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CHAPTER 2
CONSTRAINTS ON
THE PRIVATE SECTOR IN
DEVELOPING COUNTRIES
D
eveloping countries have remarkable energy
and assets, and all segments of the private sector
have demonstrated the ability to respond when
empowered. But the Commission finds that three
major structural challenges confront the private sector in all developing
countries, to varying degrees.
■ Microenterprises and many small and medium enterprises operate informally.
■ Many small and medium enterprises have barriers to growth.
■ A lack of competitive pressure shields larger firms from market forces
and the need to innovate and become more productive.
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Moreover, worker rights and developing countries, exposing FIGURE 2.2 SMALL AND MEDIUM
protections in the informal sector formal entrepreneurs to even more E N T E R P R I S E S B E CO M E M O R E
I M P O R TA N T A N D I N F O R M A L I T Y
stand up poorly to those in the risks (due to more visibility) than L E S S I M P O R TA N T A S CO U N T R I E S
formal sector. And consumers— if they remained informal. B E CO M E W E A LT H I E R
able to purchase only goods of
Percentage of GDP
inappropriate quality and safety FEW COMPETITIVE
standards—do not have access to the 13
SMALL AND MEDIUM 31
greater choice and lower prices in ENTERPRISES
truly competitive consumer markets. 47
Small and medium enterprises tend
There are many constraints on to be engines of job creation— 51
entering the formal sector. The over- seedbeds for innovation and 39
arching issue is one of costs versus entrepreneurship. By providing 16
benefits for the individual entrepreneur new entry and competition, they
who has to choose between formal can boost efficiency and growth
and informal operations. and lead to economic development. 37 36
30
In most developing countries it is Indeed, recent research indicates
costly to be formal. Formal players that economic growth in poor Low Middle High
are often overtaxed (a vicious circle, countries is accompanied by a income income income
countries countries countries
since they are overtaxed because a more than proportional growth in
few formal companies carry most the share of the formal small and ■ Informal activity
of the tax weight). Registering a medium enterprise sector. In low ■ Small and medium enterprise activity
■ Remaining activity
business can be a long and expensive income countries the share of formal
proposition (in Angola it takes 146 small and medium enterprises in Source: Ayyagari, Beck, and
Demirguc-Kunt (2003)
days and more than 8 times the per employment is about 30% and in
capita income). Regulations and GDP about 17%, while in high
government requirements are income countries the shares are Rules that constrain market entry and
complex—and compliance costs about 60% and 50%. Indeed, richer expansion have a chilling effect on
high. The opportunities for bribery countries see far less informal and small and medium enterprises at the
increase with the complexity of much more small and medium expense of established larger firms.
regulations, exposing smaller players enterprise activity (figure 2.2). Small and medium enterprises
who lack the legal resources to often could compete effectively in
defend themselves. The reality in many poor countries, niche markets, but the advantages
especially in Sub-Saharan Africa, that accrue to established large
Entrepreneurs also see little benefit is that the small and medium players fend off competition from
in going formal. While formal enterprise sector is relatively the small and medium enterprise
businesses in developed countries marginal in the domestic ecosystem. sector. Without the reasonable
can raise capital by mortgaging their Why are small and medium compliance costs that exist only in a
assets, this is often not possible in enterprises not able to “graduate” fairer system of competition, small
many developing countries where to the ranks of larger companies? and medium enterprises cannot
mortgage laws are weak and banks
For this evolution to be possible, grow and become more productive.
prove reluctant to finance small
it is essential that a reasonably Ineffective or arbitrary tax laws,
players. In theory, being formal
level playing field and supporting onerous business regulations and
would facilitate selling beyond
institutional structures exist other restrictions penalize them.
geographic boundaries, but poor
local infrastructure and customs between (often larger) incumbents
abuse limit the opportunities. and (often smaller) new entrants.
And bankruptcy laws, which
protect formal players in developed
countries, are often ineffective in
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Widespread informality and the LACK OF COMPETITIVE alliance between large protected
lack of skills also affect the ability PRESSURE ON LARGE incumbents and poor people,
of entrepreneurs to scale up a COMPANIES who fear a loss of jobs in
business. While often animated competitive markets.
by innovative ideas or addressing Large companies form the hub of
networks and clusters and, by the Corruption combined with weak
untapped markets, small and
virtue of their size and range of and arbitrary legal enforcement
medium enterprises suffer from
business activities, provide the spark buttresses incumbent firms at
lower total factor productivity,
for the private sector ecosystem. the expense of potentially more
by using older technologies or
But in many developing countries competitive ones. Specifically,
employing inferior workforce
large incumbent companies can also incumbents might receive subsidies,
practices. The cost of business
stifle entrepreneurial energy and special licenses or other privileges
services is often more than small
initiative. Too often, they can take that preserve their position and
and medium enterprises can pay,
advantage of weak institutional dampen the incentive to innovate
or is not in tune with their needs.
environments to raise anticompetitive and reduce prices. Such firms may
Lower export sales from small
barriers and protect their dominant respond to perverse incentives to
and medium enterprises come
position. While local informal strip assets or dole out contracts to
in large part from lack of access
markets can often function without uncompetitive suppliers even when
to knowledge about foreign
much regulation, more mature and more efficient providers exist. The
standards of quality.
complex markets need appropriate poor domestic macro environment
Perhaps most important, small and regulations to function effectively. encourages wasteful rent-seeking and
medium enterprises lack access to retards the growth of competitive
financing and long-term capital, A dynamic financial sector, in which firms based on productivity.
the base that companies are built new entrants and incumbents can
get finance under competitive terms, These firms might also indirectly
on. High risks associated with
is also important for creating starve competitors from receiving
small and medium enterprises,
competitive pressures in the market. capital by contributing to an
whether real or perceived, exist in
But companies with a protected environment that keeps finance
the absence of financial instruments
position in these markets often underdeveloped. Large firms
that manage and diversify the risk.
have strong incentives to use their thus command the lion’s share of
Banks also face high costs or
lobbying power to slow government resources in an underdeveloped
cannot acquire information that
progress in improving the institutional financial system.
they can trust, even when small
and medium enterprises are credit- infrastructure for markets.
worthy. These factors raise interest Such practices directly hurt poor FOUNDATIONS FOR
rates and reduce lending volumes, people, through higher prices ENTREPRENEURSHIP—
setting up price and quantity and lower quality products. Poor NOT YET IN PLACE
barriers to small and medium people benefited from the opening Building a sound private sector
enterprise growth. Small and medium of competitive markets in India in requires a strong foundation in
enterprises have to resort to financing the early 1990s. Until then the the global and domestic macro
from networks of family or friends, population was effectively subsidizing environments, physical and social
from retained earnings, or from a large part of the private sector, infrastructure and rule of law
short-term credit from other small which was selling low quality (figure 2.3).
buyers or suppliers, rather than products at high prices—made
from larger institutions providing possible by controls on entry by Global macro environment
dedicated long-term financing domestic competitors and severe The foundations for growth in
vehicles for specific purposes. quotas and high tariffs on imports. the private sector start with a well-
Such anticompetitive policies are functioning global macro business
often perpetuated by an unlikely environment involving a dynamic
global economy that provides
markets, as well as adequate trade
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Maintaining high quality physical Improving the social infrastructure property rights circumscribe private
infrastructure is largely, but not and ensuring that those surviving sector behaviour. Confusing and
solely, a matter of capital investment. on the lowest incomes have access contradictory legal systems make
Efficient contracting, open bidding, to affordable and high quality formal business practices difficult
regulatory credibility and private health and education services is an and push businesses to become or
and public managerial capability important foundation for private remain informal. Poor legislation
carry weight as well. sector development. buttresses oligarchic and corrupt
firms against competitive forces,
Studies demonstrating the social The rule of law
often at the expense of small
and private returns from investments The rule of law means that
and medium enterprises. Cosy
in education and health spotlight government decisions are made
relationships between business and
their efficacy. High levels of according to a set of written laws and
regulator impair the development
investment in human capital, rules, to be followed by every citizen.
of open, free market competition.
especially in education and health, The rules are applied consistently,
The poor are likely to be the first
lay the groundwork for private administered by a professional
victims of lawlessness.
sector growth. A healthy, educated bureaucracy and adjudicated by a
workforce is a productive workforce. fair and transparent judiciary that is Even though a written set of laws
One need look only at countries adequately compensated. In nearly may exist, the legal system in many
ravaged by poor health or disease all cases, courts provide reasons for developing countries works informally.
to see the deleterious effects of their decisions based on the law, In the shift from informal to formal
an underfinanced or inadequate through some form of due process. systems, many countries have old
health infrastructure on previously Countries may subscribe to different and new systems coexisting, often in
productive economies. Private firms legal systems arising from different conflict. The loser is often the more
profit from investments in education, political and social cultures, but the formal new system, implemented in
from primary to university, from fair administration and enforcement a shallow and ineffective manner.
universal to targeted. Ensuring that of a just system of laws is a cardinal One estimate suggests that as many
such education is appropriate for a principle. Both elements matter— as 80% of the legal issues facing the
future workforce is a core task of laws and their administration. poor are addressed through customary
a well-functioning education or informal systems.
Laws form an intrinsic layer of
infrastructure. Educating women
the foundation for a robust private Corruption and confusion over the
has particularly positive effects on
sector. Without a transparent legal enforcement of rules are often to
their future earnings—and society’s.
framework and a fair judicial and blame for high compliance costs.
Investments in health and education administrative system, other efforts Bureaucratic red tape, backlogs,
involve both the public and private to foster private sector development arbitrary decisionmaking and other
sectors, and counter to conventional cannot work as intended, and may onerous requirements and inefficient
belief, many education and health even do harm. Home governments practices hamper private activity.
services in developing countries are must establish the “rules of the game”, Arbitrary or corrupt enforcement
delivered through private initiatives, a system that reduces transaction subvert laws intended as benevolent
including cooperatives and mutual costs by making them predictable protections, including laws for worker
health insurance organizations. In and enforceable. Legal and admin- safety, environmental protection
some systems 70–80% of health care istrative systems influence whether and consumer safety. And corrupt
expenditures are through private and how transactions take place. practices distort prices and markets,
actors. Often, but not always, and hinder free and fair competition.
The rule of law manifests itself in
private involvement is a response
the private sector with commercial The World Bank estimates that
to government underinvestments.
laws, customs laws and contract corruption can reduce a country’s
laws, among others. Critically, growth rate by 0.5 to 1.0 percentage
the assignment and protection of points a year. Transparency
International’s Corruption
Perception Index could, with
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very few exceptions, almost FIGURE 2.4 ENTERPRISES IN LOW INCOME COUNTRIES
be ordered by income—poorer FA C E M A N Y M O R E B U R D E N S W H E N R E G I S T E R I N G
countries are almost universally Income Number of Duration Cost (% of
rated more corrupt, though there procedures (days) GNI per capita)
is plenty of recent evidence that
corruption is not limited to lower Low and ■ Enterprises
lower 11 70 115
income categories. middle
in low and
lower middle
income
countries face
THREE PILLARS OF the longest
Upper
ENTREPRENEURSHIP— middle
11 58 29 duration and
the highest
TOO OFTEN MISSING cost (as a
percent of GNI
Even with strong macroeconomic per capita).
and institutional foundations, three High 8 42 17
additional factors are indispensable
for entrepreneurship and the private
sector to flourish in an economy: a Note: Low and lower middle-income countries had GDP per capita (purchasing power
level playing field, access to finance, parity) of less than $2,976 in 2001, upper middle-income countries were between
$2,976 and $9,205, and high income countries were above $9,205.
and knowledge and skills.
Source: World Bank (2003a)
A level playing field—
with fair rules, fairly enforced
Perhaps most important in allowing and licensing procedures raise the need to make choices about the
entrepreneurship and the private cost of entry into the formal sector products they purchase and the
sector to blossom is a level playing and tilt the playing field in many capital they allocate. Labour market
field for firms competing in the developing countries (figure 2.4). rules are critical to protecting
domestic market. That can be For example, the World Bank’s Cost employees from exploitation. But
created only by a system of rules of Doing Business survey estimates a number of developing countries
and enforcement mechanisms that that starting a business requires have excessively complex labour
is fair, trustworthy and effective. $5,531 in Angola (more than eight rules, more than wealthier countries.
Predictable rules ensure that times the per capita income) and For laying off employees, companies
entrepreneurs have open access about $28 in New Zealand (far less in middle and low income nations
to markets and can do business than 1% of the per capita income). face higher barriers on average than
efficiently. And basic trust in the Cumbersome entry regulations their counterparts in developed
system encourages entrepreneurship are directly correlated with lower economies. The mechanisms for
and attracts talent (local, foreign productivity. When countries are social dialogue to find ways of
and diaspora) to embark on ranked by ease of starting a business, mitigating the effects of layoffs,
entrepreneurial ventures. the top quartile of countries has and safety nets to protect the poor
labour productivity of about $40 are often weak or non-existent
Good rules are a critical element in per worker, almost twice that of the in most developing countries.
creating a level playing field, and bottom quartile. Longer registration Moreover, rigid employment
effective regulations are essential processes are directly associated regulations are associated with
for the market economy. Rules, if with higher levels of corruption. higher female unemployment.
excessively complex and incorrectly Note, however, that few of these
applied, can turn into significant Operating rules. Disclosure
rules are regularly enforced, making
barriers for enterprises and hamper requirements can have a positive
the case for simpler rules with
business growth. This applies to rules impact at the industry and business
for entry, operating, market and exit. environment by giving consumers
and investors the information they
Entry rules. Excessive procedural
requirements for business registration
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better enforcement. Complex tax Product market barriers also not have the skills and resources
rules and structures also impose stifle growth. Subsidies and trade they need to enforce the laws.
high costs that fall more on small barriers in the developed world They often require additional
and medium enterprises than on are the biggest culprits. But many training or tools.
large enterprises, which can afford developing countries also raise
Access to financing
tax experts. barriers to entry—say, by forbidding While foreign direct investment
small companies to distribute has had an essential role in the
Credit rules. Many countries lack
electricity in rural areas, even development process, it is impossible
rules for sharing credit information,
when state monopolies do not for a country to progress without
which makes it virtually impossible
serve those areas. domestic investment based on
for creditors to check how indebted a
potential client already is. In addition, Restrictions on pricing can also domestic savings. This requires
domestic financial institutions
creditors have limited protection in cloud the business environment.
that can efficiently manage risk
the case of default, significantly For example, many governments
and allocate capital to productive
lessening their willingness to assume charge excessively high prices for
investments. Many developing
the risks associated with small and fixed-line domestic and international
countries have had weak, state-
medium enterprise lending. telecommunications services. The dominated financial sectors unable
monopolies that operate in these to act as a catalyst for development.
Tax rules. High tax rates and
conditions are highly profitable as a But where genuine reform has been
complex tax administration is a
result, but their capital and labour implemented, the benefits have
significant constraint for small and
productivity are low. The high been quick and evident, even if
medium enterprises and can lead
prices provide few incentives for creating and restructuring an
them to the informal sector if tax
telecommunications players to use efficient domestic financial sector
burdens become excessive.
their resources more effectively. is a long task.
A large informal economy can
Exit rules. Inadequate bankruptcy Large companies are well served
mean lower government revenues
rules and protections can create by existing banking systems, and
and higher taxes for firms in the
additional hurdles for financing there has been good progress in
formal economy, creating more
enterprises. Countries with better microfinance over the last 10 years—
incentives for informal operation.
insolvency regulations tend to have with 41 million poor people served
For example, in Brazil the informal
more and cheaper lending. in more than 65 countries. But the
economy grew as tax revenues
progress on small and medium
increased from 24% of GDP in Poor enforcement by formal enterprise financing has been slow
1991 to 29% in 1999. institutions permits enterprises at best. It is not only about money
to avoid some or all of these rules, needed, though. Small and medium
Market rules. Barriers in the land
advantaging some of them over enterprises are risky ventures. They
market are high in many nations.
others. Breakdowns in formal require risk capital, but the sources
For example, it takes about 168
institutions occur when officials of such capital are difficult to tap.
steps, involving 53 public and private
do not have the skill or will to So small and medium enterprises
agencies and 13–25 years to acquire
carry out their oversight functions. generally have to turn to classic debt
“informal” land and receive legal
Government officials may not have financing. This can be difficult for
title to it in the Philippines. This
the will to enforce the laws because them, because few entrepreneurs in
arduous process discourages people
the institutions they work for do developing countries can leverage
from formally purchasing land,
not provide the right incentives. assets as collateral the way they do in
making it impossible to use land
The institutions may not reward developed countries. Why? Mainly
as collateral for getting credit, one
officials for applying the law fairly because of informal property rights
of the main sources of capital in
and equally, and the organizations and the lack of mortgage markets.
developed countries.
may lack transparency and may not Collateral requirements act as a
supervise officials sufficiently. In screen that selects wealthy borrowers
addition, government officials may and crowds out many entrepreneurs
with high growth potential.
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Most emerging markets finance up accustomed to full-blown risk It contributes directly to a firm’s
to 90% of their investments locally, assessments working with large productivity by enabling the
although for Sub-Saharan Africa clients—too costly for small adoption of innovative technologies
the figure is closer to 65% and medium enterprises. and processes. A firm’s competitive
(and most productive enterprises At the other end of the spectrum advantage comes from its
generate revenue in local currency, microfinance institutions lend with entrepreneurial capabilities;
so the reliance on local financing very limited analysis, relying mostly its management and technical
is sustainable). Private credit as a on social networks for repayment. know-how, including labour-
percentage of GDP rises from This does not work well for the management relations; and the
12% in low income countries larger amounts that small and skills, education and adaptability
to 25% in lower middle-income medium enterprises require. of its employees.
countries, 30% in upper middle- ■ A lack of reliable credit information
The level of education matters,
income countries and 85% in also hampers the growth of
and the skills of employees need to
high income countries. small and medium enterprise
be continually upgraded through
lending—usually because there
A web of factors is at work, more on-the-job training to increase the
are no credit information agencies
than just the lack of capital. firm’s productivity and its ability to
and disclosure requirements are
absorb new technologies. In Costa
■ Rules and their enforcement are weak or not enforced.
Rica, Mauritius and Singapore the
often at the core. Most countries ■ Investors lack exit opportunities.
private sector has benefited from a
have weak property rights, Capital markets are absent or
virtuous cycle with formal education
making the use of assets as highly illiquid in many poor
reinforced by on-the-job learning
collateral difficult. Even when countries, making public offerings
and training. Costa Rica has the
property rights are well defined, impossible. Private offerings
most software exports per capita
the enforcement of mortgage can work, but most markets are
in Latin America, making it a
contracts is often impossible, far from liquid, with very few
technological hub in the region,
for both political and judicial transaction opportunities.
thanks to its investments in both
reasons. In addition, bankruptcy ■ Entrepreneurs often lack the skill
basic education (producing one
laws are typically lacking, and the will for receiving risk
of the highest literacy rates) and
increasing the risk to creditors capital. On skill, management
technical education.
and further deterring them talent is limited. On will,
from investing in small and private equity investors report Many developing countries suffer
medium enterprises. the reluctance of small and from low levels of human capital
■ Poor financial institutions medium enterprises to open investment, aggravated by the
are also a problem. Domestic their books to outsiders in outward migration of highly skilled
financial institutions can operate environments where parallel professionals. The cumulative
in oligopolistic or monopolistic accounting is widespread. “brain drain” since 1990 has been
conditions, with limited share- estimated at 15% for Central
Access to skills and knowledge
holder pressure to enter new and America, 6% for Africa, 5% for
Technological innovations and the
more difficult markets, such as Asia and 3% for South America.
shift towards knowledge-based
lending to small and medium The International Organization
economies make human capital
enterprises. Added to the lack for Migration estimates that some
investment a prerequisite for
of incentives is the public 300,000 professionals from the
sustained economic growth and
borrowing that crowds out African continent live and work
central to the start-up, growth
private borrowing. in Europe and North America.
and productivity of firms. Human
■ Even when financial institutions
capital can determine the potential
have the will, they often lack
for a firm’s growth and survival.
the skills for small and medium
enterprise lending. Banks are
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