Thursday, October 28, 2010

What’s The Impact Of The 2011 Mega Projects?

There’s a raging controversy in the aftermath of the budget regarding the spate of big mega-projects that were announced – the yet-to-be awarded Mass Rapid Transport system for Greater KL, the Dubai-based Mubadala Group and 1MDB hook-up for the development of a KL Financial District (I still have no idea where this will be located), and of course PNB’s 100-story Warisan Merdeka project. The last has especially attracted an uncommon amount of vitriol from Malaysians. The least troublesome of these projects would be EPF’s Sg Buloh development project, as there won’t be any “special” needs involved.

I’m going to forbear commenting on the feasibility of the projects as I’m not really qualified to comment on them. What I will do is speak to the possible macroeconomic effects of these projects, insofar as that’s possible with virtually no information beyond their projected development value.

To provide a basis, I’m going to rely on a research paper that I’ve quoted on before, though it’s now passed the draft stage into a working paper (i.e. it’s awaiting peer review):

How Big (Small?) are Fiscal Multipliers?
Ethan Ilzetzki, Enrique G. Mendoza, Carlos A. Végh

We contribute to the intense debate on the real effects of fiscal stimuli by showing that the impact of government expenditure shocks depends crucially on key country characteristics, such as the level of development, exchange rate regime, openness to trade, and public indebtedness. Based on a novel quarterly dataset of government expenditure in 44 countries, we find that (i) the output effect of an increase in government consumption is larger in industrial than in developing countries, (ii) the fiscal multiplier is relatively large in economies operating under predetermined exchange rate but zero in economies operating under flexible exchange rates; (iii) fiscal multipliers in open economies are lower than in closed economies and (iv) fiscal multipliers in high-debt countries are also zero.

Now if you’re wondering why I’m using a paper on fiscal (i.e. government) spending to evaluate private investment, it’s because by rights they’re about equivalent – the only difference is the sector that does the work.

I’m not going to quantify the effects, as there’s too many unknowns involved here – who the principal contractors will be, what the linkages are, cost of raw materials and labour, source of raw materials and labour, and a few of other parameters. But I’m going to take the empirical results from the paper quoted above and apply them generally (i.e. I’m speculating).

The impact of a flexible exchange rate and trade openness with respect to Malaysia imply that there’s going to be a whole lot of leakage from these projects. Intuitively, you can follow the argument this way:

  1. The size and potential complexity of these projects preclude most contractors from undertaking them (excepting maybe MMC, Gamuda, UEM? and even then there’s a question of expertise), which means the probability of foreign firms getting the main contractors role. Consider that the Petronas twin towers were constructed by Japanese (tower 1) and Korean (tower 2) consortiums. Even if Malaysian companies take the lead,  foreign expertise might have to be hired for specific roles.
  2. Source and costs of raw materials may be from overseas. Given the huge openness of the Malaysian economy(we’re in the top twenty in both exports and imports) and competitive markets, that means some portion of raw and finished materials will be imported if they are produced more cheaply than domestically, or if there is no domestic source. That doesn’t benefit the domestic economy, or domestic income.
  3. A similar and stronger argument for capital equipment e.g. rolling stock for the MRT'.
  4. A preponderance of manual labour will also be “imported”, as is the case with many construction projects.
  5. These leakages put downward pressure on the exchange rate, which reduces external purchasing power.

As against these factors, there’s the known over-capacity in the domestic building materials industry (as much as 50% for concrete and steel), though I have some doubts as to whether any of this capacity can actually be used for these projects due to the specific demands these projects might place on material requirements.

So although these investments will definitely add to GDP (build any kind of infra, and it will get added), the leakages through imported goods and services might partially or fully offset that positive impact during the actual construction phase. Later, I suspect the impact will be largely positive, but by how much more I don’t know.

The Ilzetzki et. al. paper finds a maximum positive long term multiplier of 1.3 times for investment, but this has to be set against the potential leakage from imports. I’m discounting any crowding out effects, where these projects displace other private investment, as there’s plenty of excess liquidity in the banking system and considerable foreign interest in Malaysian papers – I don’t consider the finance part to be much of a problem.

Technical Notes:

Ilzetzki, Ethan & Enrique G. Mendoza, Carlos A. Végh, "How Big (Small?) are Fiscal Multipliers?", NBER Working Paper No. 16479, October 2010

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