High returns, low investment

Al Harberger is the father of the Chicago boys, who took Latin American economic policy by storm during the 1970s and 1980s. He recently gave an interesting talk at the Center for Global Development, the transcript of which can be found here.

The main puzzle that Harberger addresses is the very high rates of (realized) return to capital in Latin America--of the order of 20-30 percent year in and out. Why is this a puzzle? Because the actual rates of investment are quite low. In El Salvador, one of the cases which Harberger discusses, these high returns co-exist with an overall investment rate that is barely above 10 percent of GDP.

What is the explanation? Harberger thinks it is risk and uncertainty:

Perceptions of risk are a tremendous mess. I know people, personal friends, who have – who emigrated from Mexico prior to the recent election because they didn’t want to be around when Lopez Obrador won and so they’re somewhere else than in Mexico because of that I feel utterly confident that people who were thinking about investing in Mexico prior to that last election were saying eh, we don’t know what’s gonna happen there. We’re going to be careful. How does that carefulness work out? They want a high rate of return and a quick payback of their investment. What does that mean? They’re leaving off the list of interesting investments; those with a 15, 20, 30-year life or those without this very high rate of return, but with rates of return that are perfectly acceptable in most parts of the world. They’re just squeezed out of that.
It isn’t even by bad policies. It’s just by this expectation of what might happen if. And we have that in all kinds of places. We have it in El Salvador with the FMLN sitting in the sidelines and waiting to jump in. We had it in Nicaragua with the Sandinistas and to a degree with Ortega again in power. It is still there as a deterrent to people who want to invest and to overcome this kind of uncertainty is not sufficient that the government will come in and say well, you know, we did bad things in the past or we said bad things in the past, but we’re not gonna say or do those things any more. Everything’s going to be different. People are not going to react quickly to that kind of statement. What they’re gonna react to are actions of government and their own experience as time goes on.

In other words, people want a high return in order to be compensated for the high risk they are taking. The risk-adjusted return is low, not high. Note how this also can explain why the Washington Consensus reforms have not (yet) paid off: the policies may be OK, but it is their permanence that is in doubt.

I do not quite buy the Harberger story. The risk story has two problems that I can see. One is that it applies to ex-ante returns, not ex-post returns. If what is deterring investment is really risk, then over a sufficiently long period of time we should see the ex-post, realized rate of return to be low, not high. Yet, as Harberger reports, the high rates of return have been there for quite some time. In El Salvador, private investment was as depressed when FMLN was not a serious electoral threat. Second, when we look at instances of rapid increase in investment, it is hard to argue that there was less uncertainty in those policy environments. I have in mind cases like South Korea in the early 1960s or indeed Harberger's own Chile in the late 1980s. I read the evidence as suggesting that investment responds pretty quickly to profitability-enhancing reforms, even in the presence of uncertainty about their permanence. Which is of course why I think the Washington Consensus reforms failed: they simply did not increase the private profitability of investment sufficiently (whatever their risk profile).

An alternative story is that there is a large gap between the social and private returns to investment in countries such as El Salvador due to coordination and information externalities. The national-account statistics, on which the Harberger rates of return are based, show high aggregate returns to investment, while individual investors perceive low returns to their own investments. For the full story, check this paper.  

Comments

[notsneaky]

"If what is deterring investment is really risk, then over a sufficiently long period of time we should see the ex-post, realized rate of return to be low, not high."

Wait. Wouldn't we see high returns but with a high variance? I mean see a lot of people who have realized low rates of return but the average still high? Am I missing something?

Having said that I don't buy the risk story either (at least not as a sole factor). To the story about the wedge between the private and social return I'd also add something about Hayekian-type tacit knowledge wrt investment opportunities - you have to know the country, its investment world etc. very well to get those high returns. Combine that with a fairly low domestic saving rate and I think there's a third hypothesis here.

[Tim Worstall]

"very high rates of (realized) return to capital in Latin America--of the order of 20-30 percent year in and out. Why is this a puzzle? Because the actual rates of investment are quite low."

Perhaps I'm being a little Econ 101 here, but why is this a puzzle? If something (capital) is in short supply, then the price of it (returns) will be high.
No?

[hari]

Reading ALs message at an USAID-type of seminar, I can only say that in substance and framework of policy [I've managed them from Brussels under Lome Convention] there's a lot of problem which arise from CGD session.

1. In terms of comparative analysis, LatinAmerica is not a good example. Rule of law has always been a problem in their development process.

2. In Asia, Asean in particular, it was rule of law and property rights enactment which eventually led to GDP takeoff.

3. In Sub-SharanAfrica, we've a distorted economic perspective since a lot of good positive development is not identified/accounted for by (official) reports. Case studies would allow them to become useful in terms of successful mainstream project implementation.

4. In terms of island developing countries (SouthPacific Region), the case studies tell us that as long as property rights are not legalized (as official statutes), FDI would be difficult to attract over time.

CGD, and its counterparts, can help us to get down to basics by being a bit more
concrete in terms of policy prescription; one can't advise a sovereign govt based on what AL said at CGD. One would need to develop a type of decision-making cabinet paper which minister's have to decide upon. They're the bolts and nuts of development process.

[Per Kurowski]

There are many angles to this story.

1. My greener valley theory that states that investment thrives foremost on blissful ignorance. Venezuelans who know well about Venezuela risks go to Miami. Americans who like Italy but now little of it go there. And Italians invest in Venezuela.

2. All the opposite. Those in El Salvador are aware that they have better long term growth opportunities in the USA and so they migrate there requiring to compensate those who are left behind with much higher rates. The El Salvador GDP outside El Salvador (in the USA) is larger than the GDP of El Salvador in El Salvador… hold on to your hat!

3. Country Risk premiums. It should say that you need to expect a very high rate of return 20% to compensate for the fact that the country is risky and so that you average out a decent 10% return… but it has been confused with that you should expect a 20% return on all your investments.

4. Currently in the subprime mortgage crisis we have read how some investors have a vested interests in mortgages not getting paid and people losing their homes, since that is how they make their own money shorting the markets. Now who on earth is there to tell us that an Ortega in Nicaragua is not actually the chairman of a The Sandinista hedge fund, that has shorted Nicaragua and that are feeding the markets with some convenient scares in line with their current positions. Once it hits bottom then they will go long on Nicaragua again.

[corvad]

wow. just wow. all those lefty governments scaring the crap out of investors, eh? screw investors, and que viva la revolucion bolivariana.

btw, investors like countries where angry citizens aren't chasing the pharisees out of town. Morales' Bolivia is a far better investment climate than Goni's ... or, for the good old law and order days of the 1990s, former Condor-era dictator and School of the Americas grad Hugo Banzer.

Latin America has indeed had a problem with the rule of (martial) law: it's trumped human rights and human dignity over and over and over again, and since "democratization" (rule by oligarchy till recently) its raison d'etre was protecting the investment climate.

foreign investment is not necessarily a bad thing, I'm no isolationist, but it's pretty much always a bad thing when the only concern is maximizing return rather than actually improving human development and respecting human rights. Law is not neutral: problems with its rule may indicate a vibrant civil society.

I do realize the rule of law issue also seems to refer (maybe completely) to corruption. I just don't see the difference between corporate lobbyists in the US and corruption, well, anywhere -- one is institutionalized and never blamed for lack of development (usually applauded for contributing to growth, actually). finally, corruption with respect to translocal transactions requires translocal responsibility. The issue is so often discussed as though the people taking bribes are the ones responsible rather than the ones giving bribes ...

[Owen Willcox]

Surely it would be useful to break investment down into what it's used for? For example there would be different determinants of FDI for services to be used only in country versus FDI for using the country as a base for exporting, as seen in China.

I don't know too much about Latin America but one possible explanation could be that the investment was going into monopolised industries. Thus we would see low levels of investment because there are no other investment opportunities but with high returns. Is this a possible explanation?

[Per Kurowski]

Owen Wilcox puts forward "but one possible explanation could be that the investment was going into monopolised industries"

Well I guess that if he is looking at why Carlos Slim has become richer than Bill Gates he might be on to something.

[corvad]

investment was going into export-oriented, low value-added industries and managed by oligarchic elites, who tended to line their own pockets and deposit the proceeds offshore. other industries included for example private security. this is a broad generalization, too be sure, but a fair one. lots of FDI, corporate and entrepreneurial, has also been going into (often "eco") tourism, real estate speculation, and so forth throughout the Americas.

remember, too, that it wasn't until the end of the 1980s that countries such as Argentina and Chile "democratized", while in Central America under nominally democratic regimes, US-sponsored and trained death squads roamed the country attempting to establish the "rule of law." the dictators, like the oligarchic elites, lined their own pockets and sent the money offshore.

it is astonishing to see, in this thread, an evaluation of rational-choice Salvadorans moving to the US, without any acknowledgement that most of them were primarily political refugees fleeing the country's US-supported regime. it is a huge irony that in the early 90s that regime legally moved to facilitate remittances from the US. see anthropologist Susan Coutin's work on that ...

[corvad]

re: Carlos Slim. right on. Slim's purchase of the state's telecom industry when national enterprises (except oil) were being sold off to the lowest bidder were facilitated by his close connections with Salinas de Gortari, who was also implicated and charged with connections to Mexican drug trafficking organizations (DTOs, not "cartels", as the economists here should insist).

Slim = Russian oligarchs, more or less, who capitalized on that country's huge sell-off at the end of the cold war through, outright theft, extortion, and corruption.

By the way, with all the grrring and making nasty faces about oil and gas privatization/increased revenue sharing going on in Bolivia, Ecuador, Venezuela, no one ever seems to mention that Mexico never privatized its oil company.

[Guccio]

I think Harberger is correct. See Bolivia, a country with thousands and thousands of gas reserves under the earth, that is suffering now from lack of energy. How can this happen? The answer is simple: Evo Morales' Bolivia is a totally uncertainty. Nobody knows what will happen after the Constituent Assembly finishes and of course nobody would like to invest in a country where property rights are not respected.

[Dani Rodrik]

Guccio --
You are rights about the gas issue, but you have to consider that investment was low under market-based policies for two full decades before Morales appeared on the scene. So you may have cause and effect reversed: Morales is the result of low investment (and low growth).

[corvad]

it kind of depends on one's time frame: Bolivia has been quite the FDI recipient for 500 years, starting with Potosi's silver (it was a wealthier city than London). foreign investment has never worked to the benefit of Bolivia's indigenous majority.

you could say that actually there's quite a lot of foreign investment -- Brazil's Petrobras is a prominent example. Venezuela, certainly, has been "investing" in Bolivia -- as has Cuba, with their rural doctors. Bolivia's problem is clearly one of distribution: it's produced vast amounts of wealth over the years, for the entire world, and its native peoples have paid dearly for it.