PART II A MACRO-ECONOMIC METHODOLOGY FOR THE APPRAISAL OF THE EFFECTS OF PRI V A TE FOREIGN INVESTMENTS IN LESS DEVELOPED COUNTRIES

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1 PART II A MACRO-ECONOMIC METHODOLOGY FOR THE APPRAISAL OF THE EFFECTS OF PRI V A TE FOREIGN INVESTMENTS IN LESS DEVELOPED COUNTRIES

2 TABLE OF CONTENTS SUMMARY OF PART II 53 CHAPTER I. GENERAL INTRODUCTION Introduction 1.2. The appraisal of the effects of PFI 1.3. The quantitative approach in general CHAPTER II. A MODEL OF A LDC's ECONOMY WITH SPECIAL REFERENCE TO PFI Introduction The PFI sector The external sector of the rest of the economy and the b.o.p Private savings The public sector Investments in the rest of the economy Income for the total economy Demand Employment O. Alternative formulations of some equations Alternative ways of financing investments from abroad 72 Appendix I : Terminology and abbreviations 74 Appendix 2: Ust of symbols 74 Appendix 3: The model 76 CHAPTER III. THE ECONOMIC EFFECTS OF PFI Introduction The effects on investments in the rest of the economy and on the growth of income The effects on the b.o.p Import substitution and export promotion The effects on wages, profits and employment The effects on the distribution of income 82

3 50 PRIVATE FOREIGN INVESTMENT IN DEVELOPING COUNTRIES 3.7. The effects on government revenue and expenditure 3.8. The effects on private savings 3.9. Substitution effects CHAPTER IV. OTHER ECONOMIC EFFECTS OF PFI NOT CON- SIDERED BY THE MODEL 4.1. Introduction 4.2. The exchange rate 4.3. The internal price system 4.4. The terms of trade 4.5. The external effects 4.6. The demonstration effects 4.7. The savings rate CHAPTER V. THE INTERDEPENDENCE - SIMULTANEOUS AND OVER TIME - OF THE EFFECTS OF PFI Introduction The income effect The b.o.p. effect The private savings effect The public savings effect The interdependence of the effects of PFI 100 CHAPTER V I THE 'CUMULATIVE' EFFECTS OF PFI Introduction The formulation of the cumulative effects Economic interpretation of the cumulative effects A general solution for the cumulative effects A solution in terms of the growth of the cumulative effects 104 CHAPTER VII. THE 'MARGINAL' EFFECTS OF PFI Introduction 7.2. A marginal approach and the related problems 7.3. The marginal effect on the b.o.p The marginal effect on private savings 7.5. The marginal effect on public savings 7.6. The time behaviour of the marginal effects 7.7. The marginal effect on income III III

4 EFFECTS OF PRIV ATE FOREIGN INVESTMENTS The formulation or the four marginal effects and their eco- 115 nomic interpretation CHAPTER VIII. CUMULATIVE AND MARGINAL EFFECTS COMPARED Cumulative vs marginal effects Practical applications of the cumulative and marginal effects A numerical exercise and some variations for the marginal and the cumulative effects The effect on wages, profits, and income distribution The employment effects The substitution effect The impact of the financial mechanism of the annual additions to PFI 131 CHAPTER IX. SECTORAL DISAGGREGATION AND INPUT- OUTPUT ANALYSIS Introduction The sectoral use of the methodology in general The sectoral use of the methodology taking into account just one PFI sector or sub-sector The sectoral use of the methodology taking into account various PFI sectors and/or sub-sectors The introduction of input-output analysis Other possible extentions 142 CHAPTER X. VARIOUS PRACTICAL SITUATIONS AND THE USE OF THE MODEL CHAPTER XI. THE USE OF THE MODEL FOR DECISION MAKING CHAPTER XII. THE USE OF THE MODEL FOR EMPIRICAL IN VESTIGA TIONS CHAPTER XIII. EVALUATION AND CONCLUSIONS 150 LIST OF REFERENCES 152

5 SUMMARY OF PART II This part of the research concentrates on the macro-economic methodology, indicating also how it can be used both for decision making (Chapter XI) and for empirical applications (Chapter XII). The methodological framework presented is not considered to be complete, both because some problems still need a more satisfactory solution, and because some extentions are possible in order to get a better analysis (Chapter IX, in particular). The introduction points out how the approach is meant first of all to be analytical, i.e. limited to the analysis of the effects of PFI, leaving any decision about their acceptibility to the policy makers themselves, for whom it is hoped that the methodology would provide a useful starting point and a base for their decisions (Section 1.2). Furthermore, the approach is meant to be at a macro-economic (sectoral) level, and not a project level. The purpose of the methodology is to quantify the economic effects of PFI in LDC's. A number of such effects is discussed in Chapter III. Attention is given to the more quantifiable ones, and consequently the list may not be complete. Some other economic effects of PFI, not taken into account by the model, are discussed in Chapter IV. The methodology is based on a multi-sectoral dynamic model. A twosector version of this model is given in Chapter II. Two sectors are considered: the 'PFI sector', and the 'rest of the economy' sector. Attention is given to the relations which are more relevant in a study about the effects of PFI; moreover, it is shown how the model could be extended to take into account employment (Section 2.9) and to take into account other ways of financing an investment project from abroad than through PFI (Section 2.l1). The formulation of some equations may raise some questions; Section 2.l 0 discusses briefly why certain specific formulations have been choosen. Finally, in Chapter IX it is pointed out how the model can be extended to become a multi-sectoral one. The purpose of the model presented in Chapter II is not to get a set of full solutions for the endogenous variables it considers, but to provide a starting point for the quantification of the economic effects of PFI. The model is needed in order to have a detailed and consistent picture of a LDC's economy, with special reference to what happens to some key variables as a

6 54 PRIV ATE FOREIGN INVESTMENT IN DEVELOPING COUNTRIES consequence of the presence of PFI. Starting from the model, it will then be possible to get some quantified expressions for the economic effects of PFI, which are consistent with each other, and which take into account direct and indirect effects. In order to estimate the effects of PFI, the approach proposed is to compare (by difference) a situation with PFI and a situation without PFI, using the model as a basis to get the relations referring to the various effects. Two sets of effects, corresponding to two different approaches, are distinguished in the report. In the NEI terminology, they are called, respectively, the cumulative and the marginal effects of PFI. The cumulative effects (Chapters V and VI) are obtained by difference, comparing, for various variables corresponding to various effects, from time 0 to time t, a situation where PFI is always present, and a situation where PFI is always absent. Since the effects of PFI on some variables 'cumulate' from year to year, this particular terminology was choosen. This can be seen considering, e.g. the cumulative effect on income. Since the increase in GDP from 0 to t is determined by the investments, through the capital-output ratio. the effects of PFI on domestic investments for every year will be present in the cumulative effect referring to time t. And since all other effects are also related to income, this same situation applies also to them. Moreover, for the balance of payments effect (b.o.p.) one must also consider the effects on it in the previous years, which are assumed to represent the debt effect of PFI 1. Consequently, using this approach, it is also possible to point out how the effects of PFI are interdependent simultaneously and over time (Chapter V). The analysis of both cumulative (Chapter VI) and marginal (Chapter VII) effects mainly concentrates on four of them (income, private savings, public savings, and b.o.p.). However, in the report it is also pointed out how it is possible to extend the analysis to some other effects, like the one on employment (Section 8.5) the one on the distribution of income (Section 8.4) and the substitution effect (Section 8.6). The report discusses also how it is possible to take into consideration various practical situations different from the model given in Chapter II, like, e.g., different ways of financing an investment project from abroad, or joint ventures, or also different structural parameters for the two sectors (as it is the case when the Government wants to provide incentives or disincentives to PFI). Chapter X further points out how these various practical situations can be incorporated into the model changing some of the parameters, or introducing 1 For the foreign debt, the model assumes that its annual increase corresponds to the deficit of the b,o.p" equal to the foreign capital inflow (under the assumption of no variations in reserves etc,l.

7 EFFECTS OF PRIVATE FOREIGN INVESTMENTS 55 some new variables, and how the formulations of both cumulative and marginal effects can be modified accordingly. The interdependence -- simultaneously and over time - of the cumulative effects of PFI has been mentioned above. This makes the practical solution of the system which expresses them rather difficult. A general solution could be obtained in terms of a system of difference equations (Section 6.4), while an approximate solution, much more operational for its simplicity, can be obtained considering the rate of growth of the cumulative effects. It is proved that the latter is approximated by the rate of growth of the PFI capital stock (or gross value added), and consequently it is possible to arrive at a solution for the main effects considered (Section 6.5). Such a solution is given as a system of four linear equations, where the four effects are the unknowns. Substituting the value of the parameters, and of the PFI gross value added in a given time t, it is possible to solve it, and to get the numerical value of the four effects. Since, in practice, both for lack of data for a reasonably long period of time, or because the LOe's economy or the PFI capital stock do not behave exactly according to the assumptions of the model, it might be difficult to apply the cumulative approach, also a simpler one has been developed, called the 'marginal' approach" Under the assumption that the situation in time t is given and that one is simply interested in finding out what happens from time t to time t+ 1 as a consequence of the presence of PFI on some variables, the marginal effects are defined as the variation in these variables from t to t+ I imputable to the presence of PFI. This approach is obviously quite different from the cumulative one. The two are compared in Section 8.1, where the reader may also find a useful picture, showing the cumulative and marginal effects on income. The formulation of the marginal effects still involves the presence of lagged endogenous variables. However, it is possible to prove that the rate of growth of these effects is exactly the same as the rate of growth of the PFI capital stock (or gross value added), and consequently it is possible to eliminate the lags. Also the marginal effects are given as a system of four equations, where the four main effects considered are the unknowns and which can be solved once the parameters and the gross value added of the PFI sector in t are given (Section 7.8). The basic difference between the two effects is that the cumulative effects refer to the effects of PFI on certain variables from time 0 to time t, while the marginal effects simply point out the effect imputable to PFI in the development of the economy from time t to time t+ I. These different con-

8 56 PRIVATE FOREIGN INVESTMENT IN DEVELOPING COUNTRIES cepts point out also the different practical possible uses of the two approaches (Chapter VIII). If detailed information is available for a long period of time, and if the economy and the PFI sector behave according to the relations of the model, then it is possible to use the cumulative approach. If, on the contrary, only data for one or two years are available, it is possible to use the marginal one. The former gives a more complete answer to the question of the economic effects of PFI; if it is not possible to apply it, then the latter can still provide some useful answers. A numerical exercise is given in Section 8.3, with reference to both cumulative and marginal effects. First, a general solution is obtained giving some arbitrary values to the parameters. Then some variations are studied. The exercise proves quite useful both to compare different practical situations reflected in the various alternative values given to some of the parameters, and to get some insights in how the model reacts to some variations in its parameters. As it was said at the beginning of this summary, the last chapters discuss the use of the methodological approach for decision making (Chapter XI) and its use for practical investigations (Chapter XII).

5 NATIONAL ACCOUNTING AND ECONOMIC POLICY DECISIONS (with special reference to the Netherlands)

5 NATIONAL ACCOUNTING AND ECONOMIC POLICY DECISIONS (with special reference to the Netherlands) by C. A. van den Beld I. INTRODUCTION IN the Netherlands there exists already a long-term tradition in quantitative