I. Introduction II. The Importance of the Private Sector in Third World Development III. Nature of the Challenge to the Development of Market Economies in LDCs IV. A.I.D. Policy to Meet the Challenge V. Specific Components of the A.I.D. Policy VI. The Responsibilities of Missions and Regional Bureaus ANNEX A Wednesday, 11-Jul-2001 16:54:12 EDT

The following specific policy guidance reflects A.I.D.'s experience in designing, reviewing and implementing project and non-project activities in support of private enterprise development. A specific mission program to carry out this policy will depend on the policy, institutional and legal conditions which prevail in the country. Therefore, this policy paper will not set specific Agency program priorities indicating which A.I.D. supported activity should take precedence. These decisions are to be made at the mission strategy, program and project levels.

A. Agency Target Group

The FAA states in Section 101 and 102 that one of the four principal goals of U.S. foreign economic assistance is "...the alleviation of the worst physical manifestations of poverty among the world's poor majority...". It further declares "...that the principal purpose of the United States bilateral development assistance is to help the poor majority of people in developing countries to participate in a process of equitable growth through productive work and to influence decisions that shape their lives, with the goal of increasing their incomes and their access to public services which will enable them to satisfy their basic needs and lead lives of decency, dignity, and hope." Projects which implement A.I.D.'s private enterprise policy should clearly demonstrate the linkages between the activity which is to occur on the project and progress toward this primary FAA objective.

B. Policy Dialogue

1. Before entering into discussions with the host country representatives on specific project activities, missions should have a firm knowledge of the macroeconomic policy environment including the overall development strategy of the host country and how this affects the emergence or operation of the LDC's private sector. The mission's program should concentrate on macroeconomic or sector policies as appropriate in the specific country circumstance. Efforts to reform policies considered subsidiary to the country's development strategy more likely will be successful when the overall strategy is complementary (or not an impediment) to the reform of these subsidiary policies. However, pursuit of a policy dialogue within a specific sector may be a valuable way to help LDCs overcome political difficulties associated with macroeconomic reforms. "Experimental" reforms within a sector may be more politically palatable to the LDC and may become a model to be applied to other sectors and the economy at large. From our experience, the policies most damaging to the indigenous private sector are those discussed in Section III above.

2. Project and non-project assistance which is primarily aimed at reforming policy should include complementary actions which institutionalize the reforms in the form of revised laws, regulations, or procedures. In addition, projects should seek to institutionalize the capacity to carry out policy analysis to support continued reforms.

3. Each project which provides assistance to stimulate specific activity within the indigenous private sector must recognize the policy environment and its effects on the outcome of the project. Insofar as the policy environment is not conducive to sustaining the outcome of a proposed project after the A.I.D. resources have been expended, the mission should not proceed with the final design of the project until it can demonstrate that the appropriate policy reform will take place when it is needed. Such reform may be undertaken by the host country as part of the project design or implementation effort (learn-by-doing approach) or it may result from other A.I.D. or other donor activities. However, the project documentation must show that there is a reasonable expectation that the appropriate policy reforms will occur.

4. A.I.D. believes that the operation of the heterogeneous, dynamic and largely unregulated informal economy provides a powerful argument in favor of eliminating uneconomic controls on the formal economy. In countries amenable to policy dialogue and related reforms, direct A.I.D. assistance to enhance the importance of the informal economy is a valuable complementary program to policy dialogue with the LDCs governments. In countries which are reluctant to discuss policy, assistance to productive activities carried out in the informal private sector may be the only effective way to stimulate broad-based growth and development-such assistance is, in any case, highly cost effective in terms of meeting A.I.D.'s mandated target group who are found in great numbers in this labor-intensive, capital-saving sector. A.I.D. has a strong interest in programs which support the informal private sector.

C. Legal and Regulatory Constraints

The expansion and efficiency of the private sector depends upon a supportive legal structure and a positive regulatory environment. The existence of an adequate structure of property rights-including patent and copyright law, contract law and judicial arrangements which facilitate adjudication are essential.

1. Each project which provides assistance to the indigenous private sector must describe and analyze the relevant legal and regulatory structure which affects the outcome of the project. The project must also show how changes in this structure will occur as necessary for the project to achieve its purpose.

2. It may be that individual country circumstances will require a significant institutional development effort to build appropriate legal and regulatory institutions conducive to private enterprise. Specific projects or sub-project activities which provide assistance for studies or advisory services to review or reform legal and regulatory barriers, are encouraged.

D. Assistance to the LDC's Private Sector

A.I.D.'s purpose in these policies covering assistance to the indigenous private sector, is to stress management improvement and technology transfer through advisory services and training. In addition, A.I.D. believes it is essential to avoid creating fictitious (non-market) conditions for the indigenous private sector through the offering of highly concessional terms for A.I.D. financial capital. A.I.D.'s highly concessional terms will not be the cost of capital required by the indigenous private sector to sustain and expand production and services. Consequently, A.I.D. agreement to highly concessional terms postpones the need for the recipient firm to manage its resource's and make its decisions on the basis of market forces. It also relieves pressures to institute essential reforms in financial markets such as the introduction of positive interest rates for savings and lending. Finally, concessionality is, in essence, a grant of capital to the owners of equity of the firm and, therefore, generally an inappropriate use of U.S. funds.

1. A.I.D. resources should be channeled through the private sector rather than the public sector, when host country conditions make this possible. In many cases, it may be feasible to contract with a private sector firm to provide what might have been provided through a government ministry.

2. Recognizing that concessional assistance to a private sector firm is, in essence, a grant of capital to the owners of equity of the firm, its appropriateness must be based upon the unusual innovations or developmental risk assumed. That is, the loan or grant must be based on the externalities of the project which go beyond the business itself (examples: development of a new, easily replicable technology, introduction and marketing of new services, etc.).

3. If an indigenous private enterprise is to receive and manage A.I.D. resources to accomplish a specific development objective, and several LDC firms are capable of carrying out the activities, the firm to be used should be selected by an appropriate competitive process or evaluation.

4. A.I.D. may use grants or loans with concessional terms to finance direct training of and technical assistance to LDC private enterprises. Concessional assistance is particularly useful when:
   1. Training and technical assistance has as its direct objective the improvement of competition in the industry.

   2. New technology is transferred to the country. In this case A.I.D. should take care that its use of concessionary finance is proportionate to the transfer of technology (not the normal commercial risk) and does not hurt the marketing of such new technology by the U.S. private sector through normal commercial channels.

5. A.I.D. will not take an equity position in a private enterprise. However, long term or subordinated debt or convertible debentures may be permitted where it is appropriate that A.I.D. share in the risk or the growth of a new operation.

6. A.I.D.'s provision of financial capital to an LDC private enterprise will be subject to the following conditions:
   1. When its purpose is to provide financial capital to a financial institution so that it can increase its current on-lending to a specific A.I.D. target group: In this case A.I.D.'s resources should be channelled only to development activities which are 1) consistent with A.I.D.'s country development strategy and 2) unable to attract the full amount of required financial capital from commercial sources. A.I.D. is willing to assume the risks associated with a country's political or economic situation, which maybe impairing institutional access to commercial credit.

      The on-lending of the financial institution to the A.I.D. target group should be at LDC market determined terms (interest and repayment period). If interest rates or repayment periods are artificially set by the government, the rates agreed to under A.I.D. projects should be part of a planned effort to achieve market terms in the LDC's capital market. As a minimum, it should be at positive rates to prevent decapitalization and economic misallocation of resources.

      In situations in which foreign exchange risks make it inappropriate for private borrowers to assume a dollar debt, A.I.D.'s financing may be passed through a host country's government entity (e.g. central bank), the discount rate charged to the financial institution by the government entity should reflect the real cost of capital within the LDC.

      A.I.D. funds provided to financial institutions should avoid introducing government ministries or parastatals into the on-lending approval process where such involvement does not now exist. Furthermore, such projects should seek to extract government ministries and parastatals from the process if they are now so involved.

   2. When its purpose is to initiate an entirely new venture or activity in the LDC's private sector to reach a target group previously not served. In this case, concessionality may be warranted to finance the extraordinary start-up costs associated with introducing the new venture or activity. (Extraordinary costs are costs which would not be incurred by subsequent investors who enter the market on the basis of the success of the initial enterprise.) In this case, the concessionality may be linked to project components such as advisory services and training. Concessionality may also be warranted to finance special costs arising from the newness of the venture or the requirement of direct benefit to a specific AID target group. These special costs could include the need to hedge certain risks and provide for normal profit. In developing such projects, Missions are encouraged to consider alternative methods of providing concessionality in order to avoid distorting sound business management practices which may follow from the offer of up-front concessionality as a hedge against losses.

   3. Detailed guidance on A.I.D. Loan Terms will be provided in a forthcoming Policy Determination.

E. Private Sector Participation in the Provision of Traditional Government Services

A.I.D. encourages an expanded role for the private sector in delivery of services and supports the development of a multiplicity of channels for services. The private sector is an important factor in allowing consumers to have truly free choice and A.I.D. will continue to support its growth.

1. With regard to population, the flexibility and innovativeness of the private sector, both voluntary and for-profit, are a vital component of an effective system for the distribution of contraceptives. Where supplies are sold through the commercial market, either at full price or at subsidized prices, cost recovery can be maximized and dependence on external sources of support is decreased. In many developing countries, there is not a nationwide government structure for the delivery of services. But in almost all towns there are market outlets through which contraceptives can be sold along with other common commodities. AID support for social marketing of contraceptives has expanded proportionally more than any other type of delivery system over the last few years, and we will continue to support such programs.

2. With regard to improving health care, a variety of opportunities should be pursued to harness private resources. First, private funds (i.e., client fees or payments in other forms) should be encouraged to pay for services for which there is existing demand. Fees-for-service, fees for drugs, and prepaid cooperative or insurance schemes have been implemented successfully in different settings. Second, private channels (radio, advertising media) can be used to stimulate demand for services. Third, private sources can be used to manufacture drugs and medical supplies, and private channels employed for their distribution, thereby eliminating costly and inefficient duplication between public and private sources.

3. In education, A.I.D. encourages the diversification of school providers so that parents have a choice in determining the type and quality of their children's education. For many LDC's this implies an expansion of private education and community based schools. A.I.D. supports a shifting of more costs of education to the private account, particularly at the higher levels of education. Finally, A.I.D. assistance should engage the private sector in a wide variety of schooling related services from construction of facilities to the provision of instructional materials.

4. In agriculture, A.I.D. supports a substantial transfer of responsibility to competitive markets and private enterprises. In particular, the market should have primary responsibility for determining the price of agricultural commodities and inputs. Similarly, the private sector should have principal responsibility for the provision of agricultural inputs and credit. For example, irrigation offers opportunities for an expanded private sector role in activities such as on-farm development and systems design. In addition, A.I.D. should seek creative ways to increase the involvement of the private sector in traditional government programs such as agricultural research and extension. In particular, A.I.D. encourages the development of new arrangements between input suppliers, farmers and marketing firms such as "contract" or "satellite" farming.

5. In energy, A.I.D. encourages private sector development of fossil fuel resources where there is a potential for equity investment or for private operation and management. Energy conservation activities should tap private engineering capabilities rather than government owned or controlled organizations. For renewable resource development, especially for applications for rural development, the private sector should be viewed as the primary dissemination mechanism for providing new technologies for cooking, heating, irrigation, mechanical power and lighting.

6. A.I.D. supports programs to involve the private sector in a wide variety of public service activities through such techniques as contracting for management, operation and maintenance of facilities. This is particularly important in the transportation sector.

F. Parastatals and Government Authorized Monopolies

1. A.I.D. assistance to or through a parastatal should be given in the context of exposing the parastatal to market forces and scheduled divestiture of the government interest. This objective is more likely to be achieved through an evolutionary process rather than as a result of an A.I.D. insistence on the immediate and complete divestiture by sale to the private sector. A.I.D. resources should start a policy dialogue which initiates the process even if there is no initial commitment from the LDC on eventual divestiture. AID resources should assist the process as LDCs indicate interest in reducing the financial and management burden accompanying state ownership of companies. The experience of a number of LDCs which have divested parastatals suggests that measures to improve the management and operational efficiency of a parastatal has helped the divestiture process. A.I.D. projects designed to improve parastatal performance must have identifiable benchmarks upon which substantive progress towards divestiture can be measured. However, the burden of proof rests squarely with Missions proposing such activities to demonstrate that the proposal can achieve meaningful objectives, and that the selected benchmarks represent substantive evolutionary progress in moving the parastatal towards market-based operations and divestiture.

2. A.I.D. encourages the introduction of employee stock ownership plans (ESOPs) as a method of transferring a parastatal to private ownership.

3. In assisting an LDC through the divestiture process, A.I.D. should explicitly consider the consequences to the parastatal's employees of transferring all or part of the parastatal's activities to the private sector. In this regard A.I.D. resources could be used to assist those employees who may be adversely effected by the firm's transition from state to private ownership by job retraining or job placement assistance.

G. Capital Saving Technology

Decisions on what technologies are promoted by A.I.D.'s private sector related activities should be based on a rational assessment of the particular economic and financial circumstances in which the specific private sector effort is taking place. Where appropriate in terms of capital and labor availability, capital saving technology should be encouraged.

Capital saving technologies of interest include tools, production processes and delivery systems. Capital saving technologies should in general have the following characteristics: (1) they should be compatible with the local cultural, economic, environmental, political and social context in which they are imbedded and in which they interact; (2) they should involve the local community or be otherwise physically and financially accessible to the poor; (3) They should be able to be maintained and repaired by relying on locally available labor skills, spare parts and organizational capacity; (4) They should be widely replicable; and (5) they should be economically efficient. Generating employment and increasing income for the poor is a fundamental objective of AID's development efforts. Accordingly, a project which uses more local labor and less capital goods without substantially increasing project costs or entailing a loss in output quality is to be preferred to alternative projects with a more capital intensive nature.

H. Training Activities

A.I.D. should promote and assist in training LDC indigenous entrepreneurs in business related topics. Such training could range from very short training sessions for small, independent entrepreneurs in both the formal and informal private sector, to more substantial efforts utilizing participant training and advisory services. A.I.D. will encourage public and private efforts to develop the human resources of the host country consistent with our policies as stated in the Basic Education and Training Policy Paper and the Participant Training Policy Determination. This is especially important in countries with low literacy rates.

I. Infrastructure

The infrastructure systems most relevant to improving competitive markets and private enterprise are reliable power, transport and communications.

A.I.D. is willing to assist in the development of these facilities under the following terms:

• A.I.D.'s first priority is the provision of technical assistance and training toward institutional development defined as improved management so that services are reliable, well maintained and managed in a businesslike manner in terms of cost recovery and capital growth.

• A.I.D. is willing to cooperate with other donors in parallel efforts to improve these types of infrastructure. However, where possible, A.I.D.'s involvement should be focused on the institutional development aspects of the project rather than the finance of capital development.

• When budgets permit, A.I.D. is willing to finance capital costs of infrastructure systems when it can be demonstrated that such finance is an essential complement to the institutional development objective and no other funds are available. However, the long-term financing of infrastructure is a matter of critical concern to A.I.D. Where possible, the costs of infrastructure (particularly operation and maintenance) should be covered by user fees. Where infrastructure is provided as a public good such that user fees cannot be introduced, costs must be recovered through some other mechanisms such as the use of community funds, special assessments or general tax revenue. Where charges or other revenue sources do not cover the cost of at least maintaining the infrastructure, A.I.D. will not, in general, support a major investment in infrastructure.

J. Research and Studies

A.I.D. is willing to assist in research and studies which provide a better understanding of the importance of competitive markets and private entrepreneurship to LDC policy makers. Such research and studies should be results oriented in support of policy dialogue. These activities could be carried out with direct A.I.D. sponsorship or by building up the capability of host country institutions to carry out such research and studies.