Djibouti: Selected Issues

Abstract

Djibouti: Selected Issues

Public Investment, Growth, and Debt Sustainability in Djibouti1

Djibouti has engaged in many large-investment projects to reinforce its port capacities and to catch-up with some of its infrastructure gaps. The debt financed investment program can bring about higher economic output, but it also exacerbates fiscal and external debt vulnerabilities when the country is already at high risk of debt distress. This note studies the implications of scaling up public investment on debt sustainability and growth when the government is subject to inefficiencies on the spending and revenue side. A baseline scenario, based on the staff report projections, is compared to a high investment scenario. The simulations show that the success of investment projects in terms of sustainability and growth depends largely on improving the efficiency of public management, investment returns and the readiness of the government to raise taxes. In presence of inefficiencies, the high investment profile does not generate significantly higher growth than the baseline scenario and public debt becomes unsustainable.

A. Introduction

1. In recent years, debt financed investment has been the main driver of growth and economic activities in Djibouti. The country has been essentially dependent on the port activities and the transportation sector. Diversifying economic base remains difficult given that the country lacks natural resources and agriculture and industrial sectors are almost non-existent. Consequently authorities have continued to welcome new investment projects for expanding the port and transportation sector. Investment is expected to reach more than 60 percent of GDP in 2015 in contrast to 44 percent a year earlier. Main investment projects include a railway, water pipeline, construction of new ports and expansion of the existing ones.

2. Djibouti has contracted non-concessional borrowing for public investment, as have many other African countries in recent years, although most of these countries have lower debt-to-GDP ratios than Djibouti. The main public investment projects are the Djibouti-Addis Ababa Railway with a total cost of $570 million and the Djibouti-Ethiopia water pipeline with a cost of $339 million. Both infrastructure projects are externally financed. Authorities consider these projects vital to reduce poverty and unemployment. However, these projects—which are very large investments compared with the small size of the economy—will aggravate the fiscal and debt external debt vulnerabilities when the country is already facing a high risk of debt distress. The fiscal deficit is expected to reach 16.8 percent of GDP in 2015 and the nominal PPG debt is projected to hit 80 percent of GDP in 2017. Strong growth and fiscal reforms are therefore necessary to generate enough resources for the government to service its debt.

Figure 1.
Figure 1.

Djibouti: Investment, Debt, and Revenue, 2010–20

Citation: IMF Staff Country Reports 2016, 249; 10.5089/9781498386449.002.A002

Sources: Djibouti authorities; and IMF staff estimates and projections.

3. The impact of investment projects on growth has not been carefully evaluated and there are questions that these investments can reduce poverty and unemployment. Many recent projects are capital intensive with little domestic job creation. For the investment program to generate inclusive growth and employment in a sustainable way, the business environment needs to be improved. Reducing the cost of utilities, improving the labor supply skills, promoting financial inclusion, reducing corruption and enhancing the efficiency of the judicial system are among the most important factors to ensure sustainable growth in Djibouti

Figure 2.
Figure 2.

Public Investment Management Index Scores by Country

(4 = best practices)

Citation: IMF Staff Country Reports 2016, 249; 10.5089/9781498386449.002.A002

Source: IMF Public Investment Management index.

4. As in many other low income countries, public investment in Djibouti is subject to capacity and management constraints. In capital-scarce countries such as Djibouti, public investments are expected to have high returns, but the impact on growth depends crucially on the quality of public management. An IMF study1 used the World Bank diagnostics on public investment management system, budget survey databases and donors and experts analyses to build a Public Investment Management Index (PIMI). This index measures the efficiency of public investment management process for a number of developing and emerging economies. In the PIMI, Djibouti ranked 50th out of 71 developing countries, of which 40 countries are LICs. As a result, improvements in the public investment management system can pave the way for strong income generation and allow the pursuit of sustainable fiscal and debt paths.

B. Model Description

5. The model proposed in Buffie et al (2012) provides a framework to analyze the benefits of higher public investment and higher growth versus its cost in terms of higher public debt. The goal of the model is to analyze in a comprehensive framework the relationship between the induced growth from higher economic investment and the debt sustainability taking into account the capacity constraints. This is to address two criticisms toward the DSF: First, it does not take into account the relationship between public investment and growth, and second, the DSF does not treat the fiscal policy in a forward-looking framework with the possibility of major correction when the country faces a shock. Indeed, in Djibouti, public projects will take time to repay and meanwhile all the debt thresholds will be breached. But prescribing that the country should abandon its investment plans because of debt sustainability risks depends on absorptive capacity, efficiency of public spending, and the authorities’ ability to adjust taxes and spending.

6. The model provides a stylized representation of a dynamic stochastic general equilibrium small open economy which includes concessionary as well as non-concessionary public debt and multiple taxes and spending. The model’s features are as follows:

  • Two types of households: savers and non-savers. Non-savers consume all of their disposable income in each period and are liquidity constrained. Savers have limited access to international capital market with portfolio adjustment cost. The presence of these two types of consumers is necessary in the model to break the Ricardian equivalence.

  • Two production sectors. The country produces traded as well as non-traded goods according to a Cobb-Douglas production function with labor, private capital and productive infrastructure or public capital as input factors.

  • The public capital formation process is subject to absorptive capacity and government efficiency constrains. In other words, one dollar of additional public investment does not translate into one dollar of effectively productive infrastructure, i.e. the public investment spending does not increase the stock of productive capital in one-to-one relationship. The PIMI index can be used to calibrate the absorptive capacity parameter.

  • The government finances its current and investment expenditure with taxes and debt. The government spends on transfers, debt service, infrastructure investment and it collects consumption VAT taxes from households and user fees for infrastructure services which are expressed as a fixed fraction of recurrent cost. Debt sustainability requires that adjustment in the tax and transfer policy covers the fiscal gap. The fiscal gap corresponds to expenditures less revenues and concessional borrowing when taxes and transfers are kept at their initial steady state values. The foreign debt is subject to a premium that depends on the deviation of the stock of the external debt from its steady state value.

C. Investment Scenorios and Results

7. The baseline scenario delivers the best outcome in terms of debt sustainability and growth. The baseline scenario is based on the current projection of the staff report, assuming a high level of public investment over 2015 and 2016 (30 and 25 percent respectively) and it will be anchored at 15 percent, afterward. This path is driven by the authorities’ current investment plans and contracted projects and future investment projects with undetermined sources of financing. In the baseline scenario, the efficiency of the public investment and initial gross return on infrastructure investment are supposed at 60 and 30 percent respectively. Two cases are analyzed in the baseline scenario: in the first case, given the public investment surge and the path for concessional borrowing and grants, taxes and transfers adjust continuously to cover the government fiscal gap; in the second case, the government uses external commercial loans to fill its fiscal gap. In the first case, the government’s fiscal response to cover the fiscal gap by raising taxes is immediate.

8. Access to commercial debt market can smooth the transition dynamic associated with the public investment scaling up. In the absence of external commercial borrowing, as shown in Figure 3, the tax rate should exceed 60 percent to sustain the public investment level at 15 percent of GDP.2 On the other hand, when commercial borrowings supplement concessional borrowings, it can help with the adjustment. In this case, the tax rate will increase to reach 20 percent and will decline until growth finally generates enough revenue to reconcile repayment of commercial debt.

Figure 3.
Figure 3.

Baseline Scenario, Constrained VS. Unconstrained Tax Adjustment

Citation: IMF Staff Country Reports 2016, 249; 10.5089/9781498386449.002.A002

Source: IMF staff calculations.

9. The following simulations compare the baseline scenario (with external commercial borrowing) with a high investment scenario. Each scenario considers three cases, i.e. investment return, public investment efficiency and tax policy reaction function. The debt profile includes concessional and non-concessional debt profile:

  • High investment scenario considers the same investment profile as in the baseline scenario until 2017 and although afterwards the public investment declines, it remains at a high level of 21 percent of GDP.

  • In addition, for each scenario, three alternatives cases are also considered. First, the gross return on infrastructure investment drops to two thirds of its initial value; second, the efficiency of public investment is cut by half; and third the government delays in raising the tax rate.

10. The baseline scenario with low return on infrastructure projects, declining efficiency of public investment or delayed tax adjustment illustrates the danger of a pronounced debt-financed public investment. In each case, the public debt level exceeds 80 percent of GDP and the high risk of debt distress persists for more than 20 years. In case of delayed fiscal policy adjustment, the growth and consumption do not decline comparing to the baseline, but in turn, the country becomes more indebted and the high level of debt persists for a longer period of time.

11. The high investment scenario produces limited benefit compared to the baseline scenario while it leads to an unsustainable debt level. Although the long-run investment level is only a few percentage points higher than the baseline scenario, the public debt becomes very sensitive to the parameters in the model. Under all scenarios, the commercial debt and the public debt embark on an unsustainable path. Again, growth and consumption are not as much hurt as in “low return on infrastructure investment” and “declining public investment efficiency”, but still the debt remains unsustainable. Overall, compared to the baseline scenario, the high investment scenario does not result in higher growth, but it can push the debt on an unsustainable path. Notice that the model did not include public default, but clearly, an explosive path for public debt with low growth rate would lead to default in future.

D. Policy Recommandations

12. Efficient public management together with public enterprise and structural reforms play an important role in the country’s investment plans. The contrast in Figures 4 and 5, especially for lower efficiency of public investment and delayed tax rate adjustment, illustrates the gains from enhancement of fiscal policy, business climate and the government’s investment management capacity. In face of higher public investment, a reactive fiscal policy would raise the tax rate and look for new sources of financing to preserve the long-run fiscal sustainability (blue graphs). However, as shown in all simulations, the higher tax levels will suppress private consumption under both baseline and high investment scenarios.

13. The components of the PIMI index suggest a starting point for further improvement in public investment management. Indeed, Djibouti needs to improve in all of four dimensions of PIMI, but comparing to other LICs and emerging countries, the public management suffers the most from appraisal and evaluation of investment projects. A sound public investment management manifests its importance in the wake of an increase in international interest rates given that the two biggest public investment projects’ applied interest rates are marked to LIBOR.

Figure 4.
Figure 4.

Baseline Scenario with Different Friction

Citation: IMF Staff Country Reports 2016, 249; 10.5089/9781498386449.002.A002

Source: IMF staff calculations.
Figure 5.
Figure 5.

High Investment Scenario with Different Frictions

Citation: IMF Staff Country Reports 2016, 249; 10.5089/9781498386449.002.A002

Source: IMF staff calculation.
A02ufig1

Djibouti: Public Investment Management Scores

(4 = best practices)

Citation: IMF Staff Country Reports 2016, 249; 10.5089/9781498386449.002.A002

Source: IMF Public Investment Management index.

14. Public investment and project appraisal helps ensuring that investments are selected based on development priorities. Efficient investment requires sound decisions in the selection of projects. Also because of the multi-year nature of investment projects, a medium-term framework that translates fiscal objectives into credible plans for sustainable investment program is necessary. The execution phase can be particularly affected by an inefficient budget execution and weak procurement practices. Last but not least, after the implementation of projects, an ex-post evaluation of projects by general auditors should be reported.

References

  • Buffie, Edward F. and others, 2012, “Public Investment, Growth, and Debt Sustainability: Putting Together the Pieces,IMF Working Papers 12/144 (Washington: International Monetary Fund).

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  • Melina, Giovanni and others, 2014, “Debt Sustainability, Public Investment, and Natural Resources in Developing Countries: the DIGNAR Model,IMF Working Papers 14/50 (Washington: International Monetary Fund).

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  • Ghilardi Matteo; Sola Sergio, 2015, “Investment Scaling-up and the Role of Government: the Case of Benin,Working Papers 15/69 (Washington: International Monetary Fund).

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1

Prepared by Hamid-Reza Tabarraei.

1

Dabla-Norris et al (2011).

2

The path of concessional debt is exogenous in the model.

Djibouti: Selected Issues
Author: International Monetary Fund. Middle East and Central Asia Dept.