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

Greater reliance on competitive markets in LDCs and the growth of indigenous private enterprises are constrained by policy, administrative and developmental impediments. This section focuses on often encountered constraints.

A. Constraints Established by Government Policy

1. The LDCs' Strategy for Economic Development

Government determines the direction of development by establishing the overall development policy environment and a particular strategy. From these government determinations flow the sector policies and regulations which govern the day-to-day activities of the economy. The success of A.I.D. and other donor efforts to support reform of sector policies and government procedures through individual project efforts may not meet expectations if the country's strategy for economic development is not compatible with proposed-reforms.

Many LDCs enunciate their overall strategy in their published development plans. But this is not always the case. In fact, development plans sometimes mask real priorities with rhetoric designed to appeal to donors. Efforts to introduce market pricing and producer competition in an LDC committed to socialism and central economic management will not yield the desired results. However, A.I.D. is more often confronted with less severe strategies which also may involve a strong element of central control of the economy by government. In particular, an LDC with a strategy of general import substitution may be reluctant to expose its domestic market to imports even though this may be a policy reform essential for long run, broad-based economic growth. A country whose fundamental development strategy is to achieve food grain self-sufficiency also may not be receptive to policy changes which stress its comparative advantages in other products and its ability to more cheaply satisfy its food requirements through international trade.

The results of general import substitution policies have largely been contrary to the LDCs' expectations.¹ They have entailed serious resource misallocations, have not reduced the dependency on imports (although they may have changed their composition) and have inhibited export growth. As a consequence, foreign exchange constraints and dependency on external resources have been aggravated, not improved, and growth potential has been adversely affected.² In contrast, export oriented strategies have given rise to a variety of LDC success stories.³ Overall, countries that have adopted measures which have let their private sectors aggressively pursue opportunities to export have done relatively well in terms of growth and improvement in living standards. The exports may have been products of indigenous resources (agriculture surplus, natural resources, etc.), or value added to imports. Export oriented strategies have proven their value in promoting economic growth because LDC domestic demand is usually neither sufficient to support the number or sizes of domestic production units required for healthy competition in many product markets, nor sufficient to achieve full employment. Consequently, A.I.D. encourages a shift from policies which promote general import substitution to policies which open an economy to international trade.⁴

The transition to an export oriented strategy and A.I.D.'s involvement in it must, however, take cognizance of two basic issues. First, the obstacles to economic liberalization are substantial. Many LDCs have conceptualized their form of import substitution strategy in terms of national security objectives and are reluctant to consider alternatives. In most cases the most sensible (and feasible) approach to assisting an LDC reorient its overall strategy involves the gradual dismantling of controls and price distorting policies first in those areas where success is most likely and change is least threatening to the LDC's perceived national security objectives.

Second, import substitution is not bad per se. Efforts that do not run counter to reliance on the price mechanism and which seek to exploit productive activities in which a country has a real competitive potential are sound.

Thus, A.I.D. believes it is critical to focus on the development scheme of the government, to assure that its effects are known and weighed. It is also critical to determine the real motives behind what otherwise appear to be poor economic choices in the management of an LDC economy. Finally, in cases in which an LDC is reluctant to modify its overall strategy, there still may be significant scope for private sector activity and use of market prices. A key objective of A.I.D.'s strategy is to promote, through the policy dialogue associated with U.S. assistance, a greater reliance on market determined prices and the initiative of the private sector.

Government Policies and Regulations Derived from Its Development Strategy

A country's fundamental strategy gives rise to policies and regulations through which that strategy is implemented. The economies of many LDCs are burdened with diverse policies and regulations which seriously impede enhancement of the private sector's role because, as previously explained, many LDCs have until very recently followed development strategies which involve import substitution and public sector control of the economy. This section describes frequently encountered policies and regulations. In this review, it is important to be aware that there is frequently a lag between a change in an LDC's basic strategy and the subsequent change in sector policies and regulations which were derived from it.

• Foreign exchange policies and regulations: Most LDCs do not operate an open market in foreign exchange. As a consequence, their foreign exchange rate often differs from that which would occur under free market conditions. When this difference reflects an undervaluation of foreign exchange the outcome is equivalent to a tax on exports and a subsidy on imports. This distorts factor prices in production.

  In countries that do not rely on the market for foreign exchange operations, government rules regulating banking sector activities prohibit or severely limit the buying and selling of foreign exchange except for specific (sanctioned) purposes as determined by the national planning process. Foreign exchange for essential requirements of the private sector, such as spare parts, fuel or other inputs, becomes unavailable or is rationed on political criteria, rather than priced according to the urgency and economic importance of its use. Consequently, the buying and selling of foreign exchange by private firms requiring non-sanctioned commodities occurs in black markets or through totally offshore transactions. The domestic private sector serving the domestic market usually operates in the black market while foreign investors conduct their foreign exchange transactions offshore. In both cases the regulations impose an extra cost on doing business. While some LDCs have allowed parallel markets to develop, the exchange rates in each market are almost always different from each other. Individuals or firms permitted to deal in the official market have a significant price advantage over those who must deal in the parallel market.

• Import and export restrictions: LDCs frequently restrict certain types of imports and exports, severely tax some goods, use non-market mechanisms to allocate other imports and establish a large number of procedures for import and export transactions. On the import side, most LDCs require businesses to obtain licenses prior to importing needed commodities. The issuance or denial of these licenses is the mechanism by which the government substitutes political control for the economic judgments of the market place. Licenses are also used to help ration undervalued foreign exchange. On the export side, restrictions are imposed to artificially maintain the domestic supply of a particular good so that prices for domestic consumers may be held down. Of course, the result is also to depress the incentives and financial capability to expand supply.

• Banking restrictions: LDCs have traditionally controlled the activity of the private sector through a wide array of rules and restrictions imposed on the banking sector. Interest rate regulations frequently set less than market interest rates causing only the most risk-free loans to be made. The low lending interest rate also suppresses the interest rate on savings, which results in little institutionalized mobilization of resources. Institutional capital does not flow to the most productive uses, particularly the more dynamic and labor intensive small and medium enterprises. Rigid controls may substitute for economic considerations in determining the quantity of loanable funds which can be made available for different types of production and investment credit needs. Government imposed or permitted collateral requirements narrow the number of entrepreneurs who are eligible for institutional credit.

• Market entry restrictions: Many LDCs have erected a ponderous structure of rules and procedures related to the issuance of business licenses and the establishment of corporations. A firm can be established in a few days in a developed market economy, but it may take months or years to legally establish a firm in an LDC. Not only are a large number of steps formally required; the reality of LDC bureaucracy is that each step may require unofficial payments by the entrepreneur in order to move to the next step. Even without corruption, time is money, and long planning times impose a substantial cost which small-scale entrepreneurs lack the capital reserves to manage. Thus, there are considerable financial as well as administrative barriers to market entry.

• Limitations on investment: Many LDCs specify a level of investment which they feel is warranted in a particular industry. In some cases the specification is in the form of a limitation on the maximum size of private sector investment. Any number of entrepreneurs may enter the industry, but none can operate above a certain size. This restriction is usually made to protect a large firm which may be owned by the government and would not be able to compete with a private firm of equal size.

  Other LDCs restrict the number of firms which can operate in a specific industry. While the purpose of these restrictions is to prevent over investment in the industry, the effect is to give the lucky investors excess profits, and government personnel another opportunity to exercise discretionary authority for political or other interests through the rationing of business licenses.

• Investment promotion programs: Government may offer a package of investment incentives in order to attract entrepreneurs into activity which the government wishes to promote. This can be done without restricting investment in other industries, but often it is not. However, problems arise when the activities which are promoted follow from administrative determinations which do not reflect the country's comparative advantage in production as might be determined in an open competitive market. Funds invested in promoted industries may be funds denied to other more productive activities which have not been included in the promotion program.

• Price-fixing: Countries often set a maximum price to maintain artificially low prices for certain goods. The activity is easiest to enforce when the government operates a price-setting parastatal. However, price-fixing and related enforcement is practiced even without parastatals. The most popular items for price regulation are essential foods and agricultural inputs; however, many countries fix the price of other commodities such as shoes, clothes, batteries and liquor. Price fixing which results in higher than market prices also occurs when the number of private firms in a particular industry is limited so that a suppliers' cartel can be formed.

• Subsidies: Closely related to price-fixing are government subsidy programs. Subsidies may be offered to expand consumption or to temporarily protect particularly vulnerable groups from the cost of well advised corrections. However, they are often required to compensate for inefficiencies in production which arise because of policies which restrict private enterprise. Furthermore, perpetuation of subsidies frequently becomes a political necessity for outlasting any temporary justification.

• Labor Market Laws and Regulations: Minimum wage legislation that sets excessive levels of wages and fringe benefits, and employment rules that overly restrict hiring and firing processes act to reduce employment opportunities and favor the substitution of capital for labor. Minimum wage laws which set wages above market clearing wage rates do not reflect labor market demand and supply conditions. Either because they are set at unrealistic levels or through their effect on other wages (which change when minimum wages change), they act to push labor costs beyond the capacity of some firms. The impact of fringe benefits, which form a substantial proportion of labor costs in many LDCS, and of regulations covering hiring and separation practices, tends to further dampen demand for labor. Developing countries with a large labor surplus should ask themselves whether the economic and social costs of higher unemployment and economic dislocation are truly compensated for by the perceived political or social benefits of high minimum wage laws.

• Taxation and User Charges: LDCs depend more on indirect taxes which are relatively easy to administer (e.g. taxes on exports and imports) than on direct taxes which are more expensive to administer (e.g. income or consumption taxes). Such indirect taxes often impact primarily upon the producers of export commodities, particularly rural producers, and retard export growth. LDCs also tax in an effort to accomplish a specific social purpose, sometimes resulting in very high marginal rates being applied to high income earners and very high duties being levied on "luxury" goods. In these cases, the administration of the tax usually has serious shortcomings and tax amount of evasion is widespread. Also, taxes on income and property usually have high exemption floors. The effect of exemption floors and tax evasion is that the actual number of people or amount of property subject to the tax is very limited and inequitable; administration becomes politicized, and law abiding taxpayers in effect subsidize those who evade taxes. High rates exacerbate inequities and encourage the sheltering of income, including offshore investments. Tax policies should be reviewed, and generally revised to foster development and encourage saving and investment.

  User charges, particularly for water, sewers, power and transportation rarely cover costs, and the supply of these services must be financed in part from tax revenues.

3. Policies That Discourage Private Sector Participation In Traditional Government Programs

A variety of policies and regulations similarly discourage private sector participation in the social sectors. For example, the private sector has an important role to play in the delivery of health and family planning services in developing countries. Government resources often cannot support the provision of services for all those individuals who may want them, and some individuals may actually prefer to receive services from sources other than the government.

Governmental policies not only affect their citizens' desire for family planning services, but also this acceptability and availability of the services themselves. Private sector involvement is likely to be more consumer oriented and more likely to offer the range and mixture if product and assistance desired by the public. Moreover, and this is especially important in the family planning area, use of the private sector as a delivery mechanism increases emphasis on personal choice and responsibility and reduces dependency upon the government. The active involvement of the private sector in the delivery of family planning services may depend to some degree on government policies regulating not only the distribution and advertising of particular contraceptive methods, but also on policies which cover the organization and operations of non-governmental organizations.

Many LDC governments sustain policies whereby all government services are provided free of charge, regardless of governments' ability to finance these services and in spite of demonstrated client willingness to pay for some or many of these services. Yet, at the same time, all LDC governments lack the financial resources to provide nationwide access. The result of these policies is the underfunding of basic health services, which are often of extremely poor quality (thinly staffed and deficient in drugs and supplies) or existent more in theory than in fact. Clients are left de facto to rely on whatever private health services exist, and these services must compete with "free" (albeit inaccessible) goods.⁵ Furthermore, insistence on government provision of services has impeded the private sector from filling the health care gap. Studies in various settings have demonstrated strong consumer demand (as evidenced by willingness to pay) for quality health services provided by government and private sources.

Similarly, there is potential both for involving the private sector more fully in the provision of education and training services and inputs, and for shifting some of the costs of education from the public to the private account.

At the primary or basic schooling level there is potential for private and local organizations to play larger roles in the administration of schools. People in most LDCs are no different from people in our country. Education of one's children is a highly valued objective. In most cases, schooling at this level will continue to require some public subsidy from central revenue sources. However, most strategies of localizing and diversifying school systems require the active encouragement of private and local organizations including community self-help groups, in the provision of basic schooling (see A.I.D. Policy Paper entitled Basic Education and Technical Training).

Such organizations are also prominent in the provision of pre-school education and non-formal education or skills training for adolescents and adults. The initiative for starting and sustaining these programs tends to be private, as they tend to be additional to the government's basic education mandate. The most effective form of public support is often some form of technical support services, rather than direct subsidies.

At the secondary, vocational/technical and higher education levels there is an even stronger case for shifting more of the costs of education to the private account, either through tuition and other fees or through reliance on private organizations and employers to provide the training, perhaps supported by partial tax credits. In many countries, half or more of the education at these levels is provided privately, with little or no public subsidy other than essential technical services such as examinations administration. It is essential to keep in mind that at higher levels of education and training, the private benefits tend to equal or exceed social benefits. This is true especially where only a minor fraction of those eligible are able to benefit. Thus, excessive public subsidy of these levels and types of education and training drains resources needed for the provision of basic education and skills training with higher social benefits.

Finally, regardless of how education and training systems are administered and funded, there is great potential for the private provision of education and training inputs. For example, private contractors can often build schools and handle the printing and distribution of texts and other instructional materials at less cost, more quickly and with more attention to local demand or design requirements than can central ministries. (And not to be overlooked is the development of managerial and entrepreneurial skills which can have a multiplier effect on a society.) As school systems expand, other opportunities for privately provided services also expand, ranging from housing and transport for students and teachers to commercial media, data processing and telecommunications services.

In the agricultural sector, government policies and programs have restricted the operation of markets and entrepreneurs. Agricultural subsidies and related price controls adopted by many LDC governments in areas such as food marketing and distribution, marketing of agricultural inputs, and agricultural credit have tended to result in substantial reductions in efficiency and productivity with little or no benefit to the disadvantaged groups they are often supposed to help. Moreover, LDC governments often intervene directly in the physical distribution system for both agricultural inputs and outputs in order to enforce such controls.

While there are certain areas in the agricultural sector (such as agricultural research and extension) where government involvement is useful or essential, this involvement should permit parallel or complementary private sector activity. For example, private seed and fertilizer/pesticide companies have been important research centers in the U.S.

Finally, many LDCs maintain policies that discourage the efficient provision and maintenance of infrastructure, both in rural and urban areas. Private road maintenance, urban public transit, water supply and sanitation are examples of other areas where enhanced private participation in the provision of both services and infrastructure can produce significant efficiencies.

Performance contracting for private road maintenance is one such instance. In 1970, for example, in a very large South American country, the highway department began a contracting-out program that by mid-1981 had reduced the size of the public maintenance network by 75% and there were 264 contracts for private maintenance. Similar experience in many other countries for some 19 categories of private road maintenance activities was shown in a recent IBRD study to have resulted in an average 37 cost percent reduction in comparison to public provision of like services. In one large African country, the results were more dramatic because no maintenance had been occurring prior to private contracting.

In urban "public" transport also, the pressure for private provision has grown as a result of shifts in public attitudes and the demonstrable efficiencies that have occurred as the result of the shift from public to private provision. Until rather recently, conventional attitudes were that large public systems operating with fixed routes, large operating units and larger vehicles were more efficient than private systems. These attitudes have changed substantially as the result of careful empirical studies comparing the relative efficiency of public vs. private service in numerous large Asian and South American cities, as well as the experience with large operating deficits and poor service of the existing public systems.

The experience with private vs. public provision in the developed world and the problems of infrastructure provisions in LDCs has also led to renewed interest in private ownership as well as operating and maintenance agreements between ministries and private firms. Careful econometric studies of private water enterprises in the U.S., for example, have shown that private operating expenses were some 25 percent less than those of comparable public operations. Other studies have shown that as the result of existing patterns of public cross-subsidization in many LDCS, existing users of public systems are resistant to extending service to low-income areas even though the prices that low-income water users are currently paying substantially exceed the cost of supplying water from a central system. As a result, through private systems, with fewer cross-subsidies and appropriate pricing, higher quality central system service can often be supplied to low-income residents when it would not have been possible with a public system.

The above examples are particularly interesting in that sole public provision of infrastructure and services often has been based on theoretical justifications (e.g. natural monopoly, externalities, merit goods) set forth in annex A. However, these justifications have often proved erroneous (as is clear in the case of urban transit) and rarely justify a policy of both public finance and supply.

These erroneous justifications and rationales for public provision also characterize a wider range of other state-owned and controlled public enterprises discussed in the section to follow.

4. Government Ownership of Enterprises and the Designation of Monopoly Responsibility

The policies, regulations and programs described above are often used to support not only a specific development strategy, but also a set of government owned enterprises (parastatals) or authorized private monopolies. The rationales used to justify these enterprises are many. While the validity of a public enterprise must be judged in the context of the individual country setting, many of the original rationales underlying their establishment -- mostly having to do with self-reliance, equity objectives and the assumed inefficiency of the private market -- have been found to be erroneous.

Even today, many LDCs operate public enterprises without having to account for the real costs of operation. Revenues are rarely matched against expenses in terms of full cost recovery. Nor are they ever compared in accounting practices. During the 1970s, because markets for primary products remained reasonably buoyant and development was supported by borrowing from the private capital markets and by the introduction of new technologies, the costs of public enterprises were not an issue. However, in a number of LDCs, deceleration of development, declines in prices of primary products, and failures to adjust to the new cost of energy have led to mounting debt and foreign exchange shortages. Governments have been forced to examine the economic efficiency of current resource allocations.

The poor record of state enterprises has become a drain on scarce resources and a liability to economic growth. However, political pressures have slowed the dismantling of these institutions. Thus, the changing attitudes toward parastatals have been accompanied by interest in mechanisms short of sudden divestiture which might be used to correct their poor performance. In general, the performance of state enterprises appears to reflect the degree to which public authorities have relied on market forces to guide the activities of both public and private enterprise. Studies of the market structure in which many LDC public enterprises operate, have revealed an essentially non-competitive environment, including insulation from both foreign and domestic competition. This insulation is buttressed by wide ranging subsidies as well as tax and regulatory preferences. ⁶ Indeed, where the market has not been relied upon to allocate resources, the operation of parastatals and government authorized monopolies has resulted in considerable financial and economic costs.

This problem has been compounded by problems of multiple and unclear objectives for these firms which make it easier for public enterprise managers to excuse inefficient performance by appealing to conflicting objectives. Furthermore, in many cases these firms are subjected to short-term political pressures and interferences in day-to-day operations. If objectives are multiple and unclear or political expediency determines corporate policy, it is inherently difficult to measure and evaluate performance on any objective scale.

B. Constraints Related to Commercial and Country Risk

Certain constraints to private enterprise development can be attributed to risks associated with a country's level of development. Some stem from government action or inaction but others depend upon the resource endowment of the country. These constraints frequently include inadequate infrastructure, lack of access to technology, underdeveloped human resources, inadequate energy supplies, vulnerability to natural disasters, poor communications, rural, urban and regional disparities and other market imperfections. These constraints affect development through the availability and cost of investment funds, including insurance.

The large increases in LDC debt which occurred during the 1960's and early 1970's demonstrated that many LDCs had not faced a situation where capital was lacking. Today many LDCs still can obtain foreign capital; however, the terms have hardened considerably. Large variations exist, but the costs of foreign borrowing to LDCs are substantially higher than the costs to developed countries, and the higher costs reflect a more sober assessment of risks related to the country's level of development. These risks are viewed by lenders to be of two types -- investment risks and country risks. Their relative importance depends on the specific country in question.

1. Investment (Commercial) Risks

The first category of risks relates to the quality of the investment. Many LDCs face serious constraints which limit their ability to comprehensively design, analyze and implement public investment proposals. In embracing a significant development agenda, staff resources of LDC ministries become stretched too thin; important data may be unobtainable; and adequate management resources for implementation may not materialize. Despite potential economic gains, public investment proposals often lack the creditability needed to immediately obtain donor or commercial funds. Five year development plans contain many such investment proposals. The consequence is that donors and international lenders discount the LDC's estimated rate of return on public investments and frequently conclude that even a small investment will exceed the LDC's absorptive capacity. If elements of the proposal have merit from a donor's perspective, the donor will become extensively involved in assisting the LDC redesign the proposal before making funds available. Commercial lenders will not expend such an effort but will look elsewhere, usually to more developed countries, for investment lending.

While an LDC's national pride or its sense of urgency for development may in part explain the quality of public investment proposals, an important cause is the scarcity of trained personnel in the LDCS. In many LDCS, particularly those in the lower per capita income range, a mere handful of trained people relative to the population at large can be found to develop the public sector's investment proposals. A similarly small group of people can be found to manage effectively project implementation.

Private sector investment proposals by LDC firms may also tend to lack realism. Particularly, assessments of indigenous firms' capabilities in terms of meeting production targets, delivery schedules and quality standards may be overstated. More importantly, the success of many investments depends upon the personal relations between the local businessman and key government officials. These are subject to sudden change.

2. Country Risks

The second group of risks which have hardened the terms of capital available to LDCs are the risks associated with the political and economic instability of the country. On the political side, wars, revolutions, coups and civil disturbances will influence the cost of commercial capital and availability of donor assistance. On the economic side, fluctuation in the price and supply of LDC primary commodities has raised foreign lenders' risks.

Besides raising the interest rate of commercial capital, the risks of political and economic instability cause the lenders to reduce the repayment period. In fact, one of the most noteworthy behavior characteristics of both foreign and indigenous investors in LDCs is the extremely short time horizon expected for an investment payback.

These two risk effects have dramatically restricted investment opportunities in LDCs since rates of return must be very high to cover investment risk interest and very short payback periods (on the order of six months to one year and a half to hedge the country risk. Given this fact, there is a strong preference among foreign and indigenous investors to finance trade rather than fixed plant and equipment.

²Anne O. Krueger, Trade and Employment in Developing Countries Synthesis and Conclusions (Natural Bureau of Economic Research 1993).
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³Ibid.
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⁴This overall objective is not intended to conflict with specific statutory provisions (e.g. FAA Section 620(d)) and existing Agency policies proscribing activities that would result in direct competition with U.S. enterprise.
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⁵A.I.D. Evaluation Specific Study No. 20, "Prospects For Primary Health Care In Africa: Another Look At The Sine Saloum Rural Health Project In Senegal", April 1984, Abby L. Bloom.
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⁶See World Development Report 1983, The World Bank.
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