Crowding-in or Crowding-Out? Complementarity and Substitutability Between Public and Private Investment in Pakistan

Starting in the early 1990s, Pakistan initiated a comprehensive program of deregulation and privatization. The program focused on deregulating the energy, finance, and banking sectors as well as privatization of hundreds of state-owned enterprises, finally broadening to increased opportunities for private sector firms in areas previously reserved for public sector firms such as airlines, ports, shipping, highways, and telecommunications. The deregulation and privatization programs succeeded in raising the real gross fixed capital formation in the private sector by 133% from 1991 to 2018. Yet, as a share of GDP, private investment in Pakistan has remained relatively stable at around 13% of national output, while public investment has remained around 2.8% of GDP. This paper investigates the debate on complementarity versus substitutability between public investment and private investment in Pakistan. A structural vector error correction model (SVECM) is estimated to examine how the relationship between public and private investment in Pakistan has evolved over time. Using the "great ratio" of output and investment, a stationary long-term relationship between output, public and private investment is embedded in the modeling framework, and identification of the SVECM is achieved by decomposing structural innovations into those producing temporary and permanent effects on the system. Applying the empirical framework to data from the World Bank over the 1964–2019 period, it is shown that while public investment may crowd out private investment temporarily in the short run, its effects on output are positive both in the short run and in the long run. Economic growth is the most important source of growth in private investment, even as private investment itself does not appear to contribute to economic growth in a major way. These findings have important policy implications. First, policies that increase government spending on public capital are likely to enhance productivity and output growth in the short and long run. Moreover, this effect may more than offset the negative impact of debt-financed government consumption. Second, a full accounting of investment undertaken by Pakistan’s military-owned (but privately listed) companies may correct for the potential underestimation of the positive effects of public investment on output and private investment.