World View : Private Money Pours Into Third World Business : Influx of foreign investment is a vote of confidence in economic reforms. But public spending for schools, roads and relief lags.

In a hopeful sign for the economies of the developing world, private investors--and particularly foreign investors--are putting more money into the Third World. But at the same time, cash-strapped governments there are putting the brakes on the vital spending needed for schools, health, roads and relief of poverty.

The developments represent a turnaround from the experience of the early and mid-1980s and reflect a vote of confidence by business in recent economic reforms, according to a study by the International Finance Corp., a World Bank affiliate that finances private-sector projects and advises businesses and governments on investment issues.

In theory, at least, the increase in private investment bodes well for future economic growth in the developing countries. These new investments eventually create jobs and generate tax revenues.

The problem, according to Guy Pfeffermann, IFC economics director and co-author of the recent study, is that businesses generally don’t build schools and roads. That’s where public spending is important.

“The government has to do everything that the private sector won’t do,” Pfeffermann said in an interview. “The private sector is not going to build railroads and fix the potholes in the road.” And eventually, he noted, “if the government does not do that, the private sector will suffer.”

Public investment has been dropping in part because of the Third World debt crisis of the early 1980s, which crippled the ability of many Latin and other countries to finance public works spending with money borrowed abroad. As developing countries cut spending, they tend to reduce investment before cutting wages and other expenses, according to Pfeffermann.

In their report, Pfeffermann and IFC research analyst Andrea Madarassy offered both encouraging and troubling statistics for the Western governments and international organizations that are trying to institute a free-market system in the developing world. The report concentrated mainly on private investment but included data on public investment as well.

The political atmosphere in the Third World, according to the report, is changing enough to attract private investment. But the governments are not doing enough to alleviate social problems that are sometimes exacerbated by the pace of change.

According to the report, private investment in the developing world, which had decreased sharply through the mid-1980s, has now jumped back to its peak level of the late 1970s. In all, investment increased 16.4% from 1971 to 1991. A boost in foreign investment of almost a third powered most of the increase in total investment.

These trends were uneven. Six countries--Mexico, China, Malaysia, Argentina, Brazil and Thailand--received more than half of the foreign investment from 1985 to 1991. Although total private investment--including both domestic and foreign sources--increased throughout the developing world, the most noticeable increases came in East Asia.

The statistics illuminated some of the successes and failures of what economists call “structural adjustment.” Under these programs, pushed strenuously by the World Bank, the International Monetary Fund and others, developing countries are trying to hold down inflation, balance their budgets, lower tariffs, lift price controls, rid themselves of inefficient state-owned industries and end subsidies that prop up inefficient industrialists and farmers. This creates a free-market atmosphere that encourages private investment.

But, though economists believe that these countries will all benefit in the long run, there have been severe social costs in the short run: increased unemployment, more poverty, larger gaps between the rich and poor.

This demands some kind of balancing act. In its 1993 report on the world’s social situation, for example, the U.N. Department of Economic and Social Development said, “It has become apparent that without a strong public sector, there is no possibility of easing the human costs of structural adjustment.” In short, developing countries may need to streamline their governments, but they still need substantial government investment to ease the social costs of the streamlining.

Mexico illustrates the difficulty of doing this. President Carlos Salinas de Gortari has been widely praised for his strong moves to slim down the government and foster an atmosphere that encourages investment both from foreigners and from Mexicans who used to invest outside the country. U.S. officials, for example, have hailed Salinas’ decision to sell the government-owned telephone company to private investors.

Yet critics contend that, while economic statistics underscore the steady growth of the Mexican economy, the government has not done enough to alleviate poverty and decrease the gap between rich and poor.

In their IFC study, Pfeffermann and Madarassy report that private investment in Mexico amounted to 13.2% of its gross domestic product in 1971, dipped to a low point of 11% in 1983 and climbed to a high of 15.1% in 1991. On the other hand, the government’s public investment amounted to 6.6% of the nation’s gross domestic product in 1971, rose to a high of 12.1% in 1981, dropped to a low of 3.8% in 1989 and limped up to only 4.6% in 1991.

Pfeffermann, in the interview, said this shows that Mexican public investment was definitely too low to handle the problems caused by its free-market program.

The World Bank economists did not attribute all private investment to the attraction of structural adjustment programs. Efficiency, education, good government and the absence of corruption count heavily as well.

“The risks of doing business are much increased in countries where the rules of the game are unclear or where the state does not ensure that private contracts are enforced and where the judiciary system does not function well,” Pfeffermann and Madarassy wrote.

” . . . Inadequate administration of justice, deficient property rights, frequent political interference in private business, corruption and excessive red tape are among the most serious obstacles to private investment. The existence of even one single major institutional obstacle may thwart private investment.”

The World Bank economists have some difficulties dealing with the powerful economies of countries like South Korea, Singapore and Taiwan in East Asia. These countries, in fact, should probably no longer be classified as developing nations.

The report attributes their success largely to government industrial policies that employed incentives and penalties to encourage industries that could export goods throughout the world. This was done at a time when most other developing countries were using tariffs and subsidies to create local industries that would manufacture goods not for a world market but only to substitute for imports in the local market.

Although the report praises East Asian government industrial policies, Pfeffermann and Madarassy do not recommend them for the rest of the developing countries. Government corruption is the main problem. “Only a very few developing countries enjoy public administrations of the competence and integrity that characterize these East Asian countries,” they write.

As a result, Pfeffermann said, foreigners and local citizens will invest in these countries only if they feel that the governments will interfere as little as possible in the free market.

In a report on worldwide debt last December, the World Bank cited another reason for increased investment in the developing world--the low interest rates in the industrialized world. Investors feel they can get a better deal elsewhere. “Any increase in these rates would have some effect in slowing down this phenomenon,” the report said.

The increase in foreign investment underlines cultural as well as economic changes in the Third World. Foreign businesses were still considered dangerous in many developing countries only a generation or so ago--the advance parties of neocolonialism. The only foreign investment that was welcome was that aimed at “import substitution”--meaning it eliminated the need for imported products.

Now, some developing countries are even inviting foreign investors to help modernize telephone systems and other infrastructure that used to be a government monopoly.

ON THE REBOUND

Investment in developing countries sank in mid-1980s, then soared. Among those benefiting most was China, whose Shenzhen stock exchange is pictured below. Chart shows estimates of net foreign direct invetment in developing nations.

* 1976: $4.0 billion

* 1981: $12.1 billion

* 1983: $7.8 billion

* 1991: $27.1 billion

THE PUBLIC-PRIVATE GAP

The Third World debt crisis forced many governments to slash public spending even while the market economy grew. Mexico is typical. Chart shows public and private investment there as a percent of the gross domestic product.

Private

* 1976: 12.6%

* 1991: 15/1%

Public

* 1976: 8/2%

* 1991: 4.6%

Source: World Bank

REGIONAL INVESTMENT (1980-90) % of GDP

East Asia towers over other regions in private investment. Big contributors: South Korea, Singapore and Taiwan.