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DO BUDGET DEFICITS CROWD OUT PRIVATE INVESTMENT? AN ANALYSIS OF THE SOUTH AFRICAN ECONOMY By Biza R. A1; Kapingura F.M2 and Tsegaye A3 ABSTRACT South Africa has been experiencing unprecedented budget deficits since the 1960s, in light of this, the study investigates whether budget deficits crowd out or crowd in private investment in South Africa, using quarterly data covering the period 1994 to 2009. An empirical model linking private investment to its theoretical variables is specified and used to assess the quantitative effects of budget deficits on private investment. The study augments the cointegration and vector auto-regression (VAR) analysis with impulse response and variance decomposition analyses to provide robust long run and short run dynamic effects on private investment. The variables have been found to have a long run relationship with private investment. Results suggest that budget deficits significantly crowds out private investment. These results corroborate the theoretical predictions and are also supported by previous studies. Keywords: Economic growth, Budget Deficits, Investment, South Africa, Cointegration, VECM JEL Classification: H30, H62, H63 Paper prepared for presentation at the Financial Globalisation and Sustainable Finance: Implications for Policy and Practice (29 to 31 May, 2013, Cape Town, South Africa) 1 British High Commission, 255 Hill Street, Arcadia Pretoria, South Africa University of Fort Hare, Department of Economics, East London Campus, East London, South Africa, Email: [email protected] 3 University of Fort Hare, Department of Economics, East London Campus, East London, South Africa 2 1. INTRODUCTION Although increased government involvement in the economy may crowd-out private investment as supported by the neoclassical school, public spending may help in developing infrastructure for encouraging private investment. Accordingly, the Keynesian model argues that an increase in the government spending stimulates the domestic economic activity and “crowds-in” private investment (Darrat, 1989). The model asserts that the government might help lay the ground for the development of private sector through the provision of legal infrastructure that ensures physical and intellectual property rights. The government also helps by undertaking investments that intensifies the physical and human capital infrastructure in the country. One of the bones of controversy between Keynesians and Monetarists is on the effectiveness of fiscal action in stimulating economic activity. According to Easterly and Rebelo (1993) fiscal deficits have been blamed for the variety of ills that beset developing and industrial countries. These ills include overindebtness, high inflation and poor investment and growth performance. The driving force behind economic policymaking lies in the macroeconomic objectives which are price stability, employment, economic growth, balance of payments surplus and equity (Chowdhury and Hossain, 1998: 130). Economists have a common belief that budget deficits are harmful for the total functioning of the economy. The South African economy is a prominent emerging economy and its government expenditures show direction to infrastructure and include investment in public works, education, and health care facilities. Consequently to this expenditure in productive investments and human capital infrastructure by the state, the expenditure might crowd in, rather than crowd out, private sector investments. In addition, the South African government may use fiscal policy that involves increased spending in infrastructure projects as an aggregate demand management tool. If such policies turn out to be successful, decreased macroeconomic volatility and a more stable level of aggregate demand may provide an incentive for private businesses. The decline in government budget deficits in South Africa has had implications for the public sector borrowing requirement, which declined substantially to around 0.9 percent of GDP in 2008. At the same time, although the government remains cautious about financing the deficit through foreign borrowing, increased recourse has been made to this source of finance. The combined effect of increased foreign borrowing and lower deficits has resulted in less pressure on long-term bond rates and reduced the cost of government borrowing. Marcus (2003) proposes that, in fact, the declining deficit and the moderately increased foreign borrowing have led to a shortage of paper in the market, which has reinforced the downward pressure on long-term interest rates. It is also important to note that although there is rich literature on the structure of interest rates, the empirical impact of this on budget deficits has received less academic attention. Persistent budget deficits will result in tax cuts leading to expansion of aggregate demand, thus, private savings rise by less than the tax cut so that desired national savings declines. Expected real interest rate will rise to restore equality between national savings and investment demand; as a result, crowds out private investment which will affect economic growth. Budget deficits automatically increase government debt, requiring income to finance the debt. Financing of the debt by domestic borrowing may raise interest rates which crowd out private investment. Reliance on high taxes place a burden on future generations as it reduces their income and spending accordingly. The higher taxes also distort economic incentives and thus weaken future economic performance. It is interesting to note that since the transition to democracy, South Africa’s macroeconomic performance has been solid but not spectacular. Between 1994 and 2003 GDP growth has fluctuated over this period, it has neither declined nor exceeded 4.5 percent in any calendar year since 1993. In this respect, South Africa appears locked into a path of sustained but moderate growth. Despite an improving situation, it must be emphasized that investment spending remains low. Private investment spending averaged 12.1% of GDP between 1994 and 2003. Optimists point to a number of factors that could sustain the current acceleration and allow South Africa to approach this target – higher levels of government spending “crowding in” further investment on the part of the private sector. However, these higher levels of spending bring about fiscal deficits which will need to be financed through borrowing thus raising external debt. In light of the above, the study will seek to answer the following questions. Firstly, does a higher level of public spending and budget deficit crowd out or crowd in private investment in South Africa? Secondly, given the structure of government spending in South Africa, increased government intervention also raises the level of employment and anchors growth of the economy, thus does this crowding out effect really matter? Thirdly, to what extent will interest rates rise in response to the greater demand for money and the supply of bonds prompted by the government deficits? And lastly, how will investments fall in response to the rise in interest rates? The rest of the paper is organised as follows. Section 2 presents a background and overview of budget deficits in South Africa. Section 3 presents a selective review of relevant theoretical and empirical literature on the impact of budget deficits on investment. Section 4 provides the methodology employed in the study. Section 5 draws conclusions. 2. BACKGROUND AND OVERVIEW OF BUDGET DEFICIT TRENDS IN SOUTH AFRICA The relationship between the government’s fiscal position and market interest rates breeds much controversy as claims have been made by some researchers and economists that there is a strong relationship between the two, while others argue that there is no relationship at all. Generally interest rates in South Africa have been higher than the deficit to GDP ratio. In the early 1960s both the deficits and the rates of interest were low, a trend that continued until the mid-1970s.The treasury bill rate was about 3% in the 1960s when the yield on government bonds was close to 5% and the lending rate of commercial banks was almost 6%. The rates were stable at treasury bills being a little over 4%, government bonds at 6% and the lending rate of commercial banks a little over 8% until 1970 (SARB, 1994). During the early and mid-1970s, the rates increased such that by 1981, the Treasury Bill Rate (TBR) was about 10%, government bonds yielded 13% and lending rates 14%. This period coincided with rising budget deficits. Interest rates were still generally high in the 1980s, and so were budget deficits. By the 1990s, interest rates began to fall such that by 1996, the TBR was 16%, almost on a par with the yield on government bonds, although the commercial banks’ lending rate was close to 20% (SARB, 1996). From the 1960s to the early 1980s, it appears that the interest rates and the deficit to GDP ratio moved in the same direction. Changes in the deficit to GDP ratio have been followed by similar changes in interest rates, or vice versa. The extent of the variation in interest rates was more distinct in the early 1980s and beyond. Whereas the deficit to GDP ratio changed slowly, there were sharp reductions in interest rates around 1986–7 and 1992–3 (SARB, 1996). Figure 1 shows the relationship between budget deficits and interest rates on government bonds of 0-3 years and 10 years and above for the period 1993 to 2009. Series 1 shows the trends in budget deficits as a percentage of GDP. Series 2 shows trends in interest rates on government bonds of 0-3 years and series 3 shows the interest rate tendencies on government bonds of 10 years and above. The variations in the different interest rates are analysed in line with the trends in budget deficits to establish the relationship between these macroeconomic variables. Figure1: Budget deficit-interest rate relationship 1993-2009 35 30 25 percent (%) 20 Interest rates on government bonds of 10 years and above 15 Interest Rates on government bonds of 03 years 10 Budget Deficits (% of GDP) 5 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 0 -5 -10 Source: Department of trade and industry: Economics statistics, 2010 In 1993 both the deficits and the rates of interest were high, a trend that continued until mid1994. As budget deficits decreased from 7.3% of GDP in 1993 to 4.9% in 1996, interest rates on government bonds of 0-3 years rose from 10.97% to 15.95% and rates on government bonds of 10 years and above increased from 12.34% to 16.19%. At a level of 2.1% of budget deficits in 1999, interest rates on bonds of 0-3 years decreased to 12.92% from a high level of 16.91% in the previous year. Interest rates on government bond of 10 years and above were 13.96% in 1999 from a high level of 16.36% in 1998. This trend supports the conventional view that high budget deficits cause an increase in the long term interest rates. Budget deficits continued to decline as there was an improvement in revenues as well as economic performance. Budget deficits were at their lowest in 2005 at 0.5% of GDP. Interest rates on bonds of 0-3 years declined to 7.27% and that of bonds of 10 years and above were 7.57%. The general trend at this period was that, as budget deficits declined interest rates also declined but at a slower pace. In 2006 South Africa experienced its unanticipated surplus of 0.3% of GDP; however interest rates (on bonds of 0-3 years) increased to 8.87% and rates on 10 year bonds and above slightly rose to 7.81%. In 2007 there was an increase in the budget surplus to 0.7% of GDP but on the other hand interest rates on 0-3 year bonds increased significantly to 10.56% and those on government bonds of 10 years and above increased to 8.29%. The rise in interest rates contradicted with the economic activities as real output was bolstered due to the improved economic performance. However the global financial crisis impacted negatively on other sectors of the economy as a result the surplus of 2007 turned into a fiscal deficit of 0.4% of GDP in 2008. Interest rates on government bonds of 0-3 years declined to 9.87% in 2008 and rates of government bonds of 10 years and above reduced to 7.82%. The budget deficit increased substantially in 2009 to 4.9% of GDP due to the forceful performance of the economy as well as increased government expenditure to finance infrastructural developments. Interest rates in 2009 on 0-3 year government bonds declined significantly to 7.56% while those on government bonds of 10 years and above increased to 9.03%. The external events associated with the East Asian crisis in 1998 negatively impacted on the GEAR objectives (Freund and Padayachee, 1998). The rand depreciated extensively and forced a monetary policy response that resulted in short term interest rates being increased by 400 basis points while long term bond rates rose slightly. As a result the real rate of interest moved from 3% in 1994 to almost 14 % in 1998 (Ibid: 82). Yan Kuo et al. (2003) assert that under a repressed financial sector, taxes on financial assets are a major source of revenue for the government. On the other hand, in a liberalized financial system, where the government finances its deficits via domestic borrowing, public sector will compete with the private sector for loans. This puts upward pressure on interest rates. According to Akinboade (2004) from the 1960s to the early 1980s, interest rates and the deficit to GDP ratio moved in the same direction. Changes in the deficit to GDP ratio have been followed by similar changes in interest rates, or vice versa. The magnitude of the change in interest rates was more pronounced in the early 1980s and beyond. The change in deficits from negative to positive percentages resulted to lower interest rates. There were sharp reductions in interest rates around 1992–3 with interest rates declining from 16.66% to 14.9% The Reserve Bank has practiced inflation targeting by keeping interest rates high in order to control domestic demand. In 1993-1998 the nominal interest rates rose while inflation was declining, leading to a sharp increase in real interest rate. Data indicate that the nominal interest rate on long-term bond financing rose considerably in the 1970s and remained high until around 2000, before declining quite considerably. The main reason for the increase in nominal bond yields in the 1970s was the acceleration in inflation to double-digit rates from around 1974 (SARB, 2010). The SARB raised interest rates by 200 basis points in the last six months of 2006 while the government controlled growth in expenditure. As economic conditions deteriorated with the unfolding global recession, the Monetary Policy Committee (MPC) of the SARB progressively reduced the repo rate. The repo rate was lowered by 500 basis points, from 12% in November 2008 to 7% by August 2009. South Africa’s commercial banks tagged along, lowering the prime overdraft rate to 10.5% over the same period (SARB, 2010). This monetary reduction was supported by an improved inflation position, but the MPC had also recognized the need to provide some recovery stimulus to a poor performing economy. The MPC left the repo rate unchanged at its meeting held on 17 November 2009. The relationship between budget deficits and interest rates remains sceptical as the trends show different movements as a result of different ways of financing. South Africa uses domestic borrowing and foreign borrowing as a way to finance its debt and deficits thus, the effects of the various forms of financing on interest rates and hence private investment are sceptical. The deficit-interest rate relationship in figure 1 generally shows a negative relationship between the two variables such that an increase in budget deficits results in lower short and long term interest rates. It shows correlation between the two macroeconomic variables. Beyond the relationship between fiscal deficits and interest rates, analysis of the impact of fiscal deficits on private investment has been an area of interest. Writing on the macroeconomic determinants of domestic private investment in Africa, Mlambo and Oshikoya (1999), using a sample of 18 African countries for the period running from 1970 to 1996, found that fiscal, financial and monetary policy, macroeconomic uncertainty, and trade variables were significant determinants of private investment in Africa. Figure 2 below shows the budget deficit-interest relationship in South Africa from 1991 to 2009. Figure2: Budget deficit-private investment relationship 20 15 percent (%) 10 5 0 Budget Deficits (% of GDP) GFCF-Private Enterprises (% change) -5 -10 -15 Source: Department of trade and industry: Economics statistics, 2010 Figure 2 indicates that change in private investment was -5.53 and -2.38 percent in 1991 and 1992 respectively. After a period of declining, change in private investment made a sharp rise in 1993 and 1994 to 4.25 and 12.71 percent and began single-handedly to determine the trend of South African investment. On the flip-side, budget deficits were 1.9 percent in 1991, 3.7 percent in 1992 and 7.3 percent in 1993. Structural adjustment programmes were put in place in 1994 which put emphasis on fiscal adjustment and this resulted in the budget deficits falling to 5.6 percent of GDP. From 1995, private investment began declining before reaching a low change of -3.17 percent in 1999. Change in private investment increased to 8.14 percent and continued to fluctuate reaching its peak of 14.74 percent in 2004. Private investment continued to be positive and increasing until in 2009 when it reached its low of -9.58 percent. This was due to the global economic crisis that saw many economies plunging and as a result economic performance was weak. The main shift in fiscal stance occurred in 1999 as the government sought to achieve fiscal stability through the reduction of the deficit. Budget deficits continued to decline to 2.1 percent in 2000, 1.1 percent in 2003 and 0.3 percent in 2006. South Africa experienced a budget surplus in 2007 and 2008 of 0.7 percent and 0.9 percent before recording a 0.7 percent budget deficit in 2009 as a result of deteriorating economic conditions as a result of the global financial crisis which started in 2007/8. As budget deficits steadily declined due to better revenue performance, change in private investment increased showing fiscal policy as a significant determinant of private investment in South Africa. 3. LITERATURE REVIEW AND THEORETICAL FRAMEWORK Literature is abounding, with studies on the impact of budget deficits on private investment and the crowding out effect. A large body of evidence comes from developed countries and African literature is scarce. In particular, there are a few studies that have been done to find whether budget deficits have an impact on private consumption and investment and whether the crowding out paradigm holds in the South African context. Cebula et al. (1981) used three models in their study of the 'crowding out' effect of Federal government outlay decisions. Their study examined the crowding out effect of aggregate federal government spending decisions upon purchases of new physical capital by private firms. In particular, the study examined crowding out by determining to what degree the proportion of actual GNP that was devoted to private investment in new physical capital was affected by the proportion of actual GNP devoted to federal government spending. Their new approach to the empirical dimension of the crowding out sought to provide further insight into whether or not the crowding out issue is substantive. The three alternative models were estimated, all of which found evidence of (a) a definite pattern in which private investment is crowded out by government spending and (b) only partial crowding out. These findings are inconsonance with Arestis (1979), Abrams and Schmitz (1978), and Zahn (1978). Dewald (1983) tested for the effects of deficits on both short- and long-term interest rates, using two different estimating techniques. In one approach, annual data were used; in the second approach, data were averaged over the business cycle. In either case, deficits had a statistically significant effect on long- but not short-term rates. The author concluded that deficits did not have a large and consistent effect on interest rates. However, an equally important conclusion would seem to be that deficits have an effect on long-term interest rates, although not on short-term rates. This meant that deficits had an impact on long term consumption and investment and did not affect short term investments, hence fiscal deficits crowded out long term investments. On the other hand, Hoelscher (1983) constructed an empirical model of the short-term credit market, with the interest rate on three-month Treasury bills a function of the money base, inflation expectations, a cyclical variable-proxied by the unemployment rate and net borrowing by the federal government. The results indicated that the coefficient on government borrowing was quite small and not statistically significant. Makin (1983) used a simple univariate regression equation for the changes in the three-month Treasury bill rate as a function of either the change in the actual deficit (relative to GNP) or the change in the high employment deficit. The coefficients for the deficit variable were not statistically significant. Similar results of non-significance for the fiscal variable were also reported for long-term interest rates. However, the analyses made were said to be faulted for not including other important determinants such as the monetary base and inflationary expectations. According to Motley (1983), the budget deficit financed by borrowing from the private sector leads to an increase in the supply of government bonds, and to attract the private sector to buy these bonds, the government has to offer them at a low price, which essentially implies an increase on interest rates, which causes crowding out of investment in the private sector. It was noted that the loanable funds model predicts that, in the nonexistence of debt monetisation, the effects of large fiscal deficits could lead to large effects on interest rates. However, Brunner (1984) notes that portfolio analysis suggests that interest rates are determined by stock demand and supply, and not by flow demands and supply, as suggested by the loanable funds model as this could lead to either significant or negligible effects of deficits on interest rates, depending on the sizes of accumulated stock of debts and deficits. In Tanzi’s (1985) study of American statistics for the effects of federal fiscal deficits on the interest rate and macroeconomic performance, the results found a mixed association between higher fiscal deficits and interest rates. The statistical significance of several alternative fiscal measures in a model of interest rates on one-year Treasury bills was tested. In the formulation, the interest rate was made a function of inflationary expectations using the Livingston Index, the gap between real GNP and potential real GNP, government debt, total private investments as a percentage of real GDP and measures of the fiscal deficit, including the deLeeuw and Holloway (1985) measure of the structural deficit. The study did not include a specific variable to capture the effects of monetary policy, although the inflationary expectations variable may indirectly capture some aspects of monetary policy. The results found were mixed. The sign on the structural deficit was negative, suggesting that higher deficits lowered interest rates and positively impacted on investment, a result that is difficult to reconcile with any theory. On the other hand, the actual debt variable had the hypothesized positive and statistically significant effect. Consistent with Tanzi’s results Evans (1985) used a conventional Keynesian model to explain why deficits might be expected to affect interest rates which have an impact on private investment. In his formulation, the nominal interest rate was a function of real government spending, the real deficit, the real money stock, and expected inflation. While much of his analysis pertained to wartime, the period analysed of most interest was from October 1979 to December 1983 (Evans, 1985). The study used monthly data and two-stage least squares estimation to deal with the problem of the endogeneity of the deficit. In any case, the coefficient on the deficit was usually negative and statistically significant. This result is difficult to explain with any theory, and stopped short arguments that deficits lower interest rates. The author did, however, argue that no empirical support could be found for the notion that deficits raise interest rates. The explanation was that the Ricardian equivalence theorem must have held. But other interpretations were also possible, such as that international capital mobility dominated interest rate movements for the period, or that price controls and rationing accounted for the results for some of the wartime periods. Easterly et al. (1994) in their study on public sector deficits and macroeconomic performance pointed out that there was a positive relationship between fiscal balances and interest rates. This assertion was in contrast with the common prediction that deficits cause high interest rates and surpluses low interest rates. There were a large number of negative real interest rates in the sample study and their finding was explained by the relationship between financial repression and fiscal deficits. Economies which go through budget deficits risk the possibility of financing their debt through seigniorage resulting to high inflation. The study showed little correlation between fiscal balances and inflation rates. In their study they acknowledged the work done by Haan and Zelhorst (1990) in their study on the impact of government deficits on money growth in developing countries that the correlation between interest rates and inflation holds for countries with high inflation. Ball and Mankiw (1995) published one of the studies to test empirically for a relationship between deficits and interest rates. Their model was in the Keynesian tradition, emphasizing income determination. In their model, the ten-year government bond rate was made a function of the log of real per capita government debt, the log of real per capita nongovernment GNP, expected inflation, the monetary base, and the lagged change in the dependent variable. The results reported showed that the government debt variable had a statistically significant though small effect, thus, revealing that budget deficits had a small effect on the level of interest rate. The literature discussed above shows that the relationship between budget deficits and investment is ambiguous. However, the literature has indicated a number of significant variables that are essential to investigate, in order to explain to what extent the literary theories on the crowding out effect can explain the effect of the unprecedented budget deficits on private investment in the South African economy. It is obvious that economic indicators such as budget deficit, interest rates, change in real gross domestic product and inflation are relevant to investigate, in order to explain the impact on the South African economy. Thus the literature has provided a guideline in the selection of the relevant variables to be used in the study. 4. METHODOLOGY The study seeks to investigate the crowding out effect of budget deficits on private investment. The reason is because South Africa has experienced budget deficits during most parts of the study period and the study seeks to analyse whether these have detrimental effects on private investment. The study will adopt a model developed by Blanchard and Perotti (2002). The model is specified as follows: ……………………………………………………………………… (4.1) Where: PI is private investment, BD is budget deficits, IR is interest rates, PCY is change in GDP and P is inflation. For analytical convenience the variables are all expressed either in ratios or percentages. Because changes in the natural logarithm are (almost) equal to percentage changes in the original series, it follows that the slope of a trend line fitted to logged data is equal to the average percentage growth in the original series. Percentage changes in the variables and rates are not logged because of their negative nature. When expressed, equation (1) becomes: ……………………………………………… (4.2) Budget deficits resulting from public investment can act as a substitute (negative effect on private investment) to or a complement (positive effect on) for private investment. The sign of the effect depends on the area in which the government executes the investment projects. Public investment may encourage private investment when such expenditure contributes to increasing private owned firms’ productivity. On the other hand, it may crowd out private investment when: (i) the government invests in inefficient state-owned firms; (ii) private investors expect higher taxes to finance such expenditures; and/or (iii) the public sector competes with the private sector for domestic loanable funds. Thus the relationship between the two variables is ambiguous. The anticipated sign on budget deficits is not clear – it can either be positive or negative because it is dependent on the area in which the government executes the investment projects. Interest rates are expected to have a negative impact on private investment as proved by empirical theory (Easterly and Rebelo, 1993). This stems from the assortment that if interest rates are high then it makes it expensive to borrow money. This will deter investment because investment is often financed through borrowing. Also when interest rates are high it makes it more attractive to save money. Investment is often financed out of retained profit. High interest rates mean that investment is relatively less attractive than saving money in a bank. Theoretically, the relationship between private investment and growth can be derived from an accelerator model with the underlying assumption that the production function has a fixed relationship between desired capital stock and a level of real output. The a priori expectation is that a percentage change in real gross domestic product will have a positive impact on private investment. The expected sign for the percentage change in real GDP coefficient ( in equation 4.2) is a positive sign. This follows from the path that a positive change in real GDP will result in increased private investment and hence growth. Studies by Hernandez-Cata (2000), Kormendi and Mcguire (1985:145-163) prove beyond doubt that there is a positive linkage between private investment and the rate of growth. As an indicator of macroeconomic instability, inflation can hamper private investment as it spells out the level of government efficiency. Greene and Villanueva (1991:33-58) and Oshikoya (1994:573-596) point out that, high and unpredictable inflation distorts the information content of relative prices and increases the riskiness of longer time investment. Therefore, a negative association between inflation and investment is proposed thus a negative sign of the coefficient is expected. 4.1 Data Sources and Measurement of Variables The study will employ time series data for the period between the first quarter of 1994 to fourth quarter of 2009 by tracking trends, seasonal fluctuations and variations in data or statistics. This period will be studied to establish the crowding out effect of budget deficits on private investments, when the government sought a leading era and enabling role in guiding the mixed economy through reconstruction and development. The variables, in level form, are of quarterly frequency and are obtained from various publications of the World Bank, The South African Reserve Bank (SARB) electronic data delivery systems and Department of Trade and Industry (DTI). 4.2 Analytical framework and Estimation Techniques The first step in our analysis is to test for stationarity of our variables. Gujarati (2003) suggest that a stationary stochastic process implies that the mean and variance are constant overtime, and the covariance between two periods depends only on the lag between the two time periods and not the actual time at which the covariance is computed. This implies therefore that a non-stationary time series will have a varying mean or varying variance or both. The statistical and time series properties of the data set were first carried out using the Augmented Dickey-Fuller (ADF) and Phillips-Perron (PP) to test for unit root. Mallik and Choudhry (2001) and Ahmed and Mortaza (2005) point out that the PP test can properly distinguish between stationary and non-stationary time series with high degree of autocorrelation and presence of structural break. Having determined the order of integration of out variables, the next procedure would be to test for the possibility of co-integration among the variables used. Cointegration is an econometric technique for testing the correlation between non-stationary time series variables. If two or more series are themselves non-stationary, but a linear combination of them is stationary, then the series are said to be cointegrated. Gujarati (2003:830) points out that the cointegration of two or more series suggests that there is a long run or equilibrium relationship between them. This means that even though the series themselves may be non-stationary, they will move closely together over time and their difference will be stationary. The long run relationship between the series is the equilibrium to which the system joins over time and the disturbance term can be interpreted as the disequilibrium error or the distance that the system is away from equilibrium at time t. The Johansen technique is preferred to Engle Granger in this study since it captures the underlying properties of time series data and provides all co-integration relationships between variables. Since our model is multivariate, there is a likelihood of having more than one cointegrating vector. According to Seddighi et al. (2000: 297) in the presence of more than one co-integrating relationships, the Engle-Granger approach would produce inconsistent estimates. Thus, in light of these problems, the Johansen methodology, developed in Johansen (1991, 1995) is preferred as it allows hypothesis tests to be done using the vector autoregressive co-integration based (VAR) tests. In addition, a VAR is a useful method for analysing the impact of a given variable on itself and on all other variables in the system by using forecast error variance decompositions (FEVD) and impulse response functions. By breaking down the variance of the forecast error for each variable into its components, FEVD are useful tool to analyse the impact of budget deficits on private investment. IRFs are also useful in tracing out the effects of one-time shock to deficits and private investment. 5. ECONOMETRIC PROCEDURE, RESULTS AND CONCLUSION Time series properties of the data were carefully evaluated through the Augmented Dickey Fuller (ADF) and Phillip-Peron (PP) tests. All variables were regarded as non-stationary at their levels. The variables were tested for stationarity at first differences. The results indicated that all variables are stationary. The results confirmed therefore that differencing once was all that was required to bring these variables to stationarity at all levels of significance. This suggests that our variables are integrated of order one I(1). Having established the existence of unit roots, cointegration tests were conducted. The optimal lag order was determined empirically. Based on several criteria (AIC, SIC, FPE, LR and HQ), a lag order of 1, which produced a stable VECM, was selected. The Johansen test proved evidence of three cointegrating vectors. Based on the results of cointegration, the VECM was specified which provided the parameter estimates for the long-run relationship. The main concern is to determine which variables have the greatest impact on private investment demand and hence our discussion is mostly concerned with the influence of those other variables on private investment rather than how all the variables influence each other. We proceed to estimate a VECM normalized on private investment where we have the private investment in the VEC as a function of the remaining variables. The long run regression test results are given as follows: PI = 50.17484 + 1.585597BD + 0.281064IR - 6.290677PCY + 4.747208P (0.93802) (0.72552) (1.43529) (1.02707) [1.69037] [0.38739] [-4.38287] [4.62209] Notes: ( ) standard error [ ] t-statistic The empirical findings, as reported by the positive coefficient of the variable BD in the equation above, indicate that budget deficits have a negative long run relationship with private investment. Real lending rate and inflation also have a negative long run impact on private investment demand whilst percentage change in real gross domestic product has positive long run implications on private investment demand. The empirical results indicate that there is a negative relationship between budget deficits and private investment. This supports the theory that postulate that an increase in deficits reduces private investment since higher deficits is seen as reflecting an increase in government spending signalling higher government debt. In this case the deficits are seen as deflationary in the sense that they depress private investment hence economic growth. The debt financed deficits crowd out interest sensitive private sector spending, in particular investment in homes and in new productive capacity. Increase in government spending, given that government revenue is fixed, which brings about a budget deficit, results to higher interest rates, thereby crowding out private investments. The result of increase in interest rate comes from the neoclassical loanable funds theory. In the theory, bond-financed government spending creates an insufficient fund for private investment. Since it is assumed that the supply of fund is fixed in the theory, the competition between government and private sector for the available funds gives rise to higher interest rates. As a result, (at least some of) private investors leave the loan market and hence depresses private investment. This result is consonance with Gale and Orszag (2004) and Anoruo and Braha (2005) who discovered a negative relationship between budget deficits and private investment. Interest rates even though insignificant have a negative long run relationship with private investment. This shows that an increase in interest rates results in a decrease in private investment as investment is interest sensitive. This confirms to theory and a-priori expectation again as in the neoclassical theory of investment, increasing the interest rate reduces investment by raising the cost of capital. This means that a fall in interest rates should decrease the cost of investment relative to the potential yield and as a result, planned capital investment projects on the margin may become worthwhile. A firm will only invest if the discounted yield exceeds the cost of the project. When interest rates are high, investment becomes more expensive. The relationship between the two variables is represented by the marginal efficiency of capital investment (MEC) curve. The IS/LM model also shows that investment is sensitive to interest rate changes. This is consistent with Bljer and Khan (1984) and Greene and Villanueve (1991:33-58) who in their studies in developing countries deduced a negative relationship between investment and interest rates. Fielding (1997: 349369), after concluding a study on the aggregate investment in South Africa, concluded that investment is a negative function of the real interest rate. The empirical results show that the inflation rate can have an adverse long run impact on private investment and the coefficient is highly significant. This is consistent with theory as an increase in the inflation rate results in the central bank increasing the repo rate to reduce inflationary pressures thereby discouraging private investment. As a variable also influenced by government spending, it can be considered as an indicator of government efficiency. High and unpredictable inflation also distorts the information content of relative prices and increases the riskiness of longer time investment which discourages potential investors. This result corroborates the outcomes that Greene and Villanueve (1991:33-58) found that a higher inflation rate had a negative impact on private investment for 23 developing countries in their pooled time series/ cross sectional study. Similar studies by Abbas (2004) also confirmed the negative relationship between the two variables. Change in GDP has postulated a positive long run relationship with private investment and the coefficient is highly significant. This shows that an increase in GDP growth results in an increase in private investment. This conforms to a-priori expectation. Khaled (1993) confirms the positive relationship between private investment and GDP growth rate. Impulse response and variance decomposition functions were also constructed to trace the temporal and directional response of private investment to structural innovations in the macroeconomic variables and as well as tracing the proportion of the movements in a sequence of private investment to its own shocks versus shocks to other variables. It was therefore established that innovations in BD, IR and P are negatively related to private investment whilst innovations in PCY are positively related to private investment in both the short and long run. The most interesting result which emerged from this analysis and which is supported by previous research is that among other variables, GDP growth explains the largest proportion of the variation in private investment. On balance, the evidence therefore suggests that private investment fluctuations in quarterly data are predominantly equilibrium responses to real and monetary shocks rather than fiscal policy shocks. CONCLUSION The study investigated whether budget deficits crowd out private investments in the South African economy in the period 1994Q1-2009Q4. Based on an extensive review of the literature on the determinants of private investments, a background of the unprecedented budget deficits in South Africa, an empirical model that links the budget deficits to private investment was specified. All the variables have a long run relationship with private investment. An increase in the budget deficit, real interest rate and inflation negatively impact private investments in the long run, while changes in real GDP positively impacts on private investment. The budget deficit coefficient was significant at 5% significant level revealing that budget deficits had a significant effect on the South African economy. This means that if an economy continuously experiences fiscal deficits, private investment deteriorates, thus being crowded out. It follows from these findings that private investment is largely a function of both real and nominal variables in the long run. Both the theory and previous research are contradictory and ambiguous as other researchers found that fiscal deficits caused by public investment crowds in private investments and deficits caused by public consumption crowds out private investment. 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