Private Provision of Infrastructure

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Development Policy Review, 2006, 24 (2): 175-202

Private Provision of Infrastructure in EmergingMarkets: Do Institutions Matter?

Sudeshna Ghosh Banerjee, Jennifer M. Oetzeland Rupa Ranganathan

Governments in developing countries have encouraged private sectorinvestment to meet the growing demand for infrastructure. According toinstitutional theory, the role of institutions is paramount in privatesector development. A longitudinal dataset of 40 developing economiesbetween 1990 and 2000 is used to test empirically how differentinstitutional structures affect private investment in infrastructure, inparticular its volume and frequency. The results indicate that propertyrights and bureaucratic quality play a significant role in promotingprivate infrastructure investment. Interestingly, they also suggest thatcountries with higher levels of corruption attract greater privateparticipation in infrastructure.

1 Introduction

Globalisation provides enormous opportunities for domestic and multinational firms to

serve the billions of aspiring poor, the so-called bottom of the pyramid, in emergingmarkets that are joining an increasingly integrated world (Prahalad and Hart, 2002).

However, after more than two decades, it is clear that private sector development does

not occur in a vacuum, but requires facilitating conditions to unleash its potential. A

significant literature has evolved in the past few years evaluating the causes and the

impact of private investment in infrastructure. Two interesting perspectives arise: what

characterises countries that open up for infrastructure investment, and what

characterises countries that are successful in attracting infrastructure investment. We

contribute to these arguments by examining the factors that might explain the differing

levels of private sector participation in infrastructure projects. We evaluate the drivers

of private investment in infrastructure in developing countries, in particular the role ofinstitutions. How have institutions made the transition to markets smoother for some

countries than for others? Does the unique nature of infrastructure investments high

sunk costs, economies of scale, high levels of risk and uncertainty and high transaction

Respectively, Economist, Africa Region, World Bank, Washington, DC; Assistant Professor, Kogod

School of Business, American University; and Operations Evaluation Department, World Bank,

Washington, DC. Correspondence address: S. G. Banerjee, 1818 H. Street NW, Washington, DC 20433

([email protected]). The authors are grateful to Shokraneh Minovi and Shelly Hahn of the World

Bank for making its private participation in infrastructure database available to them, and to Kalpana

Seethepalli and Jorge Rivera for commenting on previous drafts of this article. The opinions andconclusions are, however, theirs alone, and should not be attributed to the organisations with which they

are affiliated


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176 S. G. Banerjee, J. M. Oetzel and R. Ranganathan

costs change the way institutions affect private infrastructure investment relative to

other forms of investment?

Researchers have argued that institutions play an important role in supporting

market economies and may help to explain differing levels of growth, development and

private sector interest around the world (North, 1990; Hoskisson et al., 2000; Rodrik et

al., 2002). Institutional differences across countries may explain differences in

economic development, productivity and overall business risk. Hall and Jones (1999)

find that social infrastructure, that is, institutions and government policies, explain the

large variation in output per worker across countries. Rodrik et al. (2002) argue that,

compared with geography or trade, the quality of institutions is the most important

factor explaining income differences. Acemoglu et al. (2001) take a step further in

understanding the exogenous variation in institutions explaining their impact on

economic performance. Taking a sample of countries colonised by Europeans, they use

the mortality of settlers (soldiers, sailors, and clergy stationed in colonies during the

seventeenth to nineteenth centuries) as an instrument to measure the current state of

institutions, and this variation in colonial experience to explain the large effects of

institutions on income per capita.

For obvious reasons then, the role of institutions is paramount in private sector

development. Protection of property rights, the operation of effective capital markets,

and the rule of law can reduce investment uncertainty and promote private sector

development. Private enterprise is also thought to flourish in environments with low

levels of corruption and a high degree of political and economic stability. Investors need

to understand how specific institutions impact on their business ventures and how

managers should assess the institutional environment while engaging in the process of

site selection. Institutions are said to provide the rules of the game that structure humaninteractions in societies (North, 1990). By reducing uncertainty, institutions reduce

transaction and information costs in an economy. The absence of market-supporting

institutions can create added risk for private firms and possibly threaten firm survival.

This type of risk may have a significant effect on the willingness of the private sector to

participate in infrastructure projects (Ramamurti and Doh, 2004; Doh and Ramamurti,

2003).

While there have been a significant number of studies examining the effect of one

or two institutional variables (or categories of variables) on firms strategy (Doh et al.,

2003; Wan and Hoskisson, 2003) or private sector development (Banerjee et al., 2003;

De Soto, 2000; Bergara et al., 1998), few, if any, have simultaneously examined theeffects of a wide variety of institutional variables on private participation in

infrastructure projects. Such an examination is important because institutions do not

operate in isolation from one another. For example, effective property rights protection

requires a strong set of laws and the bureaucratic ability and political will to enforce

them. Univariate studies of institutions and their impact on markets can thus lead to

incomplete and even inaccurate findings.

The purpose of this panel study is to examine how the institutional environment

affects private sector participation in infrastructure projects in developing economies.

This question is particularly important, given the recent decline in the levels of such

private participation. The results of this analysis suggest important implications forformulating foreign firms site selection strategies. We develop a number of theoretical


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Private Provision of Infrastructure in Emerging Markets 177

related to higher levels of private sector investment in infrastructure projects. In the

following section, we discuss how the nature of infrastructure lends itself to both a

complex risk profile and a promise of high returns. Next, we develop the hypotheses

relating institutions to infrastructure investment. We then proceed to discuss the data

and present the descriptive statistics. In the final two sections, we present the results and

discuss our findings.

2 Background on private participation in infrastructure

2.1 Trends in private participation in infrastructureGiven the linkages between infrastructure, development and poverty reduction,

providing good quality infrastructure has emerged as a top priority of development

policy in the past two decades. In an analysis of the relationship between infrastructuredevelopment and economic growth and income distribution across 100 countries

between 1960 and 2000, Calderon and Serven (2004) note that infrastructure stock

positively affects growth, and superior quality and quantity of infrastructure reduce

income inequality. As Prudhomme (2004) writes, It is a space shrinker, it enlarges

markets, and operates like the lowering of trade barriers. The need for infrastructure is

urgent and enormous in developing countries. For instance, Fay and Yepes (2003)

predict that producer and consumer demand for infrastructure in emerging markets will

grow exponentially, based on a growth projection of 2.7% per year between 2005 and

2010. At this growth rate, $465 billion worth of infrastructure investment will be

required to meet demand, with almost 90% of it going towards telecommunications,power and roads. Electricity demand alone is expected to increase by 4% per year for

the next 20 years (Lamech and Saeed, 2003).

In the vast majority of emerging market economies, the public sector does not

have the resources to meet this growing infrastructure need. To fill the gap between

service demand and service provision, governments have encouraged private sector

investment in infrastructure projects. In response to the opening up of new markets,

private firms rushed to invest in infrastructure projects in emerging markets during the

1990s; one-fourth of total investment in infrastructure was financed by private capital,

and infrastructure investment became the fastest growing segment of private flows to

developing countries (World Bank, 2003; Dailami and Leipziger, 1998). As Izaguirre

(2002) notes, 132 low- and middle-income countries welcomed private investment in

infrastructure during the period 1990-2001, when the investment commitment totalled

almost $750 billion for 2500 infrastructure projects in emerging market countries. In

terms of the sectoral infrastructure projects undertaken, telecommunication projects are

far and away at the head of the pack, followed by energy, transportation and water.

Although private firms are participating in infrastructure projects all over the globe, the

highest levels of investment have occurred in Asia and Latin America. Since reaching

its peak in 1997, private investment in infrastructure has been declining steadily; the

investment level in 2001 was less than half that in the early 1990s. The recent

renegotiation and cancellation of private contracts, though relatively few in number

only 48 projects (2%) were cancelled out of a total of 2500 that reached financial

closure in the past decade reinforced the notion that investment may not be


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2.2 The nature of infrastructure projects

Foreign investment in natural resource and infrastructure projects has long been among

the most sensitive of all international corporate activities (Moran, 1998). Though there

is potential for significant first mover advantage given the rising customer base, the

underserved population in developing countries, and the low price elasticity of

infrastructure these projects are problematic for several reasons. First, given the high

sunk costs, the need for long-term debt capital, and the irreversible and non-tradeable

nature of most infrastructure investments, mistakes can be very costly for investing

firms. Furthermore, there are massive forecasting errors associated with these

infrastructure projects, specifically in terms of the cost of construction and the ultimate

size of the consumer base. These forecasting errors can arise out of substantive

economic, technical and institutional errors (Prudhomme, 2004).

High levels of uncertainty surrounding an investment and political or economic

instability in the host country can prove to be serious barriers to entry. Attempts at

forecasting political and economic risk events have fallen short, thereby increasing the

need for effective management of these ventures (Oetzel et al., 2001). Credible host

government support of private investment, such as tax incentives, direct financing,

guarantees and other risk-mitigating arrangements, can serve to reduce uncertainty and

encourage private investment (Dailami and Leipziger, 1998). However, a less than

credible policy reform might not lead to an investment response, unless the promise of

returns is very high (Rodrik, 1991; Serven, 1997).

Second, the risk-return relationship is different for infrastructure projects from that

of other business ventures. This is because there is strong public pressure on

governments to ensure that the returns to investors remain within certain socially

acceptable bounds. The management of returns at the back end after the project is

successful and earning what with hindsight looks like a very healthy economic rent is

widespread in both developed and emerging markets (Moran, 1998). The tendency of

host country governments to manage returns implies that private investors in

infrastructure projects will face unique challenges especially related to the complex

nature of infrastructure pricing. Despite assuming above-average risks, private investors

may be prohibited from earning above-average returns. This is also true for late movers,

who have to bear the higher cost of entering a well-established market (Ramamurti and

Doh, 2004). Private investors argue that over the past decade increased competition in

the industry has led to downward pressure on profits. Industry returns are shrinking as

more players enter the market, more capital chases projects and as a consequence a

more demanding consumer (both host country government and end user) of

infrastructure emerges.

Third, the economic and political pressures associated with natural resource and

private infrastructure projects make firms in these industries vulnerable to the dynamics

of the obsolescing bargain (Vernon, 1980; Kindleberger, 1969; Penrose, 1959). The

theory of the obsolescing bargain suggests that at the outset a foreign firm may receive

favorable concessions and benefits for locating in the host country. After the firms

investment has been made, however, the host country may be able to renegotiate the

initial terms of the investment (Kindleberger, 1969). This is especially likely when the

investment is characterised by a low degree of mobility and heavy sunk costs, as is the


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3 Hypotheses

3.1 Legal and regulatory institutions

Infrastructure investments, characterised by large sunk costs, low mobility of assets and

site specificity, face the risk of opportunistic behaviour on the part of host country

governments ex post investment (Williamson, 1985). To avoid being held hostage ex

post FDI, investors utilise contracts to reduce this risk. The legal and regulatory

environment governing contracts, contract enforcement, property rights protection and

the rule of law is obviously a critical factor for prospective investors. North (1990) has

emphasised the existence of an effective legal system as a precondition for investment

and growth. As he asserts, the inability of the societies to develop effective, low-cost

enforcement of contracts is the most important source of both historical stagnation and

contemporary underdevelopment of the third world . Low security of property willstunt the incentives to invest, innovate and obtain foreign technology (Mauro, 1995).

Rules of the game that lead to transparent and accountable economic transactions would

improve the overall returns to investment (Isham and Kaufman, 1999). Scully (1988)

comes to the empirical conclusion that politically open societies that subscribe to the

rule of law, private property, and market location of resources grow at three times the

rate of societies in which such freedoms are abridged, and are two and a half times as

economically efficient. There is significant empirical evidence that economies with

stronger property rights systems perform better with respect to private investment

(Knack and Keefer, 1995; De Soto, 2000). Establishing a legal framework is critical for

facilitating a healthy investment climate for reform (Pargal, 2003).The regulatory environment can have a significant effect on infrastructure service

firms, since these firms are often subject to regulatory intervention by the host country

government. Governments may be concerned about the monopoly position that many

infrastructure firms hold, as well as their impact on public health and safety or their

environmental impact. The regulatory framework also has a significant impact on a

countrys ability to implement major sectoral reforms successfully. Countries with

established regulatory institutions in place before privatisation experienced increased

private telecommunication investment post-privatisation (Wallsten, 2002). Adopting

regulations that liberalise the investment regime is paramount in attracting private

investment (Pargal, 2003). Furthermore, Tam (1999) noted the significant role of sound

regulatory systems and transparent and honest infrastructure investment procedures in

attracting private investors in build-operate-transfer arrangements in Asia. In fact, past

research has shown that a predictable system of regulatory enforcement is important for

reducing investment uncertainty (Brunetti and Weder, 1998). A countrys regulatory

capacity plays a significant role in attracting private investment in infrastructure by

minimising the risk of expropriation and increasing the certainty of property rights

protection.

Even more important to private investors than the presence of market-supporting

laws and regulations is the credibility of the governments commitment to enforcing

them. The uncertainty created by the arbitrary or capricious application of regulations

and laws may result in a great deal of uncertainty and institutional risk for the firm.

Furthermore, it is important to private investors that the host government avoids


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long-term development (Henisz, 2000; 2002a; 2002b). Polarised interests as a result of

multiple veto players raise the credibility of government commitment (North and

Weingast, 1989; Keefer and Knack, 2002). Thus, we hypothesise that:

Hypothesis 1: The effective enforceability of the rule of law is positively

associated with private participation in infrastructure projects in emerging

markets.

3.2 Corruption

Political corruption the abuse of public power for private benefit (Tanzi, 1998) can

be an important deterrent to private investment (Brunetti et al., 1997; Brunetti and

Weder, 1997). Corruption can create distortions in industrial activity, raise uncertainty

and increase the cost of investment (Habib and Zurawicki, 2002). Foreign investors may

avoid corrupt investment environments in order to minimise operational inefficiencies

(ibid.) and avoid the added costs of doing business (Shleifer and Vishny, 1993).

Furthermore, in a study of foreign direct investment from 14 countries to 45 host

countries, Wei (2000) finds that corruption indeed reduces the inward flow of

investment. Even when corruption does not deter investment, it may have an impact on

the nature and composition of FDI as well as on a firms market entry strategy. For

example, researchers have found that corruption reduces inward FDI and leads firms to

prefer wholly-owned subsidiaries over joint ventures (Smarzynska and Wei, 2000;

Uhlenbruck et al., 2004).

While corruption may deter FDI in the aggregate, market avoidance is not always

an option for multinational corporations, which may at times feel compelled to enter

corrupt markets to follow or pre-empt competitors or to increase revenues. This is

especially true in infrastructure projects where the first mover can pre-empt competitors

and gain a monopoly position in the market. Since there is relatively less empirical

research on MNC behaviour in such situations, it is uncertain how firms will respond to

host country corruption. Although few if any studies have found that firms actually seek

out corrupt environments in which to do business, it is possible that, in the infrastructure

sector, firms may be able to buy stability and protection for their investment by

bribing host country officials. Nevertheless, given the lack of empirical evidence for

such practices, and the preponderance of evidence suggesting that firms tend to avoid

corrupt markets, we hypothesise that private participation will tend to be lower in

markets characterised by high levels of corruption. Thus, we hypothesise that:

Hypothesis 2: Corruption is negatively associated with private participation

in infrastructure projects in emerging markets.

3.3 Political institutions

Political institutions that are generally unreliable, unstable and/or ineffective may hinder

private sector participation, particularly in infrastructure projects (Howell, 1998;

Bergara et al., 1998), and may constitute political risk for the firm. Political risks,

defined as risks that are primarily the result of forces external to the firm and which


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investors in infrastructure projects, given their high sunk costs, the need for long-term

debt capital, and the irreversible and non-tradeable nature of these investments. The risk

of nationalisation or expropriation of assets, war or civil strife, ethnic tension, and the

inability to repatriate profits can compromise a firms profitability and even survival.

Countries that are more politically stable and predictable are thus more desirable for

private sector investors.

Another measure of the political institutional environment is the political

effectiveness, or quality of the governance, in a country (Howell, 1998; Henisz, 2000;

2002a; 2002b). Research on FDI in the power generation sector has shown that political

ineffectiveness and the risk of political expropriation of foreign assets in the host

country may deter FDI unless firms have a significant level of international experience,

particularly in developing countries (Holburn, 2001; Henisz, 2002a; 2002b). Bergara et

al. (1998) have also argued that the existence of a highly credible and effective

bureaucratic infrastructure in a country should enhance private investors willingness to

participate in infrastructure projects. Thus, we hypothesise that:

Hypothesis 3: Political stability is positively associated with private

participation in infrastructure projects in emerging markets.

Hypothesis 4: Political effectiveness is positively associated with private


In recent years, some researchers have argued that democracies are more

conducive to private enterprise than other forms of government. Empirical analysis of

the transition economies has found that democracy facilitates the adoption of market-oriented reforms, and the checks and balances implicit in the democratic system help to

lock-in privatisation reforms (Dethier et al., 1999). Market-oriented reforms have been

critical for enabling private sector participation in infrastructure projects. The checks

and balances penalise self-interested politicians (by reducing their chances of re-

election) and hence limit rent-seeking opportunities (Aslund et al., 1996; Bergara et al.,

1998).

The presence of democracy is the meta-institution for the existence of other non-

market institutions (Rodrik, 2000). Democracy also changes the incentives for rent-

seeking. Scully (1988) has argued that nations that have chosen to suppress economic,

political and civil liberties have greatly affected the standard of living of their citizens.Isham et al. (1997) empirically demonstrate that higher civil liberties are associated with

better economic returns on government projects. In an empirical study of the transition

economies, Dethier et al. (1999) conclude that the existence of a vibrant civil society is

the most important factor in explaining the adoption of economic liberalisation

measures. Recent evidence has indicated that civil and political freedom may encourage

foreign direct investment. Harms and Ursprung (2002) find that the host countrys

superior political institutions and workers representation as measured by effective

unionisation affect the location decision of foreign investors, and presumably the

participation of private sector firms in infrastructure projects. For these reasons, we

hypothesise that:


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Hypothesis 5: Democratic political ideologies are positively associated with

private participation in infrastructure projects in emerging markets.

3.4 Economic and financial institutions

Another important category of institutional risks is economic and financial risks. High

levels of economic instability are associated with greater institutional and investment

risks for private investors. Financial risks can arise from volatile currencies (Geczy et

al., 1997; Allayannis and Weston, 2000) and the absence of a well-functioning capital

market (Ramanadham, 1993; De Soto, 2000). Inflation and real exchange volatility have

a negative impact on private investment in emerging markets (Serven and Salimano,

1993; Cardoso, 1993; Larrain and Vergara, 1993; Aizenmann and Marion, 1995). Both

can affect the value of a companys investment in infrastructure as well as consumers

ability to pay for utility services. According to Ghura and Hadjimichael (1995),

uncertainty and instability explain the weak investment performance in Africa. Using

variabilities in inflation and the real exchange rate as indicators of macroeconomic

volatility, they find that macroeconomic uncertainty adversely affects investment.

Taken together, economic and financial risks increase investment uncertainty and pose a

serious risk to large capital-intensive investments that are immobile, like those made in

infrastructure projects. As a result, we hypothesise that:

Hypothesis 6: Economic instability is negatively associated with private


4 Research methodology

4.1 Country sample

To study the relationship between institutions and private infrastructure investment, we

use a panel of 40 developing countries over the period 1990-2000. Four regions around

the world are represented in our sample: 18 countries from Latin America, 11 countries

from Asia, 5 countries from Europe and 6 African economies (see Appendix 1). The

selection of countries was driven by data considerations. We started out by using the

maximum number of countries in the private participation in infrastructure (PPI) datasetof the World Bank, but finally settled on these 40 countries once the explanatory

variables were added. Also, the database does not allow us to untangle domestic and

foreign flows, though foreign investors have undertaken a significant proportion of

private investment. We used the PPI database instead of traditional national accounts

data because, through the national accounts, we are not able to disaggregate how much

of the private investment has gone into infrastructure. The PPI database is specialised in

the sense that it provides information on private investment in infrastructure

specifically.


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4.2 Dependent variables

The dependent variables have been constructed from the World Banks PPI database1

which includes the following sectors: electricity and natural gas, telecommunications,

transport, and water supply and sanitation. In the case of the dependent variables, the

data on investment and revenue are measured only on financial closure and not

incrementally in the dataset, further reducing the number of observations. The

maximum number of observations is 300 country-years for 40 countries in the sample.

Private participation in infrastructure includes divestiture revenue, project cost,

and investment in Greenfield and Operations and Maintenance (O and M) projects.2In

nominal terms, the average private participation is US$1,450 million, with the

maximum being US$33,352 m. (Brazil in 1998). Deflating the nominal values by US

inflation, we used a (log) real private participation in infrastructure as the primary

dependent variable. A caveat is important here. A better dependent variable would be

infrastructure investment as a share of GDP, but the share is negligible for all countries

with very little variation. In addition, to understand if the institutional determinants

affect the disaggregated components differentially, we included (log) real divestiture

revenues, project cost, and investment. Finally, we included (log) real private

participation in the telecommunications and energy sectors.

The average contribution of private infrastructure investment in GDP is 2%, with

the maximum being 28% in Bolivia in 1998. In addition, we used the (log) real

divestiture revenues, (log) real project cost, and (log) real investment as dependent

variables to understand whether explanatory factors affect the various investment

components differentially. Furthermore, we estimated the determinants of private

participation in specific sectors that have attracted the maximum private investment

energy and telecommunications. The average participation in the telecommunications

and energy sectors is US$903 m. and US$932 m. respectively. Given the split nature of

this sample, we used only the International Country Risk Guide (ICRG) dataset that has

the highest number of institutional explanatory variables. Finally, we included the total

number of infrastructure projects in each year as a dependent variable and the number of

projects in the telecommunications and energy sectors respectively, as these are the

sectors that have attracted the most investment compared with other infrastructure

sectors such as transport and water. A description of the dependent variables, the

descriptive statistics, and the region-specific frequency and total investment of

infrastructure projects statistics are presented in Tables 1, 2 and 3 respectively.

1. Available from http://rru.worldbank.org/PPI/index.asp.2. Broadly, a private investor can enter the market by buying an existing public utility (divestiture), investing

in a new venture (greenfield) or participating in a contract with the public entity (such as an operations and


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Table 1: Dependent variables: private participationin infrastructure indicators

Variable DescriptionVolume of private participation

Total Total private participation

Addition of COST, REV, and INVEST

Cost Project cost

Rev Divestiture revenues

Invest Investment in Greenfield and Operations and

Maintenance contracts

Number of private projects

Freq Total number of projectsSource: PPI database, World Bank.

Table 2: Dependent variables: descriptive statistics

Variable Obs Mean Std Dev. Min. Max.

Total 296 1579.25 3054.13 2.9 33352

Cost 296 791.21 1329.18 0 9131.2

Rev 296 471.97 1857.13 0 23540.5Invest 296 316.07 853.28 0 8192

Freq 296 7.13 9.03 1 54

Table 3: Project count and total investment

Region Project count Mean

project count

Mean total

investment US$ m.

Latin America and

Caribbean

141 7.39 1791.85

Africa 17 2.29 624.64

Europe 43 6.06 828.76

Asia 95 8.09 1774.23


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4.3 Explanatory variables

The widely used institutional variables from the ICRG of the Political Risk Services

Group have been primarily used to test the hypotheses. There are other recent datasets

on institutional indicators Kaufmann et al. (2003) and Index of Economic Freedom

but the Kaufmann data3 are available for 1996, 1998 and 2000 and the Index of

Economic Freedom dataset includes values from 1995 to 2000. Running the regression

models using these alternative institutional datasets would significantly reduce the

number of observations.

Our primary institutional variables of interest are legal and regulatory institutions,

corruption, and economic and political institutions. To test hypothesis 1 on legal and

regulatory institutions, we include Rule of Law (RULELAW) from the ICRG database;

for hypotheses 3 and 4, we include government stability (GOVSTAB), ethnic tension

(ETHTEN) and bureaucratic quality (BURQLTY) from ICRG, and political rights

(POLRTS) and civil rights (CIVRTS) from the Freedom House dataset. Corruption

(CORR) from the ICRG dataset is employed to test hypothesis 2. Multicollinearity does

not appear to be a serious threat as the bivariate correlation between the institutional

variables ranges from 0 to 0.44 (Table 5); we also estimated the variance inflation factor

(VIF) for the regressions (reported in Tables 7 and 8). Finally, for macroeconomic

indicators and financial institutions, we included the following variables: lagged

inflation (INFLA), lagged GDP growth rate (GDPGR), lagged official exchange rate

(EXCH) and market capitalisation as share of GDP (MCAP) from World Development

Indicators (2004). One-year lagged values of macroeconomic variables such as

inflation, exchange rate, and GDP growth were entered in the system of equations, as

they may be endogenous to the model. Since the variations in inflation and exchange

rates are very high, we used the natural log values of these variables. Given the

differences in exchange-rate regimes in developing countries, a real effective exchange

rate would be more suitable for a comparative picture, but such data are very sparse and

significantly reduce the number of observations. We therefore decided to use the official

exchange rate. Further explanation of the definition, description, and sources of the

explanatory variables are presented in Tables 4 and 6 and correlations are depicted in

Table 5.


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Table 4: Explanatory variables: institutional and control variables

Variable Description

Macroeconomic and financial institutionsINFLA

a Inflation (lagged)

EXCHa Official exchange rate (lagged)

MCAPa Market capitalisation as share of GDP

GDPGRa Gross domestic product annual growth rate (lagged)

Legal and regulatory institutions

RULELAWb Rule of law: higher values mean degree to which the citizens of a

country are willing to accept the established institutions making and

implementing laws and adjudicating disputes; varies from 0 to 6

Political institutions

GOVSTABb Government stability; ability of government to stay in office and

carry out its policies. Ranges from 0 to 6. Higher values mean higher

government stability

ETHTENb Ethnic tension: measures degree of tension within a country

attributable to racial, nationality and language divisions. Ranges from

0 to 6. Higher values mean lower ethnic tension

BURQLTYb Quality of bureaucracy: measures the regulatory environment

domestic and foreign firms must face when seeking approvals and

permits. Ranges from 0 to 6. Higher values mean superior

bureaucratic quality

POLRTSc Political rights: higher values mean fewer political rights

CIVRTSc Civil rights: higher values mean fewer civil rights

Corruption

CORRb Corruption in government: degree to which business transactions

involve corruption or questionable payments. Varies from 0 to 6.

Higher values mean lower corruption

Quality of public investment

POWERLOSSa Distribution and technical losses as share of total output

TELELINESa Number of telephone lines

ROADSa Paved roads as share of total roads

LITa Adult literacy

Specific host country indicators

GDPPCa Log of GDP per capita

D_LACa

D_AFRICAa

D_Europea

Dummies for Latin America, Africa and Europe

(Asia is the reference category)

Sources: a) World Development Indicators(2004); b) ICRG database (2003); c) Freedom House (2003).


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Table 5: Correlation among institutional variables inICRG institutions dataset

GOVSTAB CORR RULE BURQLTY ETHNGOVSTAB 1

CORR 0.12 1

RULE 0.33 0 1

BURQLTY 0.32 0.23 0.39 1

ETHTEN 0.05 0.15 0.19 0.44 1

Table 6: Descriptive statistics of explanatory variables

Variable Obs Mean Std dev. Min. Max.

Economic and financial institutions

INFLA 292 89.45 396.17 -1.4 3398.68

EXCH 292 3926.88 30599.93 0.002 418782.9

MCAP 269 33.22 48.68 0.02 328.87

GDPGR 296 3.55 4.55 -13.12 14.26

Legal and regulatory institutions

RULELAW 294 3.73 1.11 1 6

Political institutionsGOVSTAB 294 7.98 2.12 1 12

ETHTEN 294 4.28 1.35 1 6

BURQLTY 294 2.19 0.77 0 4

POLRTS 296 3.15 1.95 1 7

CIVRTS 296 3.56 1.53 1 7

Corruption

CORR 294 3.2 0.94 1 5

Quality of public institutions

PAVED 266 44.32 30.13 3.3 100TELELINE 296 108.53 87.94 5.92 379.63

POWERLOSS 296 14.78 6.20 1.32 30.41

Control variables

GDPPC 296 5258.39 2842.61 750.54 15947.46

4.4 Control variables

Both public and private investments have positive relationships with economic growth,

but recent research suggests that private investment is more efficient than publicinvestment (Khan and Reinhart, 1990; Serven and Salimano, 1990). In the context of


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projects varies from 49 in Latin America (Brazil in 2000), 54 in Asia (China in 1997),

and 35 in Europe to 4 in Africa. The average number of projects is highest in the energy

sector. To model the count properties of the data, we employed a Poisson specification.

Previous empirical research has proved that the Poisson specification is well suited to

handling integer properties of count data directly and accommodating counts that areaggregated over time periods. One of the most restrictive assumptions of the Poisson

model relates to the equality of mean and variance. We tested for the appropriateness of

the Poisson assumption using the poisgof5 function for each of the regression

specifications; the large value of Chi-squared suggested that there is overdispersion and

that a more generalised negative binomial specification should be used. The mean

structures of both the Poisson and negative binomial models are the same, but the

standard errors of the Poisson model would be biased downwards because of

overdispersion (Long and Freese, 2001). In a negative binomial model, the Poissonparameter

itis distributed randomly across countries and time, according to a gamma

distribution with shape parameters (,) (Hausman et al., 1984).

it is assumed to be distributed randomly in the sample and follows a gamma

distribution. When a gamma distribution is assumed, the pr(nit) reduces to a negative

binomial distribution. can be assumed to be an exponential function of the explanatoryvariables.

5 Results

Stable rule of law is important in attracting private infrastructure investment.Economies with a stable judicial system and a low risk of expropriation provide a safe

haven for private investors. For a standard deviation rise in the rule of law index

(RULELAW), a countrys expected mean private projects rise by 31%, with other

variables remaining constant. A one unit increase in the index entails a higher project

cost of 22%, all other variables remaining constant. This is not surprising. For instance,

in a recent survey of international equity investors in the power sector, Lamech and

Saeed (2003) found that investors seek reform-minded governments that can ensure

respect for property rights and the rights of investors, the rule of law, and a fair

regulatory and legal system. They concluded that the investment climate has to

improve; that is, investors want the rules of the game to remain credible and

enforceable.

)2()|( KKKKKKKititit XV =

)3(!

)(Pr( KKit

ititititit

ef

==

)4()exp( KKKKKKK

itit X=


16/29

Table 7: Determinants of total private infrastructur

1 2 3 4 5 6 7

Total private investment Divestiture revenues Project cost Addi

INFLA -0.10 -0.15 0.23 0.15 0.00 0.03 -0

0.10 0.10 (0.135)a 0.14 0.09 0.09 (0

EXCH -0.01 -0.02 -0.04 -0.04 -0.08 -0.11 -0

0.05 0.05 0.07 0.07 (0.042)a

(0.048)b

0

GDPGR 0.06 0.08 0.08 0.08 0.03 0.06 0

(0.031)a (0.031)

b (0.042)

a(0.039)

b0.03 (0.027)

b0

MCAP 0.01 0.01 0.00 0.00 0.01 0.01 0

(0.003)b (0.003)

c -0.01 0.00 (0.002)

b(0.003)

c0

GDPPPP 1.19 2.77 1.33 2.14 1.07 2.02 1

(0.311)c (0.419)

c (0.549)

b(0.626)

c(0.306)

c(0.408)

c(0

LITERACY RATE 0.00 0.00 -0.02 -0.01 0.00 -0.01 -0

0.01 0.01 0.02 0.02 0.01 0.01 0

POLRTS -0.03 0.09 -0.10 -0.08 0.01 0.09 0

0.14 0.14 0.20 0.25 0.14 0.15 0

CIVRTS 0.48 0.53 0.73 0.90 0.30 0.35 -0

(0.235)b (0.258)

b (0.333)

b(0.402)

b0.22 0.25 0

GOVT STABILITY 0.14 0.12 0.11 0.05 0.06 0.04 0(0.080)

a 0.08 0.13 0.14 0.08 0.08 0

CORRUPTION -0.31 -0.32 -0.38 -0.41 -0.33 -0.35 0

(0.169)a (0.179)

a 0.27 0.27 (0.159)

b(0.176)

b(0


17/29

RULE OF LAW 0.09 0.30 -0.11 0.02 0.23 0.38 -0

0.14 (0.139)b 0.21 0.26 (0.124)

a(0.126)

c(0

ETHNIC TENSION -0.12 -0.14 -0.13 -0.15 -0.15 -0.13 00.12 0.12 0.18 0.19 0.12 0.13 (0

BUREAUCRATIC

QUALITY 0.25 0.27 0.51 0.58 0.41 0.45 -0

(0.149)a (0.149)

a (0.249)

b(0.303)

a(0.141)

c(0.155)

c(0

D_AFRICA -0.59 -1.04 0.39 -0.52 -1.45 -1.70 0

0.41 (0.460)b 0.86 0.99 (0.353)

c(0.428)

c0

D_LAC 0.05 -0.25 0.84 0.35 -0.71 -0.81 0

0.40 0.45 0.60 0.83 (0.397)a

(0.485)a

(0

D_EUROPE 0.31 1.74 1.23 2.05 -1.30 -0.13 10.64 (0.619)

c 0.89 (1.051)

a(0.559)

b0.60 (0

POWER LOSS 0.09 0.08 0.03

(0.031)c (0.043)

a 0.03

TELELINE -0.01 -0.01 -0.01

(0.002)c 0.01 (0.002)

c

PAVED -0.01 -0.01 -0.01

(0.005)b 0.01 (0.005)

b

CONSTANT -7.77 -21.66 -8.14 -16.34 -6.57 -14.71 -8

(2.537)c (3.587)c (4.194)a (4.983)c (2.383)c (3.495)c (3

OBSERVATIONS 264.00 235.00 137.00 123.00 250.00 221.00 116

R2 0.34 0.49 0.37 0.41 0.41 0.48 0

MEAN VIF 3.16 3.57 3.47 3.97 3.22 3.63 5

Notes: Robust standard errors in parentheses. a)significant at 10%; b)significant at 5%; c)significant at 1%. Includes time


18/29

192 S. D. Banerjee, J. M. Oetzel and R. Ranganathan

Table 8: Total private infrastructure flows in energy and telecom

1 2 3 4

Total private investment in energy Total private investment in telecomINFLA -0.037 -0.153 0.064 0.157

0.105 0.122 0.123 0.12

EXCH -0.01 -0.029 0.002 -0.055

0.044 0.054 0.049 0.048

GDGR 0.091 0.106 0.053 0.083

(0.037)b (0.039)

c (0.030)

a (0.029)

c

MCAP 0 0.001 0.004 0.008

0.003 0.003 0.003 (0.004)b

GDPPPP 0.868 1.39 1.646 3.597(0.391)

b (0.537)

b (0.306)

c (0.405)

c

LITERACY RATE -0.007 -0.011 0.002 0.002

0.013 0.014 0.011 0.012

POLRTS 0.133 0.219 0.003 0.124

0.163 0.18 0.15 0.146

CIVRTS 0.02 0.238 0.338 0.202

0.247 0.282 0.266 0.261

GOVT

STABILITY

0.179

(0.095)a

0.118

0.099

0.059

0.081

0.055

0.076CORRUPTION -0.531 -0.48 -0.03 -0.295

(0.170)c (0.169)

c 0.199 0.203

RULE OF LAW 0.202 0.466 0.061 0.356

0.16 (0.196)b 0.156 (0.158)

b

0.003 0.075 -0.184 -0.309ETHNIC

TENSION0.12 0.129 0.128 (0.119)

b

BUREAUCRATIC

QUALITY

0.161

0.161

0.139

0.197

0.292

(0.175)a

0.269

0.181

D_AFRICA -2.143 -2.546 -0.125 -0.76

(0.638)c (0.629)

c 0.409 0.589

D_LAC -0.919 -1.517 0.239 -0.396

(0.438)b (0.554)

c 0.409 0.433

D_EUROPE -1 -0.279 0.076 1.76

0.622 0.924 0.642 (0.592)c

POWER LOSS 0.058 0.099

0.041 (0.035)c

TELELINE -0.002 -0.015

0.004 (0.002)

c


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Table 8: Contd

1 2 3 4

Total private investment in energy Total private investment in telecomPAVED -0.025 -0.017

(0.008)c (0.005)

c

CONSTANT -4.131 -9.302 -12.318 -27.838

-2.784 (4.245)b (2.766)

c (3.358)

c

OBSERVATIONS 166 146 228 203

R2 0.42 0.5 0.34 0.53

MEAN VIF 3.83 5.94 3.34 3.65

Note: As for Table 7.

More corrupt countries attract more private infrastructure participation. The signof the relationship is surprising in the case of corruption; it is negative for the total of

private participation and two of its components (project revenue and project cost). More

corrupt economies invite more infrastructure investment 31% more for a one-unit

increase in the corruption index. For every additional rise in the index, which implies

the prevalence of less corrupt practices, a countrys mean private projects decline by

17%, with other variables held constant.

Political institutions have an ambiguous effect on government stability.(GOVSTAB), a measure of a governments ability to stay in office and carry out its

policies significantly, has an impact on private infrastructure flows, but the effect issignificant only for total flows and not for their disaggregated components or the

frequency of projects. Bureaucratic quality is a significant determinant of total private

investment. Before the onset of market-friendly policies, bureaucrats in a number of

developing economies benefited from the maze of regulations that constrained private

enterprise and gave them enormous power. Economic liberalisation and private activity

benefited when the quality of the bureaucracy was superior, with bureaucrats acting in

the larger interest.

The political rights and civil liberties indexes, which range from 1 for countries

with complete freedom to 7 for those which are not free, reveal an interesting pattern.

Political rights hardly matter in total private flows, but civil rights adversely affectprivate flows. There is some evidence to suggest that private investment is more secure

in countries with less civil freedom. The civil liberties variable (CIVRTS), where higher

values mean fewer civil rights, has a positive coefficient suggesting that countries with

more civil rights have less overall infrastructure investment and fewer infrastructure

projects. For a standard deviation increase in the civil liberties index, a countrys

expected mean private projects reduce by 37%, with other variables held constant.

Greater civil rights often mean that companies must go through a process of civic

approval, in addition to a structured and potentially lengthy process in order to gain

approval for each project. This raises the transaction cost of the project and can delay

the final award of contracts or sale.


20/29


Macroeconomic indicators and financial institutions influence privateinvestment positively. Not surprisingly, a higher exchange rate (local currency unit per

dollar) affects private flows negatively, as it makes the local economy uncompetitive.

Stock-market development has a positive impact on private infrastructure flows, though

its effect is negligible. Market capitalisation has a positive impact on project cost and

total infrastructure flows. A 1% rise in market capitalisation as a share of GDP increases

private infrastructure flows by 1%. There is some evidence that inflation affects the

additional private investment negatively, though it positively affects the divestiture

revenues. For instance, a one-unit rise in (log) inflation lowers the private additional

infrastructure investment by 53%. High-growth countries attract more private projects

and higher flows. For a standard deviation increase in the GDP growth rate, the

expected private projects rise by 28%, with other variables held constant, and total

private flows rise by 8%. Furthermore, a 1% rise in the GDP growth rate increases the

private flows in energy by 9% and in telecommunications by 5%.

GDP per capita has a significant impact on private infrastructure flows.Intuitively, countries with higher GDP per capita are more attractive to private

investors, given their higher purchasing power and greater projected demand for

infrastructure. This variable is significant across all specifications. Countries with

superior well-being with respect to GDP per capita (GDPPC) experience higher telecom

and energy investment, higher additional private investment, divestiture revenues,

greater total private infrastructure investment and a larger number of projects. For every

international dollar increase in GDP per capita, a countrys expected private projects

rise by 237%. The former public utilities in emerging markets have a long history of

charging below-cost recovery tariffs. As such, private involvement in these sectors

would mean a move towards aligning prices with market rates, which can be politicallyvery sensitive in poor countries, given the low price elasticity especially for water and

electricity. GDP per capita is a good indicator of market size and affordability. Higher

GDP per capita would mean greater ability to pay for infrastructure services, making

such emerging markets attractive destinations for private investment.

Quality of public investment might be crowding out private investment. There

is some evidence of the crowding-out of private investment in the presence of a superior

quality of public investment. Our results suggest that countries with a higher share of

paved roads and telephone mainlines attract lower private infrastructure flows. For

instance, a higher ratio of paved roads to total roads (PAVED) reduces total private

investment by 1% and the private investment in energy by 2.5%. For every additionalpercentage rise in paved roads as a share of total roads, a countrys mean private

projects decline by 1.6%, holding all other variables constant. A higher number of

telephone lines per 1000 persons (TELELINES) reduces private infrastructure

investment by 1.3%. A higher percentage of transmission and distribution losses

(POWERLOSS) raises total divestiture revenues by 8.6% and total telecom private

investment by 9.9%. There can be two processes at work here. Public investment may

be crowding-out private investment or the demand for private investment may be lower

in economies with better quality public investment. Agosin and Mayer (2000) note the

possible negative relationship between FDI and domestic investment. However, the

evidence is not consistent across different types of public investment, suggesting thatparticular types of domestic infrastructure might be more valuable to investors than


21/29


22/29


23/29


hoped that future research will add valuable insights into the relationship between

corruption, ethnic tension and private investment.

first submitted February 2005

final revision accepted December 2005

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Williamson, O. E. (1985) The Economic Institutions of Capitalism: Firms, Markets and

Relational Contracting. New York: The Free Press.

World Bank (1994) World Development Report: Infrastructure for Development.


World Bank (2003) Private Participation in Infrastructure: Trends in Developing

Countries in 1990-2001. Washington, DC: World Bank.

World Bank (2004) World Development Report:Making Services Work for Poor

People. Washington, DC: World Bank.


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Appendix 1

The countries in the sample are:

Latin America (18) Argentina, Mexico, Chile, Colombia, Bolivia, Dominican

Republic, Venezuela, Ecuador, Peru, Brazil, Honduras, Guatemala, Nicaragua,

Paraguay, Panama, Uruguay, Trinidad and Tobago, and Costa Rica;

Africa (6) Botswana, Zambia, Kenya, Tunisia, Zimbabwe, and South Africa;

Europe (5) Bulgaria, Czech Republic, Hungary, Poland, Romania;

Asia (11) China, India, Indonesia, Iran, Pakistan, Sri Lanka, Malaysia, Mongolia,

Philippines, Thailand, and Turkey.

Appendix 2

Table A1: Common private sector participationmodes in infrastructure

Dependent variable Definition Source

Concession A private entity takes over the management

of a state-owned enterprise for a given period

during which it also assumes significant

investment risk.

PPI database

Divestiture A private entity buys an equity stake in a

state-owned enterprise through an asset sale,

public offering or mass privatisation

programme.

PPI database

Greenfield projects A private entity or a public-private joint

venture builds and operates a new facility for

the period specified in the project contract.

The facility may return to the public sector at

the end of the concession period.

PPI database


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Documents

Private Provision of Infrastructure