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1.1        Background of the Study

The economic problems of third world countries are not, in their totality, uniform. But their basic characteristics transcend the boundaries of individual countries (Ray, 1983). These problems according to Jhingan (2005) are the problems of a fundamental disequilibrium of the economy, with the attendant features of stilted economic growth, an adverse balance of payment, low capital formation, unequal distribution of income, price level instability, severe unemployment among others. The African continent is worst hit by underdevelopment, while Sub-Saharan Africa is generally described as the poorest region of the world; one that is getting poorer in the face of sustained growth and significant improvement of living standards in the rest of the world (Todaro and Smith, 2006; Bayraktar and Fofack, 2007). Virtually all countries in the region have been confronted with deep-rooted developmental constraints: rapid population growth, low physical and human capital development, and inadequate infrastructure. These and other similar economic problems have constituted major impediments to private sector development and to their economies in general. In addition, ethnic conflicts, political instability, and adverse security conditions have aggravated the economic performance of several countries in the region. These all have been putting huge obstacles to the capital formation in the subcontinent- one of the very crucial factors of production for the progress of economies (Chhibber and Dailami, 1990; Sima 2007)

Private investment is essential for ensuring economic growth, sustainable development and poverty reduction. It increases the productive capacity of an economy, drives job creation, brings innovation and new technologies, and boosts growth. Private investment plays an important role in developing nations for the same reason that it does in industrial countries: investment determines the rate of accumulations of physical capital and is thus an important factor in the growth of productive capacity (Agenor and Montiel ,1996). However, the amount of physical capital in general and private investment in particular falls short of development needs in these countries especially African nations. Several studies, such as Mlambo & Oshikoya (2001), Anyanwu (2006),Bayraktar & Fofack (2007), Douglas and Quentin (2007) and Bakare (2011) show that the contributions to growth of physical capital and total factor productivity in Sub-Saharan Africa (SSA) have been low and have declined over time.


Fiscal Policy and Private Investment in Africa: A Test of The Crowding-Out Hypothesis.

In economic growth literature, neoclassical growth models such as Solow (1956) and Swan (1956) postulate that economic policies do not affect steady state economic growth, although they can affect the level of output or its growth rate when the economy is in transition from one steady state to another; while in endogenous growth models some fiscal policy instruments are harmful for growth while others are not (Barro, 1990; Lucas 1990). However, these days it is believed that macroeconomic policies may affect economic growth either directly through their effect on the accumulation of factors of production, namely capital, or indirectly through their impact on the efficiency with which factors of production are used. Macroeconomic stability (reflected in low and stable inflation, sustainable budget deficits, and appropriate exchange rates) sends important signals to the private sector about the direction of economic policies and the credibility of the authorities regarding their commitment to manage the economy efficiently. Such stability, by facilitating long-term planning and investment decisions, encourages savings and private capital accumulation (Ghura & Hadjimichael, 1995).

Specifically, endogenous growth models have shown that fiscal policy can have significant effects on economic growth in the long run. For example, in a model that assumes constant returns to scale with respect to government inputs and private capital combined but diminishing returns with respect to private capital alone, Barro (1989 and 1990) has shown that high levels of government taxation distort savings decisions, which in turn lower economic growth in the steady state. Fiscal policy can foster growth and human development through a number of different channels. These channels include the macroeconomic (for example, through the influence of the public investment, as a catalyst, on private investment) as well as the microeconomic (through its influence on the efficiency of resource use) channels.

Since 1980s, extensive efforts have been directed at generating economic recovery in Africa through the Structural Adjustment Program (SAP) and other similar programmes. However, little (or only recently) attention has been given to the need to promote private investment, although investment is essential in any country for a number of economic reasons (Arin, 2004). Policy makers have not tended to give much practical attention to the link between private investment and socio-economic progress (Atukeren, 2010). The Structural Adjustment Programme of the World Bank (WB) and the International Monetary Fund (IMF), aiming to address the problem of poverty and declining private investment, emphasize the need to reduce government budget deficits; Hermes and Lensink, (2001) stressed that these bodies assume that reducing fiscal


Fiscal Policy and Private Investment in Africa: A Test of The Crowding-Out Hypothesis.

deficits is beneficial for the long-run growth process, no matter how such a reduction is achieved.

Fig 1.1 Sub-Saharan Africa Government Final Consumption Expenditure Annual % Growth

The investigation on the effectiveness of fiscal spending in Africa is essential in the decision making process. This is because government spending has been on the increase since the turn of the millennium, especially during the peak of the global economic crisis which witnessed the region increase expenditure from 5.47% in 2008 to 23.29% in 2010 while the developed world were battling with public spending cuts (see fig 1.1) and most governments in the continent have been running a budget deficit for more than a decade (Motlaleng, Nangula and Moffat, 2011). According to the WB and the IMF, reducing the role of the government would reduce barriers to the economic endeavours and ginger private initiative and intervention. Despite these efforts, the continent's poor economic performance has been persistent due to, among others things, the low levels of private investment as the share of GDP in the subcontinent (Alfredo, 2006; Udah, 2010). This opens a door for suspicion of those policies formulated by these two organizations. However, there is a need to emphasize that the aim of this study is not to attest whether the public policies designed by the WB and/ or the IMF, particularly for the developing world, such as the SSA region, are correct or not. Rather, the study will focus on investigating the effectiveness of fiscal policy measures in enhancing the performance of private investment in the region.

The association between public investment spending and private investment is a controversy in the realms of macroeconomics and public policy making that has strong implications for determining the government policy to promote economic growth (Kollamparambil and Nicolaou, 2011). On the one hand, increased government involvement in the economy (mainly through expenditure activities) might distort the economic and political environment of business and discourage or crowd-out private sector investment. On the other hand, government protective and productive investments in physical, legal, and human capital infrastructure might crowd-in


Fiscal Policy and Private Investment in Africa: A Test of The Crowding-Out Hypothesis.

private sector investments (Atukeren, 2010). It is thus vital to establish whether efforts being made by the governments of African nations, with regard to their investment contributions, are thwarting or fostering the private sector’s incentive to invest. Ascertaining such a relationship between these two key elements is imperative for economic growth-oriented public policy in the region.

1.2        Statement of the Problem

Private investment is a powerful catalyst for innovation, economic growth and poverty reduction (Todaro and Smith, 2006). Chhibber and Dailami (1990), Oshikoya (1994), Ndikumana (2005) and Bakare (2011) particularly stress that the importance of private domestic investment to the growth and development strategy of developing countries is emerging with particular clarity from the convergence of two strands of empirical concerns. One is the evidence that in almost all these countries, domestic investment has borne the brunt of the aggregate demand contraction associated with the process of external adjustment. The second, which derives partly from the first, is the growing agreement on the desirability of increasing private sector’s share in total capital formation through increased reliance on market forces and incentives.

In addition to its documented contribution to growth, private investment in the case of Africa deserves serious attention for three additional reasons. First, sustained increase in private investment serves as a visible proof of the private sector’s confidence in public policy both in the sense that policy is heading in the right direction and that policy reforms are deemed sustainable in the long run (Ndikumana, 2005) Achieving the growth rates needed to alleviate poverty and raise employment will require active participation of private investors. Second, sustained increase in private investment is a sign of efficiency of public investment especially in reducing the costs of private investment, thus raising profitabi

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