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

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)

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.

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.