# **1. Introduction**

During the global financial crisis, many governments employed unprecedented fiscal stimulus packages aimed at sustaining employment and spurring economic growth. The ability to select appropriate public investment projects and implement them quickly, however, varied significantly and in the aftermath of the crisis there have been strong concerns about the efficiency of capital spending. Moreover, advanced and emerging economies with large current account surpluses are often called to accelerate the global rebalancing by shifting demand from foreign to domestic markets. Consequently, public investment has received a lot of attention in recent years, as it is commonly seen as a potential tool to narrow imbalances.

Beyond these growth enhancing and stabilization functions, the role of the public sector in closing the massive infrastructure gaps in many developing countries has been widely acknowledged. For example, the United Nations Millennium Project (2005) called for a “big push” in key infrastructure investment to help countries meet the Millennium Development Goals.<sup>2</sup> As a result, there has been a renewed focus to strengthen the public investment management (PIM) system in many countries.

Institutions play a critical role in determining whether public investment spending will generate sustainable productive assets, or be inefficient and wasteful. For example, institutional mechanisms dictate whether projects undergo a rigorous cost-benefit analysis to evaluate their social and economic value, whether they are implemented on time, whether there are legitimate procurement practices, whether they adhere to their projected costs, and whether they are adequately maintained. In settings with weak institutions, there is a strong risk that public investment will be used to serve the ruling elite. Moreover, if politicians seek as many rents as are compatible with remaining in power, the amount of rent-seeking should vary in presence of partisan and electoral shocks (see Persson and Tabellini, 2000). The latter are likely to be more frequent in countries with weak institutional quality (e.g. without strong parties that tie people’s electoral preferences), positively affecting the volatility of capital spending.

This paper expands upon Keefer and Knack’s (2007) cross-country analysis into the impact of institutional quality on public investment levels by using a more recent and longer time period 1984-2009, and a broader sample within a panel framework. Additionally, it extends their research by studying how the volatility of capital spending and the quality of infrastructure are affected by institutional quality, and by exploring the contribution of other important factors such as conflict, aid, revenues and natural resources.

Our findings suggest a negative relationship between public investment levels and institutional quality. At the same time, aid, revenues and natural resources contribute positively to capital spending, even though there are no higher effects in resource rich countries with low quality of governance. These results suggest that governments use public investment spending as a vehicle for rent-seeking. Alternatively, they could imply that governments might increase public investment to compensate for the fall in private investment due to the country’s inability to create an attractive business environment.

We also find that high volatility of public investment is associated with lower quality of governance, possibly because of more frequent political shocks. While aid flows and natural resource abundance increase the volatility of public investment, growth in revenues is associated with its reduction, suggesting a good macroeconomic management that results in a smoother investment cycle.

> 2 More recently, Foster and Briceño-Garmendia (2010) estimate that Africa’s infrastructure needs are around $93 billion a year.

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