(introduction...)

THE development strategies of most low-income countries in the 1960s and 1970s emphasized import-substituting industrialization with economic growth led by the state. Public enterprises dominated strategic industries, and publicly owned banks served as conduits of financial flows to prop up the enterprises. Governments generated resources by taxing agriculture and trade.

This model of development had early successes, but it was increasingly viewed as ineffective in the late 1970s and early 1980s, as economic growth slowed. Many lowincome countries found themselves with large fiscal deficits and overvalued exchange rates that were unsustainable.

Recent policy reforms

Reforming low-income countries responded by implementing reform programs that emphasized macroeconomic stability, openness to trade, and price deregulation. Exchange rate reforms have eliminated large black market premiums in countries where the official exchange rate had been kept artificially low. Nominal devaluations, leading to large real exchange rate deprecations, and reduced rationing of foreign exchange, often through auctions, have been among the biggest changes. The devaluation of the CFA franc in January 1994 symbolized the changing consensus on exchange rate policy in Africa.

Trade reform has been a central part of these reform packages. To liberalize imports, governments largely started by removing foreign exchange rationing and non-tariff barriers such as licensing and quotas. For tariff barriers, most governments have adopted a gradual approach—both because of the importance of trade taxes for revenues and because firms need to adjust to reductions in effective protection. Progress often has focused on simplifying tariff codes and reducing maximum rates. On the export side, there has been movement on reducing export taxes—and several governments raised farm-gate prices even as world prices for export crops fell.

Trade reforms have been complemented by domestic pricing reforms in Africa, generally reducing the number of goods subject to price control. Most price controls on agricultural outputs have been lifted, although only half the reforming economies have removed price controls and subsidies for fertilizer. The marketing of staples (except maize) has been liberalized in almost all countries. Most manufactured products have been decontrolled, except for petroleum, where government involvement is extremely costly, especially in countries with refineries.

Reforming low-income countries responded by implementing reform program that emphasized macroeconomic stability. Openness to trade, and price deregulation

Most reforming countries in Africa have also improved their monetary policies. But delays in dealing with fiscal deficits, which came from weak tax revenues and public sector losses, have put a disproportionate burden of stabilization on monetary policies. The costs of tight monetary policies have been high interest rates and restricted access to credit for the private sector. Small enterprises and farmers have been particularly hard hit.

In China, the government redirected the country's huge savings to the provinces by liberalizing agriculture and making coastal and economic zones attractive manufacturing platforms for export. The economic reform program emphasized gradual trade reform, exchange rate reform, and internal price deregulation. In India; the government's reform program focused on fiscal stability, with trade liberalization (particularly a reduction in the coverage of quantitative restrictions on imports) and deregulation of internal markets (including greater competition in the financial sector).

Fast and slow growers

Many low-income countries improved their economic performance after implementing these reform programs. Since the better performers included China, India, and other highly populated Asian countries, this economic growth improved the living standards of more than 2 billion people. But many lowincome countries did not enjoy better economic performance because reforms were minimal or because the supply response stimulated by new incentives was constrained by structural and institutional weaknesses and by deficiencies in physical infrastructure and human resources. The variation across countries— in GDP growth, in savings and investment, in export growth and diversification, and in the reduction of poverty—has been enormous.

GDP growth

Real GDP growth for low-income countries as a whole was 5.1 percent a year during 1987-93, with real per capita growth of 3.1 percent a year—significantly higher than the 3.4 percent and 1.3 percent for other developing countries. But the lowincome country average was pulled up by rapid growth in East Asia and the Pacific and, to a lesser extent, in South Asia (figures ]. I and 1.2). China, driven by high rates of savings and investment and by solid export growth and diversification, recorded the strongest growth in real GDP and per capita GDP (9.3 percent and 7.8 percent a year) during ]987-93, while India, Pakistan, Sri Lanka, and Viet Nam grew between 4.0 and 7.5 percent a year.

Between 1980 and 1993, nearly half the countries in Sub-Saharan Africa achieved positive per capita GDP growth, a quarter with rates above the 1 to 2 percent target set in the report, Sub-Saharan Africa: From Crisis to Sustainable Growth-A Long-Term Perspective Study (World Bank 1989; also known as the LTPS). The other half, some beset by social and political unrest, had negative growth rates. But even the worst performers in Sub-Saharan Africa performed better than the transition economies in Eastem Europe and Central Asia, where per capita incomes plunged 10 percent a year and more in the face of economic and political revolution, followed in several cases by civil unrest.

Figure 1.1 Real GDP growth in low-income countries.

· China races ahead to catch middle-income countries within a generation—other 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

Figure 1.2 Real per capita GDP growth in low-income countries

Sub-Saharan Africa's poor economic performance meant a deterioration in living standards for many and an increase in the number of absolute poor, from 184 million in 1985 to 216 million in 1990 (table 1.1). With 48 percent of its people impoverished, Africa is second only to South Asia in terms of absolute poverty. The growth in per capita income has been small because of Africa's rapidly growing population. Labor productivity, the key to increasing incomes, remains low. And in contrast to India and Pakistan, where faster growth was based on an increase in domestic savings, growth and investment in many African countries were driven by external assistance.

There also has been considerable variation across sectors within countries (figure 1.3). For most low-income countries, growth in real GDP during 1987-93 came more from industry and services (especially commerce) than from agriculture.

TABLE 1.1 POVERTY IN THE DEVELOPING WORLD, 1985 AND 1990

	Population (millions)		Number of poor (millions)		Headcount indexa (percent)		Poverty gap indexb (percent)
Region	1985	1990	1985	1990	1985	1990	1985	1990
East Asia	1,379	1,496	182	169	13.2	11.3	3.3	2.8
China	1,049	1,133	108	128	10.3	11.3	2.2	3.1
Eastern Europe	70	70	5	5	7.1	7.1	2.4	1.9
Latin America and
the Caribbean	388	429	87	108	22.4	25.2	8.7	10.3
Middle East and
North Africa	196	221	60	73	30.6	33.1	13.2	14.3
South Asia	1,027	1,147	532	562	51.8	49.0	16.2	13.7
India	765	848	421	448	55.0	52.8	17.6	14.5
Sub-Saharan
Africa	387	452	184	216	47.6	47.8	18.1	19.1
Total	3,446	3,815	1,051	1,133	30.5	29.7	9.9	9.5

a. Ratio of the number of poor to the total population.

b. Mean distance below the poverty line (zero for the nonpoor) as a percentage of the poverty line.

Source: Chen, Ravallion, and Datt 1993.

This was not the case for the reforming economies in Sub-Saharan Africa, where the larger contribution of agriculture to growth reflected liberalized agricultural producer prices and marketing arrangements and lower taxes on agricultural production and exports in the second half of the decade. African countries that made large improvements in their macroeconomic policies had stronger growth in the industrial sector (mining and petroleum and small industry and services in particular). It is encouraging that many reforming countries have been able to raise their agricultural growth rates close to those of China and other rapidly growing Asian economies; the challenge is for them to emulate the Asian developing economies by converting the fruits of increased agricultural growth into broader growth and development. But for most Sub-Saharan African countries and other low-income countries outside Asia, annual growth in agricultural output during 1987-93 still fell short of population growth.

Investment and savings

Divergent GDP growth rates in low-income countries match wide differences in their investment rates (figure 1.4). In East Asian countries, particularly China, the investment-GDP ratio rose markedly and remained high during 1987-93. Low-income countries in East Asia have been investing more than a third of GDP over the past decade. Rapid growth follows such high rates of accumulation—even with large, continual leakages to public enterprises, as in China where the leakages are 3-5 percent of GDP. Most low-income countries in South Asia have maintained investment rates around 20 percent of GDP throughout the past decade. But in Sub-Saharan Africa, the ratios rose only marginally, languishing around 16 percent of GDP, below what is needed for sustainable long-term growth, although a few strong reforming countries raised investment close to the 25 percent target of the LTPS. Fueled by expanding official aid flows, the increase in investment in reforming countries was driven by a recovery in government investment. The main reason for the limited increase was the low level of private investment.

The impact of investment on growth depends not only on levels of accumulation but also on the efficiency of investment. Measures of efficiency for low-income countries show the same variation as growth rates and investment.

Figure 1.3 Growth in agriculture, industry, and services in low-income countries, 1987-93

Figure 1.4 Gross domestic investment in low-income countries

But the correlation is strong between rates of accumulation and efficiency of investment—a strong rate of accumulation has been matched by low incremental capitaloutput ratios (ICORs). The ICORs of most Sub-Saharan African countries have been consistently higher—reflecting lower efficiency—than those in Asian low-income countries.

China maintained a high gross savings rate, at 39 percent of GDP, during 1987-93. In Sub-Saharan Africa, though, savings rates have been low (figure 1.5), and the worst performers have even had negative savings. The reforming countries increased savings to finance an increase in investment and to narrow their external current account deficit. But few countries in Africa have reached 15 percent, let alone the 18 percent savings target in the LTPS. The poor showing in gross savings in Africa has generally been caused by government dissaving, reflecting the increased burden of state-owned enterprises on the budget and difficulties in restraining public expenditure growth and raising tax revenues. The limited success of many low-income Sub-Saharan countries in containing fiscal pressures increased their recourse to the financial system, crowding out the private sector.

Exports

Export performance has also varied widely among low-income countries (figure 1.6).

Figure 1.5 Gross domestic savings in low-income countries

Figure 1.6 Merchandise exports

China's export growth was striking: total exports reached $85 billion in 1992 and accounted for 2.3 percent of total world exports (China's exports rose to $101 billion in 1993). In India, while exports have registered double-digit growth rates over the past two years in response to economic reforms, the export base is still relatively undiversified and dependent on a few categories of consumer goods—such as gems, jewelry, and ready-made cotton garments. India will soon reach market saturation in gems and jewelry, unless it upgrades its technology to cut and polish higher-value diamonds. And in ready-made cotton garments, growth has occurred through better use of textile quotas being phased out under the Uruguay Round. Maintaining current export growth rates and long-term competitiveness will require diversifying exports and making substantial investments to improve productivity and efficiency across a broad range of manufacturing industries, as was done in the East Asian economies.

Sub-Saharan Africa's share of world exports declined from about 1.3 percent in 1987 to less than 1 percent in 1992, while the market shares of other low-income countries remained constant.

TABLE 1.2 AVERAGE SHARE OF PRIMARY COMMODITIES IN EXPORT EARNINGS OF SUB-SAHARAN AFRICAN COUNTRIES, 1990-93 (Percent)

Coffee	Cotton		Diamonds
Uganda	70.6	Chad	49.5	Cen. African Rep.	53.4
Burundi	66.7	Mali	48.2	Sierra Leone	17.7
Rwanda	59.3	Burkina Faso	31.9	Zaire	12.1
Ethiopia	525	Sudan	25.2	Guinea	10.0
Equatorial Guinea	39.4	Zimbabwe	205
Tanzania	20.3	Tanzania	19.6	Aluminum
Kenya	15.3	Togo	18.0	Sierra Leone	19.8
Madagascar	10.9	Guinea	19.0
Cocoa		Timber		Copper
Sao Tome	80.2	Central African Rep.	18.8	Zambia	80.4
Ghana	32.9	Ghana	12.6	Zaire	44.7
Cd'lvoire	30.5
Tea		Fish		Petroleuma
Kenya	27.5	Mauritania	53.0	Nigeria	94.2
Rwanda	24.4	Mozambique	38.8	Congo	83.2
Burundi	12.8	Senegal	22.4	Angola	77.1
Malawi	9.5			Cameroon	48.1

a. Data are for 198587.

Source: World Bank data.

Africa's export growth was concentrated in a small number of countries: Cd'Ivoire, Ethiopia, Gabon, Ghana, Kenya, Mozambique, Nigeria, Tanzania, and Uganda. And it came mainly from an increase in export volumes of primary commodities, which still account for about 89 percent of Africa's exports. Moreover, many Sub-Saharan African countries are very dependent on one or a few commodities for most of their export revenues (table 1.2). Continued concentration in primary commodity exports keeps low-income countries vulnerable to external shocks, particularly changes in world commodity prices. With the exception of primary commodities, export ratios in Africa's low-income countries remain extremely low, especially in manufacturing. However, a few countries, such as Kenya and Madagascar, are now diversifying into nontraditional exports such as horticulture and agro-based manufacturing (box 1. 1).

Foreign direct investment

The experience of the Asian economies shows that foreign direct investment (FDI) can accelerate the rate of growth and diversification of exports—not only by providing finance but also by giving access to technology and markets. In China, FDI increased from a trickle in the early 1980s to $7.2 billion in 1992 and $20.0 billion in 1993. Firms benefiting from foreign investments accounted for $36 billion, or 36 percent, of the country's exports in 1993 (box 1.2). In

BOX 1.1 EXPORTS OF KENYAN FRESH VEGETABLES: THE IMPORTANCE OF NETWORKING

Among developing countries, Kenya has some of the longest standing and most diversified fresh vegetable exports to Western Europe. Pioneered in 1957, the vegetable trade has expanded since the 1970s. Exports increased from $2.3 million in 1970 to $47.7 million in 1987-89. Exports cater mainly to the niche market for "Asian vegetables" consumed by Asian ethnic communities in Europe. During the 1980s, despite increased competition from European and Mediterranean countries, Kenyan exporters managed to obtain price premiums for quality, maintain market share, and penetrate distribution channels of supermarket chains. Exports grew because leading producers, of Asian origin, exploited ethnic and family ties in buying countries, and because of a major increase in available air-freight space, enabling exporters to provide vegetables year-round while competitors had a shorter growing season. Over the past decade, Kenyan exporters have diversified into products such as tropical fruit and cut flowers. The industry has grown from a handful of medium-size and large producers to thousands of smallholders, providing an important source of income and employment to many Deoole.

India foreign investment amounted to $4.7 billion in 1993, with a sharp increase f $4.1 billion in portfolio investment. Foreign direct investment increased to about $452 million in Pakistan in 1993. Sub-Saharan Africa has had limited success in attracting investment, and many countries have been wary of efforts to promote it. Of worldwide flows of $200 billion a year, the region received only $693 million in 1993 (figure 1.7). Indeed, there is increasing concern that, outside mining and petroleum, there has been considerable foreign disinvestment from Africa, reflecting the uncertain economic environment and growth prospects, the high cost of doing business, and the fears that policies and regulations discriminate against foreign investors.

BOX 1.2 UNLEASHING THE PRIVATE SECTOR: FDI AND EXPORT GROWTH IN CHINA China's record of sustained reform attracted a massive increase in foreign direct investment (FDI), which grew from a trickle in the early 1980s to $7.2 billion in 1992 and to more than $20.0 billion in 1993. Investment was initially concentrated in tourism, commercial real estate, and petroleum. Close to half the FDI was in Fijian, Guangdong, and Jiangsu, where it accounted for between 50 and 60 percent of gross capital formation. This concentration of investment in the coastal zone was stimulated by local governments that had taken advantage of their administrative and policy freedom to build the infrastructure needed to attract foreign investment, to provide attractive tax deals to foreign investors, and to refrain from intruding in businesses or overburdening firms with regulation. In recent years, nearly 80 percent of FDI has been in small and medium scale export-oriented manufacturing industries, with the average investment increasing from $0.5 million in the late 1980s to $1.5 million in 1992. Most of the investment was by overseas Chinese who had already established strong links to the main export markets in Europe, Japan, and the United States. As a result of this boom in export-oriented FDI, exports have become the main engine of growth for the Chinese economy, and the country has significantly increased its share of world trade. The share of exports in GDP grew from 10.4 percent in 1985 to 24.6 percent in 1992, and China's share of world trade increased from 1.5 percent to 2.3 percent during the same period. FDI is now being more evenly distributed as more of the funds are moving to the eastern and northeastern areas. Included are investments in power, where China expects about $67 billion in new investment by 2000, and in the telecommunications, chemical, petrochemical, and automotive industries. Unlike the coastal areas, firms in the expanding regions face more difficult problems of inadequate infrastructure, bureaucratic controls, opaque rules and regulations, and an underdeveloped legal system. But the lure of China's large and growing market and the government's commitment to transforming China into a dynamic market economy is irresistible—and the entry of such large investments will help correct many of the structural weaknesses facing China today.

Figure 1.7 Net foreign direct investment

Private sector-led growth

Growth in the better-performing low-income countries was led by the private sector. In China the reform program unleashed the pent-up energies of its people and added the capital, know-how, and connections of overseas Chinese and other foreigners. A large share of China's industrial growth came from foreign investors and from collectively owned enterprises (COEs), which were subject to competitive pressures similar to those facing the private sector. In India and Pakistan, now growing at a respectable 5 percent a year, the private sector has responded to trade liberalization, deregulation of the real and financial sectors, and a lowering of entry barriers in previously restricted industries.

In almost all Asian countries, the growth of the private sector has spurred the development of financial markets. Many private banks and nonbank financial institutions entered the market to serve the growing trade and investment needs of the private sector. Perhaps most important for building a constituency and consensus for reform, this growth was shared by a large group of people.

In reforming African countries, the private sector was the engine of growth— evident in the strong performance of the agricultural sector as well as the growth of small enterprises in industry and services.

Explaining differences in performance

What accounts for the large variation in performance across low-income countries and particularly in the strength of the private sector response to economic reforms? The reforms had their foundation in exchange rate reform—necessary but not sufficient for growth. In general, there has been a strong correlation between improvements in performance and the depreciation of the real effective exchange rate needed to compensate for worsening terms of trade (figure 1.8). Sub-Saharan African economies with fixed exchange rates lost competitiveness during the 1980s, since prices were inflexible downward. In contrast, Sub-Saharan African economies with flexible exchange rates engineered substantial deprecations of the real exchange rate—enough in most cases to eliminate black market premiums for foreign exchange. Movements of similar magnitude are observed for China and India.

However, the difference between China and India on the one hand and Sub-Saharan African economies on the other was that the latter increased growth rates by less than what the scale of real devaluation would suggest. Much of the explanation lies in their deficient infrastructure and human resource weaknesses, but also in public sector inefficiencies and losses, leakages from the financial system, and low saving and investment rates. These have compounded the deficiencies in the business environment that raise the cost of doing business. Insufficient transport, telecommunications, and other public utilities—and limited human and institutional capacities (low literacy rates and shortages of specialized business expertise in particular)-combine with low levels of savings to impose basic structural obstacles to rapid supply responses. These can be overcome only with time and sustained investment and support by governments.

The better-performing low-income countries have put in place more comprehensive and sustained reform programs—of macroeconomic stabilization, trade and tax reform, and internal market liberalization. By doing this, they conveyed to their people—and to the world—their commitment to developing market-oriented economies. They complemented trade liberalization with reforms to increase internal competition. And they started to put in place legal and regulatory systems and institutions supporting greater private involvement in the economy. As a result; the better performers got closer to achieving the "critical mass" of structural reforms necessary to improve the business environment and induce a significant supply response from the private sector.

Getting closer to the critical mass of structural reforms is part of the explanation of higher growth.

Figure 1.8 Real effective exchange rates and terms of trade

But some high performers succeeded despite shortcomings in their policy and institutional frameworks. The key difference was in their high savings rates. Countries with high domestic savings, such as China and India, enjoyed substantial benefits as sizable fractions of domestic savings and investment were allocated more efficiently, despite gradual and often partial structural reforms. While macroeconomic imbalances could and did occur in these countries as a result of fiscal slippage in India and the fiscal drain of state-owned enterprises (SOEs) in China, solutions have been more under their control. There was a reasonable degree of confidence among domestic and foreign investors that macroeconomic balance was achievable, based on the countries' efforts and track records.

In the low performers, mainly in Africa where partial reforms were insufficient to support sustained growth, chronically low or nonexistent domestic savings and very low investment made the impact of any structural reforms much more limited and slow-working. Sizable public sector losses and major expenditures on a large and inefficient civil service—the two main causes of fiscal instabilities—have also contributed to the stop-and-go reforms characterizing many African economies. Moreover, their heavy dependence on foreign aid flows presented a dilemma. Aid was crucial to maintain investment at levels required to achieve growth and poverty reduction. But at the same time, the dependence on aid tended to put a serious damper on domestic and foreign investors' confidence. Given low domestic private savings, and aid flows supporting public rather than private investment, the pool of investable resources for private sector development was limited, making private sector-led growth slow (and easily reversible).

To accelerate private sector-led growth, low-income countries need to move farther and faster to complete the agenda of structural reforms. But for the poorest performers (and their donors), the challenge is greater, and the risks of failure higher. To provide the resources for private sector development as well as for needed public investments, they must raise domestic savings—a process that will take time. In the meantime, putting in place a comprehensive package of reforms and maintaining it over time is particularly important for creating conditions for increased private savings and investment. If some crucial element is missing, progress is likely to be limited and easily reversible— these countries cannot afford the luxury of a partial approach and have less margin for error and delay.

Problems of political economy only complicate the picture—with low levels of income and human resource development, a history of ethnic problems, and weak political and civic institutions. Maintaining the political stability and commitment required to get on a virtuous circle is much more difficult.

The remainder of this chapter looks in more detail at three areas that will need to be addressed to raise domestic savings and private sector investment in low-income countries. First are the fiscal drain of public enterprises, the leakages from the financial sector, and the efficiency costs imposed by public enterprises. Second are barriers to internal and external competition and the harsh business environment faced by the private sector. Third is the poor quality of infrastructure and human resources.

The drag of public

Recent policy reforms in many low-income countries have failed to reduce significantly the dominance of the public sector in the economy. The inefficiency of public enterprises and the spread of their losses throughout the economy continue to drag down savings, investment, and economic growth.

The dominance of the public sector

In most low-income countries, the public sector is dominant in infrastructure, heavy industry, agricultural marketing, and finance—typically accounting for more than 10 percent of GDP, 20 percent of employment, and 25 percent of investment. But public enterprises account on average for 14 percent of GDP, 18 percent of employment, and 27 percent of investment in Sub-Saharan Africa. In many countries public enterprises have retained their shares of production and employment even after public sector reform. This persistence reflects continuing investment in public enterprises as well as the slow pace and limited scope of divestiture. With few exceptions, divestiture programs in low-income countries have consisted mainly of privatization or liquidation of small enterprises, with little impact on the structure or performance of the economy.

Public enterprises dominate large industry, especially in Asia. In China, stateowned enterprises are particularly dominant in capital goods, such as steel, machinery-building, cement, and energy production, despite the growth of COEs and private firms during the past decade. This pattern also holds in other Asian economies that historically have adopted a mixed economy approach. In India, the public sector owns 50 percent of industrial assets, mainly in heavy industry; and accounts for 25 percent of industrial production. In Pakistan, the integrated steel works is publicly owned, while the private sector owns small arc furnaces, foundries, and ship-breaking. In the heavy engineering sector, large state enterprises in machine-building and machine tools exist alongside private engineering firms.

Agricultural development is still circumscribed by heavy state intervention, mainly through direct involvement in the marketing of inputs, outputs, and support services. The inefficiencies of these institutions have muted the supply response of the agricultural sector since increases in the price of tradables resulting from exchange rate reform often have not been fully passed through to producers. Even when marketing systems have been liberalized, private sector entry has been limited because of restrictive and discretionary licensing systems and the limited, high-cost credit provided by a state-dominated financial system.

The dominance of public enterprises in the economies of low-income countries means, when they perform poorly, that they drag down overall growth rates. In Kenya, for instance, total factor productivity in majority-owned state enterprises declined 3 percent during 1986-91, compared with a 5 percent increase in the private sector. If state enterprises had been as productive as the private sector during this period, Kenya's GDP would have grown by an additional 2 percent each year. Public enterprise inefficiency has an even larger impact in countries with more dominant public sectors than Kenya's.

For private firms, the inefficiency of public enterprises raises the cost of doing business. In Sub-Saharan Africa, the poor quality of utilities and infrastructure services adds 10-25 percent to firms' costs. It has been estimated that the efficiency losses of the publicly owned petroleum sector in Sub-Saharan Africa amount to about $1.4 billion a year (box 1.3)-more than the Bank's annual disbursement of adjustment policy loans to the region, and about two times the foreign direct investment in 1993.

Fiscal drain and financial sector leakages

The losses of unprofitable public enterprises are typically financed by a combination of transfers from the fiscal budget, a tax on the financial system through forced investments and portfolio requirements, and domestic credit, which increases the cost and reduces the volume of credit to the private sector. Public enterprise losses often are large relative to the size of low-income economies and reduce the availability of resources to finance private sector activity as well as alternative public investments. Often, the lack of data on state-owned enterprises, their losses, and the distribution of those losses throughout the economy makes it even more difficult to deal with them.

Covering public enterprise losses with fiscal transfers forces governments to finance larger fiscal deficits and increase tax revenues or reduce public expenditures in other areas, or both. Increasing tax revenues to finance the losses of state enterprises is difficult in many low-income countries, where the tax base is narrow and tax administration weak. During the 1980s most reforming low income countries reduced their budget deficits by cutting spending rather than by increasing revenues. Faced with strong political pressures, governments often sacrificed public investments with long-term benefits—including social and infrastructure investments—rather than cut current expenditures. In Sub-Saharan Africa, for example, average capital expenditures fell from 8.7 percent of GDP to 6.1 percent during the 1980s.

BOX 1.3 THE HIGH COST OF INEFFICIENT PUBLIC ENTERPRISES: PETROLEUM IN SUB-SAHARAN AFRICA Oil products in Sub-Saharan Africa represent 70 percent of total commercial energy consumption, consume one-third of available hard currency reserves, and account for two-fifth-sofindirect taxes. The petroleum products industry in Sub-Saharan Africa is extremely inefficient. A 1992 study estimated total annual potential savings of more than $1.4 billion (approximately $51 a ton). The scale of these efficiency losses can be gauged from the facts that they exceeded IDA's total disbursements in that year to Sub-Saharan Africa for adjustment programs and they were twice the FDI inflows. The key areas of inefficiency: Procurement ($690 million). Most countries suffer from lack of foreign exchange and from monopolistic and inefficient government involvement in procurement. Refining ($550 million). Most refineries are too small, lack adequate technology, and face inadequate incentives for efficiency improvements. Distribution ($180 million). Transportation infrastructure is run-down. The study indicated that more than half the estimated savings could be achieved without new investments— by changing policies and procedures, particularly opening markets to competition and providing adequate pricing policies, and by regional cooperation. The key investment require meets would be for rationalizing and rehabilitating transport and storage facilities. Governments in low-income countries often have controlled interest rates to reduce the fiscal cost of accommodating budget deficits. But reduced real deposit rates, often negative, have been a disincentive to savings (encouraging savers to seek nonfinancial assets), fostered capital flight, and encouraged over-borrowing by enterprises. As a result, financial depth is shallower in low-income countries than in other economies. This is especially true in Sub-Saharan Africa, where bank deposits are only 15-20 percent of GDP (compared with 40 percent in Pakistan, 60 percent in India, and 80 percent in China). The financing of state enterprise losses through the domestic financial sector—directly, through credit to state enterprises, or indirectly, through credit to the government to finance budget transfers—increases the cost and reduces the availability of credit to the private sector. In Africa, the public share of domestic bank credit averages around 40 percent and exceeds 80 percent in some countries. In countries where banks are required to invest a certain portion of their assets in government paper or other forced investments at belowmarket returns, the effect is a tax on the financial sector that is usually reflected in higher intermediation margins. Even in countries that do not require banks to invest in particular industries, the allocation of credit often is not fully market-determined. Where state-owned banks dominate the financial sector, as they do in most low-income countries, they often channel resources to public enterprises rather than act as independent financial intermediaries. In addition, where the public sector is a dominant force in the real sectors, banks are under continual pressure to lend to public enterprises to prop up the banks' own nonperforming assets and to prop up their client firms that are linked with state enterprises (figure 1.9). In many low-income countries, state enterprise losses are so large that they are two to three times public expenditures on education and health. Typically, a majority of these losses is attributable to a relatively small number of large state-owned enterprises. These normally are utilities (power, telecommunications, water, railways, ports), capital-intensive industries (steels, fertilizers, chemicals, pulp and paper, cement), and agricultural marketing boards. The fiscal drain of public enterprise losses is a form of continual government dissaving that makes it difficult for low-income countries to generate the total savings needed for accumulation and growth.

Figure 1.9 Public enterprises crowd out private credit, 1986-88

In Africa, the drain on the fiscal budget and the leakages from the financial system resulting from public enterprise losses can be as high as 12 percent of GDP, nearly as great as gross domestic savings (averaging 12.5 percent) and two to three times the spending on health and education. So, few resources remain for investment, public or private.

In China, fiscal losses of SOEs (that is, not counting losses in the banking system) are 3-5 percent of GDP. They are less significant in crowding out investment since gross savings have been about 39 percent during 1987-93. Still, accommodating such losses threatens the viability of the financial system, where it is estimated that 15-20 percent of the loans of state banks are nonperforming. The fast-growing economies would thus have done better but for the drag of the public sector on savings and investment.

Regulation and barriers to competition a harsh business environment

Although reforming countries have taken significant steps to improve the business environment, private sector development in many low-income countries is still discouraged by a harsh business environment that increases the cost and risk of doing business—often hitting small and medium-size firms the hardest. Even informal sector firms are not exempt, for they benefit from freedom from regulation at the cost of being excluded from opportunities participation in the formal sector could bring. And despite considerable progress in trade liberalization, further progress is still required. True, many low-income countries have reduced the coverage of nontariff barriers and rationalized tariff codes. But many have not yet introduced low or moderate tariffs, in part because of the continuing importance of tariffs for government revenues.

The result is a continuing bias against exports and a high cost for inputs. Making things worse, marketing boards continue to be heavily involved in agricultural exports in most African countries.

Further trade reform must be accompanied by legal, regulatory, and institutional reforms. Increasingly, the emphasis on improving the business environment needs to swing toward the wide range of legal, regulatory, and institutional deficiencies that are only now being addressed in most countries' reform programs.

In many low-income countries, internal competition—and thus the capacity of domestic firms to respond to external competition—has been limited by incomplete price liberalization, licensing requirements, and special concessions. These policies create barriers to the entry of private sector firms and insulate firms from competitive pressures to innovate, reduce costs, and seek new markets. Such policies also tend to preserve the rents received by privileged firms, discriminating in particular against small and medium-size enterprises.

One major obstacle to creating competitive markets is the presence of public enterprises in key sectors of the economy. Public enterprises tend to deter private entry, in part because they enjoy privileges not available to private firms, such as tax exemptions, access to government contracts, immunity from normal commercial law, and so on. The small markets in many low-income countries mean that public enterprises may enjoy a monopoly, particularly in nontraded goods industries. Even where such state monopolies have been abolished, state enterprises often retain privileges that deter private producers and traders.

In addition to improving the capacity of the private sector to respond to improvements in incentives for production and investment, deregulation of the economy in turn has an important impact on the public sector. It reduces the administrative burden on public services and redirects the efforts of government toward areas that help firms to exploit market opportunities and develop technological, management, and marketing skills to improve their productivity. Issues relating to improvement of the business environment are discussed in chapter 2.

Poor quality of physical infrastructure and human resources

Physical infrastructure services—power, transport, roads, civil works, telecommunications, water, sanitation, and waste disposal—represent a significant share of every economy, typically 7 to 11 percent of GDP, with transport the largest. They are not only important consumption goods, as with clean water and electricity for households, but also vital inputs into the production process, as with power, transport to markets, and communications with buyers and sellers. Provision of infrastructure services lags behind in low-income countries, severely hampering development efforts as well as welfare improvements.

The share of infrastructure services provided by state-owned utilities is much higher in low-income countries than elsewhere. The dominant public role, exercised largely through vertically integrated and monolithic entities, has arisen for a combination of reasons: technological characteristics, economic and political importance; and scale of financial requirements, as well as high levels of uncertainty and risk that have deterred private investment. Provision of infrastructure services in low-income countries presents common problems—operational inefficiency, overstaffing, poor maintenance, and an inability to meet rapidly increasing demands for new infrastructure.

Inefficiencies in the provision of physical infrastructure are quickly felt throughout the economy because of their impact on the costs of doing business. In Nigeria, power shortages have induced most large private enterprises to install their own electricity generators, increasing total machinery and equipment costs by 10 to 25 percent. Inefficiencies and shortages also restrict access to markets. Neglect of rural infrastructure in particular has slowed the integration of rural and urban markets and cut off farmers from inputs at competitive prices. Moreover, lack of access to new technology, especially in telecommunications and transport, erodes the competitiveness of both rural and urban producers.

Low-income countries are also characterized by widespread deficiencies in human resources, which are the key to long-term competitiveness. While many countries have improved their social indicators—enrollment ratios in primary and secondary education, literacy ratios, access to clean water and sanitation, life expectancy at birth, and infant mortality rates—they continue to lag behind middle-income countries, especially in Sub-Saharan Africa (figures 1.10, 1.11, and 1.12).

Low-income countries are also characterized by widespread deficiencies it? human resources and infrastructure services which are the keys to long-term competitiveness

Adult illiteracy rates remain high, especially for females, in most of Sub-Saharan Africa and Asia. There are exceptions, such as China, Kenya, Madagascar, Myanmar, and Sri Lanka, where literacy rates are relatively high for both males and females. The link between literacy and productivity improvements is strong, and experience has demonstrated the difficulty of imparting information about technologies, markets, and so on to an illiterate population. In addition, the relatively high rates of female illiteracy in most low-income countries are significant for private sector development—because women are major actors in the informal sector and agriculture, and because public extension services and other agencies relevant to business development typically focus their activities on males.

Some countries where illiteracy remains high, such as India, now have relatively high primary and secondary enrollment ratios—the result of efforts to improve the quality of human capital. But in most Sub-Saharan African countries, primary and secondary enrollments have grown relatively slowly and still lag well behind those in other developing countries. Indeed, between 1985 and 1990 primary enrollment fell as a percentage of all those eligible to attend primary school—a most troubling development. Moreover, while the share of outlays on education in total government expenditure in Sub-Saharan Africa has increased—in 1989, the average was 4.1 percent of GDP, on par with many middle-income countries—African governments have been less successful than those elsewhere in shifting spending toward primary and secondary education.

Figure 1.10 Adult literacy rates in low-income countries, 1992

Figure 1.11 School enrollments in low-income countries, 1990

Figure 1.12 Access to sanitation in low-income countries, 1985-91

To support growth and poverty alleviation and promote the private sector, governments in low-income countries need to use the fiscal space created by public enterprise and tax reform to redirect spending toward infrastructure and human resources, subject to the first priority of maintaining fiscal stability. The challenge is not only to expand spending and increase its efficiency in these areas, but also to focus spending on essential public goods, such as transport, water, and primary and secondary education.

The reform agenda

With the severity of poverty and the speed of population growth in most lowincome countries, even the respectable growth rates of the successful performers are not enough. With population increases of 3 percent a year, a 4-5 percent GDP growth rate means per capita incomes will rise only 1-2 percent a year. At that rate it would take African countries more than half a century to join the ranks of middle-income countries. To reduce the number of poor, low-income countries must grow by 7-8 percent a year and ensure that the benefits of this faster growth reach the more than I billion people living in poverty. These high growth rates are also required to absorb the unemployed, new entrants into labor markets, and those made redundant by public enterprise and civil service reforms.

The key to accelerated growth is much higher investment and domestic savings, combined with systematic efforts to introduce structural reforms, which are necessary to maintain macroeconomic stability and stimulate the private sector. This is particularly true for the slow-growing economies, which need to raise savings and investment rates from the current 12-16 percent of GDP to at least 20-25 percent.

Raising the level and efficiency of investment requires further reforms to create a competitive, enabling environment for the private sector, to redirect financial resources to support private production and investment, and to shift the composition of public expenditures toward infrastructure and human resource investments that are essential for long-term sustained development. These reforms represent a fundamental change in the role of the state in the economy—from direct owner and operator to partner and regulator of the private sector.

The agenda requires governments to:

Create a competitive yet attractive business environment. An efficient private sector-led development strategy means shifting from am protecting domestic industry to making concerted efforts to reduce the cost of doing business—so that firms can compete in the global economy. To help firms respond quickly to changing market conditions, competent and agile institutions are needed— particularly those responsible for creating and enforcing legal and regulatory systems and tax and customs administration, and those dealing with trade, investment, and technology support. Fostering competition means going faster and farther with trade reform and price deregulation, removing remaining restrictions on FDI, and eliminating incentives and regulations that inhibit competition. By harnessing the skills and creativity of all segments of the population—including ethnic minorities and foreigners—the benefits of economic liberalization will support pluralistic societies. (Creating an attractive business environment and introducing an array of legal, regulatory, and institutional reforms are the subjects of chapter 2.)

Stop the hemorrhaging of public enterprises. Fiscal stability is fundamental to sustained growth. The key elements are broader tax bases and improved tax collections to increase fiscal revenues and, above all, reductions in government dissaving. For most countries, this means greater efforts to stem the losses of public enterprises—through privatization or, as an interim step, through the imposition of a hard budget constraint. As a first step, better information on state-owned enterprises is required to allow policies, programs, and performance targets to be defined. Privatization programs, beginning with the largest loss-makers, will have a bigger impact on the fiscal account and establish credibility for the overall program. Failure to deal with state enterprise losses will keep low-income countries from making social and infrastructure investments needed for growth and poverty alleviation. (These are the subjects of chapter 3.)

Increase the flow of financial resources to the private sector. The priority should be severing the links between banks and nonperforming assets. This means not only eliminating the leakages from the financial system to public enterprises and privileged firms, but also strengthening prudential supervision and regulation of the banking system. Reducing public sector ownership and promoting entry and competition will increase the volume and efficiency of financial intermediation. Removing impediments to private sector development in general will drive this process. At the same time, development of basic financial infrastructure—such as payment systems—is crucial. (Chapter 4 examines issues of financial sector development.)

Although all low-income countries share this reform agenda to some degree, their diversity—in initial conditions and the extent to which reforms are already completed or under way—means that priorities, sequencing, and implementation will vary.

The key to accelerated growth is much higher domestic saving and investment to reduce the dependence on aid flows China's priority is to maintain its current growth rate and good macroeconomic management and to concentrate its efforts on integrating its segmented domestic market. Restructuring large public enterprises, building the financial sector, and strengthening the legal and regulatory frameworks are critical challenges. And large investments in infrastructure are needed to sustain growth.

For South Asia, the priorities are to reform tax systems, improve tax administration, accelerate the efforts to liberalize trade, deregulate the economy to increase internal competition, significantly reduce the cost of doing business, and accelerate the reform of public enterprises (particularly utilities) and the financial system.

In low-income countries with low domestic savings and low per capita GDP growth rates, including Bangladesh and most of Africa, the key to accelerated growth is much higher domestic savings and investment to reduce the dependence on aid flows. Reducing government dissaving in Africa will require a major change in the size and structure of public revenue and expenditure—by broadening the tax base, improving tax collections, and stopping the hemorrhaging of public enterprises. Increasing the flow of financial resources to the private sector will depend on cutting links between banks and nonperforming borrowers, privatizing banks, and strengthening prudential regulation and supervision.

Private sector development calls for a major effort to reduce the cost of doing business through deregulation to complement steady progress in trade reform. But private sector development is only one element of the development agenda. Complementary public investments in people, infrastructure, and the environment are essential. The emergence of a vibrant private sector will also hinge on a major sustained effort to develop competent, respected, and agile public institutions—a difficult and slow process.