How Investment Quality Shapes Economic Stability in Emerging Markets and Developing Economies

The paper introduces a new index to measure public investment quality, showing that high-quality investment reduces sovereign risk and improves debt sustainability, while low-quality investment has the opposite effect, particularly in emerging markets and developing economies. It underscores the need for improving investment processes in these regions to foster sustainable growth.

A new study by Amat Adarov and Ugo Panizza, part of the World Bank’s Policy Research Working Paper series, introduces a groundbreaking index that assesses the quality of public investment across 120 countries from 2000 to 2021. This index, built on the World Bank’s extensive project performance data, serves as a vital tool in understanding how the quality of public investment influences sovereign risk and debt sustainability, particularly in emerging markets and developing economies (EMDEs). The paper’s core argument is that the effectiveness of public investment in driving economic growth and ensuring fiscal stability is heavily dependent on the quality of the investment itself, rather than merely its scale. High-quality public investment, according to the research, can be self-financing, meaning that the economic benefits generated by such investment can offset the initial costs, ultimately leading to a reduction in the debt-to-GDP ratio. On the other hand, low-quality public investment, which is often plagued by inefficiencies and poor project outcomes, can exacerbate sovereign risk and deteriorate fiscal fundamentals, particularly in countries with already fragile economies.

The Perils of Low-Quality Public Investments

The authors emphasize that not all public capital investments yield productive outcomes. In some cases, particularly where governance is weak and corruption is prevalent, public investment may lead to "white elephant" projects large-scale ventures that are costly but deliver minimal economic benefits. These projects can distort economic growth and lead to a negative impact on a country's fiscal health. In contrast, high-quality public investment, which is well-planned, efficiently executed, and effectively managed, tends to enhance long-term economic productivity and growth. This, in turn, improves fiscal revenues and reduces sovereign risk, creating a virtuous cycle where public investment supports overall economic health. The study finds significant disparities in public investment quality across different regions and income levels. Lower-income countries and those reliant on commodity exports typically display lower public investment quality. The authors note that this gap has widened over time, exacerbating the challenges faced by these countries in using public investment as a tool for economic development. In particular, countries in Sub-Saharan Africa and the Middle East and North Africa regions show significantly lower investment quality compared to other EMDEs. This finding is crucial because it underscores the importance of not just increasing public investment but also ensuring that the investment is of high quality.

Public Investment Quality and Sovereign Risk

The paper uses the newly developed index to explore how public investment quality interacts with sovereign risk. Sovereign risk, which reflects the likelihood of a government defaulting on its debt obligations, is a critical factor for countries in the global financial system. The study reveals that in countries with high public investment quality, an increase in public investment is associated with lower sovereign risk. This relationship is particularly strong in countries that are classified as sub-investment grade, where financial markets are more sensitive to changes in public investment quality. In these contexts, high-quality public investment can signal to investors that a country is improving its economic fundamentals, thereby reducing the risk premium that investors demand. Conversely, in countries with low public investment quality, increasing public investment tends to raise sovereign risk, as the inefficiencies and poor outcomes of these investments do not justify the additional debt incurred.

Implications for Long-Term Debt Sustainability

The research also delves into the implications of public investment quality for long-term debt sustainability. Using a series of econometric models, the authors show that in countries with high public investment quality, scaling up public investment can lead to a reduction in the debt-to-GDP ratio over time. This effect is attributed to the higher fiscal returns generated by efficient public investments, which enhance economic growth and, consequently, fiscal revenues. On the other hand, in countries with low public investment quality, increasing public investment tends to result in higher debt ratios, reflecting the poor returns on such investments and the additional fiscal burden of maintaining inefficient infrastructure.

Policy Recommendations for Emerging Markets and Developing Economies

The study's findings have important policy implications for EMDEs, particularly those grappling with high sovereign spreads, limited fiscal space, and challenges in accessing international capital markets. The authors argue that these countries should prioritize improving the quality of their public investment processes. This includes addressing systemic issues such as corruption, weak governance, and ineffective project management, which are major impediments to achieving high-quality public investment. Moreover, the paper highlights the need for intensified technical and financial assistance from the global community to help low-income countries enhance their public investment management capabilities. Such support is essential for these countries to effectively use public investment as a catalyst for sustainable economic growth and to avoid the pitfalls of low-quality investment that can lead to fiscal instability and increased sovereign risk.