE LT SI HU CZ

% GDP

17

Outline• Relevant economic theory – main implications

• The need to upgrade infrastructure and enhance catching-up

• Public investment in the EU budgetary surveillance framework

• Public investment in new MS and relation to private investment and EU transfers

• Conclusions

18

Public investment in the EU budgetary surveillance framework

S&G pact - no special treatment of public investment as regards the definition of the budget balance - but - in the context of the EDP – when preparing a report if the actual or planned deficit goes above 3% of GDP according to Article 104(3) the Commission “…shall also take into account whether the government deficit exceeds government investment expenditure…”.

Currently, none of the new members states has a golden rule at the central or general government level.

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A rational for the golden rule

1. Financing investment from current revenues may clash with consumption-smoothing objectives of governments

2. Productive public investment can pay for itself over the longer term

3. Institutional/political constraints – cutting public investment often politically easier than reducing current expenditure or rising taxes

4. Inter-generational equity – current generation should not carry the whole burden of public investment when enjoying only part of the long-term benefits

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Arguments against the golden rule

1. No strong empirical evidence that governments undertake too few public investments

2. In case of constrained financing/excess demand pressures – overall balances matter

3. Public investment may not be sustainable or may yield inadequate returns

4. Negative expenditure composition bias:financial constraints softened on investment in fixed assets, while investment in human capital or R&D constrained by deficit ceiling

21

Impact of EU accession on GFCF by GGs

Average public investment decreased slightly,but there is no clear pattern (decline in SK, RO, HU, EE, MT)

0

1

2

3

4

5

6

EU15

EU10 LV SK LT SI CY PL HU CZ

EE MT

02-03 average04-05 average

Public investment in new MS between 2002 and 2005

% GDP

22

Public investment and borrowing in the EU

Public investment on average exceeds public deficits both in EU15 and in EU12, but not in the EDP countries(CZ,CY,HU,MT,PL,SK)

GG deficit and GFCF (2001-05 averages)

-2-1012345678

EU15

EU12 BG CZ

EE CY LV LT HU

MT

PL RO SI SK

Budget deficit GFCF

% GDP

23

Outline• Relevant economic theory – main implications

• The need to upgrade infrastructure and enhance catching-up

• Public investment in the EU budgetary surveillance framework

• Public investment in new MS and relation to private investment and EU transfers

• Conclusions

24

Complementarity or substitution between public and private investment?

Positive relationship between public and privateinvestment in the new MS seems to have faded outin the last 5 years

Cross-country relationship between public and private investment in new MS

5

10

15

20

25

30

1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0PUBLIC INVESTMENT (% GDP)

PRIV

ATE

INVE

STM

ENT

(% G

DP)

96-00 average01-05 average96-05 averageLinear (96-00 average)Linear (01-05 average)Linear (96-05 average)

96-00

96-05

01-05

25

EU funds and public investment

Higher net inflows of EU funds might enablegovernments to undertake more investments

Cross-country relationship between net inflows of EU funds and public investment in the EU15 between 1986 and 2005

DK

FI IT

FR

AT

SE

UK

NL

DE BE IE

EL

LU PT

ES

0

1

2

3

4

5

-1 0 1 2 3 4

Net inflows

Publ

ic in

vest

men

t % GDP

% GDP

26

Net inflows of EU funds into new MS

Absorption of EU funds in new MS in the first years of membership lower than in some old MS

Net inflows of EU funds in 2004 and 2005

0.0

0.5

1.0

1.5

2.0

2.5

3.0H

U CZ

CY SI SK PL MT

EE LV LT

EU10

EL PT ES

20042005% GDP

Absorption of structural funds

Absorption has been relatively low so far, but time frame was also relatively short

28

Conclusions• There appears a role for public investment in

catching-up. The composition of investment is important.

• New member states have on average higher total and public capital expenditure and lower expenditure on education and R&D

• Given lower stock of capital, capital investment should generate higher returns and thus growth until a steady-state level of capital/output ratio is reached (Solow model)

• Moreover, new (especially foreign) capital usually embodies up-to-date technology (free-riding on global technological progress) −> higher productivity growth

• Nevertheless, the right time to switch to more “knowledge” based growth should not be missed

29

Conclusions

• No clear impact of EU accession on public investment levels;

• Positive relationship between public and private investment in new MS seems to have faded out in the last 5 years

• EU funds can support public investment, but sufficient absorption capacities need to be established