|Private Sector Development in Low-Income Countries - Development in Practice (WB, 1996, 188 p.)|
|Chapter 2-Establishing an attractive business environment agile firms, agile institutions|
One of the most important attributes of economies that foster private sector activities is that individuals are freeand believe themselves to be freeto take all actions in their economic interest that are not specifically prohibited.
The legal framework in these market economies has at least four basic economic functions:
· To define the universe of property rights in the system.
· To set a framework for exchanging those rights.
· To set the rules for the entry and exit of actors into and out of productive activities.
· To oversee market structure and behavior in ways that promote competition and protect consumers and the environment.
These four basic functions can be loosely related to well-recognized areas of law. Property rights are defined in the constitution of a country and in more specific laws dealing with tangible and intangible property. These should give individuals the freedom, flexibility, and security to acquire, use, and leverage property rights. Exchange is covered generally by contract law. Entry is governed by company and foreign investment law, bankruptcy and exit, by liquidation laws. Finally, to promote competition and protect consumers are antimonopoly and unfair competition laws. These basic areas of law are joined by many other important onessuch as labor, taxation, and bankingin a rich and intricately woven web of laws that constitutes the complex legal framework for private sector activity in advanced market economies.
BOX 2.3 OVERCOMING PRIVATE SECTOR SKEPTICISM IN GHANA AND SENEGAL
By the end of the 1980s, Ghana had undertaken major economic reform, yet had achieved little supply response in the private sector. An IDA sponsored survey of the sector identified regulations inhibiting private sector operations and found that many private entrepreneurs felt that the government was ambivalent toward them.
To address these problems the government formed a private sector advisory group (PSAG), comprising representatives from the private sector and the government, and asked it to develop a set of recommendations for the revision of business regulations. The group's final report was then discussed with private entrepreneurs, and many of its recommendations were adopted, resulting in removal of price controls and business licensing requirements and simplification of foreign direct investment regulations. Equally important, the process reduced the gulf between government and the private sector. Ghana's PSAG has been succeeded by the Business Roundtable, which holds periodic discussions with the government on issues relating to the financial sector, privatization, export promotion, and legal and judicial reforms. These efforts have facilitated privatization and encouraged both domestic and foreign investment.
In Senegal in 1994, the Bank Group sponsored an assessment of the private sector, while the government established a competitiveness review group (CRG) made up of representatives of employer associations, labor unions, and government. The CRG was to look for ways to remove obstacles to economic competitiveness and to involve both government and the private sector in formulating and carrying out economic reform. Supported by technical assistance from IDA, Senegal's CRG has assembled five commissions to poll the private sector view of reforms on important and contentious issues (including conventions specials, high transaction costs, high taxes, complex government procedures, and lack of competition policy). The commissions' work has resulted in the dismantling of most conventions specials and the simplification of business regulations supported by an IDA credit.
Important gaps in laws and rules need to be plugged, and the institutional mechanisms for implementing laws and rules need to he strengthened, streamlined, and made more efficient and responsive.
The challenge in strengthening the legal and judicial system in many low-income countries is twofold: important gaps in laws and rules need to be plugged, and the institutional mechanisms for implementing laws and rules need to be strengthened, streamlined, and made more efficient and responsive. In low-income countries that previously operated under socialist systems, the challenge is to reconstruct the basic elements of the legal and judicial system to create a regime friendly to private property rights.
Four important deficiencies in laws and their implementation are frequently cited:
Laws relating to property rights and collateral. In most low-income countries, legal restrictions or deficiencies in collateral laws limit borrowing options for enterprises, particularly for new and small firms that cannot offer unencumbered landed property. Banks' unwillingness to lend against movable and intangible property stems from the high costs of creating a loan secured by collateral, the slow and costly judicial procedures to repossess and sell collateral, and the inadequate registries for filing claims against collateralmaking it difficult for lenders to publicize their security interests.
In Bolivia, the economic cost of deficiencies in collateral laws has reduced equipment investment by as much as $500 million, leading to a loss of potential output of about 2 percent of GDP (box 2.4). In most African countries lending against movable goods (and receivables) is uncommon. In many countries, the problem extends to landed property. Laws for land markets are not clear, land registries have not been updated, and establishing clear unencumbered title to land is difficult. That discourages long-term investment, reduces access to institutional finance, and mutes incentives for the greater productivity and commercialization of agriculture.
BOX 2.4 BOLIVIA: THE ECONOMIC VALUE OF COLLATERAL
In Bolivia commercial bank lending is mainly collateralized by land or the personal guarantee of wealthy individuals. Because of inadequate property laws and legal procedures, assets such as inventory, industrial equipment, and accounts receivable are not considered acceptable collateral. And because the registries for recording security interest in property function poorly, it is hard for lenders to trace claims and identify their collateral in the eyes of the court. Repossessing collateral is made complex and time-consuming by gaps in laws that govern financial transactions. The judicial process for enforcing these laws, for instance, takes considerably longer than the times specified under law. As a consequence of these legal and administrative deficiencies, persons without real estate cannot finance equipment purchases. Only those with unencumbered fixed assets can get credit for working capital. Credit sales are discouraged. Non-bank credit is very expensive. And lenders must rely on criminal rather than civil law to enforce contracts. If deficiencies in laws governing collateral were rectified and financing were easier, demand for equipment in Bolivia could rise by more than $500 million. That in turn would increase the country's output by an estimated $150-$200 million, roughly 2 percent of GDP.
Basic business laws. Many countries have not adapted the business laws introduced by colonial powers to today's economic circumstances. Madagascar's commercial code is virtually unchanged from the French code adopted in 1867. In Sierra Leone, company law dates from 1929 and has undergone few modifications. Business laws need to provide for fuller disclosure that allows outsiders to evaluate the financial position of firms and firms to effectively leverage their assets. One of the biggest problems is inconsistency in laws relating to foreign exchange transactions, income taxes, and customsa consequence of the failure to repeal obsolete laws and regulations and formulate new laws to reflect changes in policies. For example, despite government policy to provide duty-drawback relief to Nigerian exporters, rules for operation of the scheme have yet to be formulated and incorporated in customs regulations. In most countries, consumer protection laws also are poorly developed, and most countries still lack laws on standards allowing the public or smaller firms to challenge monopolistic behavior.
Laws governing financial transactions. Laws often do not permit full play of financial relationships and instruments. In many African countries, laws and regulations governing capital market transactions are inadequate and an underdeveloped legal framework for leasing prevents small firms from increasing their equipment investments and denies lenders a more secure method of lending to small enterprises. In Ghana, small firms improved their access to credit following introduction of leasing laws.
Most countries have neglected the legal issues of debt recovery. Inefficient adjudication has often rendered court-based remedies ineffective and encouraged willful default. In Bangladesh and India, judicial procedures relating to debt recovery can take years. Extra-judicial foreclosure arrangementsallowing lenders to exercise control rights over the security or operations of firms are normally not available in most lowincome countries. As a result, financial intermediaries prefer to lend only to established firms. Newer and smaller firms without a track record or unencumbered real property find it difficult to get finance.
Sustained growth will require large infusions of capital, much more than entrepreneurs can get from their own resources or from friends and relatives. And expanding access to outside financefrom banks and institutional investorswill require comprehensive revision of laws relating to the creation, trading, and enforcement of security interests.
Laws for arbitration and other dispute resolution mechanisms. In many countries, such laws and mechanisms are not responsive to changing commercial needs. In the absence of quicker alternative dispute resolution mechanisms, firms must rely on tedious court procedures, increasing the costs and risks of market transactions and squelching the opportunities to expand markets.
Specialized institutions, such as law reform commissions, can improve the relevance of laws and provide a mechanism for gradually revising laws on a consensual basis in harmony with existing social and legal traditions. In many low-income countries, these institutions either do not exist or have become moribund, as in Sierra Leone. Strengthening institutional mechanisms for law reform is particularly important for privatization programs, for the private provision of infrastructure services, for attracting foreign investment, and for protecting the interests of small and new enterprises.
Equally important is strengthening public awareness of laws and legal decisions. When the substance and applicability of laws are known only to a few, uncertainty rises for all business decisions. Poor law reporting arrangements, outdated legal indexes, and delayed gazette notifications are the main culprits. In Ghana, there is a considerable backlog of law reportingand until recently, even summaries of court decisions were unavailable. In Sierra Leone, the last available law reports date back to 1984.
The efficacy of laws depends on disposing of court cases expeditiously. In most low-income countries, adjudication is cumbersome and unreliable. Serving summons, filing suits, obtaining judgments, and executing decrees are all time-consuming. Efficiency is impeded by limited knowledge of economic laws and severe shortages of trained court clerks, process servers, transcribers, and bailiffs. Further handicapping the functioning of the legal and judicial system is the poor state of the physical, logistical, and informational infrastructure. In many low-income countriessuch as Bangladesh, Ghana, Sierra Leone, and Tanzaniathe facilities for recording court proceedings are rudimentary. Judges often have to record the proceedings manually, so delays in completing cases are common.
In many Sub-Saharan African countries and formerly socialist economies, government agencies are ill-equipped to convert legislative proposals and government intent into coherent legislation. Legislation, rules, regulations, and public notices fail to keep pace with government policy announcements and decisions, particularly in matters relating to investments, foreign exchange, customs, taxes, and finance. That naturally hurts the credibility and timeliness of reforms. The result is confusing and inconsistent legislation that allows civil servants wide latitude in interpretationthus denying predictability, flexibility, and security for property transactions.
Efforts to improve the quality of legal drafting and analysis can pay large dividends in private investment. Witness the mining sectors in many African countries, where the private sector responded positively to clear, revised mining codes. The Bank Group has been helping low-income countries to address specific deficiencies in laws through technical assistance directed at improving institutional and infrastructure capacity (box 2.5). These efforts are collaborative undertakings by governments, the judiciary, and the private sector, with IDA's support. They are creating a broad consensus about reform and the most effective way of implementing itto strengthen the legal and regulatory system in low-income countries.
The objective of this effort is to establish, visibly, a rule-based economic system in which the rules governing economic activity are generally available and understood by the population. Those rules are to be enforced uniformly and universally, with a stable, predictable pattern over time. And they are to be changed through transparent means. Such open processes have special merit for countries that have experienced gradual breakdowns in their judicial systemand where the expropriation of private property in the 1 960s and 1 970s left many private companies, particularly foreign ones, doubtful about the wisdom of continuing to invest.