Morales is the Senior Policy Analyst of Action for Economic Reforms. This piece was published in the Yellow Pad column of Business World, 26 July 2004 edition.

The latest buzzword in the multilateral agency scene, particularly the
World Bank, is “investment climate.” In March 2001, then Chief
Economist of the Bank, Nicholas Stern, identified the task of improving
investment climate as “the central challenge in reaping benefits from
globalization.” By the next year, the Bank, through its Private Sector
Development Strategy program, embarked on surveys and assessments of
investment climate conditions in most countries. Today, the World Bank
is set to release the World Development Report 2005, (WDR2005)
preliminarily entitled “A Better Investment Climate – For Everyone,” by
September 2004.

History shows that buzzwords, especially when they develop in affluent
donor circles, eventually evolve into central themes of focus of
research, and subsequently into policy work. Globalization and
openness, institutions, and governance are but a few of the more recent
examples of this evolution. In other words, buzzwords usually become
identified as X-factors, or those which are identified to be
bottlenecks or constraints to the process of development. The
simplicity in logic appeals to those who believe in the monocausality
of underdevelopment, that is, the belief that “underdevelopment is due
to constraint X; loosen X, and development will be the inevitable
result.” It is thus significant to understand what investment climate
really means, and to monitor towards which directions policies may go.

In the draft of the WDR2005, investment climate as the World Bank uses
it refers to the institutional, policy, and regulatory environment in
which firms operate. It refers to the location-specific factors that
shape the opportunities and incentives for firms to invest
productively, create jobs, and expand. David Dollar, Mary
Hallward-Driemeier, and Taye Mengistae, three economists who have done
much work on this topic, use the analogy of sowing and reaping, saying
that investment climate is that which dictates whether returns on
potential investments are low and uncertain, perhaps due to regulations
on the expropriation of multinational firm profits or perhaps to a high
risk of diversion of the returns to their investments, or if these
returns will be at levels acceptable to investors. Moreover, investment
climate encompasses three broad categories of factors that have long
been acknowledged to be of importance to business decision-makers,
namely:

  • Macroeconomic and country-level matters, such as fiscal, monetary, exchange rate policies, and political stability
  • Governance and institutions, including bureaucratic harassment, and the financial and legal systems
  • Infrastructure necessary for productive investment, including transportation, electricity and communication.

The concept therefore is closely related to other concepts in the
economics literature, such as “high-quality institutions,” “social
infrastructure,” and “governance.” The main hypothesis that they want
to test is that variations in “investment climate” across locations can
explain much of the variation in growth rates of economies within the
developing world.

What is of primary significance is that in its effort to assess
investment climates across the globe, the World Bank has employed the
use of firm-level survey instrument and has gathered firm-level data,
instead of simply looking for national level aggregate data. In other
words, by going down to the firm level, the survey instrument is able
to look at the actual impact on the firm’s production and cost
efficiency of deficiencies in infrastructure provision, policy
implementation, and even institutional efficiency. Some examples of
questions asked are:

* On the costliness of bureaucratic regulation and
corruption: How much management time is spent either discussing or
adapting to new regulation? As a percentage of sales, how much do
informal payments cost?
* On access to appropriate infrastructure: As a
percentage of sales, how much do power losses cost the company? Does
the firm have its own well or generator?
* On access to international and resource markets:
how long does it take for goods to clear customs? Do you have a bank
loan or an overdraft facility?

The surveys were then conducted across a good sample of countries in
various continents, and were stratified according to location within
one country (so as to measure the effect of differences in local
government regulation) and then according to sub-sector (so as to check
for the possibility that certain factors may impact firms in one sector
of the economy more than others). Size of the firm and its form of
ownership are also taken into account. Because of these
characteristics, the data garnered from these surveys is a treasure
trove not only for researchers, but more importantly for policymakers.

What are the preliminary results? In pilot assessments of the
investment climate in several countries, many traditionally accepted
notions of “investor-friendly” policies have been confirmed by the
firm-level data. For example, firm performance in China was positively
correlated to investments in research and development, the share of the
firm’s labor force that receives training from the firm, and access to
financial markets, while time spent with regulators was negatively
correlated with firm productivity. In India, where sub-national
governments are given much leeway in defining their own state policies,
regional gaps in overall business productivity are largely explained by
inter-state disparities in labor market flexibility, the burden of
industrial regulation in other areas, the power supply and
telecommunications infrastructure. Bangladeshi firms have been found to
have serious problems with the country’s infrastructure, governance and
corruption, and access to finance.

More than confirming long-standing notions of “investor-friendly
climate” however, there are other lessons that may be derived from
these surveys that can inform policy as to how we can encourage
investment and still pursue other societal objectives. The WDR2005
Draft is quick to extensively enumerate the seeming confirmation of the
soundness of policies which they have long advocated. After all,
infrastructure, good governance, and access to markets via
liberalization are all standard ingredients in the World Bank’s Poverty
Reduction Strategy Papers. Private sector fundamentalists and market
ideologues will be delighted that access to markets of private firms is
almost always directly correlated with higher firm productivity. But
looking at the problem of underdevelopment more broadly, in other words
acknowledging that the problem of underdevelopment is not simply a
problem of low growth due largely to low investment, and therefore its
remedies may not be solely limited to growth-enhancement, one finds
that the data may be saying much more than what some are willing to
hear.

This brings us to one of the major difficulties of the Draft WDR2005:
its tendency to lapse into a framework that subscribes to the faith
that growth is enough for the poor. This framework relies on the
assumption that investments bring about economic growth, and this
growth in turn results in poverty reduction. However, many
theoreticians, policymakers, and development practitioners can attest
to the fact that there are various types of economic growth, and not
all result in poverty reduction. For example, a growth that is largely
driven by asset bubbles and speculation will not have the same
developmental impact as compared to one that is driven by
labor-intensive industries like manufacturing, or the so-called
pro-poor growth. Work in this area suggests that a bias for poorer
sections of the population must be deliberately fostered so as to
ensure that the benefits of growth accrue mainly to the poor.

If one then keeps in mind that for development to ensue, one needs to
pursue a particular type of growth, what are the things that one should
look for in the firm-level data on investment climate?

One must first keep in mind that investment climate refers to no single
policy or structural characteristic of the economy. It is a confluence
of factors affecting business, an overall picture made up of sectoral
policies and conditions. As such, policymakers may be able to resort to
policies that may be deemed “unfriendly” to business in pursuit of
other societal goals (e.g. technology transfer requirements) for as
long as the overall picture is still tenable. In other words, one need
not pursue “investor-friendly” policies in every single sector. What is
important is to have the proper mix of policies to ensure not just that
investors are able to reap the benefits of their business but also the
realization of other socio-economic objectives such as human capital
build-up, employment generation, and even employment quality.

The firm-level data can inform us regarding investor preferences as to
which areas of business conduct are most dear to them and which can be
sacrificed. The economic mainstream has long asserted that investors
are attracted to economies with scant regulation (which is usually
assumed to translate into low corruption), a generous degree of labor
market flexibility, and free access to credit markets. However, the
revisionist accounts of the East Asian miracle economies argue that in
moderate degrees, firms are quite tolerant of regulations across many
areas of business conduct. China is a perfect current-day example of
this argument. In spite of heavy regulation on firm conduct and huge
bureaucratic regulatory burden, the firms in China are staying put;
nay, they are flourishing. This tells us then that there are other
factors that convince these firms that the cost of heavy regulation in
China is more than offset by, among others, its efficiency in
infrastructure provision.

Furthermore, businesses and investors across firm size, nature of work,
and even location are idiosyncratically affected by investment climate,
and this is something that World Bank also recognizes. If one however
again departs from the mainstream notion that all investments are
equally good in character, and recognizes that some activities are
better than others, we can then ask the question “which investors
prefer what?” Many multilateral agencies and conservatives dismiss the
efficacy of selective and targeted policies geared towards encouraging
certain business activities, saying that this is an avenue for
rent-seeking and corruption. Again, however, the East Asian miracle is
testimony to the viability and usefulness of such policies. South Korea
is now one of the largest producers of steel in the world, thanks to
the concerted effort of the government to promote this sector. There
are admittedly dangers to such kinds of policies, but their efficacy is
something that cannot and should not be so easily written off.

And so, one may ask, “What kinds of businesses are attracted by the
huge tax incentives being given by governments in Asia, prompting many
to be concerned about a so-called race-to-the-bottom?” Preliminary
studies show that in fact, tax incentives attract footloose industries,
or those which can easily transfer to other locations once the tax
incentives are removed. These are also the industries that find no
incentive to invest in human capital or show no concern for an
economy’s long-term goals. Knowing which investors prefer what may be
very helpful for developing countries to map out their policies
alongside the development path which they wish to pursue.

The authors of the various investment climate assessments readily point
out that there is much else that we can learn from the data. For sure,
there is much more that we can learn from these firm-level survey data.
As the case is for many however, the answers heavily depend on how we
ask the questions. The concept of investment climate may offer us more
lessons rather than affirmations of commonly held notions and beliefs.