Accelerating growth and poverty reduction requires governments to reduce the policy risks, costs, and barriers to competition facing firms of all types -- from farmers and micro-entrepreneurs to local manufacturing companies and multinationals, concludes the World Bank’s annual World Development Report for 2005, launched on September 29.

“A good investment climate is central to growth and poverty reduction,” said Fran?ois Bourguignon, the World Bank’s senior vice president and chief economist, when presenting the report. “A vibrant private sector creates jobs, provides the goods and services needed to improve living standards, and contributes taxes necessary for public investment in health, education, and other services. But too often governments stunt the size of those contributions by creating unjustified risks, costs, and barriers to competition.”

The report, A Better Investment Climate for Everyone, draws on surveys of over 30,000 firms in 53 developing countries, the bank’s Doing Business database, country case studies, and other new research. It highlights opportunities for governments to improve their investment climates by expanding the opportunities and incentives for firms of all types to invest productively, create jobs, and expand.

Policy-related risks dominate the concerns of firms in developing countries. Uncertainty about the content and implementation of government policies is the top-rated concern, with other significant risks including macroeconomic instability, arbitrary regulation, and weak protection of property rights. These risks cloud opportunities and chill incentives to invest productively and create jobs. Nearly 90 percent of firms in Guatemala, and more than 70 percent of firms in Belarus and Zambia, find the interpretation of regulation unpredictable. More than 80 percent of firms in Bangladesh, and over 70 percent of firms in Ecuador and Moldova, lack confidence in the courts to uphold their property rights. Improving policy predictability alone can increase the likelihood of new investment by more than 30 percent, the report found.

The policy-related costs shouldered by firms can also be substantial, and make many potential investment opportunities unprofitable. The bank’s Doing Business in 2005 report, published earlier this month, highlighted the heavy burden imposed by outmoded or ill-conceived regulation. The World Development Report 2005 shows that regulation is part of a larger problem. 

Unreliable electricity supply and other infrastructure, crime, and corruption can impose costs that are more than double those of regulation. Together with weak contract enforcement and onerous regulation, these costs can amount to over 25 percent of sales, or more than three times what firms typically pay in taxes. The costs associated with unreliable electricity supply alone amount to over 10 percent of sales in Eritrea, India, and Kenya, while the costs of crime exceed 10 percent of sales in Armenia, Azerbaijan, and Peru. Bribes average more than six percent of sales in Algeria, Cambodia, and Nicaragua.

Barriers to competition are also pervasive and dull incentives for firms to innovate and increase their productivity -- the key to sustainable growth. High risks and costs restrict competition, but governments also limit competition through policy barriers to market entry and exit, and through inadequate efforts to curb anticompetitive behavior by firms. Nearly 90 percent of firms in Poland report strong competitive pressure, more than twice the share of firms in Georgia. Stronger competitive pressure can increase the probability of innovation by more than 50 percent, the report found.

The level and composition of risks, costs, and barriers to competition vary widely not only across countries, but also within countries. This is true among states and provinces in Brazil, China, and India, but also across locations in smaller countries. National and sub-national governments each have important roles to play in improving the investment climate.

Poor investment climates also hit small firms and those in the informal economy the hardest. The report found that these firms have more difficulty in gaining access to finance and public services, have less confidence in the courts, and find the interpretation of regulation less predictable. Constraints that involve fixed costs -- such as the need to self-generate electricity -- also impose a disproportionate burden on smaller firms.

Progress requires more than changes to formal policies

“Over 90 percent of firms report gaps between policy and practice, and the informal economy accounts for more than half of output in many developing countries. Governments need to close these gaps and confront deeper sources of policy failure that can undermine the investment climate,” said Warrick Smith, lead author of the report.

While many investment climate improvements require changes to laws and policies, the report highlights four deeper challenges that governments need to address to improve their investment climates:

l         Restraining corruption and other forms of rent seeking. The majority of firms in developing countries report having to pay bribes when dealing with officials, and many rate corruption as their most pressing obstacle. Policies and their implementation are also distorted by the disproportionate influence exercised by politically-connected firms.

l         Building the credibility of government policies. Passing new laws has little impact if firms don't believe they will be enforced or sustained.

l         Fostering public support for policy improvements. Failure to build public support for creating a more productive society slows reforms and jeopardizes their sustainability.

l         Ensuring policy responses are adapted to local conditions. Approaches that are transplanted uncritically from other countries often lead to poor or perverse results. 

Focus on delivering the basics

Governments should focus on improving the basic foundations of a good investment climate to benefit all firms and activities in the economy. The report reviews lessons of experience in the four core areas:

l         Stability and security. Secure property rights are central to a good investment climate. In Poland, Romania, Russia, Slovakia, and Ukraine firms that believed their rights were secure reinvested between 14 and 40 percent more of their profits than those that did not. Rights can be made more secure by verifying rights to land and other property, improving contract enforcement, reducing crime, and restraining expropriation by government.

l         Regulation and taxation. Regulation and taxation make important contributions to a good investment climate and to other social goals. But too often approaches create unnecessary risks, costs, and barriers to competition, and lead to a swelling of the informal economy. Successful reforms include those that streamline regulatory procedures, as in Uganda and Vietnam, improve tax administration, as in Kenya and Peru, and modernize customs administration, as in Morocco and Ghana.

l         Finance and infrastructure. Finance and infrastructure are critical inputs to most investment activities. Governments are getting better results by improving the investment climate for providers of these services, rather than by involving themselves more directly in service provision.

l         Workers and labor markets. A good investment climate helps connect people to decent jobs. Governments need to foster a skilled workforce and ensure that labor market interventions benefit all workers (including those currently under-employed and in the informal economy). They also need to help workers cope with change in a more dynamic economy.

Going beyond the basics by targeting particular firms or activities for special policy privileges is a risky strategy, the report warns.

“Governments have been experimenting with selective interventions for centuries. But international experience reveals no sure-fire strategies, and such interventions have gone spectacularly wrong in many cases,” said Michael Klein, vice president of World Bank/International Finance Corporation (IFC) for Private Sector Development and IFC chief economist. The report reviews experience with a range of approaches and offers guidelines on ways to reduce the risks inherent with such strategies.

Persistence, not perfection, is the key

Citing the success of countries such as China, India, and Uganda, the report emphasizes that everything does not have to be done at once. Rather, significant progress can be made by addressing important constraints that face firms, and by sustaining a process of ongoing improvements. Improving property rights in China launched a process that lifted 400 million people out of poverty, with initial reforms followed by a succession of ongoing improvements covering most aspects of its investment climate.

Because the main constraints facing firms can vary widely across countries, even in a single region, priorities need to be assessed in each case. To maintain the momentum of reform, countries as diverse as Senegal, Turkey, and Vietnam have established dedicated institutions for engaging stakeholders and reviewing constraints. Effective public communication also plays a vital role in sustaining progress, the report says.

The int'l community should do more to help

The growth and poverty reduction unleashed by investment climate improvements in a country can easily dwarf the impact of international aid flows. The report calls on the international community to strengthen efforts to help developing countries improve their investment climates by:

l         Removing trade restrictions, subsidies and other market distortions in developed countries that harm investment climates in developing countries. This can deliver benefits to developing countries worth more than four times the value of aid they receive to improve their investment climates.

l         Providing more effective assistance to help governments improve their investment climates. Technical assistance on the design and implementation of policy improvements can be especially potent, but currently receives fewer resources than the support directed to individual firms and transactions.

l         Helping to tackle the huge knowledge agenda on investment climate issues to provide more guidance to policymakers on the design and implementation of policy improvements.

(China.org.cn September 29, 2004)