Investment in public infrastructure has long been considered important for developing countries and recently has assumed a central role in the context of the expanding European Union. Services associated with the use of infrastructure account for roughly 7 to 9% of GDP in low and middle-income countries. Infrastructure in these countries typically represents about 20% of total investment and 40 to 60% of public investment. The stock of physical infrastructure is thus an important input in the production process of such economies, raising the efficiency and productivity of the private sector, and thereby providing a crucial channel for growth, distribution of output, and ultimately higher living standards.
However, financing new investment in infrastructure is a contentious issue, especially in poor, resource-constrained developing countries. A significant source for financing new investment in public infrastructure is external financing. Such financing could be in the form of borrowing from abroad, through bilateral or multilateral loans, or through unilateral capital transfers, in the form of tied grants or official development assistance, as recently observed in the European Union. In several instances, the per capita level of GDP of joining members to the European Union has been below the Union average, accompanied by low and, in some cases, declining growth rates. As a consequence, the EU introduced pre-accession aid programs to assist these and other potential member nations in their transition into the union.
This process of “catching up” began in 1989 with a program of unilateral capital transfers from the EU to its aspiring members through its Structural Funds program, and subsequent programs were introduced in 1993 and in 2000. These assistance programs tied the capital transfers (or grants) to the accumulation of public capital, and were aimed at building up infrastructure in the recipient nation, thereby enabling it to attain strong positive growth differentials relative to the EU average in the short run, achieve higher and sustainable living standards in alignment with EU standards, and ultimately gain accession to EU membership.
The objective of this paper is to analyze the process of developmental assistance in the form of tied-capital transfers to a small growing open economy. The model has the following key characteristics. First, the assistance is tied to the accumulation of public capital, which is therefore an important stimulus for private capital accumulation and growth. Second, we assume that public investment in infrastructure is financed both by the domestic government, as well as via the flow of international transfers, thereby incorporating the important element of domestic co-financing, characteristic of most bilateral aid programs that are tied to specific public investment projects. The international transfers are assumed to be tied to the scale of the recipient economy and therefore are consistent with maintaining an equilibrium of sustained (endogenous) growth.
We also assume that the small open economy faces restricted access to the world capital market in the form of an upward-sloping supply curve of debt, according to which the country’s cost of borrowing depends upon its debt position, relative to its total capital stock, the latter serving as a measure of its debt-servicing capability. This assumption is motivated by the large debt burdens of most developing countries, which give rise to the potential risk of default on international borrowing. Indeed, evidence suggesting that more indebted economies pay a premium on their loans from international capital markets to insure against default risk has been provided by Edwards (1984).
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