|Private Sector Development in Low-Income Countries - Development in Practice (WB, 1996, 188 p.)|
MANY previously low-income countries have made impressive advances in the past three or four decades. The most successful ones have pursued market-friendly development strategies. Their private sectors have been the engines of growth, generating sustained increases in incomes to allow investments in broadly based and long-term development. And their governments have been focusing on macroeconomic stability, on the business environment, and on basic physical infrastructure and human resources. The results: sustained high growth rates, with widely shared gains in living standards.
Many of today's low-income countries have adopted parts of that strategy, but with major differences in results. Real GDP growth for low-income countries as a group was 5.1 percent a year during 1987-93, and real per capita growth was 3.1 percenthigher than the 3.4 percent and 1.3 percent for other developing countries. Pulling up these averages was the rapid growth in East Asia. South Asian economies were clustered around the average. And economies in Latin America, Sub-Saharan Africa, and Eastern Europe and Central Asia did less well. What stands out are the stagnation of per capita incomes in Sub-Saharan Africa and the steep declines in Eastern Europe and Central Asia.
The variations across countriesin GDP growth, savings, investment, and export growth and diversificationhave been enormous (see figures 1-4). The low-income countries doing best have gone beyond broad macroeconomic reforms, conveying to their peopleand the worlda commitment to market-oriented economies. They have introduced sustained reform programs to stimulate internal and external competition and private investment by locals and foreigners. And they have succeeded in creating vibrant private sectors in a relatively short time.
Figure 1 Reform produces results in low-income countries
· China races ahead to catch middle-income countries within a generationother East Asian countries follow
· South Asia picks up, but per capita growth rate is still between one-third and one-half of China's
· Reforming Africa recovers, but real per capita growth remains too small to dent poverty other African countries regress
· China's spectacular growth is propelled by huge savings and investment, boosted by FDI mainly from overseas Chinese
· India and Pakistan maintain decent investment, mostly from domestic savingsFDI increases from a low base
· Other Asian and African countries invest modestly, aid flows are important, FDI is small and mainly in natural resources; domestic savings are limited by wasteful public sector and private sector is wary of harsh business environment
· China's non-state (collectives) and private firms grow at 20 percent a year and account for 75 percent of industrial growth
· South Asian industry and services respond nicely to deregulation agriculture continues steady growth
· In reforming Africa agriculture grows at rates comparable to China's and South Asia's private sector picks up in industry and services
· Other Africa stagnates
Figure 2 Domestic savings and foreign direct investment fuel growth
Figure 3 The private sector leads the growth
The best performers have been in Asia. China's growth has been particularly spectacular, with real GDP growing at 9.3 percent a year and real per capita income at 7.8 percent during 1987-93. Building on past investments in human, physical, and institutional capital, that growth was the result of an ambitious, comprehensive, and sustained program. Reforms liberalized agriculture, redirected a large part of savings to the provinces, removed price controls, made economic zones attractive manufacturing platforms for export, and gradually liberalized trade and started to revamp the tax and financial systems.
In South Asia, major economies grew by about 5 percent a year, permitting real per capita incomes to increase by about 3 percent a year. Fueling the growth were savings and investment rates of around 20 percent, mainly from domestic sources building on strong legal and political traditions and a growing pool of technical skills. Deregulation and trade reform increased internal competition, reduced production costs, and improved product range and quality.
The increased private activity in Asia has stimulated the financial sector and is beginning to attract substantial foreign investment, particularly in infrastructure and the stock market.
Figure 4. Outward orientation stimulates growth, helps diversify economies
China's exports surge at 30 percent a yearfirms with FDI
account for 36 percent of exports helping China become world's tenth largest
India's manufacturing exports pick up to slightly larger share of world exports-Pakistan and Sri Lanka follow.
Other countries, dependent on a few commodities. stagnate and lose market share to more competitive producers in Asia and Latin America; with little diversification they become more susceptible to terms of trade shocks.
In Sub-Saharan Africa, real GDP grew at 2.2 percent a year during 1987-93, but real per capita income fell by 0.9 percent a year because of rapid population growth. This regional average masks considerable diversity. Of the reforming economies, the best performers had GDP growth rates close to those in South Asia. But with population growth of about 3.0 percent a year, per capita GDP in reforming economies increased by only 1.3 percent a year between 1987 and 1993. The other African countries had GDP declines of 0.2 percent a year and per capita declines of 3.2 percent a yearas agriculture, industry, and services stagnated. They include countries torn by civil war and social unrest as well as potentially rich countries that have suffered from fiscal excesses, overvalued exchange rates, poor governance, and capital flight.
Reforming African countries made considerable strides in reversing policies that had previously stifled private initiative
Reforming African countries made considerable strides in reversing policies that had previously led to rapid declines in living standards, undermined institutions fundamental to the proper functioning of markets, and stifled private initiative. Supported by substantial external aid, they liberalized exchange rates, removed import restrictions, and gradually reduced tariffsgradually because of their importance for fiscal revenue and a perceived need to phase in reductions in effective protection. They also removed price controls on agricultural products, and most manufactured product prices were decontrolled, except for petroleumwhere government involvement has been extremely costly, especially in countries with refineries. In the financial sectors, steps were taken to reduce financial repression, improve supervisory and regulatory frameworks, and address financial distress in the banks.
The primary source of growth in reforming Africa was the private sector. Agricultural growth was close to that in China and South Asia. Small enterprises in industry and services, particularly the informal sector, gained because of increased access to production inputs, raising the demand for labor and increasing the low-wage employment in the informal sector. But the supply response in the formal economy, particularly in private savings and investment, has been muted by basic deficiencies in infrastructure and human resources and lack of confidence in the permanence of reform. The reason: few governments have undertaken the necessary structural reforms, particularly to improve a harsh business environment, reduce the dominance and losses of the public enterprises, develop a robust and competitive financial system, and upgrade infrastructure services.
In Africa as a whole, the fiscal drain of public enterprises and the losses of the financial system can be as high as 8-12 percent of GDP2-3 times the spending on health and education and about two-thirds of gross investment. SO, few resources remain for private or public investment to upgrade the weak base of human resources and infrastructure. And that has severely limited the ability of a weak and fragmented private sector to respond to macroeconomic reforms (even with a considerable depreciation of real exchange rates). Even in reforming Africa, public sector inefficiencies have reduced GDP growth by at least 2-3 percentage points, limited the opportunities for job growth, and exacerbated the social costs of adjustment. This in turn has weakened popular support for difficult economic reforms and the governments' resolve to sustain them.
These public sector lossesplus major expenditures on large and inefficient civil serviceswere primarily responsible for the fiscal instabilities that have contributed to the stop-and-go reforms characterizing many African economies. The resulting uncertainty was further compounded by excessive reliance on foreign aidwhich, though crucial to support macroeconomic reforms and long-term investment needs, put a damper on domestic and foreign investors' confidence in the permanence of reform. SO, in most African countries foreign direct investment (FDI) was confined to enclave operations in mining and petroleum.
By contrast, the better performers in Asia started with more developed industrial and service sectors. They also had better infrastructure and more skilled human resources. And they often had larger markets and stronger institutions. The private sector in these economies, particularly in industry and services, responded strongly to gradual and often partial policy changes.
The Asian countries also enjoyed high domestic savings and investments and relied only moderately on foreign aid. Macroeconomic imbalances did occur as a result of fiscal slippage's and the fiscal deficits of public enterprises. But the economic impact was smallerpublic enterprises' fiscal deficits were 5 percent of GDP in India and 3-5 percent in China during 1987-93, compared with gross domestic investment of 25 percent and 39 percent, respectively. And the solutions to difficult and pressing problems were more under their control. Their track records raised the confidence of domestic and foreign investors allowing the countries to achieve macroeconomic balance through their own efforts.
China's spectacular growth reflects high domestic savings and investment rates12-15 percentage points above India's, and bringing an additional 3 percentage points in GDP growth. It also reflects a major outward reorientation, with merchandise exports growing at 30 percent annually and a large influx of FDI, mainly from overseas Chinese. Totaling about $50 billion over the past ten years, FDI contributed about 60 percent of gross capital formation in the coastal zones. In 1993, firms with FDI accounted for $36 billion of China's $100 billion in exports.
The imperatives of faster growth, led by the private sector
Given the severity of poverty and the pace of population growth, most low-income countries have no choice but to accelerate economic growth, if they are to provide new job opportunities and reduce unemployment. The respectable GDP growth rates of successful performers in Sub-Saharan Africa are not enough to make a serious dent in povertyor to generate enough new, productive jobs to replace those that may be lost initially through privatization or civil service reform. With population increases of 3 percent a year, GDP growth of 4-5 percent means per capita increases of only 1-2 percent. At this rate, it will take low-income countries more than half a century to reach the living standards of today's middle-income countries.
The keys to accelerated growth are much higher investments and domestic savings, combined with systemic structural reforms to improve productivity.
In addition to slower population growth, GDP growth of 7-8 percent in real termswith the benefits shared widelyis needed to reduce significantly the number of people living in absolute poverty below the current level of one billion. Rapid growth is also needed to maintain harmony among different groups competing for their share of the economic pie in increasingly pluralistic political systems.
The reform agenda
The keys to accelerated growth are much higher investments and domestic savings, combined with systematic structural reformsnecessary to maintain macroeconomic stability and significantly improve productivity. The slow-growing economies need to raise their savings and investment rates from the current 12-16 percent of GDP to at least 20-25 percentlevels already achieved or exceeded by India, Kenya, and Zimbabwe. Initially most of the change will have to come from reducing government dissavingsince the private sector usually responds slowly to sustained reform.
Major changes will thus have to be made in the size and structure of government revenues and expenditures. Raising revenues calls for measures to broaden the tax baseby simplifying tax regimes, abolishing exemptions, reducing the discretionary authority of tax and customs administrators, and improving collection capacity. But the biggest impact will come from reducing the budget outlays on public enterprises and stopping the leakages from the banking systemwhich eat up most domestic savings in many African countries.
The strategy for moving low-income economies from state dominance to competitive marketsbroadly outlined in figures 5 and 6-includes:
Going farther and faster on public sector reform by accelerating the privatization, closure, or liquidation of the 10-15 largest enterprises that account for most of the fiscal losses, environmental degradation, and the leakages from the banking system, while employing only a small fraction of the labor force. These enterprises typically are the utilities (telecommunications and power), petroleum refiners and distributors, heavy industrial manufacturers, and agricultural marketing boards.
Focusing the public expenditure program on public goods and cutting out investments that the private sector could better undertake.
Accelerating financial sector reform by severing the links between banks and nonperforming borrowerswhether public or private. The key steps in this are to privatize banks, allow new entry, strengthen prudential regulation and supervision, and develop basic financial infrastructure.
These measures will helpwith minimum job lossto restore fiscal stability, stop the hemorrhaging of the banking system, and reduce the crowding out of the private sector. They will also improve infrastructure services essential to a competitive private sector, reduce the demand on scarce government managerial resources, and establish the credibility of reforms.
The resulting fiscal space should be used, first, to maintain macrostability to avoid the stop-and-go policies that so often undermine the confidence of the private sectorand to expand long-term investment in people and infrastructure, particularly in rural areas, where most people live. It will also help provide social safety nets.
In parallel with these efforts, private sector development requires a more favorable, yet competitive, business environment. An array of policy, legal, regulatory, and institutional reforms are needed to stimulate competition and dismantle onerous regulations that increase transaction costs by as much as 30 percent, and often more. Such increased competitionessential for promoting agile firms that can adapt to changes in global marketsis the driving force for productivity growth.
Many elements of this agendawhich shifts the emphasis from preserving jobs in an inefficient public sector to creating jobs in a vibrant private sectorhave been implemented in many low- and middle-income countries. And the response of the private sector has been impressive.
Economies that have already accelerated their growth rates and made a start on institutional and structural reforms have some leewayto take a more gradual approach to solving their remaining problems. But the least developed and the slowest growers have no such luxury.
Figure 5 Implementing the private sector development agenda
Overbearing public sector
Distressed financial system
Harsh business environment
Utilities and large public enterprises absorb a large share of government resources
Fiscal deficits public enterprises, and privileged private firms drain system
Weak legal system
They crowd out investment in social sectors and infra-structure particularly
Remaining private sector crowded out
Private sector over-regulated and overprotected
In rural areas
Public sector banks dominate with large amounts of non- performing loans
Incentives and regulations unevenly
Public enterprise and large urban consumers receive bulk of subsidies
Financial repression provides little incentive for savings
Agriculture oppressed by price controls and marketing boards
Weak prudential regulation and
Goods and services provided by public sector increase the cost of private firms by 20-30 percent supervision
Figure 6.A long and winding road ...to competitive markets
Reformed public sector
Robust financial system
Attractive business environment
Rationalize subsidies, target them to poor
Cut off nonperforming borrowerspublic and private from further credit; make a vigorous collection effort
Reform legal and regulatory system
Sell large public enterprises on a priority basis; use sales proceeds to retire debt
Privatize banks and allow new entry by reputable banks
Reform tax and customs administration
Attract private sector in utilities (requires pricing reform competition and regulation)
Build payment systems
Deregulate economy to complement liberalization of internal and eternal trade
Operate remaining public enterprises on commercial basis
Strengthen prudential regulation and supervision
Promote foreign investment and regional integration
Prune public expenditures and focus them on public goods
Serve small savers and borrowers
Conduct these activities in partnership with the private sector and labor
The fragility of their economies means that if some crucial element is missing, progress is likely to be limited and easily reversed. Their private sector development agenda is thus very broad, requiring simultaneous and often unpopular actions in many areas over long periods. Successful reform and development will rest largely on these countries' own efforts. But external assistance remains vital to help reforming economies preserve macroeconomic and political stabilityand to invest in long-term growth.
Though pivotal, private sector development is only one part of sustainable development, which encompasses such other areas as health, education, infrastructure, and environmental protection. These topics are treated in other periodic and special reports.
This report presents the rationale for the strategy proposed (the why), its main elements (the what), and experience in implementing them (the how). It contributes to the learning process by showing how countries have adapted the menu of solutions to their cultural, social, political, economic, and institutional conditions.
Almost all low-income countries need urgently to reduce the budgetary drain of public enterprises and to put their physicaland humanresources to more efficient use. Their past efforts at reform, short of privatization, rarely produced the desired results. So, many of them turned to privatization, but almost none has divested an economically significant portion of its public enterprise sector. Yet, in the few instances where large private investors have been attracted (in power in Pakistan, for example), there has been significant impact on macroeconomic aggregates.
Needed now are stronger actions to reform public enterprises and faster and deeper programs of privatizationto produce macroeconomic improvement through major reductions in fiscal deficits and general improvements in business conditions. Simultaneous action is needed on both frontspublic enterprise reform and privatization are not "either-or" propositions.
Countries succeeding in this process have avoided investments in the public sector that could better be handled by the private sectorand imposed a hard budget constraint on the remaining public enterprises. Experience reveals that the way forward is to:
Sell public enterprises producing tradables and operating in competitive markets. (If they cannot be sold, they should be liquidated.) Prime candidates are the largest public enterprises having adverse impacts on the budget and the economythe banks, the large manufacturing enterprises, the marketing boards, and the procurement, refining, and distribution of petroleum products. Even where proceeds might be modest, as in much of Africa, ending the financial drain is the important point.
Involve the private sector in the commercialization, management, financing, and as much as possible in the ownership of infrastructure as in China, India, and Pakistan.
Focus on the larger enterprises
Why the focus on the largest public firms? Because privatizing them immediately reduces the fiscal deficit, improves public saving, and demonstrates the government's commitment to reform.
Infrastructure utilities are particularly attractive candidates for divestiture
Divestiture is neither a panacea nor an end in itself. But done well, it is a powerful tool that not only brings better performance at the level of the firm, it also helps repatriate flight capital, attract foreign direct investment, and broaden and deepen access to international capital markets. These positive macroeconomic effects are enhanced when privatization's proceeds are devoted to reducing the high-cost government debt that is crowding out the private sector and increasing real interest rates.
Infrastructure utilities are particularly attractive candidates for divestiture. The financial, economic, and psychological impact of increased private involvement is generally large. The need for improved services is incontestableconsumers always applaud increases in the quality or reliability of services. And investors are willing and able to act. Moreover, privatizing infrastructure services facing growing demandsuch as telecommunications or powertypically results in little loss of employment. And efficiency still rises because of increased investment and proper pricing.
Particularly in Sub-Saharan Africa, however, the situation is much more difficult. Product markets are less competitive. Capital markets are thin. Investors perceive high risks. And public enterprises in infrastructure have a lower net worth and are less attractive to foreign buyers, except perhaps in telecommunications. Governments resist selling to foreigners, and investors are reluctant to take an equity position in infrastructure firms before governments have established consistent policy and pricing practices. These serious obstacles delay or dilute reform. What can be done to overcome them?
Addressing the causes of delay lessons of experience
To speed the reform process, successful governments have taken the following actions:
First, they have persisted with and deepened macroeconomic reformsestablishing new relative prices, enhancing competitive forces, and creating opportunities for job and income generation. This hastens the sale of small and medium-size firms. To obtain private involvement in larger firms, reforming governments have put trade and regulatory frameworks in order, thus attracting new entrants, stimulating competition in markets, and mitigating monopoly abuse in non-competitive markets.
Second, they have made efforts to inform their citizensespecially such opinion-leaders and decision-makers as legislators, journalists, and university professorsof the high costs of inaction in public enterprise reform. And they have undertaken public relations campaigns and sponsored study trips to reforming countries to build public support for change and reveal the potential of reform and divestiture. These efforts have often mobilized popular support and broken the opposition of vested interests.
Third, they have used methods of sale combining core investors with such broad ownership vehicles as trust funds, share giveaways, employee ownership options, and other devicesto enlist widespread participation in and approval for the privatization process. These methods address fears that only foreigners, the elite, or members of particular ethnic groups benefit from privatization.
Fourth, they have streamlinedindeed privatizedthe privatization process, by keeping the public sales agency lean and agile and by contracting out the details of implementation to private lawyers, accountants, and investment bankers both local and foreign. (Policy decisions remain firmly in government hands.) This approach gains time, produces quality work, gives assurance to investorsand develops local capabilities and the consulting business. Having worked in settings as varied as Mexico, Morocco, and Russia, it is now being tried in Ghana.
Fifth, where privatization has proven difficult or not yet possible, particularly for infrastructure firms, they have made greater use of methods of privatizing managementsuch as asset leasing, franchising, concessions, and management contracts. (Governments obtain the economic benefits of private control without paying the political costs of losing ownership.) Where the value of physical assets is low, the franchise value of infrastructure networks may still be substantial. Divestiture's net positive impact on the economy can still be considerable.
Bringing the legal and institutional frameworks to a higher level of working order is a fundamental but complex task
Sixth, recognizing the importance and difficulty of putting good regulatory systems in place, they have adapted regulatory structures to fit market conditions and institutional capabilities (and they have seen that it is usually more difficult for a government to directly manage a public enterprise than to regulate and monitor it).
Seventh, they have begun to unbounded ancillary or social assets from enterprises and to transfer them to the private sector or to the responsible level of government. This is particularly relevant in transition economies, where public enterprises traditionally provided many social serviceshousing, education, health facilities.
Eighth, they have established severance funds, training programs, and other elements of a social safety netto assist those laid off in the reform process.
Ninth, with donors and the international financial community, they are trying, selectively, to give limited comfort to investors through guarantees (particularly for the policy risks in large infrastructure operations) and insurance schemes.
These are the steps that low-income countries should be taking, and in many cases are.
Addressing the less technical obstacles
As this reform process unfolds, it is clear that the role of government remains crucial. To succeed, privatization requires transparency in transactions, good competition policies and regulatory frameworks, and careful management of social and political consequences. All these are functions of the political system. In all low-income countries, bringing the legal and institutional frameworks to a higher level of working order is a fundamental but complex task that calls for redoubling the efforts of reforming governments and the donors.
A fundamental obstacle to divestiture and public enterprise reform in lowincome countries has been concern that the "winners" in the process would be the few, the foreign, or the elitewhile the "losers" would be the many, the indigenous, and the workers. Studies of privatizations in middle-income countries show these fears to be exaggerated. Gains outweigh losses, winners outnumber losers, workers and locals do as well as foreign investors. It may not be possible to obtain the same results in the more constrained settings of lowincome countries. But that does not mean that the sociopolitical obstacles to reform are insurmountable.
There is much that governmentsand donorscan do to accelerate and deepen the reform and privatization process. A good place to start is to shed light on the performance and costs of public enterpriseswith their implicit subsidies, their concessional lending rates, the losses they inflict on the banking system, and the frequent need for government to assume their debts and arrears. In too many instances, this information has not been systematically collected and analyzed. Doing so would publicly expose the cost of inaction and provide governments with the ammunition needed to launch reform programs.
Many low-income countries made substantial efforts in the 1980s to reverse policies that undermined their financial systems. They reduced fiscal deficits, strengthened central banks' conduct of monetary and financial sector policies, gradually freed interest rates, eliminated credit ceilings, reduced directed credit, and restructured banksalbeit at high cost.
But these measures produced limited results, and the financial systems in most lowincome economies remain very weak. Rudimentary payment and settlement systems hinder commerce, as does a severe lack of banking skills especially for credit appraisal. Most financial systems are still dominated by state-owned banks, subject to little competition and supervision. Typically, more than 50 percent of domestic credit goes to the public sector. And credit to the private sector is garnered by large and politically well-connected firms and traders. Farmers and small firms are left to finance growth from retained earnings.
The agenda: address the fundamentals
Building effective financial systems in low-income countries will take a long timegiven the lack of skills, poor institutional and regulatory capacity, and the pernicious links between financial and public enterprises. Needed first is a solid foundation of banking infrastructuresound and effective payment systems and accounting, auditing, and supervisory systems. The biggest challenge, however, is to restructure the banking system in a way that minimizes the cost to the taxpayer, reduces the likelihood of recurring crises, and develops sound and competitive banking and nonbanking systems that provide basic services to the whole population. These services include, on a priority basis, safe and secure savings (particularly in rural areas), reliable payment systems, and working capital finance, especially trade finance.
Sever the link between banks and loss-makers
The first and most difficult task in restructuring the banking system is to sever the link between state banks, which still dominate the banking system, and nonperforming borrowersby cutting them off from new credit and collecting outstanding loans. In practice, it has proved difficult, if not impossible, for state banks to enforce a hard budget constraint on large enterprises and cooperatives. Central bank attempts to enforce credit ceilings often result in large interenterprise arrears. When these arrears accumulate and threaten the solvency of banks and enterprises, the central bank is forced to relax credit. The result is that state banks continue to accumulate large losses and have to be recapitalized frequently.
The first and most difficult task ii! restructuring the banking system is to sever the link between state banks and nonperformant borrowers.
The drain of big loss-making enterprises is likely to worsen as they face increased competition from imports and domestic private producers. That underscores the urgency of privatizing these enterprises and using the proceeds to reduce the high-cost government debt that crowds out the private sector and increases real lending rates. The proceeds could also be used to restore the integrity of the contractual savings system that governments have often raided to finance their deficits.
Go beyond recapitalization
One of the main reasons that restructuring the banking system often fails is that governments normally bear the entire coststopping short of changing the incentive system and the structure of the banking sector. Losses are seldom shared with other stakeholders. Nor are loan recovery efforts vigorous. In most cases, restructuring merely transfers nonperforming loans to recovery agencies, where they languish uncollected.
By contrast, successful restructuring has been accompanied by changes in the incentive system. This involves bank privatization and changes in management, since it is much easier to establish an arm's length relationship between properly regulated and supervised private banks and their clients.
Reduce the role of state banks and stimulate competition
In general, privatization and liquidation have proved easier for small and medium-size banks, particularly when part of an overall reform program that allows new entry. Pakistan and some African countries in the CFA zone are cases in point.
But in small countries particularly, liquidating or privatizing state banks that account for the bulk of banking system assets is difficultboth economically and politically. What can be done? Maintaining the dominant position of big banks, even while allowing new entry, does little to change their performance. An alternative is to downsize them and to seek management contracts from reputable domestic and foreign banks, preferably with a preferred equity position, to run them until improvements attract suitable buyers. Some governments are considering breaking larger state banks into competing networksas they were before their nationalization in the 1960s and 1970sthat service both urban and rural areas and sell them to reputable buyers.
Attracting reputable private banks will be difficult, however, unless government reduces the dominant position of public enterprises and develops an attractive environment to stimulate the private sector. Indeed, a good part of the banking development in China, India, Pakistan, and Sri Lanka has been stimulated by the growth of a competitive private sector that demands a wider range of efficiently delivered services. In turn, a competitive banking system helps foster a competitive private sector, since borrowers are not limited to a few banks that service only selected and wellconnected clients. And the presence of foreign banks has helped promote and facilitate FDI.
Still, bank privatization, if not done well, carries risks. In some cases, banks have been sold to privileged buyers less than transparently in an unregulated environment. In other cases, banks have been sold with little information about the quality of the portfolio. This underscores what is needed for privatization to succeed. Banks should be sold in a transparent manner only to qualified and reputable buyers who have access to the necessary information. They then have to be properly regulated and supervised. And they should not be bailed out if they fail. In many low-income countries, the difficulty of restructuring and privatizing banks is often compounded by ethnic considerations, and privatization methods should include ways to broaden ownership.
Strengthen prudential regulation and supervision
Most low-income countries have strengthened their banking laws and regulations, and some have improved their supervisory and enforcement powers. But the information and skills needed to apply these standards remain limited and will take time to develop. As an interim step, some countriessuch as Bolivia and Indiahave successfully used twinning or subcontracting arrangements with central banks and accounting firms to supplement and speed up the building of their own capabilities.
Creating an inviting environment for business
In a world where technological change is reducing transport costs, hastening globalization, and changing the nature of competition, firms must be agile and acquire new skills to survive and grow. Yet firm-level surveys for private sector assessments document the maze of restrictive regulationscovering labor, pricing, licensing, investment, monopoly privileges, fiscal and tax incentives, and so onthat continue to segment markets and encourage rent seeking, illegality, and corruption. The consistent message from these surveys: the cost of doing business is high, particularly for small and new enterprises.
In many low-income countries, the central challenge for government is to cut risks and transaction costs and to instill confidence in the private sector confidence that the business environment will change. A first step is to signal an unequivocal commitment to this goal at the highest political level. As a practical expression of the commitment, government can consult business leaders and groups (through public-private discussion councils) to identify major reform needs. While the precise reform agenda varies widelyreflecting the progress of policy reform and the extent of regulatory and institutional interventions in business activitiesthere are four common key areas for improving the business environment:
· Strengthening the legal and judicial system.
· Reducing the barriers to competition and improving regulation.
· Supporting entrepreneurial development.
· Promoting global integration through foreign direct investment and regional integration to complement trade reform.
Strengthen the legal and judicial system
For some low-income transitional economies, such as Albania, China, and Viet Nam, the legal underpinnings of a market economy must be built. But for most, the task is to remedy deficiencies in the existing framework.
The main deficiencies relate to legislative, judicial, and administrative processes necessary to ensure that laws support the public interest and private economic rights and are enforced equitably and expeditiously. In many countries, the enactment and enforcement of laws for arbitration, intellectual property, debt recovery, and collateral are typically inhibited by the lack of appropriate legal institutions, procedures, and qualified personnel. Even routine and minor commercial disputes take years to settle, because procedures for rendering and enforcing judgments are protracted and alternative dispute resolution mechanisms are ineffective. Enforcement is also constrained by poorly trained staff and run-down facilities. Effective enforcement of laws will require revision of civil and penal procedure codes, reorganization of administrative systems, and greater investment in physical and human capital.
Reduce barriers to competition and deregulate product and factor markets
Competition, a driving force for creating agile firms, is fundamental for efficient private sector development. If firms are to court markets for profit and not the state for favors, deregulation is essential for promoting competitive markets. And wherever trade liberalization has been accompanied by measures to reduce the administrative impediments to exports and the cost of doing business, the supply response has been considerable.
Liberalize external and internal trade. Many low-income countries have made notable progress in liberalizing external trade by reducing trade and nontariff barriers for both imports and exports. In particular, African countries have removed almost all quantitative restrictions. But most countries have adopted a gradual approach to reducing tariffs. Many low-income countries, again particularly in Africa, have also liberalized the rules governing internal commerce, removing most price controls and restrictive policies limiting private entry and marketing.
The major impact of liberalizing trade has been to give firms easier access to capital, technology, intermediate goods, and critical raw materials. This has increased internal competition, reduced production costs, improved product range and quality, and boosted exports.
One concern often expressed by governments and the private sector is that rapid liberalization will lead to deindustrialization, decimate small and medium-size industries, and retard the growth of budding domestic entrepreneurs. Indeed, some firms do suffer when incentives changeespecially inefficient, capital-intensive public enterprises that have developed behind tariff barriers and that might see their domestic market shrink as a result of import competition. But in many countries, exemptions and quantitative restrictions abound, particularly in Asia. And tariffs remain highit is not unusual to find effective rates of protection between 40-60 percent. This inhibits exports and mutes competition in domestic markets.
Much of this protection is eroded by the high cost of doing business stemming from onerous regulatory requirements, high financing costs, and the poor quality and high cost of supply from the public sector. The solution is not to have more selective protection, which requires a competent civil service to implement, monitor, and adapt effectively. Instead, the emphasis has to be on systematically reducing the costs of excessive economic and administrative regulations. This would complement continuing efforts to lower the effective rates of protection, reduce the dispersion in tariffs, eliminate quantitative restrictions, and remove impediments to internal trade. Among these impediments are government monopolies and the privileged access of public enterprises and well-connected firms to finance and to markets.
The emphasis has to be on systematically reducing the costs of excessive economic and administrative regulations
Reform regulation and deregulate. Many countries have started the long process of regulatory reformgenerally by simplifying taxes, eliminating licensing for investment, and improving the tax and customs administration. Experiences in most eases have been positivewith increased tax revenues and generally higher private investment. Reforms in these regulations frequently need to be complemented by reform in labor markets to allow firms more flexibility in restructuring their operations and responding to changing competition. To increase investor confidence, deregulation should be done through systematic search and dismantle campaignsin joint efforts with the private sector.
There is no shortage of entrepreneurs in low-income countries. Most of them are found in agriculture, industry, and servicesand mainly in small firms in the informal sector, where many are women. And although small entrepreneurs have benefited from liberalization and deregulation, they still need special support to grownot protection, which has failed in so many countries, but easy access to markets, finance, and technical know-how.
Most small firms acquire their capabilities in the normal course of operating their businesses. A large part of their know-how comes from suppliers, traders, and larger companies. Beyond that, experience shows that well focused technical assistance from productivity centers and extension services can make a difference. Some countries are thus redirecting their technological infrastructure from expensive basic and applied research to activities that help improve the productivity of their industries. Many countries could benefit from a similar shift.
Small entrepreneurs still need access to markets. finance, and technical know-how
There are also an increasing number of specialized financial institutions credit unions, nongovernmental organizations (NGOs), and so onthat rely on local savings, reliable banking services, careful screening of borrowers, and lending at market rates to reach a large number of small clients, particularly women. Gradually replacing costly subsidized credit programs, which have often failed to reach the intended targets, these budding institutions need temporary help (seed or equity capital and technical assistance for small entrepreneurs) to grow, to evolve into licensed financial institutions, and to have refinancing facilities with banks. The better ones with long track records are starting to tap capital markets and attract private investors.
Promote foreign direct investment
Foreign direct investment can be critical in introducing widespread technological change, improving the agility and competitiveness of firms, and providing access to skills and global markets. This is evident in China, and to a lesser extent in Bangladesh, India, and Kenya, where FDI is increasingly generating slipover effects in many sectors. Successful cases show the importance of having governments promote and welcome FDI, particularly in infrastructure such as communications and energy. They also show the importance of avoiding excessive regulation and restrictions on expatriates and financial flows and the business activities of firms.
The need for FDI is greatest in Sub-Saharan Africa, but little has been received outside the enclaves of mining and oil. Indeed, there is concern about considerable foreign disinvestment from Africa in response to the uncertain political and economic environment, the high cost of doing business, and the fears that policies and regulations discriminate against foreign investors, who have many other opportunities all over the world. FDI inflows and FDI stock already in the country would benefit from a more stable and dynamic environmentand a willingness to accept investment from all sources, including minorities and ethnic groups.
Promote regional integration
There are strong aspirations for regional integration in Africa. Indeed, many countries are starting to coordinate and harmonize policies for tariffs, taxation, investment, and business regulations. But the biggest and most productive impetus to regional integration would come from removing the restrictions on movements of goods, capital, and people. These restrictions have severely limited trade and encouraged smuggling. In addition, there is considerable untapped potential for regional cooperation in power, transport, and the distribution of petroleum products (oil and gas) to reduce the costs of supplying these services.
Regional integration is also likely to get a boost from the development of regional growth poles-South Africa and Zimbabwe in the south, Cd'Ivoire, Ghana, and Nigeria in the west, and Kenya, Tanzania, and Uganda in the east. These could produce important pull effects on growth throughout the continent if the limitations and impediments on local and foreign investors and movements of goods, people, and capital are removed. They would also help promote FDI by enlarging markets. But regional integration should not be a substitute for opening up to the global economy. It should be seen as the way to help firms connect to global markets at lower cost.
The strategy outlined here implies a major change in the role of the governmentfrom an owner and operator to a policymaker and regulator that works closely with the private sector in developing a competitive, outward-looking economy. Fundamental to the success of this orientation is accelerating the efforts of many governments to build competent and agile institutions that can help firms respond quickly to changing market conditions.
This accelerated growth strategy stresses going farther and faster on the privatization of enterprises and banks and on economic deregulation. It redirects scarce managerial and institutional resources within government so that it can concentrate on providing basic public goods that only government can provide and that have been neglected in the past. Beyond the government institutions responsible for macroeconomic management, the most important are those for enacting and enforcing legal and regulatory systems, for providing public finance in close interaction with the private sector, for dealing with trade and investment, and for supporting technological development, particularly for small and medium-size firms. In fast-growing countries, these institutions have worked closely and regularly with business and labor associations and other civic groups to solve problems that affect the ability of firms to compete effectively both internally and externally.
Even in countries that have well-established legal, institutional, and human resources to underpin a strong political commitment, systemic reform has been fraught with difficulties. It is a fragile, long-term processoften taking 15-20 yearssubject to many reversals. The poorest countries, however, lack these resources, and thus have little latitude for error. Entrepreneurs in Africa are particularly disadvantaged. Their environment is highly uncertain, markets are smaller, skills are shallower, the supporting infrastructure is weaker, and the legal and regulatory environment very restricting. Not only must the poorest countries lay strong foundations for private sector growth through intensive efforts to develop their human capital and physical infrastructure, but they must also persist in this effort over a long period to achieve sustained, visible results.
Over this long haul, government ownership of the reform program and a broad consensus for reform are the products of public-private partnerships and the prerequisites for success. But low-income countries will still need assistance to design, implement, and sustain reform programs. Wherever governments do adopt comprehensive and consistent reform plans, donors must be ready to step in, in a coordinated way, with all necessary support for the sustained implementation of reforms. Where these plans are still being formulated, donors should focus their support on helping governments lay the foundation for change.