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Private Investment & Macroeconomic Stability in Ethiopia

Hausarbeit 2008 8 Seiten

VWL - Fallstudien, Länderstudien





3.1. Private Investment and Inflation
3.2. Private Investment and Debt Overhang
3.3. Private Investment and Political Instability



The irreversible nature of long-term private investment expenditures has been emphasized in recent literatures on investment behavior. The irreversible nature of investment suggests that installed capital can seldom be putäto productive use in a different sector or economic activities, at least not without incurring a substantial cost. In this context, private investors, foreign and local, will be reluctantäto commit large expenditures on fixed investments when they are uncertain aboutäthe future political, social, and economic environment. Changes in uncertainty are usually associated with unpredictability. Thus, macroeconomic instability-a phenomenon making the domestic macroeconomic environment less predictable-is expected to hamper resource allocation including capital.

As it is well known, investment especially for developing countries like Ethiopia is a motor for growth. Especially private investment (both domestic as well as foreign) should hold the lion share of the total investment of such countries as the capacity of governments in these countries to undertake investment in areas other than infrastructure is very limited. Of the number of determinants of private investment in developing countries, macroeconomic and political stability is believed to be the major one as such countries rate worse in this regard unlike developed countries.

In this regard, a sort of preliminary assessment of the rough relationship between private investment and some key macroeconomic and political stability variables which are relevant in the context of Ethiopia, of course taking into account availability of secondary data, is sought in this term paper work. The hypothesis formulated to be tasted is that high macroeconomic and political instability has significant negative effect on private investment in Ethiopia.

As data in regard with private investment is expected to be very limited (i.e., not more than 17 years data), descriptive analysis (with the help of graphs) is going to be used to reach to some conclusions from the available data.

The next part of the term paper briefly review the basic theoretical concepts related to the title and the final part will deal with issues of data collection, analysis and conclusion.


Keynes in his 'General theory' argued that investment depends on the prospective marginal efficiency of capital relative to some interest rates, reflecting the opportunity cost of investment. He further argued that private investment is intrinsically volatile since any rational assessment of the return on investment was bound to be highly uncertain. Hence, he said that investment decisions are very much affected by how optimistic or pessimistic the investors feel. He described this as the "animal sprit" which implies there may be no good basis for the expectations on which investors base their decisions.

Various models have been used to explain the investment behavior, which were mostly based on the experience of the developed countries. Following Keynes, investmentätheory developed around growth models, giving rise to the now popular accelerator theory according to which investment is a linear proportion of output changes. This theory, however, has several limitations as it disregards expectations, profitability and the cost of capital as determinants of investment.

Jorgensen (1967) popularized the neo-classical theory which postulates that investment is a function of the level of output and the user cost of capital which in turn depends on the price of capital goods, the real interest rate and the rate of depreciation. This theory also has limitations with regard to its inconsistent assumption of perfect competition and exogenously determined output. Its assumption of static expectations aboutäthe future prices, output and interest rates also overlooks the factäthat investment is a forward-looking process.

Tobin's-Q theory (1969) postulates, on the other hand, thatäthe main force driving investment is the Q-ratio or the ratio of the market value of the existing capital stock to its replacement value. That means, entrepreneurs will wantäto invest (divest) if the increase in the market value of an additional unit exceeds (fall short of) the replacement cost. However, the marginal Q is not easily measured and thus what is used instead is the average Q ratio which has problems associated with its use. If firms enjoy economies of scale or market power or if they cannot sell all they want, marginal Q will certainly differ. Besides, the assumption of increasing installation cost is dubious.

Neither the neo-classical nor the Tobin's-Q ratio theories of investment are, however, applicable in the less developed countries. As a result of the poor empirical performance of these theories in developing countries, recent works on investment broadly falls into two categories. One of such categories is studies on " investment, irreversibility and uncertainty." In this regard, most investment decisions have three important characteristics: They are irreversible in thatäthe initial cost of investment is at least partially a sunk cost and cannot be retrieved. Secondly, there is uncertainty over the future rewards from the investment and hence the best an investor can do is to assess the probabilities of the alternative outcomes that can mean greater or smaller profit (or loss) for his venture. Thirdly, the investor has some leeway aboutäthe timing of the investment, hence he/she can postpone the investmentäto get more information (though never complete) aboutäthe future. These characteristics interactäto determine the optimal decision of investors. The argumentäthen is that, compared to the predictions of earlier models, real world investment seems much less sensitive to factors such as interest rates changes, but more sensitive to the volatility and uncertainty of the economic environment.

In connection with this, recent research has made a departure from the traditional net present value (NPV) rule which says that one should invest when the user cost of capital equals the expected return. This is because it ignores the irreversibility and the option of delaying an investment. The neo-classical theory has also been putäto question because of this anomaly. The investment rule in the presence of irreversibility and uncertainty requires that expected profits be no less than the user cost of capital plus the opportunity cost of exercising the option to invest. The other category ofürecent works on investment is work that has attempted to relate investmentäto measures of political and country risk. This branch of the literature is especially relevantäto the determinants of investment in developing countries since itätends to emphasize those macroeconomic or institutional features that are specific to developing countries such as vulnerability to external shocks, large external debt positions, etc.

In order to overcome the limitations of the neo-classical flexible accelerator model, research on private investment behavior in developing countries has proceeded in several directions, in the process, identifying a number of variables that might be expected to affectäthe private investment equation. This may be referred to as a modified version of the basic accelerator model. The inclusion of such variables has often resulted in eclectic and ad-hoc equations, constructed for econometric convenience, without a strong and convincing theoretical basis.

Theoretical considerations and empirical findings suggests that many macroeconomic variables affect private investment in developing countries of which one is macroeconomic stability.

According to Montiel et. al., macroeconomic instability refers to phenomena that make the domestic macroeconomic environment less predictable. Unpredictability hampers resource allocation decisions, investment and growth. Accordingly, it can take the form of volatile key macroeconomic variables or perceived unsustainability in their behavior.


3.1. Private Investment and Inflation

As it is well known, private investment in the previous 'Derg' regime had been blocked by law. Thus, one can say thatäthere was no private investment in Ethiopia before 1991. In view of this fact, only data on annual level of private (both domestic and foreign) investment starting from 1991/92 fiscal year up to now was required from the concerned body-Ethiopian Investment Agency and it was possible to getäthe whole required absolute amount of domestic and foreign private investment capital approved in each year from 1991/92 onward. As this is only about a 16-year data, time-series econometric analysis was ruled out from the very start. Since what should normally be taken is private investment as percentage of GDP, data on nominal GDP of the country from 1991/92 onward became necessary. However, it was possible to get annual data in this regard only up to 2003/04 from National Bank of Ethiopia which further limits the data on private investmentäto 13 years only. Furthermore, it was possible to get only 10 years (from 1997/98 to 2006/07) data on annual average countrywide inflation rate from the National Bank. As a result of all these situations, data that is available for some sort of descriptive analysis even became only of 7 years (from 1997/98 to 2003/04) of which 1 year data is to be lost by taking lagged values of the annual inflation rate. Thus, what can be said based on the available 6-year complete data is obviously questionable.

Theoretically, high and unpredictable inflation rate as an indicator of macroeconomic instability is expected to have adverse impact on private investment. That is, high rates of inflation increase the riskiness of long-term investment by reducing the average maturity of lending. Furthermore, when the rate of inflation is highly variable, it becomes difficultäto extractäthe correct signals from relative price movements which can lead to an inefficient allocation of economic resources including capital.

In this regard, the inflation rate occurring in the country is believed to be higher in recent consecutive 2 or 3 years than ever before. Unfortunately, it became impossible to see its impact on the recent years' private investment level due to lack of complete data (of both private investment and GDP levels of those years of high inflation). With regard to variability, one can observe some variability in the average annual inflation rates within the limited available data around the years from 1999/2000 to 2002/03 (see Table 1). In those years, the average annual inflation rate varies from 5.4 to -10.6 and again to 10.9. However, as can be seen on the table, private investment as percent of GDP almost increased steadily. The reason for this may lie on the factäthat private investment is affected by many macroeconomic variables other than inflation. That is, the occurrence of other favorable factors during thatätime may more than offsetäthe negative impact of inflation on private investment.

3.2. Private Investment and Debt Overhang

Theoretically, the existence of a large debt overhang in the form of high ratio of external debtäto GDP is expected to reduce the incentives for private investment because the presence of high debt ratio leads economic agents to anticipate future tax liabilities for its servicing. Thus, in this way of its effect on private investment, it can be treated as tax uncertainty (i.e., the currentätax situation is not expected to remain almost unchanged in the future) as a result of which it can be taken as one factor of macroeconomic instability that affects private investmentäthrough creating uncertainty regarding the future economic environment.



ISBN (eBook)
private investment macroeconomic stability ethiopia




Titel: Private Investment & Macroeconomic Stability in Ethiopia