Web of Life

Most countries strive to improve living standards and reduce poverty, but China, India and Uganda stand out for their achievements. China’s growth over the last 20 years has been unprecedented, lifting 400 million people out of poverty. India has more than doubled its average growth rate since the 1970s, making big inroads into poverty. Uganda achieved a growth rate from 1993 to 2002 that was eight times the average in Sub-Saharan Africa, also slashing poverty.

How did they do it? The World Development report 2005: A Better Investment Climate for Everyone, shows that a large part of the explanation lies in the progress each country has made in improving its investment climate—the opportunities and incentives for firms to invest productively, create jobs, and expand. The Bank’s recent Doing Business in 2005 report highlighted the heavy burden imposed on firms by outmoded or ill-conceived regulation. The World Development Report 2005 shows that regulatory costs are part of a larger problem, and outlines strategies for governments to broaden and accelerate improvements to their investment climates.

Driven by the quest for profits, firms of all types — from farmers and micro-entrepreneurs to local manufacturing companies and multinationals — play critical roles in development. They create most of the jobs needed to increase incomes. They provide most of the goods and services needed to improve living standards. They pay most of the taxes needed to fund public investment in health, education, and other services. But the size of these contributions depends largely on the investment climate. Too often, governments undermine their investment climates by creating unjustified risks, costs, and barriers to competition.

Policy-related risks cloud opportunities and chill incentives to invest. Surveys of over 30,000 firms in 53 countries show that uncertainty about the content and implementation of government policies is the top concern of firms in developing countries. Macro-economic instability, weak protection of property rights and arbitrary regulation add to those risks. More than 80 percent of firms in Bangladesh and over 62 percent of firms in Pakistan lack confidence in the courts to uphold their property rights. Nearly 65 percent of firms in India and Pakistan find the interpretation of regulation unpredictable. Improving policy predictability alone can increase the likelihood of new investment by existing firms by 30 percent.

Governments saddle firms with high costs that make many potential ventures unprofitable. Firms everywhere complain about taxes but they are often not the biggest burden. Weak contract enforcement, unreliable infrastructure, onerous regulation, crime, and corruption can impose costs amounting to over 25 percent of sales—or more than three times what firms typically pay in taxes. In India, losses from unreliable electricity supply are equivalent to 11 percent of sales, and firms spend more than 15 percent of their time dealing with officials. Almost all firms in Bangladesh report that bribes are needed when dealing with of officials — to the tune of 3 percent of sales.

Barriers to competition dull incentives for firms to innovate and increase their productivity, which is the key to long-term growth. Stronger competitive pressure can boost the probability of innovation by more than 50 percent. Yet unjustified regulatory barriers are pervasive, and efforts to curb anticompetitive behaviour by firms remain weak in most developing countries.

Weak investment climates tend to hit smaller firms and those in the informal economy the hardest. These firms have more difficulty gaining access to finance and public services, have less confidence in the courts, and find the interpretation of regulation less predictable. Constraints that involve fixed costs—such as the need to self-generate electricity—also impose a disproportionate burden on smaller firms. There are also big differences across locations within countries, underscoring the important role of sub-national governments.

Why are some governments making faster progress in tackling these problems than others? It’s not just about money: many improvements demand little from the budget, and faster growth increases tax revenues. Rather, governments need to address deeper sources of policy failure. They need to restrain corruption and other forms of rent-seeking that distort policies and push up costs, and to build policy credibility to give firms the confidence to invest. They also need to foster public support to enable and sustain reforms, and to ensure their policy responses fit with local conditions.

The agenda is challenging, but everything does not have to be done at once. Impressive results can be achieved by addressing individual constraints, and by sustaining a process of ongoing improvements. China began by enhancing the security of property rights, India by easing red-tape and trade restrictions, Uganda by restoring macro-economic stability and building credibility through a series of hard-won reforms. But sustaining progress is no less important, and requires commitment. Many governments are maintaining momentum through effective public education and through the creation of specialist institutions to engage stakeholders and review constraints. The pace of improvement in many countries in East Asia and Central Europe is breathtaking — the same cannot yet be said of the countries in South Asia. Will they rise to the challenge and seize the benefits of faster growth and less poverty?