Land has historically been one of the most valuable state assets. Governments around the world are disposing of public land to finance development of key infrastructure, to encourage investment, for better urban planning, and for more effective management of public assets. In a country with underdeveloped public finances and massive need for infrastructure development as is the case of Somalia, the strategic management of public assets should be a welcome feature rather than an issue of controversy.
Yet, even if the selling of public land is a good strategic decision for a developing country such as Somalia, there are economic effects prior to, during and after the land has been sold at an auction. These effects are not mere economic effects; they are also financial effects prior to, during and after the auction has taken place. So, the debate on public land auctions goes way beyond the issue of disposing of public land for revenue. It is a debate on markets and their expectations on future events including policies of government.
The lessons that can be gleaned from Somalia’s markets reflect how confidence in investment can be just as important as the actual capital that investors put to work. Indeed, when confidence declines in the face of uncertainty, businesses are less likely to expand while households will lower their levels of discretionary spending in anticipation of falling income or even of being laid off in the future. Financial institutions such as banks will reduce the amount of new credit that they extend while requiring more collateral for the few loans that they do agree to make. As a result, even sound firms will be denied access to finance in the face of high levels of uncertainty, while liquidity—a medium that flows through markets to enable the great array of transactions that occur there—will be sopped up in inventories of cash by firms, and in reduced levels of spending by households. In essence, the uncertainty of the policies that governments pursue in the market can have the effect of an invisible tax on productive activity.
The Economic Shock
Economists have long recognized uncertainty as one of the principal drivers of economic fluctuations. Investment decisions are inherently forward-looking. Businesses commit resources today based on expectations of tomorrow’s market conditions. When policy becomes uncertain or politically contested, firms often choose to delay investment until greater clarity emerges.
A wide variety of investment decisions could be affected by a wait-and-see attitude of uncertainty on the part of businesses. The wait-and-see attitude of uncertainty may lead a firm to postpone decisions concerning expansion of operations, purchasing of capital equipment, hiring of workers, or even the acquisition of additional real property. Although such caution on the part of a single business may be rational, the same attitude on the part of thousands of businesses can have very negative effects on a number of indicators of a country’s aggregate economic activity.
A number of consequences of the reduced investment follow. Construction projects are put on hold. Property transactions are put on hold. Registration of new businesses decline. Financial institutions are more risk averse in their lending. Businesses’ suppliers get fewer orders. Consumers cut back on their non-essential spending, expecting that the economy will deteriorate.
Economic expectations are known to become self reinforcing. Investors expect economic conditions to worsen, hence they reduce their investment. Lower investment reduces economic activity, which in turn reinforces the initial expectation of worsened economic conditions. This self reinforcing mechanism creates a large economic shock that far exceeds the initial shock created by the policy event.
Therefore, the public land auction is not the end of the matter. Rather, the auctions are merely a trigger for a host of uncertainties around implementation, the legal and other framework, the amount of controversy and debate that the auctions will generate and ultimately the direction that future policy on land will take.
The Confidence Channel
Perhaps the most important transmission mechanism through which policy uncertainty affects economic performance is confidence. A further dimension of confidence are the households. Consumer confidence depends on the expectations that households have with regard to employment, income and the general development of the economy. When these expectations are declining, households become more cautious in their consumption behavior. Consumers save more than before and refrain from making large purchases. As a result, restaurants are frequented less, hotels are occupied less and shops sell less. This is particularly the case for retailers of non-essential goods. Consumers cut back on consumption of luxury goods first and then on discretionary goods and services such as holidays, cars, leisure activities, travel, and consumer durables.
Investors also assess the uncertainty surrounding property rights, future regulations, or government policies as they consider their long-term investment. They require a premium to the expected return on their investment in order to assume the increased risk or delay the investment until they have a better sense of what to expect. Just like households, financial institutions such as banks have a tendency to be more cautious in their lending activities in periods of uncertainty. As a result, credit standards are tightenedand collateral requirements are increased. As a consequence, the amount of lending will decrease because financial institutions want to protect themselves from possible losses due to unforeseen events in the future. The result of this process is a decrease in the rate of circulation of the money in the economy.To take one example, a restaurant buys supplies from a wholesaler, who in turn has bought them from a farmer. Hotels are full of guests, who spend their time in restaurants and bars, buying all sorts of goods and services from local retailers. Construction companies employ engineers and architects, and buy all sorts of building materials – from bricks to scaffolding – from local suppliers. In this sense, money is always circulating between and within businesses and between businesses and households.
Similarly, the holding of funds by businesses, to guard against uncertain times ahead, is further exacerbated by the lower flow of money around the economy. All businesses, healthy and weak, suffer from the reduced velocity of money (cash flow) around the economy. The root cause being the lower than normal level of consumer and investor confidence which affects all businesses equally. Many such uncertainties function as an invisible tax on the economy.
Sectoral Effects
The effects of falling confidence do not affect one sector of activity, and instead have a ripple effect on most sectors of the economy. The real estate sector is likely to be the first to experience the negative impacts of reduced confidence, because of the high expectations that drive property markets. This means that those looking to invest in land will be reluctant to do so and developers will put off starting new developments on hold until there is greater certainty of what the future holds. This in turn will lead to a decline in property transactions and a fall in property values. It will also result in a decline in the level of construction activity, which in turn can have a major impact on employment, because of the range of employment opportunities that the sector creates in fields such as construction, engineering, transport, law and the supply of building materials. In addition,hotels such as those in tourist areas are negatively affected as fewer people travel for business, and events such as conferences and meetings are postponed or cancelled. Restaurants, bars and shops in cafes and other leisure facilities experience less custom as people’s spending on non-essential goods and services declines. Similarly, retail shops such as mini-markets, shopping malls and stores located in shops experience decline in customer flow as consumers cut back on non-essential spending and consumption. As mentioned before, even small reduction in daily consumption by households translates into huge loss of sales for shops and retailers in the long run.
The Financial Sector is also negatively impacted by uncertainty. The banking industry becomes increasingly risk-averse. Insurance companies reassess their exposure in the market. The lending industry comes to a near-halt, just as businesses need additional working capital to do business in an uncertain environment. In order to stimulate private investment to grow the economy, liquidity needs to be increased in the financial sector. As the lifeblood of private sector development, uncertainty affects the operations of Small and Medium Enterprises (SMEs) more significantly. Most small businesses do not have financial safety nets and operate on thin cash flow margins. Thus, even minor downturns in sales and/ or customer payment delays can have serious consequences. This causes many firms to cut down on their inventory and delay their investments. They may also opt not to increase the workforce even when demand for labor is expected to pick up. All sectors of economy slow down in their activities thus negative effects of uncertainty on economy are being magnified.
Why It Matters for Somalia
Understanding how uncertainty affects the economy is critical in Somalia because it is a largely private sector economy. As noted, the economy is not driven by government spending and instead is fueled by a multitude of private sector actors such as entrepreneurs, traders, investors, financial sector and households. The private sector is the backbone of Somalia’s economy; thus, confidence is the country’s greatest asset. When confidence is strong, investment increases despite institutional challenges. Entrepreneurs establish new businesses. Diaspora investors commit capital. Banks extend credit. Consumers spend with greater certainty. Market activity generates employment, tax revenues, and economic growth.
Conversely, when confidence decreases, investments are postponed while capital is searched for in safer markets. Enterprises cease their growth and employment programs while the government experiences decreases in government revenue due to the decrease in economic activities. What matters is confidence. Such intangible assets cannot be gauged like physical assets. They can’t be counted or stored. In many countries with equally formidable physical endowments, investors are unwilling to engage with often uncertain, volatile environments. Moreover, these physical assets in themselves are not enough to grow an economy, or to foster growth in the absence of effective institutions. For fragile and emerging markets maintaining confidence is not just a matter of communication, it is a macro-economic issue of critical importance.
The Policy Lesson
It does not mean that governments should avoid taking difficult policy decisions with respect to public land management. This is an essential function of government and public assets must be managed efficiently and allocated in the best interest of citizens. The government must also prevent public assets from being illegally occupied, and it has a responsibility to develop a good land administration system. Furthermore, the government must also raise sufficient domestic revenue to finance development.However, sound policy alone is insufficient. What matters most is not what government does with its land, but how it manages to communicate, implement and explain its decisions on land. Transparency in procedures for instance can go a long way in minimizing uncertainty created by such decisions and programs, clear legal framework would enhance confidence of investors, consistent and correct communication would minimize misinformation and predictability of its implementation would help business to plan for the future and succeed.
First, transparency in procedures and decision making processes of government reduces uncertainty. Clearly defined legal frameworks for the management of public land increase investor confidence and credible institutions for the management of public assets ensure that their use does not create economic costs. Consistent information communicated to the public on all issues reduces the risk of misinformation and allows for the addressing of concerns prior to their escalation into uncertainty-induced economic shocks. Predictable and efficient implementation of policies and programs of government enables businesses to plan ahead. Effective engagement with stakeholders allows for concerns and grievances to be addressedbefore they escalate into uncertainty.
Another important consideration is the distinction between a policy’s technical soundness and its political implementation. Although a policy may have sound technical foundations, it can cause immense damage to an economy if its communication is poor, if there is a lack of coordination among institutions, or if it causes a decline in public confidence. Conversely, the implementation of sound policies in a transparent manner with the backing of credible institutions can reduce uncertainty even when a policy is sensitive politically. The challenge for governments is to manage their public assets and public expectations. The credibility of a policy is an important form of economic infrastructure in modern economies.
Conclusion
The issue of public land management through land sales in Somalia is not merely a matter of who owns what piece of land and how government can generate much needed revenue. It is also a matter of how management of public assets can affect the economy’s confidence and financial stability. The greatest cost of a policy that generates controversy may well be the uncertainty that it generates and which in turn weakens consumer confidence, deters investment, reduces liquidity and puts on hold decisions to invest and grow. The economic and financial shock generated by uncertainty in one sector of the economy can easily have an impact on other sectors of the economy. In Somalia’s fragile economy where the private sector is the driving force behind economic activity, confidence is as valuable a resource as discipline in fiscal management. Establishing institutions, implementing regulations in a transparent manner and effectively communicating with various stakeholders are critical to achieving sustainable economic development. The sale of public land through auctions is an important tool that can be used for development, but success will depend on more than the value of the land that is being sold. The confidence inspired by the transparent manner in which the auctions are conducted in the market is crucial.
Dr. Mohamed Ibrahim Nor, Ph.D.