Investment Climate and Microeconomic Reforms

Alex Uriarte has called our attention to the hampering effects of high levels of informality on productivity growth in Latin America. Informality distorts competition in domestic markets as it leads to cost disadvantages by efficient, law-abiding companies and thus negatively affects incentives to invest. It also implies lower incentives to benefit from economies of scale as the growth of firms exposes them to closer surveillance by authorities.

            Nouriel Roubini in his turn laid emphasis on the links between informality and the costs of “doing business”, i.e. the burden of cumbersome regulations and difficulties to start and operate a business. In effect, as highlighted by Nouriel, most Latin American economies rank very badly in the World Bank’s doing business database and World Bank research has already asserted some evidence that productivity growth and innovation are negatively impacted when doing business conditions are not easy.

            But Nouriel also pointed out a puzzle: “if informality and difficulty in ‘doing business’ are such negative factors for productivity how come that Brazil is growing slowly but China, India and Russia are growing fast?” After all, China (#96), India (#134) and Russia (#96) exhibit as poor ranking positions as Brazil (#121), among the 175 countries currently covered by the World Bank’s index of ease of doing business, and the former three have been growing at fast speed.

            Let me try here to do two things: to offer a response to that puzzle and to suggest how the “doing business” agenda should be used as a guide for so-called “microeconomic reforms” that could enhance growth in Latin America.

            Ease of doing business is just part of the Investment Climate

            First of all, one should keep in mind that the components of the “doing business” agenda are a sub-set of the broader Investment Climate (IC): “the set of location-specific factors shaping the opportunities and incentives for firms to invest productively, create jobs, and expand” (see A Better Investment Climate for Everyone). The IC corresponds to the environment surrounding and affecting the use of capabilities and strategies at the level of the firm. Firms decide to invest – i.e. how much to incur costs today with machinery, R&D etc. to improve or increase production in the future – taking into account IC as part of a package, besides firm-specific costs, risks, and barriers to competition. For our purposes, it is the influence of government policies and behaviors through their consequences on costs, risks, and barriers to competition that is of concern.

            Researchers in the field of institutional economics have been dealing with the influence of a country’s institutional and policy environment on productivity, investment and growth for sometime now. It has become widely accepted that the impact of variables such as the rule of law, corruption, trade facilitation, financial sector depth, etc., are exogenous – even if weakly so – vis-à-vis macroeconomic performance variables. What the concept of IC attempts to do is to encompass that range of institutional and policy variables into a single field of analysis, and tentatively of measurement. The IC is seen as comprehending stability and security (especially of property rights), regulations and taxes that qualify property rights, access to finance, infrastructure, and labor and other similar factors that impinge upon forward-looking investment decisions. Poorly-designed regulations and government behavior affect negatively productivity and growth through several channels, such as dead-weight efficiency losses, layers of risk additional to normal business ones, as well as the incentives to informality highlighted by Alex Uriarte and Nouriel Roubini.

            Two are the current major sources of investment climate data collected by the World Bank. Investment Climate Surveys interview large random samples of firms to collect assessments of constraints facing firms, and combine these perception-based findings with some hard data. The Doing Business Project has a different object and follows a different approach. The project defines hypothetical firms and transactions and resorts to lawyers, accountants and other selected experts in order to estimate how costly and difficult it is to do business in a location under prevailing conditions of business registration, contract enforcement, paying taxes, hiring and firing labor, and so on. The main items comprising the IC are listed below, among which the dimensions of the Doing Business agenda constitute a sub-set.

 INVESTMENT CLIMATE  Policy uncertainty  Macroeconomic instability  Corruption  Losses due to crime  Infrastructure  Availability of skilled workers  Doing Business                                                          · Starting a business · Dealing with licenses · Hiring and firing workers · Registering property · Getting credit · Protecting investors · Paying taxes · Enforcing contracts · Closing a business · Trading accross borders  

            Now we can explain Roubini’s puzzle: Russia, China, and India can grow fast despite relative unease of doing business because either non-doing-business variables within the IC and/or intra-firm cost- and risk-conditions more than compensate for that. This is not to say, however, that those countries and Brazil – and all other Latin American economies – could not grow even faster if it were not for the existing mal-functions in their investment climate, including conditions of doing business. But the truth is that policy uncertainty and macroeconomic instability were reported by firms as top constraints in more than 50% of the developing countries covered by World Bank Investment Climate Surveys (see WDR 2005, p. 46).

            It is obviously possible to have an improvement in IC while worsening conditions of doing business. Take the case of Brazil, where fiscal deficits and public debt were until recently at the heart of deep macroeconomic instability, and where those fundamental problems have been tackled with taxes featuring revenue-generating efficiency, notwithstanding their economy-wide inefficiency. Of course, such a trade-off might have been avoided or mitigated by resorting to less distortionary tax structures, but the fact of the matter is that macroeconomic instability in Brazil would not have diminished substantially without the fiscal primary surpluses displayed from 1999 onwards.

            The weight and relevance of IC components other than macro instability and policy uncertainty rise as the latter cease to be the most binding investment constraints. Naturally, tax reform and review of public expenditures will have to be at the core of any reform agenda for the future in the case of Brazil.

            How to use the index of ease of doing business

            Let us go back to the index of ease of doing business which, as noted by Nouriel, has sparked a process of naming and shaming countries with a poor ranking and thereby raised the interest of policy-makers on corresponding reforms. In fact, Mexico and Brazil, with World Bank assistance, are developing doing-business indicators at local levels (municipalities, states), in order to stimulate a competition and a race to the top in terms of ease of doing business within their territories.

            Notwithstanding the benefits of such a healthy competition, one should keep in mind some caveats about the economy-wide index – as it usually happens with such a type of aggregate indicator. It is built as a simple arithmetic average of the rankings obtained by a country in the ten specific rankings listed as the items of Doing Business in the Table above. However, the degrees of relevance to be attributed among those ten dimensions of doing business do not tend to be equal. It is hard to imagine that the time and costs of opening a firm have the same consequences as the unease of enforcing contracts or accessing credit.

            On top of that simplification, there is the fact that those degrees of relevance will change from place to place, and over time. If too much stress is dedicated solely on the naming and shaming at the economy-wide level, one might even introduce a perverse-incentive effect, namely the stimulus for short-term-oriented policy-makers to prioritize reforms easier to be done, boosting the economy’s ranking more rapidly, rather than dedicate scarce political capital and human-resources to reforms with a higher marginal contribution in terms of productivity and growth.

            Bottomline

·        We should not lose sight of the broader IC, instead of focusing solely on the narrower measurement of costs of doing business.

·        Investment climate has acquired top relevance as a key to higher growth in Latin America and other developing regions.

·        As far as microeconomic reforms are concerned, the components of IC, including the ease of doing business, should be assessed on an individual basis, ordered in a hierarchy, and submitted to an optimum-sequencing analysis.

            To finalize, let me say something out of the current context. Systems of National Accounts as we know them nowadays sprang out of John Maynard Keynes’s macroeconomic outline in the General Theory, after a nitty-gritty hard work was made in a collective effort in which the World Bank had a leading role. Maybe, as Michael Klein from the World Bank has recently said, the current work on IC and Doing Business might yield in the future a similar measurement capacity to institutional economics.

4 Responses to "Investment Climate and Microeconomic Reforms"

  1. Bruno Saraiva   May 23, 2007 at 9:58 am

    While the ranking stemming from investment climate (and “doing business”) indicators should be taken with extreme caution, they could certainly help in shaping a growth reform agenda. However, that purpose would be better served by the refinement of the qualitative nature of the information, an issue that was only touched in passing by Otaviano’s posting. It’s been already emphasized that the importance of IC constraints varies substantially among countries and regions, as well as over time. One can also expect that IC constraints would impinge differently on diverse sectors, therefore having distinct impacts on income/wealth distribution and innovation and productivity. It seems to me that instead of pursuing more comparability and the improvement of the ranking device, something which would be related to the suggested overambitious “project” of an institutional system of accounts, research on this area should focus on the channels and the asymmetries (social, sectoral, etc.) of the IC constraints to provide more sensible guidance (basic disaggregated cost/benefit and analytical elements) for policy makers to design and implement reform agendas. The Carlin & Seabright paper presented earlier this month at the World Bank ABCDE and targeted to the “perplexed policymaker” (in view of the vast and confusing literature on business climate and development) suggests a “Doctor’s” approach, using a diversity of sources to reach a diagnosis and indicate a treatment. Might sound a little bit like a Columbus’ egg, but surely a well crafted and very much welcome one.

  2. Otaviano Canuto   May 23, 2007 at 4:16 pm

    Point taken! Hope or enthusiasm with moving forward in developing comparable quantitative indicators regarding Investment Climate should not lead us to any kind of “index mania” and thereby overlook the necessity of country-specific diagnosis.

  3. Per Kurowski   May 30, 2007 at 6:04 am

    It is not necessarily the gross amount of existing doing business obstacles that might affect the investment climate, but more so their net societal result. If the government pays back the cost of the hassle with some commeasurable reasonable services, then there might be few objections, but when many of the hurdles are raised for no good reason at all, then of course it all just breaks down.  For instance let us talk of one of the neo-world’s reasons for hurdles namely the need to combat money laundering. No doubt that if such initiatives help to keep criminality out of the way then a substantial part of the formal economy will be appreciative and prosper. If those regulations are not effective and instead just pose useless hurdles then, as mention by Uriarte, they will only help to drive out the good formal players.  Let us never forget that for the society the expected by product of doing business needs also to include avoiding doing the wrong business.  Let us never forget that what we really want our Doing Business reports to measure is Doing Responsible Business and the distinction is not always kep sufficiently clear.  As a prime example we should never be measuring the days required for starting up any company in isolation from what we really need the companies to comply with before we really would like to want them to start operations. And I guess this is what Canuto is really hinting at when at the “Bottomline” he says “We should not lose sight of the broader IC, instead of focusing solely on the narrower measurement of costs of doing business”.  In summary we need to make formality better business and informality less so. That is the only market signal that counts.  On a side line I want to bring your attention to IFC’s recently published Municipality Scorecard 2007 and that in my opinion opens up a very fertile area, with its bottom up approach. In fact if we in Latin America could make sure that our local authorities were selected better that could be the most expedite way of assuring the good quality of any central governments. Many countries has so many municipalities that for most voters it is virtually impossible for them to determine with respect to their local authorities whether they should be thrown out because they are bad or whether you should count your blessings since they could be so much worse. At this moment the “Scorecard” relates only to some practical business aspects such as the issuing of operating licenses and construction permits but we could easily see the benefits of expanding its general reach and coverage.

  4. I Job Asia   August 29, 2012 at 9:52 am

    Insightful post. I like how you take the case of Brazil's macroeconomic instability that improvement in IC can worsen conditions of doing business.