8. Develop a global partnership for development
10.4 Private sector development: delivering the basics
As with the financial sector, the World Bank (2005b) gives its view as to the
‘basics’ from a private sector development (PSD) perspective. For the private sector to efficiently and productively invest external finance obtained from the financial sector – or similarly to invest their own internal resources – a number of basic prerequisites are identified. The first and most basic of these is the provision of security and stability.
10.4.1 Security and stability
Clearly, for economic activity to develop effectively, financial institutions, firms and households require a minimum level of security: at the extreme, the outbreak of war will clearly bring lending and investment to a halt in any country. The importance of security, however, goes well beyond the avoidance of war. In particular, just as property rights and enforcement are vital for FSD, they are a similarly essential precondition for private sector development of all forms.
The World Bank (2005b) lists four elements of property rights that should be a priority in terms of implementation:
1 the verification of rights to land and property;
2 the facilitation of contract enforcement;
3 the reduction of crime;
4 the elimination of the uncompensated expropriation of property.
There is clearly a long way to go in many of these areas – as illustrated in Figure 10.8 below, a high percentage of firms in many developing countries lack con- fidence in the ability (or willingness) of courts to uphold their property rights.
Without such confidence, firms will have great difficulty securing external finance for investment purposes, and even if they are able to do so, may not have the confidence to invest. The Bank is thus correct to stress the importance of establishing an independent, efficient and credible judiciary that is able to swiftly enforce property rights.
Similarly, high levels of crime are a clear disincentive for investment, as is the risk that even if property rights can be effectively established, the gov- ernment may arbitrarily expropriate the property. Although the Bank also makes a valid point here, it is difficult to see that low levels of crime are one of the ‘basics’ in terms of PSD and investment. The United States has long had relatively high crime rates, but also has high rates of investment. Similarly, in the early years of the twenty-first century, Russia has had very high crime rates, combined with high rates of investment. The key point to make is that, while low rates of crime will generally be supportive of investment and there- fore growth, they are not a prerequisite to either.
As the Bank points out, property rights are important as they link effort with reward, and thereby encourage further effort. For example, a farmer with secure land rights who invests in machinery and fertilisers to enhance the yield of his crops will capture the rewards (or failure) of this investment. In contrast, if property rights are not clearly established, the farmer will be uncertain as to whether he will be able to capture these benefits and will therefore not be willing to put in the investment (and effort) in the first place.
Box 10.3 below explores this issue in the Ethiopian context where the lack of security of land tenure has long been an important issue.
Box 10.3 Land tenure and agricultural productivity in Ethiopia Since ousting the Marxist ‘Derg’ regime in 1993, the Ethiopian gov- ernment’s development policy has been centred on agriculture as the main driver of industrialisation. The avowed aim is to raise agricultural Figure 10.8 Percentage of managers lacking confidence in courts to uphold property
rights.
Source: World Bank WDI.
productivity and output, to ensure national food security and to pro- vide both the raw materials for industrial development and to build domestic demand for industrial output. As we can see from the figure below, however, agricultural yields remained virtually unchanged from 1993 to 2005.
Not only have agricultural yields remained largely unchanged in Ethiopia, they are also well below the average for other low-income countries. Similarly, other indicators such as agricultural value added per worker have changed little over the same period.
Regardless of repeated government initiatives, agricultural output in Ethiopia remains almost entirely a function of rainfall, so that years of good rains see output, yields and thus productivity rise. Conversely, years of drought see the opposite. Indeed, the IMF (2003) estimates that 93% of total variation in Ethiopia’s GDP is determined by climatic conditions. Although the government has prioritised fertiliser use – and retained subsidies in the sector – this has had no impact upon product- ivity levels. For many commentators, the fundamental obstacle that needs to be overcome is the lack of security of land tenure.
Without security of land tenure there is no incentive to invest in productivity-enhancing measures such as irrigation schemes. Further- more, without the collateral that land ownership provides, financial institutions are not willing to lend for such purposes.
The issue of land tenure in Ethiopia has been the focus of extensive study and (intensive) debate. To date, however, the government has refused to budge, instead incorporating common ownership of land Cereal yields 1993–2005: Ethiopia vs. low-, medium- and high-income country averages.
Source: World Bank WDI.
into the 1994 Constitution, thus retaining the Derg policy of public land ownership.
Individual farmers have the right to farm on particular plots of land, but no right to sell this land in either a lease or freehold form. Further- more, the right to farm land has been – and remains – conditional on living in particular villages, largely preventing migration away from unproductive areas. Population pressures in rural areas, exacerbated by soldiers returning from conflicts, have seen plot sizes gradually reduce, as more and more people are allocated smaller and smaller plots of land. This has led to lower productivity, as the number of plots of economically viable size declines, as well as skewed incentives: farmers have every incentive to exploit all the natural resources on their land for profit immediately, rather than wait for the land to be possibly taken away from them in a later redistribution.
Furthermore, general population pressure has increased demand for land to such an extent that the historical practice of leaving land fallow and rotating usage has all but disappeared. More and more marginal land is being brought into use, and agricultural land is generally farmed intensively on an ongoing basis. The result: deforestation, soil degrad- ation, declining productivity and reduced incomes for agricultural workers. A major shift in policy would appear to be urgently needed if this vicious circle is to be broken.
The second key element of the basic infrastructure for PSD identified by the World Bank is the area of regulation and taxation.
10.4.2 Regulation and taxation
Good regulation is designed to address the market failures that restrain pro- ductive investment and, crucially, to align the interests of firms and society.
Whilst the activities of firms can bring huge benefits to societies, the interests and objectives of firms do not necessarily accord with wider societal object- ives. The aim of regulation, therefore, is to align these two sets of objectives as far as is possible.
For example, generally speaking most firms would prefer as low a level of regulation as possible. However, firms also tend to seek dominant market positions and to maintain those positions by restricting competition in a variety of direct and indirect ways. From a societal perspective, as we have seen, encouraging competition brings undoubted safeguards and benefits, whereas the restriction of competition inhibits innovation and so improve- ments in productivity, resulting in higher costs for both firms and consumers.
Although governments can directly influence level of competition through its regulation of the anti-competitive practices of large firms operating in their jurisdiction, the extent to which this is possible in practice will be
influenced by the relative bargaining power of the firm and government. For example, the European Union is able to regulate the behaviour of Microsoft’s business activities in the EU, not least because Europe is a key market for the company which generates large revenues. An individual developing country, in contrast – particularly a relatively smaller one – has far less relative power over companies such as Microsoft. In such circumstances, the company con- cerned is more likely to be able to dictate the terms on which it will engage with the country.
For the World Bank, it is important to strike a balance between regulation to address market failure and the possibility of government failure via regula- tion designed to address this:
Too often, governments pursue regulatory approaches that fail to achieve the intended social objectives because of widespread informality, yet harm the investment climate by imposing unnecessary costs and delays, inviting corruption, increasing uncertainty and risk, and creating unjustified barriers to competition.24
For the Bank, the appropriate striking of this balance requires the govern- ment to focus on:
• the removal of unjustified regulatory burdens and the streamlining of procedures;
• the reduction of regulatory uncertainty by reducing the discretion of individual regulators and undertaking regular consultation with industry;
• the reduction of barriers to competition through the reduction of regula- tory barriers to entry and the tackling of the anti-competitive behaviour of firms.
Domestic taxes (as well as taxes and regulation ‘at the border’) also clearly influence the investment decisions and behaviour of firms. The formal/
informal sector issue is of major importance in this regard: tax rates in devel- oping countries are broadly comparable with those in developed countries but, as we have seen, the tax take as a proportion of GDP is significantly lower. In large part, this reflects the size of the informal sector in developing countries, which adds substantially to the financial pressure (in terms of extracting taxes) facing those firms that operate in the formal sector and do pay tax.
Clearly, expanding the proportion of economic activity that occurs in the formal sector is fundamental to broadening the tax base and so raising the tax take. This requires, however, that taxes are not so high that they discour- age the transition to the formal economy, and that the tax system is efficient and as simple and streamlined as possible.
The Bank is surely right that setting tax rates too high can have distorting
and often counterproductive effects. However, the reverse may also be true.
That is, ‘tax competition’ between developing countries seeking to attract FDI, in a world where the demand for inward investment far outstrips its supply, may drive tax rates below the optimal levels. As with much else, therefore, governments need to strike the correct balance in this area.
The situation with taxes ‘at the border’ is similar. Simplicity, reasonable rates and a swift and efficient collection mechanism will encourage payment.
Indeed, the relative ease with which border taxes can be collected is one reason for their continued widespread use. However, governments do need to ensure that this fact itself does not lead it to increase the tax burden in this area too much to compensate for the difficulty of tax collection in other sectors of the economy.
10.4.3 Workers and labour markets
For many firms in developing countries a shortage of skilled workers and labour market regulations are a major constraint on the growth of their firms.
To address the first of these problems, governments need to foster a skilled workforce through investment in human capital via education and training.
The success of the East Asian ‘Tiger economies’ is, at least in part, accredited to long-term efforts in this area, where countries such as South Korea invested far more in education and skills training than was usual for countries at similar levels of development.25
The World Bank (2005b) also argues that, for labour market regulations, it is important to strike a balance between protecting the rights of existing workers and protecting the rights of the entire, potential workforce. For example, overly strict regulation on ‘hiring and firing’ may make firms reluctant to take on new workers, disadvantaging those not currently in the work force and increasing (or at least not reducing) the size of the informal sector. Clearly a balance needs to be struck here, since incumbent workers do need protection from unscrupulous employers, particularly in many developing countries where abuses of workers’ rights are common.
To summarise, we have seen that the World Bank (2005b) views effective FSD as being dependent upon government ‘delivering the basics’ in terms of:
1 ensuring macroeconomic stability;
2 fostering competition;
3 securing the rights of borrowers, creditors, and shareholders;
4 facilitating the flow of information;
5 ensuring that banks do not take excessive risks.
However, for the private sector to productively employ the finance available from an effective financial sector, the government also has to provide a num- ber of other basic prerequisites in the following areas:
1 security and stability;
2 regulation and taxation;
3 workers and labour markets.
For the Bank, the ability of government to deliver in these areas determines the nature of the country’s ‘investment climate’, which is viewed as funda- mental to levels of investment, growth and poverty reduction. The next section considers these issues.