EconSouth - Second Quarter 2008

Building a Better World: Infrastructure's Role in Economic Growth

Photo of water going into a ceramic container
Courtesy of the World Health Organization
Many of the world's poor have inadequate access to water because of limited access to infrastructure.

Globalization, population growth, and urbanization are placing considerable strains on infrastructure around the world. Advanced industrial economies like the United States and Western Europe are focusing on repair and replacement of their aging infrastructures. But the developing world faces the more daunting task of creating new transportation, communication, water, and energy networks to foster economic growth, improve public health systems, and reduce poverty.

Infrastructure development is a vital component in encouraging a country's economic growth. Developing infrastructure enhances a country's productivity, consequently making firms more competitive and boosting a region's economy. Not only does infrastructure in itself enhance the efficiency of production, transportation, and communication, but it also helps provide economic incentives to public and private sector participants. The accessibility and quality of infrastructure in a region help shape domestic firms' investment decisions and determines the region's attractiveness to foreign investors.

A bumpy road toward prosperity
This relationship between infrastructure development and economic growth has not gone unnoticed by the world's two most populous countries, China and India, which have a combined population of almost 2.5 billion. The experience of these two rapidly growing nations illustrates how different the paths to growth can be.

For the most part, India has forgone the typical manufacturing export–led path to development and instead focused on its service sector. Although India has been very successful in information technology services and business-processing exports, its inadequate and dilapidated infrastructure has held back growth in the manufacturing sector.

The living standards in China, as measured by GDP per capita, overtook those in India more than 15 years ago. Since that time the Chinese economy has grown nearly twice as fast as India's, and its GDP per capita is now more than double India's. Investment in infrastructure is recognized as one of the main ingredients of China's success.

Related Links
World Health Organizationoff-site image
Organisation for Economic Co-operation and Developmentoff-site image
World Bankoff-site image

In her book The Elephant and the Dragon, Robyn Meredith writes that, beginning in the 1980s, China built new coal mines to supply electricity plants. The country developed a modern power grid, nearly quadrupling the capacity of its generators between 1990 and 2003. China is currently building nuclear power plants, hoping to triple the amount of power it generates by 2020.

China's most visible infrastructure investment, however, has been in roads and highways. By 2020 China plans to build 55,000 miles of highways, more than the total length of the U.S. interstate system, which was 46,385 miles in 2004, according to the Federal Highway Administration.

Overall, China's new infrastructure, coupled with probusiness policies and cheap labor, has made the country a very attractive market for foreign direct investment (FDI). According to the Economist Intelligence Unit, by 2011 China will be the third-largest global recipient of FDI, after the United States and the United Kingdom. Better infrastructure is one reason why China attracted nearly four times more FDI in 2006 ($78 billion) as India ($19.7 billion). In 2005 China spent 9 percent of GDP on infrastructure compared to India's 3.6 percent of GDP.

Photo montage of futuristic infrastructure, city skyline and desert road

India's government has recently acknowledged that its growth has been constrained by low levels of infrastructure development, and it is now looking to catch up with China. India's finance minister estimates that the country's inadequate infrastructure has restricted economic growth by 1.5 to 2 percent per year. India's central bank recently reported that "infrastructure bottlenecks are emerging as the single most important constraint on India's economy."

The country's manufacturing sector is held back by relatively inefficient and high-cost infrastructure—roads, railways, airports, ports, and electricity. The lack of adequate infrastructure is constraining not only foreign trade but domestic trade as well. For example, with little refrigeration available, 40 percent of India's fruits and vegetables spoil before reaching markets.

Chart 1
Private Investment in Infrastructure: Commitments in Developing Countries
Chart 1
Source: World Bank and PPIAF, PPI Project Database
Chart 2
Projected Developing Country Infrastructure Spending, 2007–09
Chart 2
Source: Merrill Lynch

The Indian government has committed to increasing its expenditure on infrastructure from 3.6 percent of GDP in 2005 to 8 percent of GDP in 2008. The government estimates roughly $500 billion is needed by the end of 2012 to sufficiently upgrade roads, ports, airports, and power.

The strength of a nation: Infrastructure and public health
In addition to machinery and technology, human capital also plays an important role in economic development. The health of a country's population, and thus the quality of its human capital, depends crucially on an infrastructure network supporting the necessities of life.

According to the World Bank, one in six people worldwide, mostly the poor, have inadequate access to water, more because of limited access to infrastructure than because of water scarcity. The availability of clean water is a requisite for maintaining a healthy population. In India, the treatment of waterborne diseases resulting from inadequate access to water infrastructure is estimated to cost the government $15 billion–$20 billion, nearly 2 percent of the country's GDP. Only three-fifths of the population of Shanghai, China, live in buildings connected to sewage systems.

Insufficient access to electricity can also prove devastating to public health. HIV/AIDS medication, for instance, must be refrigerated, so the insufficient supply of electricity in rural areas impedes the delivery of basic health care services to the poor. Increasing demand for electricity by mining companies in Africa has strained that continent's already shaky power grids, leading to increased power outages. In addition, as electricity input prices (coal, natural gas, and other petroleum products) have soared recently, projects to extend the electricity grids into rural areas have come to a halt. Storage and distribution systems of pharmaceutical drugs are so poorly managed in many parts of Africa that the World Bank estimates that only a small fraction of every $100 spent by African governments on medicines actually reaches patients.

Poorly maintained or nonexistent roads also inhibit access to health care services and medicines in the developing world. In South Asia, more than a third of the rural population lives more than a mile from all-season roads. According to the World Bank, in South Africa the poorest fifth of the population has to travel an average of nearly two hours to obtain medical attention, compared with 34 minutes for the wealthiest fifth of the population.

Inadequate transportation infrastructure is also a major factor behind what is considered one of the biggest public health crises in the world—road traffic deaths. Globally, road crashes are now the top cause of death for people aged 10 to 24, according to the World Health Organization (WHO). Eighty-five percent of traffic casualties occur in developing countries, where transportation infrastructure is poorly maintained or nonexistent. Children, pedestrians, and cyclists in developing countries represent the vast majority of these casualties. The WHO projects that by the year 2020, traffic injuries could rank third among causes of death and disability in the world, ahead of such other health problems as malaria, tuberculosis, and HIV/AIDS.

Those with the most to gain from infrastructure development are the poor. Investment in infrastructure is often cited as one of the most effective tools for fighting poverty. Access to infrastructure is essential for improving economic opportunities and decreasing inequality. For example, adequate transportation networks in developing countries could give the poor better access to schools, hospitals, and centers of commerce, which in turn would improve the education, health, and entrepreneurial opportunities that strengthen a country's economic potential.

A Renaissance for Western Europe's Aging Infrastructure
As an advanced economy, Western Europe faces many of the same infrastructure challenges as the United States. (See "Work Zone Ahead? Repairing the Southeast's Infrastructure.") But in Western Europe, where some infrastructure systems are far older, maintenance and repair issues surfaced long before they did in the United States, and European nations have already drawn up extensive infrastructure plans. As in Latin America, many European countries encourage partnerships with private operators to finance and manage infrastructure facilities.

Photo of a Western Europe city

After years of neglecting infrastructure needs during the postwar Franco era, the Spanish government has budgeted more than $120 billion since 2000 for an extensive infrastructure and public works makeover plan focused on increasing the country's road, rail, port, and airport capacity. But government funding has not always been able so ample. Twenty years ago, the cashstrapped government offered toll concessions to private builder-operators, backed by government guarantees to attract foreign loans. Spain now ranks as a world leader in building privately managed toll roads. Two decades of experience at financing, building, and calculating tolling rates has enabled Spanish companies to export their toll road expertise for billion-dollar projects across Europe and Latin America as well as to Canada and, most recently, the United States, where a Spanish-Australian consortium is operating the Indiana Toll Road.

Similarly, infrastructure has suddenly become a major priority for Italy after more than two decades of neglect and severe underfunding. The country now has budgets for more than 100 needed projects—many of them public-private partnerships—ranging from rail and roads to water management, electricity grids, and ports.

About three-fourths of France's 7,400-mile motorway system is tolled and managed by various private and semiprivate companies to which the government has sold concessions through 2032. Currently, the country is moving toward public-private partnership models to fund new projects with less state control.

In the United Kingdom, nearly 800 private finance initiative projects worth $55 billion are either under way or operational. About 16 percent of U.K. infrastructure outlays involve public-private partnerships, including all major airports and railways. Also privatized are most water systems as well as the gas and electricity industries.

Partnering with the private sector
In any country, infrastructure development and maintenance is an expensive endeavor. The poorer a country's population, the more difficult it is to foot the bill for infrastructure solely through tax revenues. Some countries are turning to the private sector as a way to finance much-needed infrastructure improvements.

Latin America has a long history of private participation in infrastructure. (The more advanced economies of Western Europe also engage in many public-private partnerships to maintain and improve infrastructure; see the sidebar.) Although Latin America has made great strides in both the quality and the scope of infrastructure development in the past decade—particularly in water and sanitation, electricity, ports, and airports—much work still needs to be done. During the past two decades, infrastructure development in Latin America has been much slower than in other middle-income regions. On average, Latin American countries invest only about 1.5 percent of GDP in infrastructure, an eighth of what China and a fourth of what India invest.

In the 1990s, because of a combination of fiscal limitations and a changing paradigm for infrastructure development, government expenditures on infrastructure, the source of nearly all investment in the 1980s, dropped drastically in many Latin American countries as financing and management responsibilities were delegated largely to the private sector. Although the region was able to attract almost half the dollar amount of private participation in infrastructure going to the developing world between 1990 and 2006 (see chart 1), this private money was not enough to offset the enormous cutbacks in public investment.

Recognizing the need to address this investment shortfall, some countries have renewed their emphasis on the public sector's role in infrastructure development. For example, Brazil and Mexico, which together constitute 55 percent of Latin America's population and 60 percent of its GDP, have taken important steps to promote infrastructure investment. Last year Mexican president Felipe Calderón presented a 2007–12 National Infrastructure Program, calling for $39 billion annually (4 percent of GDP) to be directed toward infrastructure, doubling the amount spent under the previous administration. Calderón stresses the importance of infrastructure investment to make Mexico's economy more competitive and to provide equal opportunities for its people.

Brazil is also increasing initiatives to help encourage infrastructure investment. At the beginning of 2007, the Brazilian government initiated a four-year, $235.8 billion (5 percent of GDP) program, financed largely through the public sector, to promote large-scale infrastructure development.

Investing in tomorrow
Several years of strong economic growth worldwide have highlighted the need for universal infrastructure investment and expansion. In developing countries, infrastructure spending will likely exceed $1 trillion between 2007 and 2009, led by China, Russia, Persian Gulf countries, and India (see chart 2).

Where will the money for infrastructure investment come from? In many cases, current account surpluses (more exports than imports of goods, services, and transfers) will enable developing countries to increase their investment in infrastructure. Oil revenues, as well as sovereign wealth funds (state-owned financial asset accounts), are also becoming increasingly important sources of funding. And investment banks like the European Bank for Reconstruction and Development, the Asian Development Bank, and the Inter-American Development Bank are making more money available for infrastructure in developing countries.

This article was written by Laurel Graefe and Galina Alexeenko, economic analysts in the international group of the Atlanta Fed's research department, with contributions from intern Harold Vasquez and staff writer Ed English.