Global Poverty Research Group

The Investment Climate, Private Sector Performance and Poverty Reduction in Africa

By Måns Söderbom*. April 2005

Reversing the poor economic performance of Africa’s private sector has become a central concern to policy-makers. The basic reason is that improved performance enables firms to increase wages and generate jobs, and thereby contribute to development and poverty reduction. In recent years the ‘investment climate’ has become a key issue in the policy discussion as to why the private sector performance in Africa is not better. The key components of the investment climate are the institutional, policy, and regulatory environment in which firms operate. The quality of infrastructure, the nature of business regulations and their enforcement, the prevalence of credit constraints, the quality of governance, general conditions for private investment and enterprise growth, economic freedom, country credit ratings, human development, environmental sustainability and civil rights are all examples of recently studied dimensions of the investment climate. Some of the research undertaken at the CSAE (see Collier, 2000) argues that the poor investment climate in Africa results in high transaction costs and particularly disadvantages the manufacturing sector and its ability to export, as manufacturers are intensive users of investment climate services.

Empirical research on the problems posed by a poor investment climate was long constrained by the lack of adequate data. This has changed over the last decade, primarily as a result of data collection sponsored by the World Bank in a large number of countries around the world. The first comprehensive effort was the Regional Program on Enterprise Development (RPED) surveys, carried out in Burundi, Cameroon, Cote d'Ivoire, Ghana, Kenya, Tanzania, Zambia, and Zimbabwe between 1992 and 1995. Each survey typically covered about 200 firms, and firms were interviewed three years in a row in most countries, thus yielding panel data. The CSAE played a key role in the Ghanaian surveys, and analysis of the RPED data has subsequently been a central part of the research at the CSAE. Data collection as part of the RPED slowed down after 1995.

At the end of the 1990s and in the early 2000s, the World Bank fielded Investment Climate (IC) surveys and the World Business Environment Survey (WBES) across a wide range of countries in SSA and elsewhere. The nature of the IC surveys is similar to the earlier RPED surveys in terms of firm and sector coverage, but the survey instruments are more oriented towards investment climate issues and thus far the main objective appears to have been to collect cross-section data as distinct from panel data. The WBES was designed to shed light on a wide range of issues related to the business environment, e.g. the role of governance, regulations, economic policy and public services. The WBES data too is cross-section data.

What can we learn from these cross-section surveys as to the role of the investment climate? To find out, a good starting point is the study by Batra, Kaufmann and Stone (2003) which contains a comprehensive analysis of the obstacles to business based on the WBES data. Most of the reported results have a lot of intuitive appeal. The leading constraints cited by thousands of company managers around the world are taxes, regulations and financing. The authors’ empirical analysis suggests that, other factors held constant, there is a negative and statistically significant relationship between the severity of the key constraints and the growth in sales and investment. The interpretation of this result is that firms that rate the constraints as relatively severe compared to other firms in the same country tend to have relatively low growth rates. Thus a good local investment climate is good for local business. However, the results are not informative as to whether firms in countries with poor average business environment conditions have lower growth rates of sales and investment than firms in countries with good average conditions.

The distinction between investment climate effects within and across countries is important. If a poor business environment is a common constraint to all firms in a given country, then researchers searching for investment climate effects across firms within countries may actually miss the point. It may be better in this case to measure the key dimensions of the investment climate at the country level - perhaps by means of a few case studies - and then conduct the empirical analysis at the aggregate level. One such project has generated the World Bank and IFC Doing Business Database (World Bank, 2005). This database contains information on various aspects of the regulatory environment facing private firms in a large number of countries and economic regions - e.g. how long it takes to start a business, how hard it is to hire and fire workers, how well contracts are enforced and so on. The construction of these data is based on case-studies of laws and regulations in each country and does not involve surveying individual firms. The database has been used in several studies analysing the causes and consequences of the quality of the business environment (see http://rru.worldbank.org/DoingBusiness/ for references and detailed information about the database). While the cross-country approach is sensible from a conceptual point of view, the main challenge lies in designing a robust methodological framework for estimating the effects of interest. Essentially, researchers in this area have to use very parsimonious econometric specifications with small samples of cross-section data. This means it will be hard to address potentially important methodological problems. Resolving this issue whilst at the same preserving the interpretation of the estimated effects is the Gordian Knot of this literature.

In contrast, if one believes there are large differences in the investment climate within countries – due to, say, varying quality of local governance – then exploiting firm-level data may be sensible. One methodological advantage over the aggregate cross-country approach referred to above is that researchers can allow for effects of country specific unobserved factors on outcomes. This can be important in order to maintain a causal interpretation of the results. There are other methodological advantages too, due to the fact that the size of samples available typically is much larger than for those underlying aggregate analyses. A recent study in this vein is that by Dollar, Hallward-Driemeier and Mengistae (2004), which investigates the role of the investment climate for foreign direct investment and exports in eight Asian and Latin American countries. The authors are explicit that they are primarily searching for local effects: ‘if a city has problems with customs clearance, getting phone lines, or wire transfers cleared, then its locally owned firms are less likely to take advantage of international markets’ (Dollar et al., 2004, p.6). Their econometric analysis provides mixed evidence on the role of played by the investment climate. On the one hand, the results suggest local differences in several aspects of the investment climate matter for whether or not firms export. The loss of sales due to power outages, in particular, has a statistically and economically highly significant negative effect on the propensity to export. On the other hand, the association between foreign investment and the investment climate variables within countries is quite weak, and the only statistically significant investment climate effect is from the share of firms in the area with overdraft facility.

There is still a big void regarding our understanding of the links between the investment climate, private sector performance and poverty in Africa. This situation needs to be rectified. More generally, the research in this area can be made more compelling in two ways. First, the issue of causality needs to be taken seriously. Researchers need to establish whether the investment climate truly impacts on key outcome variables, and, if so, how large are the effects. For instance, even though it seems quite plausible that overdraft facilities impact on firms’ exports decisions, it also does not seem implausible to think that banks actually choose to locate in cities where many firms export. Causality may thus run from exports to overdraft access as well as in the opposite direction. The general point is that the observed correlation between the investment climate and the outcome variable may be due to other mechanisms than causality running from the investment climate to outcomes. The estimates of investment climate effects would be easier to interpret, and more useful to policy makers, if they could be made robust to such alternative mechanisms. Second, since support programmes are devised subject to budget constraints, policy-relevant research needs to address the issue of priorities. Even if poor power supply is found to have a larger negative effect on private sector performance than, say, inefficient customs administration, it could well be that it is much less costly to sort out the latter than the former. Basic cost-benefit analysis should therefore play a more prominent part in future research than what has been the case to date. Better econometric techniques and better data are likely to facilitate progress along these lines.

References:

Batra, Geeta, Daniel Kaufmann and Andrew H. W. Stone (2003). Investment Climate Around the World: Voices of the Firms from the World Business Environment Survey. Washington D.C.: The World Bank.

Collier, P. (2000). “Africa’s Comparative Advantage,” chapter 2 in H. Jalilian, M.Tribe and J. Weiss (eds.) Industrial Development and Policy in Africa. Cheltenham, UK: Edward Elgar.

Dollar, David, Mary Hallward-Driemeier and Taye Mengistae (2004). “Investment climate and international integration,” Policy Research Working Paper 3323. Washington D.C: The World Bank.

World Bank (2005). Doing Business in 2005: Removing Obstacles to Growth. Washington D.C: The World Bank.


* The views expressed are those of the author(s) and do not necessarily represent those of the Global Poverty Research Group, Oxford University, or the Economic and Social Research Council