8. Develop a global partnership for development
10.5 The investment climate, investment, growth and
Throughout this book we have considered how different aspects of financial sector development are related to economic growth and poverty reduction.
However, it has also been stressed that, whilst FSD is important, it is a means to an end, not an end in itself. That is to say, it is the growth of private firms – that is facilitated by FSD – that potentially leads to these positive effects in terms of growth and poverty reduction.
The centrality of private sector development (PSD) is undeniable: private firms provide more than 90% of all jobs, for example, and the extent that they are able to generate these jobs is strongly influenced by a country’s ‘invest- ment climate’.
The World Bank (2005b:1) describes the relationship as follows:
A good investment climate provides opportunities and incentives for firms – from microenterprises to multinationals – to invest productively, create jobs, and expand. It thus plays a central role in growth and poverty reduction. Improving the investment climates of their societies is critical for governments in the developing world, where 1.2 billion people survive on less than $1 a day, where youths have more than double the average unemployment rate, and where populations are growing rapidly. Expand- ing jobs and other opportunities for young people is essential to create a more inclusive, balanced, and peaceful world.
As well as providing the overwhelming majority of jobs, the private sector is also the primary source of government tax revenue, either directly, as cor- poration tax, or indirectly via income taxes and indirect sales taxes on the products that it produces.
Furthermore, despite the increasing importance of external finance – par- ticularly in the form of FDI – the great majority of investment in developing countries is domestic in origin.
Figure 10.9 illustrates this by comparing the relationship between total domestic fixed capital formation (i.e. investment) with FDI, both as a propor- tion of GDP. As we can see, the largest multiple is found in South Asia, where total domestic investment is more than twenty-five times larger than FDI.
The lowest multiple is in Latin America, but even here total domestic investment is still almost six times larger than FDI.
For the World Bank, therefore, a good investment climate encourages higher levels of investments from firms, by removing unnecessary costs, risks and barriers to competition. Why does the Bank consider this to be important?
Low barriers to entry are seen as essential in order to encourage: (a) the diffusion of new ideas, (b) firms’ ability to import capital equipment as required, and (c) improvements in working practices and the way that pro- duction techniques are organised. In short, a good investment climate fosters a competitive environment where firms have opportunities and incentives to innovate, test their ideas and either succeed or fail (World Bank, 2005b).
Almost a century ago, Schumpeter described the central driver of capital- ism as ‘creative destruction’, and for the Bank this remains true today: firms must be allowed to fail as well as to succeed. A good investment climate facilitates this process by making it easier for firms to enter and exit markets and sectors. Firms innovate to secure a competitive advantage, and it is this innovation that is ultimately the source of higher productivity and economic growth.
However, just as FSD is a means to an end, growth is also not an end in itself. As we have discussed throughout the course, the reason for the emphasis on economic growth is because of the strong relationship between growth and poverty reduction, though as we have also seen the strength of this relationship is far from stable.
As well as this indirect impact on poverty through its impact on growth rates, the quality of the investment climate also affects the lives of the poor through a number of direct channels (ibid.).
Figure 10.9 Gross fixed capital formation as a multiple of FDI.
Source: World Bank WDI.
First, a good investment climate encourages job creation in the private sector, which directly reduces poverty. However, as pointed out above, the government must strike a balance between protecting the rights of incumbent workers – and so ensuring that jobs are of a high enough quality to have a positive effect on poverty levels – and avoiding regulation so strong that firms choose not to create new jobs.
Second, a good investment climate encourages competition which puts downward pressure on the prices of goods and services, from which the poor benefit. The flip side of this, however, is that this downward pressure on prices will also affect the poor directly in a negative sense, to the extent that they are selling into the market, either as farmers or as suppliers to larger firms.
In general terms, as the Bank points out, FSD enables all firms able to take advantage of profitable investment opportunities, as well as helping poor families cope with exogenous shocks, natural disasters and so on. Further- more, to the extent that a good investment climate leads to an expansion of economic activity, tax revenues will also rise, providing funds that can be spent on services which benefit the poor. Of course, this does not guarantee that additional government revenues will be used for this purpose, but it does at least create the possibility that this could occur. What can governments do to influence the investment climate directly?
10.6 ‘Tackling costs, risks and barriers to competition’
10.6.1 Costs
The most obvious example of how governments can affect the cost of doing business is through the tax system. Here ‘tax competition’ between countries – both developed and developing – has become increasingly common since the 1980s, as countries compete to attract inward investment. This has resulted in a steady decline in corporate tax rates throughout the world, but the rate of fall has been faster in developing than in developed countries, not least because poorer countries may feel a greater relative need to attract FDI, but also that their relative bargaining position vis-à-vis transnational corporations will generally be weaker than with developed economies.
As a result of these forces, average corporate tax rates in developing coun- tries had fallen to 20% by the beginning of the twenty-first century, compared with a figure of 35% for OECD countries (Murshed, 2001).
In addition to tax policy, the World Bank (2005b) also describes a number of other channels through which government policy also has strong impacts on business costs.
First, through the provision of public goods such as education, for example, the government affects the availability of skilled labour and the cost of training that companies face. As we have seen, the countries that have been most successful in terms of development in recent decades – particularly
the Asian ‘Tiger economies’ – have invested relatively high amounts of government spending to education and training. The public good element here is important, since it would not be in the interest of a private business to provide the same level of education and training as the state, since they would have no way of ‘capturing’ all the returns on their ‘investment’: once trained, the employee might well decide to go and work for a rival firm, which would then obtain the benefits of the previous training as a ‘free rider’. Con- sequently, with no public provision in this area, education and training would be far below the optimal level for society.
Second, the state of a country’s infrastructure also has a strong influence on a firm’s costs and the same public good arguments are relevant here:
countries that have the best record in development terms have tended to invest heavily in infrastructure development.
Third, by establishing the framework for contract enforcement, the gov- ernment determines the efficiency, cost and time taken for this process.
In this respect, Figure 10.10 compares the length of time needed to enforce contracts in a number of countries at different levels of development and in different regions. As we can see, it takes around 800 days in Cameroon – i.e.
more than two years – to enforce a contract, while the corresponding figure in South Korea, for example, is 230 days. It must surely be the case that this wide divergence will have a significant influence on firms’ business decisions.
In all of these areas (other than tax, of course) government activities reduce the cost of doing business, encouraging far higher levels of economic activity than would otherwise be the case. Indeed, this facilitation of business, through expenditure on public goods and the setting and policing of the regulatory and legal framework in which business operates, is essential to the workings of any successful economy. In this respect, there is no such thing
Figure 10.10 Average number of days needed to enforce a contract, 2006.
Source: World Bank WDI.
as a ‘free market’ of a genuinely laissez-faire form: well-functioning markets are not ‘natural’, but require a supporting framework of rules in which to operate, and the nature of this framework in turn influences strongly the form that market transactions take.
That said, the Bank rightly points out that excessive or unnecessary regula- tion can lead to higher costs and stifle business activity. Perhaps more important than the quantity of regulation, however, is the care with which it is crafted and enforced, and the extent to which it is tailored to the circum- stances of particular countries. In this regard, the one-size-fits-all approach to regulation in particular may well have led to many developing countries implementing regulatory frameworks that have evolved in very different countries, both in terms of history and culture, but more importantly in terms of levels of development.
A good example of the type of unnecessary regulation that the Bank rightly takes exception to is the excessive time that an unwieldy bureaucracy can produce in this area. For example, it takes two days to register a new business in Australia, but 200 days in Haiti (ibid.).
10.6.2 Barriers to competition
As pointed out above, firms will generally prefer less competition rather than more. However, it is certainly the case that high levels of competition can bring great benefits to society. It is therefore important that government pol- icy facilitates competition by eliminating barriers to entry and exit in different sectors, and constrains anti-competitive practices on the part of large, incumbent firms.
However, while the World Bank (2005b) generally sees unfettered competi- tion as optimal in all circumstances, there may be many circumstances where this is not the case. Although not particularly fashionable now, it is undoubt- edly the case that most if not all countries that are now ‘developed’ did not become so by allowing free entry to foreign competitors at all stages of their development.26
History would seem to teach that when those competing have very different levels of resources, expertise and experience, the outcome is likely to be in the favour of the stronger party. The ‘infant industries’ argument remains much criticised, but in many ways this is the result of policies being badly imple- mented, rather than a fundamental problem with the idea itself: as many countries in East Asia have proved, it is possible to develop very rapidly using this model, but only if it is done well. If it is done badly, as too often has been the case, the results can be devastating from a development perspective.