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i ~P
DEVELOPING
THE PRIVATE SECTOR
A Challenge for the
World Bank Group
--1 z THE WORLD BANK
Washington, D.C.



This volume reports the findings of the Private Sec-
tor Development Review Group, which was chaired
by J. Burke Knapp. Members drawn from the private
sector were Abdlatif Al-Hamad, Richard Debs, Jaime
Garcia-Parra, Jean-Yves Haberer, and Yoshio Tera-
sawa. Members drawn from the staff of the World
Bank Group were Richard Frank, Gautam Kaji, Ian
Newport, Judhvir Parmar, Robert Picciotto, and
Wilfried Thalwitz. The final version was written by
Douglas Gustafson, Emmanuel Jimenez, and
Johannes Linn, who drew on extensive background
work prepared by the staff of the World Bank Group.
Copyright © 1989 International Bank for Reconstruction
and Development/The World Bank
1818 H Street, NW., Washington, D.C. 20433 U.S.A.
All rights reserved
Manufactured in the United States of America
First printing April 1989
The judgments expressed in this study do not necessarily
reflect the views of the Executive Directors of the World
Bank Group or the Multilateral Investment Guarantee
Agency or the views of the governments that they
represent.



Contents
Foreword by Barber B. Conable v
Introduction viii
1. Designing a Strategy to Support Private Sector Development I
Evolving Views of the Private Sector 1
The Bank Group's Approach 3
A Strategy for Bank Group Support 5
2. Improving the Enabling Environment 7
Macroeconomic Conditions and Policies 8
Domestic Incentives 9
The Legal and Regulatory Framework  11
Public Institutions 12
The Need for a Comprehensive Framework Il
3. Providing Infrastructure and Services 16
Private Sector Development through Public Services 16
Limits to Publicly Provided Infrastructure 18
The Private Sector as a Provider of Infrastructure  19
What Can Be Done in the Future 23
4. Financing the Private Sector 25
Financial Issues 25
Development Finance Intermediaries 27
Direct Financing 31
Facilitating Flows of Foreign Capital and Know-How 33
Conclusion: The Need for Collaborative Effort 36
Appendix: Summary of Recommendations 3 7
The Enabling Environment 3 7
Supporting Services 3 7
Financial Sector Development 38
Development Finance Institutions 38
Direct Financing 39
Support for Small Entrepreneurs and Technological Development 39
Foreign Direct Investment 40
ii



I                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                I



Foreword
The balance of economic activity in most industrial    time, and there are gaps that must be filled and areas
and developing countrics has shifted dramatically    in which thc Bank's efforts need to be intensified and
over the past three decades toward greater reliance  better coordinated.
on government to provide goods and services and to  For this reason I set up the Private Sector Develop-
regulate the private sector. In recent years, however,    ment Review Group in February 1988 to propose
there has been growing recognition that the distor-    ways in which the World Bank Group can do more
tions caused by government regulations, taxes, sub-    to help its member countries strengthen the private
sidies, and budget deficits and the poor performance    sector's contribution to development, particularly in
of public enterprises place limits on the legitimate    nonagricultural activities. The Review  Group
role that governments can play in supporting devel-    brought together five distinguished members of the
opment. In fact, private sector initiative and compet-    international business community and six senior
itive markets have reemerged as dominant themes in  managers of the World Bank Group under the leader-
development thinking today. The public policy    ship of J. Burke Knapp, a former senior vice presi-
debate now focuses on how governments can        dent of the World Bank.
improve incentives and business conditions to help  The Review Group's report, which is published in
stimulate domestic entrepreneurs, attract foreign    this volume, considers how the private sector can
investment and technology, and ensure that    contribute to economic growth in developing coun-
resources are used efficiently, while making progress    tries and how governments can reform their policies
in the critical areas of poverty reduction and envi-    and interventions to give the private sector greater
ronmental protection.                            scope. The report also provides an overview of the
The World Bank Group has long emphasized the    World Bank Group's experience with private sector
advantages of market discipline and private initiative    development, formulates a strategy for the future,
in promoting efficient development. Over the past    and recommends ways to expand and improve the
five years it has intensified its work in this regard    efforts of each member of the World Bank Group.
through a number of new departures: the Interna-    The recommendations of the report formed the basis
tional Finance Corporation (IFc) has grown rapidly;    for an action program, which the Bank Group's man-
the Foreign Investment Advisory Service was cre-    agement has adopted to expand and focus its support
ated by IFC in 1986; the Multilateral Investment Guar-    of private sector development in the following prior-
antee Agency was established in 1988; and the World    ity areas:
Bank itself has increasingly emphasized the business    * improving the business environment for the pri-
environment in its adjustment lending. Development  vate sector
strategies have been changing during the 1980s, and  * restructuring or privatizing public enterprises and
the World Bank Group's approach has changed with   other public efforts to provide infrastructure and
them, as staff in all sectors and regions are increas-  services
ingly working with member countries to seek in the  * developing the financial sector, particularly to
private sector solutions to development problems.  improve the operation of financial intermediaries
But this approach has evolved unsystematically over  and the transfer of resources
v



* undertaking research and policy analysis to lay the    Group's report has provided a broad overview of the
basis for future operations.                    many areas in which the Bank Group can and should
Three considerations are at the core of the Review  be active; implementation is now proceeding in
Group's report and have shaped our thinking about    those areas in which the Bank Group can make the
how to implement the recommendations. First, the    greatest difference in the short and medium term.
Bank Group's membership includes countries with     Although the Review Group also considered orga-
different economic, political, and social objectives,    nizational and staffing issues, this report focuses on
and their private sectors are at different stages of    the substantive issues that the World Bank Group
development. This necessitates an approach tailored    faces in intensifying its support for private sector
to the circumstances of each country. Second, the    development. I believe these issues will interest
World Bank Group will continue to focus on effi-    many readers concerned about the way the Bank
ciency, not ownership alone. Efficiency requires    Group conducts its business in support of develop-
competition. Competition, in turn, requires an    ment in its member countries. The report provides
appropriate  legal and  regulatory  framework    the framework and sets the agenda for the World
designed to ensure the validity of contracts and own-    Bank Group in private sector development.
ership rights, to facilitate the entry and exit of firms,
and to limit the scope of monopolies. Third, private
sector development cuts across virtually all aspects    Barber B. Conable
of the Bank Group's work, and there are ways to    President
pursue it in every sector and subsector. The Review  The World Bank Group
vi



Introduction
In the past few decades public sector activity has         In all three areas government has a critical support-
expanded greatly in many developing countries-as         ing role to play, while minimizing the distortions
it has in the industrial world. Although this expan-     caused by regulations, taxes, subsidies, and budget
sion has often supported development efforts, it has     deficits. In fact, the reform  of government policy
also frequently and unnecessarily stifled private ini-   and institutions is a critical component of better per-
tiative and market forces and has reduced the flexi-    formance in the private sector. Private sector devel-
bility with which economies can respond to the           opment cuts across all major components of the
rapid changes in the international environment.          Bank Group's support for its client countries and
Increasingly, developing countries have recognized       therefore must be an integral part of its strategy for
the need to expand the role of the private sector and    country assistance. PSD is not a separate topic or dis-
market forces. This presents an opportunity and a        cipline requiring isolated treatment, either in the
challenge for the World Bank Group to intensify its      instruments to be used (policy and project lending,
efforts and find new ways to support private sector      technical assistance, research, and policy dialogue)
development in the developing world.                     or in organizational responsibilities. Moreover, given
Private sector development (PSD) requires three        the wide variety of socioeconomic systems and
main elements:                                           stages of development of the countries belonging to
* a supportive (or "enabling") business environ-         the Bank Group, there is no universal approach to
ment consisting of a stable macroeconomic set-        private sector development. Analysis and prescrip-
ting, economic incentives that promote efficient       tions need to be country-specific and closely tied to
resource allocation by the private sector, and laws    the development aims of each member country.
and regulations that protect the public interest but     The Bank Group has traditionally carried out a sig-
do not unnecessarily interfere with private initia-    nificant amount of activity and financing that sup-
tive                                                  ports PSD. This has included policy analysis and
* the services in infrastructure and human resource      advice on a wide range of macroeconomic and sec-
development necessary to permit private enter-         toral issues, as well as direct or indirect financial sup-
prises to function effectively                        port for private sector enterprises. A number of
* a financial system that provides the incentives and    recent initiatives have further strengthened the Bank
institutions needed to mobilize and allocate finan-    Group's role and responsibilities in support of PSD,
cial resources efficiently.                            including the initiation of MIGA, the expansion and
diversification of trc activities (including new initia-
tives in Africa), and the reorganization of the Bank.
1. The World Bank comprises the International Bank for   But gaps remain in some areas of the Bank Group's
Reconstruction and Development (IBRD) and the International
Development Association (IDA). In this report they are referred to  PSD work; in other areas its efforts need to be
together as the Bank. These two institutions and their affiliates,  expanded, intensified, and better coordinated. For
the International Finance Corporation (IFC) and the Multilateral  example, there is a need for greater involvement by
Investment Guarantee Agency (MICGA), constitute the World Bank
Group and are referred to here as the Bank Group. The fiscal year  private providers of goods and services traditionally
of the Bank Group ends onJune 30.                        produced by public agencies; for more attention to
vii



legal and regulatory reform; for more innovative,       tic investors, as well as advising governments at their
effective, and expanded support for financial sector   request on ways to improve the setting for foreign
development and the financing of private sector        investment.
activity; and for more support for privatization         The Bank Group's newest member, MIGA, will offer
efforts. In addition to these particular issues, there is  a product herctofore not available from the Bank or
a pressing need for the development of explicit    IFC: it will provide insurance to foreign investors
country-specific PsD strategies for the entire Bank    covering noncommercial risk, including breach of
Group.                                                 contract by the host government. Coverage is avail-
Filling these gaps and expanding and intensifying    able for equity investments in MIGA member coun-
efforts presents a great challenge. It requires more   tries, as well as equity-like forms of production
active and explicit pursuit of priorities in PSD       agreements, management contracts, franchises,
throughout the Bank Group. It requires more effec-    licenses, leases, and turnkey agreements. MIGA will
tive use of existing managerial and procedural tools   support the development of bilateral investment
to ensure a consistent and sustained focus on PSD      protection agreements; it will advise governments
issues. And it requires the strengthening of analytical  on the protection and promotion of foreign invest-
work and staff resources. PSD is of central importance  ments; and it will sponsor dialogues on investment
to the prospects of the Bank Group's client coun-      policies between governments and investors.
tries, and the Bank Group is uniquely placed to facili-  The three institutions thus have distinct capabili-
tate PSD by drawing on the different but complemen-    ties and will play different roles in supporting private
tary roles of its member institutions. At the risk of  sector development. In some areas there is a poten-
oversimplification, these roles can briefly be summa-  tial for overlap, but this report finds that no rigid
rized as follows.                                      boundary lines can or should be drawn between the
The strengths of the Bank (IBRD and IDA) lie in its    functions of the Bank, IFC, and MIGA. In many cases
ability to (a) help develop the macroeconomic and      what is needed is a flexible response by the three
structural (sectoral) policy climate conducive to PSD,    institutions to the specific requirements of a particu-
(b) finance the social and physical infrastructure     lar country. Collaboration rather than separation is
needed to support the development of productive        frequently in the country's best interest.
enterprise, (c) assist in identifying and setting the    This report explores how private sector develop-
framework for transferring public sector activities    ment can contribute to overall development and
that are more efficiently operated by the private sec-  what in turn is needed by the private sector to make
tor, and (d) organize major lending operations         this contribution possible: an effective enabling envi-
designed to provide substantial foreign exchange       ronment, the required physical and human infra-
resources or other benefits to the private sector.     structure, and a supportive financial system. The
IFC'S strengths lie in its ability to (a) do the hands-  report also recommends a variety of ways to harness
on job of helping specific companies structure and     the energies of the institutions in the Bank Group,
finance new investments, restructure existing opera-   first, to identify appropriate PSD initiatives; second,
tions, or assist with privatization, (b) use its skill base  to take the necessary actions; and, third, to ensure
for developing a wide variety of new institutions or   that Bank Group institutions collaborate in a consis-
investment vehicles to improve capital markets in    tent and productive manner. The appendix contains
member countries, and (c) facilitate foreign invest-   a summary of the report's recommendations for the
ment by brokering the needs of foreign and domes-      Bank Group.
viii



1 Designing a Strategy to Support
Private Sector Development
The purpose of private sector development is to    developed capital markets. At the other extreme are
encourage the growth of an efficient private sector    the nascent private sectors in, for example, much of
capable of contributing to economic development.    Sub-Saharan Africa. Here private activity consists
The private sector is usually defined as the collection  mainly of very small-scale businesses concentrated in
of enterprises that are owned by individuals or    the informal sector and agriculture, and a few, often
groups not representing the state, whereas the public  monopolistic or principally foreign-owned enter-
sector comprises government agencies and state-    prises. In between these two extremes are the pri-
owned enterprises. In practice, however, the divid-    vate sectors of countries such as C6te d'lvoire, Peru,
ing line between the public and the private sector is    or Tunisia, which are moving tentatively into large-
often blurred, especially since ownership and con-    scale modern activities but are still dominated by
trol by the state may vary in degree and over time.    small-scale enterprises in traditional agriculture, trad-
Furthermore, countries differ in their legal or cus-    ing, and services. Because of these and other impor-
tomary definitions of what is private and what is   tant differences among countries (in their political
public. Ultimately, this report, like the Bank Group  systems and social goals), efforts to support PSD need
generally, has to work within the conventions of    to be tailored to the specific characteristics of each
each country in drawing the dividing line between  country.
the public and the private sector.                  A private sector can operate efficiently only if it
Private sector development pertains not only to  works within the environment of a well-functioning
the realm of organized industry, finance, and com-    market system, which provides price signals that
merce, but also to all areas of activity in which pri-    accurately reflect the social costs and benefits of pro-
vate initiative can have a useful role. Private    duction. If the market environment is highly
enterprise activities in education, health, infrastruc-    distorted-in the sense that there are great discrep-
ture, and other services are therefore included in the  ancies between social and financial costs or benefits
definition of private sector in this report. (Private    due to monopolies, externalities, or government
activities in agriculture are also covered by this defi-   intervention-the private sector is likely to act in an
nition, but they have been excluded from consider-    inefficient way, wasting the economy's resources on
ation here.) Also included here are informal,    unsustainable activities. The existence of a sizable
unorganized, or underground activities, which in    and strong private sector is therefore not sufficient
many developing countries form  a sizable and    to ensure efficient development. PSD also requires
dynamic sector of the economy, outside of the statu-    that the market environment in which the private
tory framework of laws, regulations, and taxation.  sector works be improved, so that those activities
The characteristics of the private sector vary    already carried out in the private sector may be done
widely among developing countries. At one extreme  more efficiently.
are the dynamic, well-established private sectors of    Evolving Views of the Private Sector
the newly industrialized economies, such as the
Republic of Korea or Singapore, which have a diver-    From the 1940s into the 1970s public policy in much
sified structure of enterprises of all sizes and well-    of the developing world, as in the industrial coun-
I



tries, was characterized by a confidence in the capac-  As development proceeded rapidly during the
ity of government to act as the main spur to        1950s, 1960s, and 1970s, private sectors matured sig-
development and to correct market failures. This    nificantly in many developing countries. Research
confidence was based on many factors: the underde-  and experience began to demonstrate that private
veloped state of private sectors and capital markets    entrepreneurs, whether in agriculture, industry, or
in many countries; the mistrust of the private sector  services, are in fact very responsive to economic
stemming in part from the experience of the Great    incentives. Previously many development econo-
Depression and the Keynesian faith in expanded gov-  mists and planners had believed that the private sec-
ernment spending as an antidote to unemployment;    tor in the developing world was inflexible and
a fear of multinational corporations and expatriate  unresponsive to market signals. Therefore, they had
domination of major sectors in the economy; and the  reasoned, explicit government intervention, plan-
trust placed by many development theorists and      ning, and control was needed to achieve the levels
practitioners in central planning as a tool for acceler-    and distribution of investment and economic activ-
ated development and greater equality of income     ity necessary to support higher economic growth
distribution. All these factors combined to convince  and development. Increasingly it was also recog-
many governments that only they could mobilize      nized that competitive market pressures on private
and effectively deploy the financial and managerial    firms tend to improve their internal efficiency, par-
resources required to promote development.          ticularly when compared with quasi-monopolistic
In many countries, this confidence in the public  public sector counterparts.
sector as the principal agent of development began    The rapid changes in the international economic
to erode during the late 1970s and eroded even more  environment that occurred in the 1970s and 1980s
during the 1980s. Many developing countries         also shifted perceptions about the respective roles of
launched special initiatives to limit the growth or    the private and public sector. These changes
even to reduce the size of the public sector. Brazil,    included greater international competition, higher
for example, introduced a National Debureaucratiza-  mobility of factors of production, more efficient
tion Program in 1979, and Senegal set up in the early    flows of information, and faster technological
1980s a Special Commission on the Disengagement    change. Financial imbalances among the industrial
of the State. What accounts for this change in direc-    countries, the resulting exchange and interest rate
tion of development strategy?                       fluctuations, and gyrations in major commodity
Public spending and other forms of government    prices (especially for oil) also added a large element
intervention have rapidly grown in developing       of uncertainty. Countries that adjusted rapidly to
countries since 1940: central government spending   these changes were able to keep growing (Indonesia,
typically accounted for only 5 to 10 percent of gross  Korea, and Thailand, for example). In contrast, coun-
national product before 1940; now it accounts for 20    tries that pursued inward-oriented trade strategies,
to 30 percent, even without making allowance for    that borrowed heavily to finance ambitious and
the rapidly rising role of state-owned enterprises.    often misguided development programs, and that
This much-enlarged role of the public sector has    did not adequately mobilize domestic savings in
brought into stark relief the evidence of bureaucratic    response to the apparent need for structural adjust-
shortcomings associated with the shortage of well-    ment, encountered severe balance of payments and
trained and organized civil servants. It has also   debt servicing problems. These in turn translated
showed many examples of public agencies that lack    into a serious loss of growth momentum. Flexibility
market tests and competitive pressures. As a result,    of the economic structure in the face of a highly
many of them also lack financial discipline and effi-    uncertain international environment therefore came
cient management.                                   to be seen as a necessity.
The growth in government has also brought to the    Flexibility requires the capability and willingness
fore the issue of rising costs. The unintended distor-    to respond quickly to changing opportunities and
tions that accompany interventionist incentive poli-    international price signals. This response involves
cies have raised the economic and social costs of    changing levels of production and factor use, the
government. And tax burdens have increased to       entry of new profitable enterprises, or the exit
finance higher expenditures. Casual observation of    (through merger, liquidation, or bankruptcy) of
these costs has been increasingly confirmed by spe-    unprofitable ones. Experience shows that govern-
cific research in areas such as trade policy, agricul-    ments are generally not very responsive to economic
tural pricing, and tax policy.                      signals. The Korean government is an exception to
2



this rule; it has successfully orchestrated strong eco-  as the Bank Group's arm for lending to the private
nomic growth over the past three decades by show-       sector without guarantees and has done so ever since
ing considerable foresight and flexibility.             its creation in 1956. Of the total S 140 billion of IBRD
It is doubtful, however, that the Korean approach     and IDA funds lent from the Bank's creation through
is transferable to countries with weaker public         fiscal 1987, $14 billion (10 percent) has gone to non-
administrations and less cohesive central economic      project (program, sector, or policy) lending, $76 bil-
management. For most developing countries less,    lion (54 percent) to infrastructure and human
rather than more, public intervention in markets        resource development loans, and $37 billion (26 per-
would be appropriate. The reduction in the share of     cent) to finance predominantly private agricultural
public spending in the economy, which occurred in       and industrial activities. iFC investment activity since
a number of developing countries during the 1980s       its creation has totaled $ 10 billion.
following severe fiscal distress, was probably a step     Despite the Bank Group's concern with private
in the right direction. Economies based more on         sector development from its inception, it, like its cli-
market-oriented, private activities tend to be more     ent governments, took part in the shift in develop-
responsive to the signals of international markets and  ment strategy. Into the 1970s the Bank tended to
changing domestic opportunities.                        favor an expanded role for government and public
To achieve greater economic efficiency and            sector entities in seeking to increase the mobilization
growth, governments in the developing world have        of resources and the rate of investment, while also
shifted their development strategy from one based       working to improve the efficiency of public and pri-
on a growing government role to one that seeks to       vate resource allocation. During the late 1970s and
support the development of the private sector and       even more so during the 1980s, the direction of the
the improved functioning of markets. Indeed, many       Bank Group's analytical work, as well as its lending,
socialist economies have moved to reduce the scope      increasingly shifted to improving the functioning of
of central planning in favor of an increased role of    markets, reducing the distortions created by govern-
the market and have sought to increase the scope for    ment intervention, limiting or reversing the growth
private initiative.                                     of public spending, and exploring more actively the
role that private enterprises could play in traditional
The Bank Group's Approach                               public sector responsibilities. Although this shift is
One of the principal objectives of the Bank, as set     not readily quantifiable, important examples are
out in its Articles of Agreement, is the promotion and  cited in the next few paragraphs.
encouragement of private investments for produc-          Since their inception in 1978, the Bank's annual
tive purposes. Accordingly, it has always been the      World Development Reports have placed increasing
Bank Group's policy to help countries obtain the        emphasis on delineating the appropriate roles for the
advantages of private initiative and market discipline  public and the private sector and on limiting public
in promoting efficient development.                     sector involvement to those areas where it is best
Bank Group support for private sector develop-        equipped to foster development. The government's
ment has been concentrated in three areas: de-          role is seen primarily in the provision of public
veloping a supportive environment of stable macro-      goods (including defense, diplomacy, macroeco-
economic conditions and appropriate overall incen-      nomic management, and a legal and institutional sys-
tives; strengthening the support services for private   tem that defines and enforces the rules of justice,
sector productive activities by improving the physi-    property, and commerce) and in the provision of
cal and human infrastructure of a country; and pro-     social, physical, and information infrastructure,
viding financial resources for the private sector       where market failures are common and basic needs
through direct lending (albeit with government guar-    have to be met. Other areas, especially agriculture,
antees, in the case of the Bank) or through lending to  industry, energy, and mining, are better left to the
financial intermediaries.' IFC was set up specifically  private sector, although some public support and
regulation may be needed.
1. IDA'S Articles of Agreement permit it to lend directly to the  Increasing attention has been given in the Bank's
private sector without government guarantee. In practice this has  policy analysis, dialogue, and lending to improving
never been done, because of the view that the sizable subsidy  the functioning of markets, especially through mac-
implicit in IDA terms should not go directly to individual public or    roeconomic management and incentive policies in
private actors, but rather accrue to the country as a whole.
Accordingly, IDA credits are lent to governments, which may on-    trade, agricultural pricing, and finance. The initiation
lend them to private entities at market or near-market terms.  of adjustment lending in fiscal 1980 and the
3



expanded use of this instrument subsequently pro-       cial market and industrial sector development. The
vided a vehicle for translating concern for markets     Bank boosted its lending through financial interme-
into an active policy dialogue with governments (see    diaries, with most of the benefit of the on-lent funds
chapter 2). The Bank Group has also given active        going to private enterprises. It developed new lend-
support during the 1980s for the increased reliance     ing instruments (apex loans, financial and industrial
on market forces in centrally planned economies,        sector loans) to assist financial and industrial sector
particularly in China, but also in Eastern Europe and   development, and it carried out extensive research
other socialist developing economies (see box 1-1).     and sector work. For example, in the East Asia
During the 1970s and into the 1980s the Bank         Region at least fourteen major economic and sector
Group significantly expanded its support for finan-     reports were prepared during fiscal 1979-87 on the
Box 1-1. Centrally Planned Economies
What role does private sector development have to    small, private business endeavors, (b) encouraging the
play in the Bank Group's member countries where    cooperative movement, which for some time has
central planning has, at least in the past, dominated?  been more arms-length from the state than the formal
Yugoslavia, many years ago, and more recently    state sector, and (c) encouraging joint ventures
China, Hungary, and Poland all joined the Bank to  whereby enterprises that would have been in the state
secure resources and assistance in moving their econ-    are, de facto, privatized by the entry of foreign inves-
omies toward market-based, outward-oriented sys-    tors. rFc has been centrally involved in all the major
tems. All four countries also joined IFC, a further signal    joint ventures actually agreed to since these policy
of their desire to look for opportunities to begin to    changes were put in place and is financing the cooper-
reduce the role of state intervention.             ative sector in agribusiness and industry. Bank opera-
Yugoslavia adopted early on a quite radical decen-    tions in Poland have not yet commenced, although IFC
tralized structure in which the state did not own  has begun to finance nonstate ventures. Based on the
enterprises and production plans were not handed   considerable exploratory work by the Bank and IFC,
down from on high. Foreign investors were invited to    the potential for private initiative appears to be consi-
set up joint ventures, and trade was redirected toward  derable.
the West. It was a bold experiment that brought consi-  Realism is required as to the pace and result of mov-
derable dynamism to economic activity. However,    ing toward a more open and thus disciplined eco-
decentralization was not followed by adequate disci-    nomic system, given the economic history of these
pline. Yugoslavia's unique, consensus-building politi-    countries. But the start made is both courageous and
cal and managerial system  began to bog down.    impressive.
Loss-makers were excessively protected; the banking  In China, the transition to an economy where mar-
system, which ultimately is the allocator of resources  ket forces are being increasingly brought into play
for investment, was increasingly controlled by the  began with the opening up of the economy and
enterprises it was financing; and growing inefficien-    reforms of agriculture in 1979. During the 1980s these
cies in the system were covered by foreign borrow-    reforms were gradually extended to industry and the
ings.                                              towns. Price reform is a key element. Macroeconomic
Yet there are many examples of well-managed      management-including fiscal, credit, and pricing
dynamic enterprises in Yugoslavia. Efficiency can be  policies-are playing a greater role. After a reform and
improved, and Yugoslavia is on the verge of further,    decentralization of the banking system, interest rates
deep reforms to reset its course more vigorously    are beginning to reflect the scarcity of capital. Foreign
toward a market economy. Provided policy reform    investment through joint ventures has been stimu-
proceeds apace, the Bank Group through structural    lated. Individual initiative and competitive pressures
adjustment lending, financial market interventions,    are being encouraged in many areas of the economy.
and joint ventures can be of significant assistance at    Even bankruptcy rules have been established on an
this critical juncture.                            experimental basis. The World Bank Group has sup-
Hungary and Poland have also started introducing  ported this reform drive from early on. Through eco-
market forces and supporting private initiatives. In    nomic and sector work, lending operations, and
Hungary, the Bank has supported these efforts    research, the Bank has provided assistance in a broad
through its lending program and economic sector    range of sectors and issues; IFc has provided substan-
work. Actual encouragement of private activity has    tial advice on the foreign investment framework and
come in three ways: (a) loosening some restrictions on  assisted in structuring specific joint ventures.
4



topics of trade and industrial and financial develop-  nars, and similar forums; and in assisting microen-
ment.2 Similar work was undertaken in other            terprises, peasant agriculture, and the informal sector
regions.                                               by increasing access to credit, securing property
During the same period, IFc expanded its capabili-    rights, and addressing legal, regulatory, and other
ties in direct investment and lending to private sec-  factors that drive business underground.
tor enterprises, capital market development, and          However, the Bank Group's coverage of these
support for foreign direct investment. Morc recently,  issues has been unsystematic, sometimes even
MIGA was created as a new arm of the Bank Group to     neglected, compared with its more traditional con-
facilitate direct foreign investment (see chapter 4 for  cern with broad incentive systems, infrastructure
a more extensive discussion).                          development, development finance, and public sec-
In regard to infrastructure and human resource       tor management. Even in these more traditional
development, the Bank has also been increasingly       areas the Bank Group's renewed emphasis on the
concerned with identifying and supporting the          private sector and market orientation has been
appropriate division of public and private responsi-    reflected in an ad hoc way. The Bank's knowledge of
bilities. In the urban sector, for example, the Bank   enterprise and financial market development in
has actively promoted, beginning in the early 1970s,   many member countries remains fragmentary. New
a policy shift in developing countries away from the   instruments (financial sector loans, public sector
construction of public housing to the provision of     restructuring loans) have been developed only
infrastructure services (see chapter 3 for more about  slowly.
this and other examples).
Although in the past the Bank Group concentrated     A Strategy for Bank Group Support
on strengthening state-owned enterprises-and in a
number of cases supported the creation of new          As a first step in responding to these concerns, it is
ones-during the 1980s it has increasingly turned to    necessary to develop a strategic framework for the
encouraging government efforts to privatize such       involvement of the Bank Group in private sector
enterprises. As of fiscal 1988 there were some forty-  development. The six elements of such a framework
one projects approved and thirty-one projects under    are laid out as follows:
preparation by the Bank that included a component         First, private sector development is an integral part
supporting the divestiture of state-owned enterprises  of the Bank Group's work. It is not a separate topic
through liquidation, sale, contracting out, or leasing.  or discipline requiring isolated treatment, either in
Bank support has taken the form of conditions in       the instruments to be used (policy and project
structural or sector adjustment loans, studies to help  lending, technical assistance, research, and policy
identify divestiture candidates and design sales pro-  dialogue) or in organizational responsibilities. Never-
grams, and financing for legal, accounting, or invest-    theless, a sharper focus on PSD is necessary to ensure
ment banking advice (see chapter 2 , box 2-1).         that the contributions it can make to development
The Bank's reorganization in 1987 led to the crea-   are fully utilized.
tion of a new division with the explicit mandate to       Second, growth and economic efficiency, comple-
examine and support the Bank's private sector devel-   mented by the need to alleviate poverty, should be
opment efforts. Since its creation, this division has  the main criteria for judging the right boundaries to
actively developed a work program  in the area of      the private and public sectors. In this respect, the
PSD.                                                   expansion of competitive markets and deregulation
The Bank Group has been involved in assisting        may be as important as transfer of ownership. If
legal and regulatory reform to reduce red tape, pro-   there is a transfer of ownership to the private sector,
mote investment, increase competition and elimi-       positive steps should be taken to protect the public
nate public monopolies; in strengthening the public    interest by ensuring that a new private enterprise
institutions that encourage entrepreneurial develop-    does not exploit a monopolistic position. Public
ment and promoting a better dialogue between           interventions in the name of poverty alleviation have
public and private sectors through workshops, semi-    often failed to achieve that goal while imposing con-
siderable loss of efficiency. An increased role for pri-
_________________                                      vate initiative, in contrast, may improve access by
2. This work was reviewed and summarized in a regional report    the poor to essential goods and services at lower cost
by Amar Bhattacharya and Johannes F. Linn, Trade and Industrial
Policies in the Developing Countries of East Asia, Discussion  (see chapter 3 for examples).
Paper 27 (Washington, D.C.: World Bank, 1988).            Third, the Bank Group's approach tO PSD must be
5



pragmatically tailored to different country circum-  * in the highly indebted, middle-income countries,
stances. Countries have different political, social,   the Bank Group should work to develop a sup-
and economic systems and objectives. Moreover,         portive policy and regulatory environment that
their private sectors vary widely in structure, charac-  promotes domestic competition
teristics, and capacities. Thus a variety of strategies  * in Sub-Saharan Africa the stress should be on cre-
are required for private sector development,           ating the institutional and policy framework to
depending on a particular country's circumstances.     stimulate entrepreneurship and ensure the devel-
Fourth, in developing its country-specific strategy  opment of the minimum  physical and human
for PsD, the Bank Group will have to consider the      infrastructure required for long-term PSD
appropriate mix of five possible approaches:         * in much of South Asia the primary focus should be
* the incentives approach, stressing the reduction of  on the promotion of deregulation and liberaliza-
distortions in country or sectorwide incentive       tion of overly bureaucratized administrative and
structures through appropriate reform of macro-      incentive systems
economic, trade, tax, and financial market policies  * the East Asian market economies provide an
* the deregulation approach, emphasizing the           opportunity to strengthen PSD in a number of areas
reduction of unnecessary regulations, restrictions,  (for example, regulatory reforms), but mostly they
and other public interventions in the private sec-   provide a wide range of experiences of broadly
tor                                                  successful PSD, which should inform Bank work in
* the promotion approach, designed to encourage        other regions
PSD through provision of credit, information, and  * in the centrally planned economies the Bank
advisory services                                    Group's role should be to encourage and support
* the development approach, focusing on the crea-      government efforts to expand the role of markets
tion of physical and human infrastructure required   and of private initiative.
by private entrepreneurs                             Sixth, country-specific PSD strategies will have to
* the privatization approach, transferring functions  be supported by analytical work that explores the
and enterprises from the public to the private sec-  various experiences with PSD and focuses particularly
tor through divestiture of state-owned enterprises,  on areas that have previously been neglected. This
contracting out or leasing of activities or func-  work should be carried out both at the country level
tions, and reducing public involvement in particu-    through appropriate country economic and sector
lar areas while permitting greater private initiative.    work, and at an intercountry level through research
Fifth, country-oriented strategies could broadly   and policy studies.
involve the following priorities for the Bank Group:
6



2i Improving the Enabling
Environment
The private sector responds to signals from the over-    tional environment. Nonetheless, international eco-
all economic, legal, and regulatory environment in     nomic conditions-commodity prices, interest rates,
which it operates, and it depends on the supporting    growth in developing countries' export markets,
inputs, especially infrastructure services and human   access to international capital flows, and aid-are, to
resources. If the signals are distorted, the private sec-  a considerable extent, the outcome of policy deci-
tor will reflect these distortions. If infrastructure and  sions by the governments of the industrial countries.
human resource inputs are limited in accessibility,    These policies and their potential impact on the
low in quality, and high in cost, the growth of the    world economic outlook have been discussed in suc-
private sector, and thus the growth of the entire      cessive World Development Reports and will not be
economy, will be stunted. Many of the private sec-     considered further in this report.
tor's problems lie in the various factors that distort    The last two factors-infrastructure and financial
the environment for private agents. Improvements       sector policies-are discussed in chapters 3 and 4.
in this "enabling" environment are almost always       The current chapter concentrates on the remaining
necessary to enable the private sector to function     factors in the enabling environment for PSD: macro-
efficienrtly. Thus they are an essential component of  economic conditions and policies, incentives, the
any strategy for private sector development.           legal and statutory framework, and public sector
Seven main factors contribute to the enabling        institutions. For each of these four factors an over-
environment:                                           view of how it affects PSD in developing countries is
* the state of the international economy               followed by an assessment of what the Bank Group
* the domestic macroeconomic conditions and poli-      has done and could do better to assist its members in
cies                                                 strengthening the enabling environment. '
* the domestic incentives for private producers and       The Bank has traditionally emphasized the ena-
consumers                                            bling environment for private sector development in
* the legal and regulatory framework within which      its research and operations. Research staff have thor-
the private sector operates                          oughly analyzed virtually all the factors mentioned
* the efficacy of public sector institutions           above in a country or cross-country context. In
* the physical and social infrastructure               country economic and sector work, operational staff
* the efficiency with which the country's financial
sector mobilizes and intermediates financial
resources.                                             1. The analytical presentation draws on much accumulated
The first of these factors, the international econ-  Bank work, especially as summarized over the years in World
omy, is obviously important to developing econo-       Development Reports, published annually by Oxford Universitv
omy. is obviously important to developing econo-     Press. The information and conclusions on the Bank Group's
mies, especially those that are small and open to      operational experience summarized here draws on two recent
international trade and capital flows. The external    reviews: World Bank Country Economics Department, Adjust-
shocks of the 1970s and 1980s have brought home        ment Lending: An Evaluation of Ten Years of Experience, Policy
and Research Series I (Washington, D.C.: World Bank, 1988) and
the need for a flexible domestic economic system,      an internal report on the Bank Group's experience with private
which can respond quickly to changes in the interna-   sector development.
7



have assessed many aspects of the enabling environ-    duction and investment climate in which private
ment and, based on this analysis, have carried on      producers operate. Fiscal policy (especially the man-
policy dialogue with member countries. In the prep-    agement of the public sector deficit), monetary pol-
aration and supervision of investment projects, oper-    icy, and the management of the nominal exchange
ational staff have also pursued individual aspects of    rate shape the macroeconomic conditions faced by
the enabling environment for particular sectors or    the private sector. Among these three, fiscal policy is
institutions. Finally, the introduction of structural  most important for maintaining a stable macroeco-
and sectoral adjustment lending-and concomitant        nomic environment in developing countries. Mone-
assessments of the policy framework jointly with the   tary policy, because of the limited development of
International Monetary Fund in the case of low-        domestic financial markets and institutions in most
income countries-has provided the Bank Group           developing countries, has little scope for indepen-
with its most comprehensive and effective tool to      dence. Nominal exchange  rate  management,
assist member governments in improving the the         although important in the short term, is less signifi-
enabling environment for PSD. (Box 2-1 gives an        cant in the longer run.
example of how structural adjustment lending has         Imprudent fiscal management leads to an overval-
addressed specific aspects of the enabling environ-    ued and unstable exchange rate, a high real interest
ment in Thailand.)                                     rate, and high inflation. These in turn result in cur-
rent account deficits and accumulation of foreign
Macroeconomic Conditions and Policies                  debt, crowding out of private investment, inefficien-
cies in domestic production, and the serious risk of
How They Affect PSD                                    capital flight. Ultimately, the country's creditworthi-
ness may be impaired to the extent that it loses
Macroeconomic conditions in a country influence        access to voluntary lending from commercial bor-
the private sector through their effects on the pro-   rowers. This loss of creditworthiness, in turn, seri-
Box 2-1. Improving the Enabling Environment through Structural Adjustment Lending:
The Case of Thailand
The Bank approved two structural adjustment loans      * reduction in subsidies on energy prices
for Thailand in 1982 and 1983. Both loans were in      * reduction in subsidies for water, bus, and rail-
support of the structural reforms initiated by the       way prices
Royal Thai government as part of its Fifth Develop-    * elimination of price controls
ment Plan (1982-86). Thailand's experience of adjust-  * streamlining of investment incentives
ment has been one of success: it has avoided           * strengthening of export incentives (tax rebates
economic crisis and sustained strong economic and        and credit)
export growth. The responsiveness of Thailand's        * elimination of rice price support schemes
economy has been partly due to its traditional reliance  * The legal and regulatory framework
on a dynamic private sector, but also to the govern-   * elimination of export restrictions
ment's willingness to reverse potentially damaging     * deregulation of livestock and meat marketing
policy directions, some of which directly interfered   * improvements in rural land tenure system
with efficient private sector development.             * reform of domestic content legislation (auto-
The Bank's structural adjustment loans supported       mobile industry)
policy reform designed to improve the enabling envi-    * Reform of public institutions
ronment for PSD in the following areas:                * liquidation of small commercial state-owned
* iMlacroeconomic management: reduction in the           enterprises
budget deficit through reduced public spending and     * diagnostic study of all state-owned enterprises
increased public revenue mobilization (both taxes and  * review of public expenditure priorities and
user charges)                                            selective cut-backs in low-priority areas
* Incentive reform                                     * various efforts to improve performance of
* reduction in industrial tariff protection          public institutions (planning, budgeting,
* reduction in agricultural export taxation          accounting, civil service reforms).
* improvements in central and local government   Significant progress has been made in implementing
tax structure and administration            these and complementary actions.
8



ously affects private producers and financial    to the forefront of the Bank's concerns in this area
intermediaries in two ways: first, they lack direct    are:
access to foreign long-term  finance; second, and   * What must be done to ensure consistency of mac-
more pervasively, the economic crisis forces drastic  roeconomic policies with the main macroeco-
reductions in domestic aggregate spending and shifts  nomic goals of the government?
in domestic production, much of which has to occur  * What are the appropriate balance and relation-
in the private sector. This, of course, is the problem  ships between stabilization and structural reforms?
today for most of the highly indebted countries.    * What are the appropriate timing and sequencing
In the absence of a stable macroeconomic envi-      of macroeconomic and other policies?
ronment, other efforts to support PSD-through       * How  can stabilization be achieved in high-
incentives, the legal and regulatory framework, and   inflation countries?
financial sector management-will be severely lim-   * What are the lessons for macroeconomic policy in
ited in their effectiveness and may not be sustain-   the low-income, Sub-Saharan countries?
able. In fact, it is often possible to trace the    * What is the role of the real exchange rate in deter-
imposition of many inappropriate restrictions on pri-  mining economic performance and incentives?
vate sector activity (higher import tariffs, price con-  * Can the analytical models used to evaluate adjust-
trols, and interest rate ceilings, to mention just a few)  ment programs within and across countries be
to a government's effort to redress the symptoms of   improved?
macroeconomic instability rather than their underly-  Work on these questions is either under way or
ing cause.                                          planned. This report recommends that this work be
carried out expeditiously.
"hat the Bank Group Can Do
Domestic Incentives
For each of its member countries the Bank reviews
macroeconomic policies in close coordination with
the International Monetary Fund (IMF). The principal  How TheyAffectPSD
vehicles for the Bank's operational work in this area
are its country economic memoranda and reports      Achieving and maintaining stable and prudent mac-
and its adjustment lending operations. In connection  roeconomic policies are necessary but not sufficient
with these activities, the Bank routinely assesses the  conditions for effective PSD. Other elements of the
macroeconomic conditions in the member countries    enabling environment are essential ingredients. In
and reviews the policies most likely to enhance the  particular, government policies affect the incentives
macroeconomic outlook of the country in the light    faced by private producers and consumers. Trade
of expected international economic developments.    policy, tax policy, pricing of publicly produced
In addition, the Bank has for many years sponsored  products, and special incentives for investment and
research and policy reviews that have led to a better  exports are briefly reviewed here.
understanding of the major factors that need to be
addressed in the design of consistent and stable mac-  Trade Policy. Import substitution and inward-
roeconomic policies.                                looking trade policies characterized the develop-
A recent review  of adjustment lending has        ment strategies of many developing countries
addressed the adequacy of the Bank's work in this    through the 1970s. Research and policy experience
area.2 It suggests that the Bank's approach has gener-  now demonstrate that an outward-oriented trade
ally been well designed and that macroeconomic    strategy is more likely to lead to a dynamic and effi-
issues have been given adequate consideration in    cient private sector. Outward orientation is defined
country economic and sector work, policy dialogue,  here as a neutral trade regime, which does not favor
adjustment lending, and research. Nonetheless,    import-substituting activities over export-oriented
some aspects of macroeconomic policy require more   production. Private sector activity is directly
research and consideration in the design of country-  affected by protectionist trade policies, which dis-
specific policies. Questions that have recently come  tort relative prices. It is also negatively affected by
the frequent instability of such policies, and by the
need to devote scarce financial and managerial
2. World Bank Country Economics Department, Adjustment    resources to competing for the economic rents
Lending.                                           implicit in protectionist policies.
9



Trade policy reform  requires a reduction in the    Furthermore, subsidies have to be financed from
level and dispersion of protection for domestic       some source, either general taxes or higher prices for
industries and a reduction in the taxation of exports.  some consumers. This in turn results in higher pri-
Moreover, whatever level of protection is in place, it    vate costs. For example, the common practice of
is usually better achieved through tariffs than quanti-    subsidizing residential users of power and water bv
tative restrictions. Two caveats are in order, how-   charging more to industrial and commercial users
ever. First, some private producers (and consumers)   distorts private production decisions and can reduce
will be negatively affected by trade policy reform,   the international competitiveness of domestic pro-
although on balance the private sector will be better  ducers.
off over the long term. Second, full neutrality in the
trade regime, especially the elimination of all import  Incentives. Many governments have traditionally
tariffs, cannot usually be a short-term goal for devel-    sought to foster investment and exports through spe-
oping countries. Tariffs are an important source of   cial incentive schemes, which relied heavily on tax
tax revenues in many developing countries, espe-      and subsidy instruments, in addition to regulatory
cially the poorer ones, and some, albeit low, protec-  interventions (see below). Although in principle
tion of domestic industries may be appropriate to     designed to support the development of certain
deepen the domestic industrial structure.             favored segments of the private sector, such incen-
tive schemes have in practice suffered from serious
Tax Policy. Most taxes affect private consump-      shortcomings in design and implementation. Since
tion, savings, investment, and production decisions.  such schemes often compensate for distortions
But views about the ability of tax policy to control  introduced by other govcrnment policies (import
such decisions have changed over the years, just as   restrictions and tax policies), it is generally better to
views about development itself have changed. The      reduce those distortions than to expand the special
view that taxes can be effectively and widely used to  incentive schemes. In addition, streamlining existing
steer private sector development (raise savings and   special incentives systems, reducing their budgetary
investment, direct production into particular sectors  costs, and limiting the scope for bureaucratic discre-
and locations, redistribute income, and so forth) has  tion in their application can go a long way toward
now shifted to the view that taxes have a limited     strengthening the country's incentive system.
scope to achieve broader social goals. According to
the new view, tax systems should be designed to       What the Bank Group Can Do
raise the revenue necessary for public spending pro-
grams in the least costly manner, with the least dis-  Domestic incentive policies have been addressed
tortion of private sector decisions. Tax reforms,     extensively by the Bank in the context of its country
therefore, should stress broadening the tax base      economic and sector work, structural and sector
rather than raising rates, eliminating unintended dis-    adjustment lending, its policy work, and research.
incentives to investment and differentiation in tax   For example, four-fifths of all adjustment loans have
burdens for the company income tax; replacing dis-    had trade policy components; public revenue mea-
tortive turnover taxes by value added taxes; limiting  sures (including tax reform and public pricing mea-
the progression of personal income tax rates in    sures) have been pursued in about one-quarter of all
higher tax brackets, while exempting low-income       adjustment loans; reform of special investment and
taxpayers altogether; and simplifiying tax structures,  export regimes has been pursued intermittently. No
administration, and compliance at all levels of gov-  systematic accounting of the extent of country eco-
ernment. All these changes are specifically designed  nomic and sector work in this area is readily avail-
to lower the cost of taxation to the private sector.  able. Scattered evidence indicates that country
economic and sector work has been extensive in the
Pricing. Setting efficient prices for publicly pro-  case of trade policy, but more selective in the areas
vided goods and services is important for private     of tax policy and special incentives. Bankwide and
sector development. Although subsidized prices        regional policy and research studies have been car-
lower the private costs in the short term, they not   ried out in all these areas and have reviewed typical
only lead to inefficient consumption patterns, but    country approaches and drawn lessons for policy
also tend to erode the financial viability of the public  design and implementation.
agency providing the goods and services and thus        From the information currently available, it is clear
undermine its ability to provide quality products.    that the Bank's research and policy studies in this
10



area have made a significant contribution to the      For example, price controls have been introduced to
general understanding of how to design appropriate    limit inflation generated by poor macroeconomic
incentives systems. Similarly, the level of attention  policies; import quotas have often been imposed in
given to trade reform  in adjustment operations is    reaction to current account deficits resulting from
appropriate; however, more attention should per-      overvalued exchange rates; import and investment
haps be given to tax policy and special incentives    licensing has often been an effort to allocate the rents
reform. To the extent that reforms have not been      generated by import controls to preferred firms (this
implemented as expeditiously or extensively under     applies especially to restrictions placed on foreign
these operations as had been expected (tariff reduc-  investors); rent control has frequently been a
tions have been significant only in six out of forty  response to rising urban property prices as a result of
countries recently examined by the Bank; significant  poor land use and infrastructure policies. The danger
tax reform has taken place in only four countries),   of such interventions is that they tend to reduce the
more emphasis will have to be given to the details of  flexibility of the private sector, raise its costs, and
reform  implementation and constraints on imple-      increase the uncertainty under which it operates.
mentation capacity, to government commitment and      Often these interventions drive businesses "under-
political opposition, and to policy conflicts. To do so  ground" or into the "informal" realm. Perhaps most
effectively requires more intensive preparation and   important, regulations often limit the entry and exit
supervision of the relevant components of adjust-     of new  firms, especially smaller firms, by giving
ment loans.                                           existing, larger firms an advantage over the small
newcomer. Even regulations ostensibly designed to
The Legal and Regulatory Framework                    deal with market failures are often more effective in
limiting the entry of new firms than in limiting the
How It Affects PSD                                    detrimental aspects of the externality or monopoly
that they are supposed to control.
The laws governing property rights-the rules of the     Reforms of the legal and regulatory framework are
game for ownership and exchange-also govern the       thus an essential counterpart to macroeconomic and
working of markets and thus profoundly affect the     incentive reforms. The elimination of all regulations
efficiency of the private sector. Clear, simple laws,    is obviously not desirable, but unnecessary or overly
effectively applied, are essential for generating     restrictive ones should be eliminated after careful
cxpcctations of a stable and supportive busincss cli-    review. At the same timc every effort should be
mate, both for domestic and foreign investors. Short-  made to foster the local legal and accounting profes-
comings are common, however. Surveys have             sions, on whom  heavy reliance will have to be
shown that uncertainty about the rules of the game    placed in carrying out the reforms described in the
has been a major concern for foreign investors. Two   following paragraphs.
particular areas have been of special importance in
many developing countries: land tenure security and   What the Bank Group Can Do
the rules governing the exit of firms. Research has
shown that uncertain land tenure limits private       The regulatory framework has received erratic treat-
incentive for improving the land, both in rural and in  ment in Bank operations, including structural and
urban areas. Lack of clear laws governing commer-    sectoral adjustment lending and investment projects.
cial liability, bankruptcy, and liquidation may have  Some form of regulatory reform appears in 48 of 109
been one of the factors limiting the responsiveness   projects recently reviewed by the Bank, principally
of many developing countries to changes in the        in the policy-based operations.
international environment.
Government regulation of private sector activity      Streamlined Procedures. Twenty-nine projects
has a legitimate role. Indeed, it is at times preferable    involved the abolition or streamlining of controls,
to public ownership and management of firms. It is    the most frequent form of regulatory reform. Exam-
appropriate when markets fail, as in the case of natu-  ples are the elimination of most import licenses (in a
ral monopolies (water resources) or externalities     structural adjustment loan to Burundi), automatic
(congestion and pollution). In practice, however,    access to importer-exporter cards (a structural adjust-
governments have used regulatory intervention for     ment loan to Senegal), and an effort to minimize reg-
many other purposes, frequently to counteract the     ulation of investment (a structural adjustment loan to
undesired effects of other government interventions.  Pakistan). Another eight projects tried to cut red tape
11



by proposing a "one-stop-shop" for such things as    tus of informal enterprises, although the structural
approval of investment applications (a structural    adjustment loans to Jamaica supported the legaliza-
adjustment loan to Dominica) or for providing clear-    tion of certain forms of foreign exchange trading.
ances and permits to potential export industries (a  Nor were any projects found which changed the reg-
loan to Mauritius).                                  ulations dealing with informal or microenterprises. A
Investment Code. Ten projects (nine of them in    few projects supported studies or technical assis-
lnvestment~ ~ ~  ~    ~~tnc tode                ovrnen arjet  encies to invest atiowt
Africa) proposed to study and revise the private sec-    tance to government agencies to investigate how to
tor investment code to provide more effective incen-  assist the informal sector.
tives for private domestic investment. Ten projects    Property Rights. Despite the importance of own-
supported changes in the legislation governing for-    ership issues for access to credit and services, only
eign direct investment. For example, foreign inves-  one of the projects dealt with property rights, by
tors were granted more equal treatment with          accelerating distribution of land titles to employees
domestic investors (a sectoral adjustment loan to    laid off from privatized state enterprises (a structural
Indonesia); they were entitled to deduct part of their    adjustment loan to Sao Tome and Principe). In addi-
taxes paid at home ftom their tax liabilities (a loan to    tion to the projects studied a few other recent
Bolivia); and mining, petroleum, and tourism laws    projects have dealt with land reform  issues (for
were reviewed with an eye toward promoting for-    example, Thailand's structural adjustment loans).
eign private investment (adjustment loans to Tur-    The Bank's urban projects often have also supported
key). iFc has also been active in the area of foreign  the regularization of urban land titles. Other prop-
direct investment. Its activities and those of MIGA are  erty rights issues (for example, the right of women to
explored in more detail in chapter 4.                own or inherit property) have apparcntly not been
Labor Laws and Regulations. Only nine projects    addressed in Bank projects.
proposed revisions to labor legislation and practices.  Assessment and Recommendations. Although not
Labor legislation was to be revised to encourage     entirely neglected, the legal and regulatory frame-
employment by reducing social charges (a structural  work appears to be the weakest link in the Bank's
adjustment loan to Senegal); a study of wage and     support for PSD. Moreover, little systematic informa-
employment issues in the private sector was commis-    tion appears to be available about the extent of
sioned as a step toward improving wage negotiation,    implementation of the regulatory and legal measures
simplifying labor legislation, and developing a legal    agreed to, and about the impact of those measures
framework for a coherent wage and incomes policy     that were actually taken. Among the reasons for this
that encourages industrialization and growth (a loan  are principally:
to Mauritius).                                       * lack of government interest
Competition. Many of the regulatory reforms initi-  * lack of prior research and country economic and
ated in Bank projects helped increase competition.     sector work dealing with regulatory issues (excep-
Besides reducing import protection and price con-      tions are an internal 1986 study of industrial regu-
Besides~ ~ ~ ~ ~ ~ ~ ~~~~~ato reucn  import proecio  andla price con-grsso
trols, quite a few projects also eliminated public     lation in India, two similar studies in progress on
monopolies or monopsonies. But only six of the         Brazil and Indonesia, and a few research studies)
projects explicitly addressed barriers to entry and    rglimited staff resources and skills in dealing with
exit, such as giving private dealers the right to buy  regulatory and legal issues.
fertilizer stocks from both public and private whole-  This report recommends that more research,
salers (a sectoral adjustment loan to Pakistan) or the  country economic and sector work, and eventually
revision of the industrial development act to encour-    lending resources be devoted to the legal and regula-
age competition and restrict protectionist use of the  tory constraints to PSD. Future Bank operations in
licensing system  (a structural adjustment loan to    this area should also tap the technical expertise of
Malawi). Only four projects sought to strengthen the    IFC.
government's capacity to identify and curb private
sector monopolistic or oligopolistic tendencies.     Public Institutions
Informal Enterprises. There is also little apparent    How They Affect PSD
effort to regularize the legal status of the informal
sector or to remove discriminatory regulations.    In many developing countries in recent years the
None of the projects studied addressed the legal sta-  public sector has assumed new functions and rapidly
12



expanded its domain of public agencies and state-      benefits. Hence, if maximum  benefits are to be
owned enterprises. As indicated in chapter 1, this     achieved, positive steps should be taken (such as reg-
expansion is now viewed in many countries as hav-      ulatory, tariff, or licensing reforms) to create a com-
ing gone too far. Efforts are under way to limit and   petitive environment. This may not be easy in small
streamline the role and number of public agencies,     countries with limited economic development. Nev-
especially through privatization of state-owned        ertheless, it is clear that in many cases privatization
enterprises, and to improve the quality of institu-    would make a valuable contribution to economic
tions that remain in the public sector.                efficiency. Privatization can also provide new and
attractive investment opportunities to foreign inves-
Privatization. Privatization encompasses not         tors, including those interested in debt-equity swaps,
only the sale of public assets to the private sector but  as well as to holders of flight capital from the country
also the transfer of management of other services      concerned.
performed by the state to private entities. Not many
years ago the concept of privatization was almost         Other Reforms of Public Institutions. When pri-
unheard of in developing countries. Now  it has        vatization is not appropriate or possible, the efficacy
almost become a buzzword in development conver-        of public institutions must be increased, both to
sations, as countries have become disenchanted with    lower budgetary costs and to ensure greater benefits
the performance of state enterprises. Small and large  from public intervention, be it through more effec-
countries in each region have indicated intentions in    tive public spending or better administration of gov-
regard to privatization. Although hard data are not    ernment regulations. The quality of government is
available on the subject, it appears that there has    clearly crucial to the private sector. Effective public
been more talk than action. A Bank survey of thirty-   planning, budgeting, and administration are major
seven countries showing interest in privatization      areas for policy reform, but go beyond the scope of
found that in all but two (Chile and Bangladesh)       this report. (See World Development Reports for
fewer than twenty enterprises, primarily small ones,    1983 and 1988.)
had been privatized.
These results, on reflection, are not surprising.    What the Bank Group Can Do
The impediments to privatization vary widely from
country to country, but may include (a) opposition     Two issues are briefly addressed here: the treatment
from entrenched state bureaucracies or labor inter-    of privatization of state-owned enterprises in Bank
ests, (b) unrealistic hopes to sell enterprises that   operational work and the treatment of the private
should perhaps be liquidated,3 (c) indecision about    sector in the Bank's public expenditure and invest-
whether to sell "as is" at low prices or to attempt    ment reviews and related adjustment lending condi-
restructuring and then sell, (d) political concerns    tionality.
about concentration of control in the hands of local
powerful groups or foreign investors, and (e) serious     Privatization. Privatization has been supported
valuation gaps between buyers and the government.      by the World Bank as part of its broad efforts to
The two important elements to serious progress in      rationalize the performance of state-owned enter-
the area of privatization are political will and a prag-  prises and by IFc as part of its support for the devel-
matic, hand-tailored approach.                         opment of private sector activities. The Bank's work
Of course, privatization is not an end in itself and  usually involves country economic and sector work,
certainly should not be promoted merely on ideo-       structural and sectoral adjustment lending, and
logical grounds. The acid test for any privatization   public enterprise restructuring loans. Of the 109
proposal is whether, given all the circumstances in     projects in the previously mentioned survey, 33 pro-
the country concerned, it can be relied upon to pro-   vided for divestiture, 21 contained components
mote economic efficiency. For example, selling a       involving other forms of privatization (leasing, man-
firm that continues to operate in a highly protected   agement contracts, concessions, and so forth), and
environment cannot be expected to bring long-run       30 provided for liquidation of state-owned enter-
prises. In a number of countries, adjustment loans
also contained diagnostic studies which categorized
3. Liquidation is the appropriate response in cases where there  state-owned enterprises according to their appropri-
is no economic and financial merit in continuing the business.
Indeed the limited data available suggests that liquidation has out-    ate eventual disposition (public ownership and man-
paced actual privatization.                            agement, public ownership and private management
13



or leasing, divestiture, or liquidation). Interestingly,  However, it does not appear that public expenditure
divestiture and liquidation were the two most com-    reviews have explicitly considered ways to increase
mon features of institutional reforms among the       private sector participation in the provision of serv-
projects studied. Iiwc's efforts have been in both advi-    ices. This report recommends that this question be
sory and financing capacities. It has financed twelve  more explicitly addressed in future public expendi-
restructuring operations that involved privatization  ture reviews. The sector policy studies on PSD pro-
largely in Africa and Latin America. It is currently  posed below will provide guidance and support for
involved in advisory work in a number of other        the country specific work in this area.
cases.
Divestiture and liquidation, however, have proved   The Need for a Comprehensive Framework
difficult to carry out, even where governments are
firmly committed. Thin local capital markets, resis-  The factors that contribute to the enabling environ-
tance to purchases by foreign or minority investors,  ment for private sector development are highly
difficulties in determining an accurate sales price,    interactive:
political obstacles, and labor opposition were just   * A stable macroeconomic setting is essential for
some of the factors limiting the extent and speed of    effective reform of incentives.
divestiture and liquidation. Other forms of privatiza-  * Macroeconomic stabilization without structural
tion, although they are being explored, have so far     reform may damage growth performance.
found only limited application. In the Bank Group,    * Incentive reforms have fiscal implications that can
the ability to assist governments has been hampered     threaten macroeconomic stability.
by limited in-house expertise in relation to the high  ' Reform of incentives without reform in the legal
intensity of staff input required.                      and regulatory framework will limit the supply
This report recommends an expansion of the            responses.
Bank's research and advisory capacity on privatiza-   * Privatizing state-owned enterprises into a dis-
tion, especially as regards the institutional and incen-  torted market environment may make matters
tive framework; an increase in the analysis of the      worse.
legal and regulatory environment for privatization;   * "Getting the prices right" will not be of much use
an expansion of the technical operational support in    when much of the productive capacity of a coun-
the design of components for adjustment and             try is owned and run by the government.
restructuring loans dealing with privatization; and an  * Sustaining a supportive policy environment is
expansion of IFC'S capacity to provide technical assis-  impossible if the administrative capabilities of the
tance and advice to the Bank and to governments         government are weak.
and to prepare for specific privatization undertak-   * The quality of government may suffer where the
ings. MIGA'S start-up is also propitious, for it can pro-  incentive, legal, and regulatory framework pro-
vide incentives for foreign capital in relation to      vides ample opportunities for civil servants to
privatization. In any case, operations designed to       abuse their discretionary powers.
support privatization should be realistic about the     For these reasons, reforms designed to strengthen
scope and speed of progress.                          the enabling environment for the private sector have
to be based on an understanding, at the country
Public Expenditures. The Bank has carried out    level, of the binding constraints, the essential inter-
many reviews of public expenditure over the past      actions among them, and the importance of timing
decade. Many of these studies, and the adjustment     and sequencing, so that reforms may be effective and
operations drawing on their findings, have advo-      sustainable.
cated cuts in public spending and changes in priori-    The enabling environment is particularly impor-
ties, mainly to reduce the public sector deficit and  tant for two special areas of concern: entrepreneurial
eliminate low-priority projects. Reducing the deficit    and technological development. Entrepreneurship is
indirectly affects the private sector, as it reduces the  the ability to identify and exploit profitable business
crowding out of private by public activities. More-   opportunities. Entrepreneurs are risk takers, innova-
over, to the extent that high-priority expenditures   tors, people able to manage and market. They have a
are frequently those most complementary to private    central role in PSD. Studies of entrepreneurs have
sector activities (operation and maintenance spend-   found them generally concentrated in small firms,
ing for infrastructure, for example), cuts of low-    among members of minority groups, among the bet-
priority expenditure are indirectly supportive of PSD.    ter educated, and located often in the central areas of
14



large cities, where they have ready access to labor     basic research; that effective interaction between
markets and business services. Studies also indicate     publicly supported technology development institu-
that in developing countries potential entrepreneurs    tions and private industry is essential; and that fiscal
are not in short supply, not even in the least devel-   and credit measures in support of technological
oped countries in Sub-Saharan Africa.                   development should be unambiguous and simple
Instead, the scope for entrepreneurial develop-       and should involve some cost-sharing by the benefit-
ment in developing countries is often limited by poli-    ing industry. The elements that make up a good ena-
cies that tend to be stacked against the typical        bling environment in general therefore also apply to
entrepreneur. These policies are usually the ones       the specific case of technological development.'
reviewed here as determining factors of the enabling       In sum, efforts to improve the enabling environ-
environment. Weakness in supporting services and        ment are an essential part of any strategy to foster
in financial market policies further aggravates this    private sector development, entrepreneurship, and
bias. Governments can go a long way in fostering        technological development. The factors that deter-
entrepreneurial growth by removing international        mine the enabling environment are interrelated and
trade and regulatory barriers against small firms, by   need to be treated in a comprehensive framework.
reexamining their policies toward minority and          Such a framework has to be country specific and
foreign-owned firms and the domestic trading sec-       strategic in nature. This report recommends that
tor, by increasing access to basic education and infra-  considerations of the enabling environment be made
structure, and by ensuring that the financial system    an intcgral part of the Bank Group's country strate-
can respond flexibly and competitively to the special   gies for PSD. Adjustment operations are the natural
needs of the small firm.                                vehicle to translate analytical insights into explicit
Another critical element in PSD, also dependent in    support through lending operations. Without over-
part on the enabling environment, is technological      burdening existing adjustment programs, reforms in
change. Many governments in developing countries        the enabling environment should feature promi-
want to move ahead in what they see as a rapidly        nently in future adjustment loans. The scope of such
changing race in the development and adaptation of      operations can be appropriately narrowed, as in the
technology. The temptation has been to get public       case of the recent restructuring or adjustment loans
agencies to take direct responsibility for the develop-  to the Philippines and Indonesia. In any case, it is
ment and intermediation of technology, to the exclu-    essential that the narrower adjustment operations be
sion of other options. Studies of technological         firmly embedded in a clear macroeconomic strategy
development have concluded that the demand side,        accepted by the government.
in particular the competition and the incentives that
domestic industry face, is as important as the supply
side, if not more important. These studies have also
side,if no  moreimporant. hese tudie havealso 4. Other elements supportive of technological development
found that controls on technology imports are gen-      include the establishment or strengthening of scientific research
erally not an effective means of developing an indig-   and teaching institutions-this is an area where the Bank has pro-
enous technological capacity; that on balance more      vided support-and assistance to governments in locating. evalu-
ating, and acquiring technologies-this is an area in which IFC is
resources should be devoted to technology adapta-       considering the development of advisorv capabilities. Both efforts
tion than new  technology development through           by the Bank Group should be further strengthened.
15



3 Providing Infrastructure
and Services
Creating and maintaining infrastructure and social    and costs may significantly diverge for services that
services are preconditions for the development of    exhibit the characteristics of "public goods." For
the private sector, as well as general economic    example, when an individual's consumption also
growth. They affect an enterprise's cost of doing    affects the well-being of others, as it would for
business in a country and its competitiveness in    immunization, family planning, or basic education
international markets. Transport and communica-    services, a private market would lead to underutiliza-
tions systems are critical in linking production points   tion of the service. Another example is basic
with markets, whether foreign or domestic. Power    research-because findings are easily disseminated
and water are essential inputs in the production    and benefits widely shared in society, self-serving
process. Education, health care, housing, and other    individuals need to be given an incentive to do more
services affect the productivity of laborers and man-    than they would normally do. Also, the government
agers.                                            may simply have goals, such as the reduction of pov-
Many infrastructure and social services are widely    erty, that are not adequately considered by individ-
recognized to be primarily the responsibility of gov-    ual consumers and entrepreneurs.
ernment, because an unregulated private market     Another justification for public involvement in
would or could not provide them well. The first part   infrastructure is that private providers may find it
of this chapter discusses how publicly financed and    difficult to obtain a fair return on their investment.
administered infrastructure activities, to which a    For ports, telecommunications, and power systems,
large part of the World Bank's resources has tradi-   for example, expansion may require a few large
tionally been channeled, can stimulate the enabling    investments rather than many small ones. Potential
environment for PSD.                             private providers would thus be deterred from enter-
The private sector may also have a greater role to    ing without some assurance of a large market share.
play as a provider of these services, because the    In other cases, such as urban road construction, the
effectiveness of government intervention is limited.    costs of identifying individual users and charging
The second part of this chapter is devoted to the    them may simply be too high.
private sector's role as a provider of some services
that have traditionally been considered public. The    The Impact of Publicly Provided Infrastructure
Bank Group has played only a limited role in this
area.                                            The impact of such public investments on private
entrepreneurs, as well as on the general economy, is
Private Sector Development                       undeniable. Studies based on wage employment data
through Public Services                          show that the social rate of return to education, as
calculated by comparing the higher lifetime produc-
Why is public involvement sometimes necessary? A  tivity of educated workers employed in the private
conventional market sets prices where buyers' will-   sector with the social cost of education, generally
ingness to pay equals suppliers' cost of providing the    exceeds that of most alternative investments. This
last unit consumed. But private and social benefits   finding is corroborated by evidence that annual crop
16



Table 3-1. The Share of Infrastructure in Bank Lending, Fiscal 1960-87
(average annual share in percent)
Purpose                       1960-64      1965-69     1970-74      19,75-79     1980-84      1985-87
Education                                  0.5          3.4          5.1          4.4         4.4          4.7
Population, health, and nutrition          0.0          0.0          0.5          0.7         0.8          1.4
Irrigation and drainage                    7.6          6.2          6.7          9.6         8.3          6.2
Research andextension                      0.0          0.0          0.1          1.5          1.1         1.5
Power                                     32.1         25.8         17.8         12.7        15.5         16.6
Telecommunications                          1.4         3.4          4.9          2.0          1.7          1.7
Urbanization                               0.0          0.0          0.8          2.5          3.4         5.9
Water supply and sewerage                   1.2         1.5          4.6          5.2          4.6         4.9
Transport                                 40.5         29.5         24.2         16.4        12.8         11.3
All infrastructure                        83.3         69.8         64.8         55.0        52.5         54.2
Note: Infrastructure is broadly defined to include investments in human capital, as well as physical capital.
Source, World Bank data.
yields of farmers with four years of education are as      ing, particularly as agricultural area development
much as 9 percent higher than those of farmers with        schemes took off in the early 1970s and nonproject
no education. Research in Seoul and Sao Paulo has         lending grew rapidly in the 1980s. Still, lending in
shown that crowded city centers, which have good           these sectors totaled more than half of all IBRD and
transport, electricity, and communications services,       IDA lending in fiscal 1987.
are good at hatching new industries. The proof that
they act as incubators is that they have a substantial       Physical Infrastructure. The Bank's investment in
share of the total number of new jobs and firms in         physical infrastructure has significantly extended
the city and attract small firms.                          Africa's formerly skeletal road network, Asia's irriga-
If the public sector did not provide these services,    tion systems, and Latin America's power capacity.
or provided them  unreliably, the private sector           Many of these projects have eliminated bottlenecks
would have to compensate. Many of these private           to private sector growth. Although it is difficult to
infrastructure investments are inefficient because        isolate the direct impact of these projects on PSD,
they are too small. For example, Nigerian manufac-         they have generally been successful on the basis of
turers face frequent interruptions of publicly pro-        broader economic criteria.'
vided water, electricity, telecommunications, and            The problems that infrastructure projects have
waste disposal. They have had to make substantial          faced reflect the general constraints on the public
capital investments in these services themselves,          sector in developing countries (which are discussed
which adds to their production costs and thus has          more fully below). Inadequate tariff increases in the
hurt their international competitiveness. Private         face of inflation and management problems have led
water vendors, who have an inefficiently small             to problems of sustainability in railways, water, and
volume of business, operate in cities where the unit       power projects.
cost of piped water provided by a utility would
probably be much lower (by a factor of four in               Human Resources. In the mid to late 1960s the
Lagos, three in Nairobi, and two in Lome). Long-term      Bank started lending for human resource develop-
development of the economy in general and the pri-        ment. Investments in education and health raise the
vate sector in particular must therefore be comple-       level of managerial and labor skills, which is critical
mented   by  efficiently   built  and   operated          for expanding the private sector. The magnitude of
infrastructure services, many of which need public
support.
1 . A recent review of project performance results by the Bank's
Operations Evaluation Department indicates that, for projects
What the World Bank Has Done                              audited between 1976 and 1985, the average economic rates of
return for transport and urban development projects ranged from
17 to 23 percent-higher than the returns for agriculture and
The Bank has long been a major source of financing        industry in eight of the ten years in the study period. Rates of
for investment in public infrastructure and support-       return for power, water, and telecommunications projects,
ing services. In the early  1960s such lending             although not strictly comparable for methodological reasons,
were also "judged to be satisfactory." World Bank Operations
accounted for three-fourths of the Bank's portfolio        Evaluation Department, Twelfth Annual Review of Project Perfor-
(see table 3-1). Since then, the share has been declin-    mance Results (Washington, D.C.: World Bank, 1987), p. 10.
17



the Bank's involvement has been large-almost $8        encouraged closer coordination between graduate
billion since 1962 in education, for example. IDA      schools and research institutes. In Brazil two years
alone contributed 14 percent of all external resource  later, a project for science and technology financed a
flows to African education and training in 1983-85.    program of research in science, chemical engineer-
The Bank is now the largest international source of    ing, and biotechnology and promoted the setting of
lcnding for health in developing countries.            industrial measurement standards. A follow-up loan
All human resource investments, including basic    is currently being considered. These investments are
education and primary health care, affect private sec-    too recent to be evaluated.
tor development in the long run through their
impact on labor force productivity. The Bank has       Limits to Publicly Provided Infrastructure
also traditionally directed a large share of its human
resource operations toward activities that have a      Despite this record, much more needs to be done by
more direct and immediate link with the private sec-   countries and the Bank to maintain what has already
tor's labor market needs. Vocational education and      been built, never mind adding to it. In meeting this
training have taken up almost half of all Bank lending  challenge, the public sector confronts severe con-
in education from the early 1960s to 1986. As indi-    straints:
cated in box 3-1, the success of these projects in      * Finance. The fiscal crisis that began in the 1970s
delivering the needed quality and quantity of trained     slowed the expansion of infrastructure, although
labor to the private sector varies according to the      the need for it continued to grow. In a sample of
type of training provided.                                fifteen developing countries, central government
The Bank has also invested in more broadly based        spending fell by 18 percent in real terms from
scientific and technical research. These investments      1979 to 1985, while spending on infrastructure
have long-term  payoffs to industry, particularly in      alone fell by 25 percent. Many of the poorest
rapidly modernizing economies. In Korea a sector          countries have made large cuts in spending per
loan in fiscal 1984 for science and technology pro-       capita for social services. Between 1975 and 1983,
vided loan assistance to strengthen the management        for example, real expenditure for each pupil in
of Korean grant-giving agencies for science, and it       primary education declined in seventeen out of
Box 3-1. Bank Lending to Train Workers and Entrepreneurs
Although the Bank has continued its strong support    investments. For example, the recently approved
for vocational education and training in the past dec-  Pakistan highway project contained a component to
ade, there have been significant changes in emphasis    train local contractors in maintenance. Although
and considerable variation in investment perfor-    project-related training is used in many Bank-
mance. For example, Bank lending for diversified sec-    sponsored projects to fill gaps in skills needed for
ondary schools (which combine academic and         construction and operation, various reviews have
vocational curriculums) was virtually discontinued  shown that the design and implementation of these
after a rigorous evaluation revealed that it was not  components are frequently in need of improvement.
cost-effective. Graduates were not entering the labor  The Bank has had more success in implementing its
force at a higher rate than their counterparts in aca-    free-standing training projects, particularly those pro-
demic streams, even though more money was spent    viding agricultural extension, management, and
to expose them to more practical courses. Increasing  accountancy training.
emphasis has instead been given to the development   For all of these systems a fundamental difficulty is
of national industry training systems, often built    that the public sector has difficulties in matching grad-
around informal training centers and involving work-  uates, skills, and job needs. Manpower projections are
study. Such systems have closer ties with employers    cumbersome and inaccurate tools to assist the govern-
and greater flexibility in responding to rapidly chang-  ment in planning training places for the private sector.
ing demands for skills. Bank research in Latin America  The signals and incentives inherent in training that is
found them to have high rates of return.           privately provided may better serve the needs of the
Another type of human resource investment closely    labor market. Thus, options in the private sector, such
linked to the labor market is project-related training-  as private training centers or on-the-job training, need
training components attached to traditional project    to be given increased attention.
18



twenty-five low-income countries. Trends such as    run, and maintained by government departments.
these suggest that the large gap in human           However, tightening budgetary constraints and
resources between developing and industrial         administrative failures have led many governments
countries will widen.                               to reevaluate the appropriate role of the private sec-
* Inefficiency. A fundamental problem is that lim-    tor as a provider of some physical infrastructure and
ited public resources tend to be badly used. Not    social services. There are precedents for private
enough is channeled toward cost-effective serv-     involvement. In the early years of many industrial
ices. For example, a general neglect of mainte-     countries, basic infrastructure-such as roads, rail-
nance has led to accelerating deterioration in      ways, and power-was financed and built by private
existing capital stock. As a result, about a quarter  entrepreneurs.
of the paved roads in eighty-five developing coun-
tries are in need of reconstruction-at a cost three  Striking a Balance between Public and Private
to five times that of timely maintenance. In some
countries, de facto policies to have the public sec-  There is no single correct balance between public
tor act as an employer of last resort have led to a  and private providers. In each case, it depends on
large inflexible wage bill and, often, a wage struc-  the characteristics of the good or service and condi-
ture devoid of incentives.                          tions of the country. However, some general princi-
Because of these problems, the success of further   ples can be applied, which may mobilize more
investment in infrastructure depends upon comple-     resources from the private sector and may improve
mentary policies regarding pricing and institutional  competition in the provision of public services.
reform. Establishing appropriate pricing policies
would give the right signals to public sector pro-      Services Where Conventional Markets Work. For
viders regarding investment needs and to private sec-  some infrastructure services, such as housing, urban
tor firms regarding use of the service. These issues  bus transit, trucking, curative medical care, and job
are reviewed in detail in World Development Report    training, competitive markets are viable-there are
1988. Developing countries, with Bank assistance,     no technological barriers to entry, and externalities
have begun to address these issues with broadly       can be handled by government regulation. In such
based sector adjustment programs, in social as well    situations, studies consistently show  that private
as physical infrastructure.                           providers are more efficient than comparable public
Another type of reform  is institutional-public     ones. Conventional markets work reasonably well in
administrators need to be more efficient themselves   providing the appropriate service at least cost
if they are to provide efficient and effective infra-  because the agents are accountable to users.
structure conducive to PSD. Proper budgeting and        Data for urban transport illustrate this point. In
managerial reforms in the public sector are discussed  cities where bus services are provided by both
in the 1983 and 1988 editions of the World Develop-   public and private operators, the cost per passenger
ment Report.                                          is lower for private operators than public operators,
In some cases, countries have recognized that the   who are invariably highly subsidized. The ratio of
public sector's pervasive role in the provision of    private to public costs per passenger in 1985 for
infrastructure cannot be sustained. Adequate infra-   comparable bus service in selected cities is as fol-
structure depends not only on more resources for      lows:
investments, but also on improvements in the way
that such infrastructure is operated and maintained.        Ankara   0.48        Jakarta     0.50
In the face of constrained public resources and skills,
countries are considering ways to use private   Calcutta  0.37       Khartoum   0.40
many countes are consderg ways to use prvatel  0.85
initiatives-sometimes with Bank Group assistance.
These issues are reviewed in the next section.          For these same cities, the public operators have a
lower fleet utilization rate, a higher staffing ratio, and
The Private Sector as a Provider of Infrastructure    a greater incidence of fare evasion than unsubsidized
private operators.2
In most developing countries, electric power, water
supply, and telecommunications services are pro-
vided by publicly owned utilities; transport net-       2. Data are calculated from table 6.3 of World Development
works, schools, and health facilities are constructed,  Report 1988 (New York: Oxford University Press, 1988).
19



Even when these services are provided privately,     regulation of housing finance markets. Interest rate
the government still has a role. In urban transport, it    ceilings and portfolio restrictions on banking institu-
has a role in traffic regulation and management, vehi-    tions have significantly limited the ability of savings
cle licensing, safety and environmental standards,    to be channeled to the housing markets, as in Argen-
and where feasible, road pricing. Policy changes in     tina and Malaysia, and, until recently, Chile and
these areas can be cheap, congestion-relieving alter-   Korea. These restrictions can have debilitating
natives to new transport investments. The govern-       economywide effects on PSD because housing supply
ment may also want to ensure access to transport        constraints decrease labor mobility.
facilities for the poor, through subsidized ridership     Thus, private providers, whether in transport,
and neighborhood road improvement.                      housing, or other services with strong competitive
However, when government intervention itself         markets, work best with a minim<ium of control on
has stifled competition, there is little hope that the  price-setting. For the very poor, some form of assis-
private sector can be an effective provider unless the  tance may be warranted. Such intervention can also
restrictive aspects of public policy are changed. Pri-  be efficiently channeled through the private sector
vate housing markets in many cities, for example,       (as in box 3-2).
have been overly restricted by rent control, which
has often produced results exactly opposite to those      Services Where Competition Is Not Ensured. For
intended. Studies show  that the benefits of such      some infrastructure and social services, the absence
restrictions to present renters are low. Some restric-  of economies of scale or the presence of externalities
tions are simply not effective because of side pay-    hinders competition. If so, it is difficult to argue that
ments, such as key money paid directly to the          a regulated private monopoly would necessarily be
landlord in lieu of market rents. Effective restric-   more efficient than a well-run publicly owned utility.
tions, however, inhibit maintenance and new            While managers of a private monopoly are ultimately
construction-as in Kumasi, Ghana, where controls       answerable to shareholders and debt holders and
have virtually stopped new construction. Another       may have an incentive to maximize returns, their
constraint on the supply of private housing is over-   monopoly position does not provide much incentive
Box 3-2. The Private Sector Can Be Used to Meet Social Goals
Public spending is often seen as an efficient way to    areas that public providers could not financially
redistribute resources to poor households. Many gov-  sustain-this is the experience of private bus contrac-
ernments would like to have a social "safety net" to    tors in Bangkok, Istanbul, and Kingston.
ensure the poor's access to basic physical infrastruc-  Even where public subsidies are necessary, the pri-
ture and social services.                          vate sector can have an important role. If subsidized
This goal need not be inconsistent with the private    consumers were given an incentive to choose the
provision of infrastructure and social services. In  most efficient supplier of the service, there would be
many cases, the poor may have limited access to the  more resources to redistribute. Chile's restructuring
most highly subsidized, publicly provided services.    of its housing finance system, funded partly by the
Subsidies to higher education and expensive urban  World Bank, is a good example. Until the mid 1970s
hospitals go primarily to upper-income groups. Costly  Chile used directed credit (at artificially low interest
subway systems, such as those being built in Caracas    rates for everybody) and publicly built units to pro-
and Sao Paulo, will not directly serve the lowest    vide housing. This system was financially and eco-
groups, who demand few of the longer trips the sub-  nomically unsustainable. Now an explicit housing
ways provide. Subsidizing the unit cost of electricity    subsidy system is targeted to families who may have
does little good to the small consumer who has few  some capacity for savings but lack sufficient income
appliances.                                        to buy housing. The subsidy is a direct, one-time grant
Thus, encouraging unsubsidized private provision  given in the form of a certificate, which the benefi-
in some services may not adversely affect the poor. It    ciary can use to purchase or build a new or previously
may even help, if public subsidies are then redirected  occupied dwelling in the private market. This reform
toward services used by the poor, such as basic educa-    has significantly lowered the cost to the government
tion and health care. Also, lower-cost, competitive  and to the economy, while serving more poor people.
providers may find it profitable to serve low-revenue
20



Box 3-3. Public-Private Partnership: Build-Own-Operate Power Schemes
Innovative techniques to overcome the classical prob-  created Private Sector Energy Development Fund.
lems of underdeveloped capital markets, high risks,    That fund is currently being administered by the
and lack of private sector interest in financing large  National Development Finance Corporation. The rest
power projects are being tried in developing coun-  of the money would be provided by export credit
tries such as Pakistan. The so-called build-own-   agencies and private lenders. IFC, which has worked
operate scheme is designed to increase the incentives  with the Bank on this scheme, is poised to help raise
for the private sector to construct and operate facili-    private funding for these projects. Altogether about 7
ties to generate power. The scheme encourages con-  percent of the financing would come from the Bank,
tractors to own equity interests in the projects.  23 percent from bilateral agencies, 25 percent from
In Pakistan eight power generation projects are   private equity holders, and 45 percent from private
being considered. Together they would be worth    lenders.
about $2 billion and would have a production capac-  The government of Pakistan will institute measures
ity of 2,000 megawatts. All of the projects are joint    that provide financial incentives and reduce risks to
ventures by consortiums of domestic and foreign con-    lenders and investors. Important elements of this
tractors. The private sponsors would mobilize the  package are an expected rate of return providing a
equity for each project. The World Bank and several    reasonable vield to private owners, provisions for
development agencies-notably from  the Federal    repatriation of profits, and guaranteed purchase and
Republic of Germany, France, Italy, Japan, the United  price agreements between the power generators and
Kingdom, and the United States-will provide as    the national utilities. The initial reaction of interested
much as 30 percent of project costs through a recently  parties indicates that the scheme will be a success.
to reduce costs. For example, prior to its break-up in    transfer" (BOT) or "build-own-and-operate" (BOO)
1983, the Bell telephone system in the United States   basis, under which a private firm finances some or all
provided excellent service (and returns to its inves-  of the initial investment and is remunerated directly
tors), but it was needlessly expensive. The company    from  revenues earned by the project from  selling
was able to justify high local rates by adding to its  output to a public utility. BOT schemes provide for
cost base. Such a system  puts a heavy burden on       the eventual transfer of ownership to the state or to
regulatory authorities to monitor the firm closely     private domestic investors (see box 3-3 for further
and to develop innovative incentive schemes-a dif-     description of the Pakistani initiative).
ficult task, particularly in developing countries.       To increase competition in transport and water
Nonetheless, the private sector can still play a role  supply, some countries now allow free market entry
as a provider of infrastructure services in some stages  and fair treatment to qualified private contractors for
of the production where competition can be intro-      construction and, to a lesser extent, operation and
duced. U.S. telephone users now benefit from exten-    maintenance. It is difficult to assess the cost-
sive competition in telephone equipment and            effectiveness of contracting compared with force
long-distance service. In regard to electrical power,  account (that is, work done directly by a government
even though natural monopolies exist in transmis-    line agency), because force account units undervalue
sion and distribution, generation can be done effi-    the true economic costs of their operation. One
ciently by small producers, who can sell it to         example from  Brazil indicated that force account
consumers through public utilities. In the United      costs 60 percent more than contracting. A recent
States, because of the Public Utility Regulatory Poli-    review of experience found that roads under con-
cies Act implemented in 1982, most new planned         tract were well maintained in Argentina, Brazil, Cen-
power generation is anticipated from private genera-   tral African Republic, Ghana, Kenya, and Yugoslavia.
tors (mostly cogeneration facilities). A similar pro-  In addition, services such as stevedoring in Chile or
posal is being considered in the United Kingdom. In    the sale of railway tickets in Korea, which used to be
developing countries, Turkey and Pakistan have         done by public agencies, are now being contracted
recently opened the door to the private sector,        out. In Cote d'Ivoire, the public water supply
through foreign as well as domestic firms, to con-     authority is responsible for owning and financing the
struct and operate power plants. These initiatives     fixed assets, while a private company is responsible
(yet to be implemented) arc on a "build-operate-and-   for opcrations and maintenance. Contracting out is
21



also being tried in education. Chile and the Philip-  cases, nonprofit, nongovernmental organizations
pines have implemented exploratory schemes to         have been involved (box 3-4).
allow the surplus of students over the maximum
public school enrollment to be educated in private      Changing Policies toward Private Providers.
schools for a fee charged to the government.          Recent Bank sector loans have stressed the need to
Initiatives such as these require improvements in   provide an atmosphere conducive to PSD. Much can
regulatory frameworks and institutions to ensure      be done through deregulation. For infrastructure
efficiency. One major impediment to direct private    services that could feasibly have conventional mar-
sector investment is the risk that price controls or  kets, the private sector is being encouraged to partic-
government interventions will reduce returns.    ipate.
Another barrier is governments' inability to design,    Recent housing loans by the Bank in Korea and
award, and supervise contracts that ensure equitable  Chile (see box 3-2 for the latter), for example, have
risk sharing and good performance. Governments        eased financial restrictions that make it unprofitable
must shift from being doers to being regulators-      for commercial lenders to channel their resources to
which may require different skills and rewards. In    housing (see also IFc initiatives, discussed in chapter
some cases, government officials may see such         4). At the same time, the governments have limited
moves as a loss of authority. A recent Bank-funded    subsidized public construction in order not to crowd
scheme in Bangladesh to privatize lift pumps failed   out more efficient private providers, while attempt-
because of bureaucratic hurdles. Two recent BOT ini-    ing to target housing subsidies to the lowest income
tiatives for highway construction in Southeast Asian  segments of the population. The Bank supported a
countries have been delayed because of political      recent program by the government of Zimbabwe to
obstacles.                                            involve private financial institutioins in supplying
mortgage loans at commercial rates to low-income
Wlhat the Bank Group Has Done                         households.
In urban transport, the emphasis has been on traf-
fic management and safety standards. A loan to
The Bank Group is only beginning to support greater    Jamaica focused on traffic management and road
private sector involvement in infrastructure and      maintenance in direct support of the government's
service provision. This section reviews a few signifi-    privatization plan (see below). The first Mexico
cant initiatives, without attempting to compile an    urban project, launched in fiscal 1987, provides for
exhaustive list.                                      the development of a maintenance facility to be
In lending operations, Bank Group support           operated and funded by a cooperative representing
includes the following: sector work and policy-based  private bus owners and operators to make adequate
lending to enhance the enabling environment for       maintenance available at reasonable cost.
these initiatives; the promotion of private subcon-     The Bank has also made significant contributions
tractors to public agencies for construction, opera-    in the policy dialogue to expand private participa-
tion, and maintenance; and direct lending (or    tion, particularly in the social sectors. Recent papers
on-lending) to private firms in these sectors or assis-    in health and education have put topics like user
tance to divest state-owned enterprises. In some      charges, educational credit, and health insurance on
Box 3-4. The Role of Nongovernmental Organizations
Nongovernmental organizations (NGOS) often have a  implementation to consultant services to cofinancing.
good understanding of the local environment, easy  In some cases governments have made grant funding
access to intended beneficiaries, and a willingness and  available to NGOS in the context of a Bank project. In
ability to finance and use low-cost technologies. In  Bangladesh, a population project allocates support for
recent years the Bank has tried to incorporate NGOS  NGOs and emphasizes expanding their role in the
into projects, particularly those concerned with rural  delivery of services, Similar NGO support has been
development, health and education, the environment,    included in population projects in Guinea, India,
and poverty alleviation. NGO roles range from project  Malawi, and Zimbabwe.
22



the international agenda-all topics that will facilitate  pany's operations declined to the point where only
an expansion of PSD in areas traditionally reserved for  140 of the company's 575 buses were operational
the public sector. These issues are starting to be  and deficits were enormous. The Bank provided
included in some sector adjustment loans (in    loans for technical studies of privatization and for
Morocco and Ghana education programs, for exam-     road maintenance. The recent Bank loan for rational-
plc).                                               izing public enterprises in the Philippines also
included the privatization of Metro Manila transit. In
Contracting Out. The Bank has been instrumental   Guinea, Conakry's urban transport company, long
in strengthening the performance of state enterprises  plagued by administrative difficulties, is to be turned
and government departments by advancing fair    into a joint venture company with private participa-
treatment for private contractors. Contracting out    tion; its port has agreed to privatize ship and cargo
introduces private involvement in activities where  handling so that importers and exporters can now
competitive ownership is not economically or, in    freely select freight forwarders and customs agents
many instances, politically feasible. By the end of  among private companies.
fiscal 1986. the Bank had financed 169 operations in  IFc has been involved in the development of infra-
74 countries aimed at strengthening the construction  structure in a variety of ways. Examples of direct IFC
industry through technical assistance, training,    investments in the development of infrastructural
credit, and encouraging borrowers to change from    facilities are, however, few. Ventures in the 1960s
force account to contracting. Although some of this    and 1970s were mainly in electric transmission and
went to state-owned construction corporations,    long-distance telephone networks. The first and so
much of it was devoted to contractors, particularly    far the only investment in a gas transmission pipeline
in highway projects.                                was authorized in 1977 in northern Colombia. The
In addition to construction, contracting out of   1980s saw a slight broadening of IFC involvement. In
operations and maintenance has also been encour-    1981 two bulk terminals-one in Korea and another
aged. Guinea is only one of the more recent exam-   in Somalia-were initiated with partial IFC financing.
ples, where the loan covers repairs and maintenance  In 1982 rFC made its first investment in a health-
of private contractors and, as important, strengthens  related field by financing about 25 percent of a $64.3
the public management's capability to supervise     million project in Yugoslavia. The project involved
such work. Another innovative project is in Nigeria,    the expansion of a medical rehabilitation facility for
where the Bank loan establishes an infrastructure    the treatment of patients with arthritic, rheumatic,
development fund to be used by selected merchant    pulmonary, and cardiac ailments.
banks to identify, appraise, supervise, and cofinance  The limited number of IFC investments in infra-
urban infrastructure projects undertaken by state    structure is not surprising. Most infrastructural facili-
governments.                                        ties in developing countries are in government
control and closed to the private sector. It is, there-
Direct Lending to Private Providers. The Bank     fore, hard to come across private initiatives that
Group has also increased its support of private     could have been supported by the IFC.
financing of infrastructure and services, although
this is still relatively rare. The Bank has provided  What Can Be Done in the Future
technical assistance to develop a management con-
tract for water supply in Senegal. It has also provided  * Promote the expansion and efficient operation of
funds to be on-lent to private bus companies to buy   public infrastructure services needed for private
equipment in Jamaica and Mexico. The only on-         sector development.
lending scheme in education has taken place in        Despite increased emphasis on institutional
Korea, where loans for private technical institutes of    strengthening and financial efficiency, there is a need
higher education provided for equipment, construc-    for further improvement in the public sector perfor-
tion, and staff upgrading. The BOO power plant in   mance of many Bank borrowers. The Bank's infra-
Pakistan was mentioned earlier (box 3-3).           structure lending has increasingly focused on cost
Some Bank projects include the divestiture of     controls, appropriate pricing, commercial operating
public infrastructure agencies. In Jamaica the govern-  practices, careful targeting, and administration of
ment returned Kingston's bus service to the private  programs to assist low-income groups. Recent sector
sector in 1984, seven years after the service had been  adjustment loans have aimed at achieving policy
nationalized. While it was publicly owned, the com-  reforms in energy, transport, telecommunications,
23



urban services, health, and education. The Bank       these innovative schemes have been tried, the expe-
needs to continue to support such reforms.            rience to date has been limited. In some cases, privat-
* Undertake more research and policy work on the      ization is the path to follow (see chapter 2). In cases
appropriate role of the private sector for various  where complete privatization is neither economi-
infrastructure services.                            cally nor politically desirable, there are other ways to
A more thorough, sector-specific assessment is    introduce private interests to enhance efficiency.
needed of the possibilities and limitations of private  This activity would include: (a) seeking opportuni-
sector involvement in infrastructure. Although there    ties to fund all or part of government's share in joint
are compelling theoretical reasons why private sec-   ventures, on-lending, or BOT schemes; (b) identifying
tor involvement will increase the efficiency of serv-  the scope for greater private participation through
ice provision  in infrastructure, the empirical       subcontracting some activities in project implemen-
evidence for developing countries is relatively weak.  tation and operation of the service; (c) where feasi-
The Bank has undertaken some case studies in bus      ble, allowing the local and foreign capital markets to
transport and housing, although these evaluations     participate in infrastructure investments.
can be improved in methodology and design; more         IFC can play an increasing role in these areas (see
rigorous analysis has been undertaken in education.   chapter 4). The enlargement of its capital base now
Carefully designed studies can address questions like  allows it to make individual commitments of a size
the following: Under what conditions and for what    that, when combined with its syndicating capacity,
services will a private competitive market work bet-  will make it a major player in infrastructure projects,
ter? Can public providers mimic the incentives inher-  a role not financially feasible even five years ago.
ent in private sector provision?                      MIGA can also play an important role by according its
In addition, research should be undertaken on       guarantees to investors, and in particular by guaran-
pricing and other aspects of regulatory policy for    teeing the stability of their agreements with the host
private natural monopolies. Questions that need       government. Because of the experimental nature of
answers include: Should prices be regulated on the    many of these schemes, on-going evaluations of the
basis of costs or on the basis of broader price indi-    lessons learned are essential.
ces? What incentives need to be given to the private    Equally important is the policy dialogue with
sector to ensure efficient competition? Can regula-   member governments. The Bank Group should con-
tory schemes be effectively enforced?                 tinue its stress on subjecting public monopolies to
This basic research should complement more          competition. Research results on the efficiency gains
operational studies on service contracting (such as    from  having some services provided privately
the one done for highway maintenance) to form the     should be used to quantify the opportunity costs of
basis for sector-specific policies on private sector  present systems. The Bank can work on liberalizing
development in infrastructure.                        regulations that prohibit or restrict such competi-
* Increase the private sector role in financing and   tion. Where public and private sectors compete (as
operating infrastructure and basic services.       in housing and bus transit), Bank Group projects
Even while the basic research and policy work is    should not give an unfair advantage to enterprises
being undertaken, the Bank Group should continue      that seek a monopoly position. Assistance should be
to assist interested member countries in tapping pri-    given to strengthen the analytical capability of regu-
vate finance and managerial skills. Although some of    latory staff.
24



* 4 Financing the Private Sector
World Bank Group activity directly addresses the   mined domestic resource mobilization and the finan-
financial needs of the private sector in five ways: (a)    cial system. Third, governments' excessive reliance
by helping governments set policies that will send  on directed credit programs and their usurping finan-
the right signals to the financial sector as a whole, (b)    cial markets for their own use had led to inefficient
by promoting the development of the local capital    resource allocation. Fourth, the task of building a
market, (c) by establishing and financing intermedi-    sound institutional base required overall develop-
aries for domestic and foreign resource mobilization,    ment of the financial system, as well as special atten-
(d) by directly financing private sector activities, and    tion to regulation and supervision and to the
(e) by facilitating foreign investment in member    underlying legal framework. The Bank Group thus
countries. This chapter takes stock of the Bank    needed to assist countries on a broad range of sector
Group's efforts in these areas.                    and institutional issues in its future financial sector
operations.
Financial Issues                                     These concerns are as pressing today as they were
in 1985. Indeed in many developing countries insol-
The financial system facilitates growth by increasing  vent financial intermediaries, both commercial
the volume and efficiency of domestic inter-    banks and specialized intermediaries, seem to be
mediation-that is, the ability of banks and other    more widespread now. Only a few years ago general
institutions to pass resources from investors to bor-    insolvency was thought to be largely a Latin Ameri-
rowers, so that rewards are maximized relative to the  can phenomenon, with origins in erratic or inconsis-
risks assumed. The starting point for financial    tent macroeconomic policies. Insolvency is now
reforms is the macroeconomic framework. Overval-    widespread in most Latin American and African sys-
ued currencies, severe trade restrictions, and high    tems, and problems caused by public ownership and
inflation will impede reforms or reduce their bene-    credit allocation may be even more serious in Africa
fits. Therefore, the opportunities for successful    than in Latin America. Severe portfolio and structural
financial reform are greatest when the incentives and  problems have emerged in Eastern Europe, as many
other macroeconomic conditions required to put an    systems there move toward financial reform. In Asia,
economy on a sustainable path of growth are already    financial distress is less prevalent, but does exist in a
in place.                                          number of countries. If judged by a criterion that less
A 1985 internal policy paper on financial interme-    than, say, 20 percent of system assets be in institu-
diation examined financial issues prevalent in devel-   tions with negative net worth, few developing coun-
oping countries, and it articulated an initial approach    tries would emerge with a clean bill of health. The
for the Bank Group.                                extent of the problem, however, is not easy to gauge
The paper identified four concerns. First, the debt    because few developing countries have adequate
crisis had created unexpectedly adverse macroeco-    systems of financial reporting, loan classification,
nomic environments that had weakened many inter-    auditing, and regulation.
mediaries in developing countries. Second, policy   One cause of financial distress has been the imple-
regimes of negative real interest rates had under-    mentation of stabilization and structural adjustment
25



programs. These have involved: (a) large real devalu-  political conditions are reasonably under control and
ations, which have increased the burden of dollar    improving-the absence of such stability can frus-
debt (for many countries, foreign debt far exceeds    trate the reform process. Financial sector adjustment
domestic financial claims-a reflection of the his-    loans have been made to countries where the macro-
toric inefficiency of domestic intermediation), (b)  economic situation was doubtful. It may not be real-
trade liberalization, which has weakened the finan-    istic to expect major goals to be achieved if the
cial position of major borrowers, and (c) tight mone-  macroeconomic situation is not under control.
tary policy, which has often been imposed to           This experience is not necessarily an argument for
provide governments with the financial resources to  delaying financial sector reform until all other com-  r
service the predominantly public sector foreign      ponents of a package are in place. The longer reform
debt. Furthermore, financial liberalization, under-    is delayed, the more costly it is likely to be in fiscal
taken as part of an adjustment program, can itself    terms. The lack of reform also inhibits recovery by
spur financial distress by raising interest costs. Con-    diverting credit from viable borrowers. Comprehen-
versely, general financial distress inhibits successful    sive financial reform  can itself have adverse side
adjustment, as insolvent, but still-operating firms  effects, such as the emergence of very high real inter-
squeeze out potentially viable firms from the credit    est rates following their liberalization. Consequently,
market. Thus fewer firms can respond to the changes    the phasing of reform is a complex question. In view
in incentives that are usually part of a country's strat-    of the problems being encountered, it is timely that
egy for adjustment.                                  the World Development Report 1989 (forthcoming)
Because of the complex links between adjustment    will have the development of financial market as its
policies and financial distress, structural adjustment    theme.
reform needs to anticipate the potential impact of     The Bank Group is now participating in financial
losses on the financial sector. Structural adjustment    reform packages that go far beyond the traditional
programs should involve regular financial reporting  scope of its financial operations, which have often
and loan classification, for example, so that the    focused on interest rates. About one-quarter of the
process of sorting out losses and considering how    operations that involved development finance inter-
the system should handle them is started early on.   mediaries have included studies or actions related to
The depth of institutional reforms needed to       overall financial policies, and conditions agreed to in
enable countries to successfully operate a market-    the negotiation of adjustment loans increasingly
based, competitive financial system has also become  touch on domestic intermediation. The Bank has
more apparent. It is not enough to liberalize interest    also begun to approach the problems directly
rates, reduce government preemption of credit, and   through financial sector adjustment loans. As of fiscal
reduce the direction of credit to privileged borrow-  1989, four such loans have been made (one each to
ers, although these in themselves are difficult goals.    Argentina and Ecuador, and two to Turkey), and
Banking institutions are likely to require extensive  additional ones are under consideration. An eco-
technical assistance to enable them to function suc-    nomic recovery loan to the Philippines also had a
cessfully in a competitive environment. Accounting   large component for the financial sector.
and auditing procedures frequently must be revised,    Three broad issues have typically been addressed
and regulatory and supervisory institutions must    in the Bank Group's financial operations. Specific
change their emphasis, away from ensuring compli-    measures have depended on the degree of distress in
ance with rules for directing credit and toward    the financial system; severely distressed systems
assessing institutions for safety and soundness. A   have required the most draconian measures to deal
change of management is often a critical ingredient    with the losses of the banking system, as was the case
for successful reform. Although some countries have  in Chile.
the skills needed to liberalize their financial systems,  * Frameworksforprudence and restructuring. Bank
most do not, since such skills have not been required   Group lending  has supported  measures to
in the existing regulatory structure. The problems of   strengthen accounting and auditing procedures
low-income and socialist countries are particularly     and to determine the state of portfolios, provi-
noteworthy in this respect.                            sions, and writeoffs; efforts to clean up loan port-
It is too early to pass judgment on the success of    folios, recapitalize banks, and merge or close
adjustment lending to the financial sector. However,    banks; and improvements in the system of pru-
the consensus is that financial sector liberalization is  dential regulation and supervision to ensure that
best introduced at a time when macroeconomic and        the financial system will be sound in the future.
26



* Freeing-up thefinancial system. The Bank Group        ents of Bank loans, there was a tendency for the
has also endorsed removing or relaxing interest       Bank to take on a larger role in the ongoing dialogue
rate controls and directed credit; moving to broad    with a number of those institutions.
methods of monetary control and away from               There were several reasons why IFC'S DFI activity
bank-by-bank credit limits; relaxing barriers to      declined while Bank activity increased. First, IFc had
entry and exit and increasing competition in the      helped to create DFIS in most markets where it was
financial sector; and reducing and rationalizing fis-  possible to assemble private sector backing for such
cal burdens on financial systems.                     institutions. Second, it had discovered how difficult
* Capital market development. Increasingly a com-       it was to establish DFIS that would meet a reasonable
ponent of Bank loans (and one where IFC is usually    test of return on equity, which, given IFC'S own
*       involved), efforts to develop capital markets have    investment criteria, led to declining interest by IFC in
included formulation of suitable regulatory and       specialized, term-lending DFIS. Third, in line with its
tax provisions to encourage a range of instru-        divestment policy lFc had rolled over its DFI invest-
ments, including equity; technical assistance in      ments where it could do so, some at a good profit,
setting up new institutions to facilitate capital mar-  while others not. The critical ingredients in the
kets, arrangements to improve market transpar-        financially successful DFIS seem to have been a rea-
ency  and  liquidity; and  cooperation  with          sonably stable macroeconomic environment and
international investors.                              outstanding management capable of adapting and
The remainder of this chapter reviews how the         changing financial product lines and services to their
Bank can mobilize its skills to meet the complex        changing environments.
challenge of financial system reform  in three main        For the Bank, the use of government-controlled
areas: reform of development finance intermediaries,    intermediaries (usually existing entities-rarely has
direct financing in productive sectors, and facilitat-    the Bank created new government DFIS) plus the use
ing flows of foreign capital and know-how.              of commercial banks (government and private)
under apex loans vastly extended the potential for
Development Finance Intermediaries                      DFI lending. Moreover, following an internal review
of DFIS in 1973, which concluded that many of these
Historically development finance intermediaries         institutions required more of a "development orien-
(DFIs) have been the principal way the Bank Group       tation," the Bank began to focus on the use of DFIS to
financed industry. DFI lending by the Bank started in   achieve specific targets within sectors regarding the
the early 1950s. Initially it was Bank policy to sup-   size and location of enterprises or the level of
port only privately controlled institutions, and lend-  employment. Finally, the Bank's widening objectives
ing activity was modest.                                and the growing number of DFIS it dealt with facili-
The 1960s saw considerable Bank Group activity        tated sizable resource transfers to the private sector
in creating new, predominantly private DFIS, as         and thus provided opportunities for policy dialogue
IFC put together the shareholding group and the Bank    on a range of issues.
provided loan financing. The short-term  objective        Today IFC holds shares in twenty-four DFIS. All but
was to develop institutions capable of competent        three are recipients of Bank loans. The total cumula-
project-based lending and equity investment; the        tive amount of IFC financing to these twenty-four
longer-term  objective was to develop institutions      institutions is rather small: about $40 million in
having the capacity to raise equity and debt            equity and $180 million in loans.' The Bank, in con-
resources independent of government financial           trast, has in its DFI portfolio some 150 institutional
support.                                                borrowers. Its lending to them has covered small as
*       In the mid 1960s the Bank began to include both       well as large private sector investment projects (see
government-controlled and privately owned DFIS in       box 4-1). The volume has averaged $1.3 billion a
its lending program, on the grounds that ownership
did not, in itself, determine competence. IFC contin-
ued to monitor its own DEl portfolio but was
1. IFC lends to creditworthy DFIS when no government guaran-
involved in creating only five new "traditional" DFIS    tee is available and IFC financing is critical to the DFI'S achieving its
in the 1970s (three in Africa), and in the 1980s only   objectives or when IFc can help more mature DFIS tap international
three new DFIS (two in Africa) have been set up with    markets. In addition to these loans to what might be considered
traditional DFIS, IFc has provided credits or agencv loans totaling
IFC S assistance and equity participation. Because      $62 million to other types of intermediaries, such as merchant
most of the DFIS in which IFc held shares were recipi-  banks.
27



Box 4-1. Small Business Development
Entrepreneurship-how  to develop it-and small           Reaching down to the small entrepreneur is a labor-
business-when and how to support it-are topics    intensive operation. Although specific credit projects
that have received considerable attention in both the  will still be desirable, the Bank Group can make more
industrial and developing countries. There is a vis-  of an impact by focusing more explicitly on govern-
ceral consensus that small business deserves support,  ment policies that frustrate small enterprise develop-
but how and with what effect, still remain somewhat   ment.  Bureaucratic  regulatory  environments,
difficult questions. It is even elusive to define what is    cumbersome tax policies, difficult business entry
meant by small. The Bank has financed about six    requirements, credit policies that reduce risk capital
small-scale enterprise projects a year over the past five  for this sector, discrimination against certain minority
years, at an average yearly total of $0.5 billion.    groups that tend to produce entrepreneurs, and subsi-
Included in the "small" classification are projects   dies and advantages given large firms are a few of the
where subloan size is $60-s100 (Indonesia), up to     policy factors that often disadvantage the small busi-
$500,000 (Mexico), and up to $2.5 million (Turkey).    nessman.
Likewise, it is difficult to determine whether programs  In working on the enabling environment issues (dis-
focusing on the $1,000 borrower are more or less      cussed in chapter 2), the Bank could put more focus
important developmentally than the ones that are 5 or  on making the playing field level for the small-scale
100 times larger. Size, in itself, does not seem to be a  sector vis-a-vis larger enterprise. This might include
reliable indicator of economic virtue.                eliminating discriminatory tariff treatment (often large
What does seem generally clear, however, is that (a)    capital goods are duty-free, while small are not), tax
small enterprises, quantitatively, make up a significant  concessions given to large but not to small investors,
portion of the productive economy in many coun-       and unequal access to credit on foreign exchange. Pol-
tries, (b) policies are often stacked against them, and  icy dialogues between the Bank Group and member
(c) distortions in the financial sector often close off    governments may yield large payoffs in these matters.
commercial sources of capital to them. Hence, the     As for direct action to promote grassroots business
Bank and to a lesser extent IFC have assisted govern-  development, the Bank may not have a comparative
ments in a number of cases to redress the imbalance.  advantage over bilateral and nongovernmental pro-
The Bank has done this for the most part through      grams that have more intensive representation in the
specialized agencies mandated to assist entities of a  field. In this respect, the intensifyinig Bank dialogue
certain size, often with a technical assistance compo-  with  nongovernmental organizations that deal
nent; the size range is wide, as noted earlier. On occa-  directly with the smallest economic units is to be
sion, however, commercial banks have been included    encouraged. Finally, one area that has not been
in the delivery process. IFC'S leasing companies also  reviewed adequately is the potential for nonagricul-
tend to deal with the smaller enterprises (leases rang-    tural cooperatives in the service and productive sec-
ing between $30,000 and $300,000), as do agency       tor. This may have particular relevance to countries
equity-credit lines (average financing of $300,000),    such as China, Hungary, and possibly Poland, where
and venture capital companies (average financing of    IFc has begun working with some market-oriented
$130,000). In addition, IFC is experimenting in the   cooperatives. More research and evaluation of small-
Caribbean and Africa with hands-on project develop-   scale projects financed by the Bank Group may pro-
ment facilities, whose job it is to assist entrepreneurs  duce some useful guidelines in this area.
to develop their projects to a bankable stage.
year over the past five years, as shown in table 4-1.      Issues
These amounts are net of adjustment lending (which
has grown rapidly to $1.9 billion in fiscal 1988) and      The 1985 Bank study of financial intermediation
also net of rather small amounts for DFI lending for       concluded that, while there were notable excep-
state enterprises in centrally planned economies          tions, quite a number of DFIS faced serious problems.
(which now averages about $100 million a year). In         About one-third of the DFIS were significantly in
recent years about 80 percent of DFI lending has been      arrears and had low or negative returns on assets.
to government-controlled institutions.                     Very few DFIS had successfully mobilized domestic or
28



Table 4-1. Bank Lending to DFIs for Private Sector      percent of DFI lending, arrears continue to present
Investment Financing, Fiscal 1960-88                    significant problems. The Bank's 1986 annual review
Billions          of project performance results points to similar con-
Year                   ofdollars          clusions.2 Data on the privately controlled DFiS in
1960s annual average               0.1             IFC'S portfolio indicate, on average, stronger perfor-
1970s annual average               0.5             mance, but quite a number of these institutions, par-
1983                               1.7             ticularlv in Africa, face serious problems.
1984                               1.5               There has been no marked increase in the use of
1986                               1.2             apex loans since 1985. Roughly half of DFI lending
1987                               1.1             during 1982-87 has been in operations involving
1988                               1.1             one or two intermediaries. About a quarter of such
1983-88 annual average             1.3             lending has involved six or more intermediaries.
Source World Bank data.                                What is of concern is that in apex lending the finan-
cial health of participating banks (commercial or
development) is often not dealt with in depth,
foreign resources without governmental support,         because these operations focus on broader sectoral
perhaps as much because of their environment of         objectives. It appears, on average, that DFIS under
directed credit and distorted interest rates as because  apex loans have weaker portfolios than those with
of their own financial health. What remained unclear    which the Bank has direct relations.
were the balance of factors that had brought this         IFc also faces several issues in its support for DFIS.
about (environmental, managerial, political, and so     In some of its DFIS, IFC expects losses on its equity.
forth) and the key elements that distinguished the      Provisions in these cases run from 30 to 90 percent
excellent from the poor performers. Although the        of original cost. A number of these institutions are
debate may go on over how serious the situation was     reasonably competcnt as project lenders, and their
for these DFIS, it was clear that their problems        shareholders, both governmental and private, sup-
deserved attention as a Bank Group response was         port them for their indirect benefits rather than their
articulated. That 1985 study argued that in lending to  direct earning capacity. Some are useful lending con-
development finance intermediaries:                     duits for the Bank and bilateral lenders, and their
* A healthy financial system  was essential to the      mixed shareholding structure helps insulate them
long-term  health of individual intermediaries.       from political influence. IFC'S posture in these cases is
Hence efforts to "fix the system" were essential.    to stay involved, usually by taking a board seat, if it
* More effort was needed to address particular DFIS'    helps maintain the institution's integrity. But IFC is
own financial strength and their managerial capac-    not setting up new institutions of this nature unless a
ity to handle adversity and opportunity in chang-     good case can be made for sustainability, opportuni-
ing environments, rather than regarding them as       ties for resource mobilization, and adequate returns.
conduits for the transfer of resources.               At the other extreme a few DFIs have deteriorated
* The objective should be to develop seasoned           beyond repair, given the environments in which
intermediaries, operating in market-based finan-      they work.
cial systems, that could move toward effectively
mobilizing commercial funds on their own.               Lending Standards. The first issue for the Bank
It was also clear in the 1985 study that, in the      Group is that it must increase the rigor of managerial
deteriorating economic environment in which many        and financial assessment in its DFI lending. Credit line
DFIs exist, no single transaction could address every   lending by the Bank to DFIS, which does not include
problem. Transitional management required, in           adjustment lending, is expected to remain substantial
many cases, second-best solutions. The goal was to      over the next three years. This implies a major opera-
develop, over time, efficient, market-based financial   tional challenge in light of the needed strengthening
systems. Finally, apex or multi-institution loans were  of standards for DFI lending.
seen as a way of reaching beyond a single DFI to          The goal should be to assist and develop entities
achieve broad improvements in the financial sector.     (irrespective of ownership) that are (a) well managed,
Data on Bank-financed DFIS since the 1985 study
suggest that problems still exist. An analysis of DFI
2. World Bank Operations Evaluation Department, Twelfth
operations originating in 1982-87 indicates that for    Annual Review of Project Performance Results, 1986 (Washing-
government-controlled DFRS, which account for 80        ton, D.C.: World Bank, 1987).
29



(b) responsive to the demands of changing markets,   mediating financial resources. The concept of
(c) able to stand independent of pressures to finance  graduation of mature institutions from Bank support
activities likely to undermine their own financial    also remains valid, particularly in countries where
position, and (d) able to operate without prolonged   the financial sector is maturing. This growing inde-
dependence on government for their domestic          pendence is certainly desirable from the DFo'S stand-
resource needs (or government's assistance in raising  point, and it is in this context that IFC can play a
foreign exchange, in those cases where country con-  bridging role by introducing such institutions to
ditions are reasonably conducive to foreign commer-    commercial markets by lending or syndicating loans
cial financing). Noncompetitive institutions should   without government guarantees.
not be supported indefinitely. Furthermore, other       The reality is that country and institutional situa-
goals, however desirable-such as sector policy        tions evolve and change, sometimes rapidly, and
changes, acceptable economic and financial rates of    thus sometimes both the Bank and IFC may be
return, or shifts in subproject lending patterns-     involved in helping a particular institution. The test
should not be allowed to divert effort (as they have  is whether the particular DFI's needs at a particular
on occasion in the past) from the principal goal of    time, both for resources and for progress toward its
institution building.                                maturation, are better served by the Bank, tFC, or
In order to ensure a consistent, rigorous, and stra-    both. Finally, for some established intermediaries
tegic approach to DFI lending, an in-depth review of    both the Bank and IFC might find a particular institu-
the Bank's experience to date is needed. In trying to    tion  a good  partner for achieving  different
explain the successes and failures of previous opera-    objectives-the  Bank for addressing systemic
tions, that review should address four issues:       reforms and IFC for gaining access to particular enter-
* the appropriate approach for institutional analysis,  prises that need its funding.
including the quality of financial analysis to be
undertaken, the types of financial performance       Subloan Pricing. A frequent issue in DFI lending
measures required, and the evaluation of manage-    that bears on financial intermediation is the relend-
ment staff, decision processes, and independence   ing terms of Bank funds through DFIS. Existing Bank
• domestic and foreign resource mobilization and     policy states that sub-borrowers should pay rates
their links with the development of the domestic   commensurate with the cost of capital, that normally
capital market                                     sub-borrowers should take the foreign exchange
* the method of pricing of resources from the DFI to    risk and, if the government takes that risk fully or in
achieve market-based levels                        part, a fee should be charged to bring the cost of
* the consistency of approach and standards across    funds to sub-borrowers to levels reflecting the oppor-
regions, to the extent that differences in experi-    tunity cost of that resource. Targeting the cost of capi-
ence cannot be explained by country-specific con-    tal is complex in many cases. Given the Bank's
siderations.                                       present currency pooling and interest rate system, the
Bank's own charges may not, in some countries, be a
Division of Responsibilities. The division of       good proxy for a market rate for private borrowers.
responsibilities between the Bank and IFC with          To add to the complexity, it is not uncommon, as
respect to DFI has to be determined in the context of  noted earlier, for many governments to back admin-
broad country strategies for private sector develop-  istered credit regimes that underprice capital. If pric-
ment by the Bank Group. Such strategies would    ing on  certain  credit streams is subsidized,
define the objectives of DFI lending and propose how  intermediation will be distorted, and commercial
these objectives can be reached, which institutions   lenders (including IFC) outside those credit streams
in a given country are likely to achieve those ends,  can be crowded out by government-guaranteed
and how collaboration between the Bank and IFC can    credits. Currently, in about half of the Bank's DFI
best be marshaled.                                    lending, governments have assumed the foreign
Although strategies will obviously vary from coun-  exchange risk on behalf of borrowers for no charge;
try to country, DFI lending by the Bank should typi-    in another third some fee was levied; for the balance
cally aim to address systemic financial or institutional  sub-borrowers took the full exchange risk on Bank
problems that impede the country's financial          funds. Greater rigor is needed to ensure that pricing
intermediaries-those directly supported by the        issues, taking into account foreign exchange risk, are
Bank, as well as others-from playing a more effec-    handled in a way that avoids significant distortions
tive and self-sustaining role in mobilizing and inter-  or subsidies.
30



With respect to the secondary question of the         What are the lessons learned so far? By and large
exchange risk itself, there are a range of options that    the leasing activity has gone well, as evidenced by
may be justified. In some cases it may be appropriate  good portfolios and earnings. Leases are often an
to pass the risk on to sub-borrowers. In others an    attractive way to finance equipment for smaller firms
option might be for foreign resources, not necessar-    for a combination of fiscal and financing reasons. In
ily just Bank loans, destined for domestic borrowers  many cases IFc has had to work with governments to
to be pooled centrally-by the central bank or some    get appropriate regulations in place to allow lease
other mechanism-and the proceeds relent in local    financing to proceed. In most countries, after IFc has
currency at a rate reflecting the cost of capital, with  helped open the field, a number of additional leasing
an appropriate fee to cover the risk assumed by the   companies have started. Further scope exists for
*     pooling agent. A variation is for the sub-borrower to    introducing leasing to smaller economies, and IFC
take a single currency, or fixed mix of currencies,    intends to pursue this.
again with a pricing and fee arrangement reflecting     In housing, IFc has set up five finance companies,
the cost of capital and the risk assumed by the pool-    and all are doing reasonably well. The scope for this
ing agent. Ultimately (although this is not the case for  activity is limited by significant governmental inter-
many Bank borrowers) for economies with open          ventions in housing finance and directed credit. To
currency and credit markets the market will establish  the extent that the Bank Group is successful in
relevant rates for whatever currency is borrowed,     reforming the financial sector and freeing up finan-
and this is the ultimate objective to which Bank      cial markets, however, relatively more opportunities
Group assistance should be aimed. Whatever solu-      would develop for IFC to play a catalytic role in this
tion is adopted, care should be exercised that    sector.
government-guaranteed foreign exchange loans not        The same holds true for the insurance sector,
become part of a privileged credit stream that subsi-  where IFc has done two projects. The merchant-
dizes private borrowers and crowds out commercial,    investment banks have a generally good record.
market-based funds that would otherwise flow to the   These banks provide a wide range of corporate
private sector without recourse to the government.    finance activity, advisory services, underwriting, and
the like. IFc has divested, profitably, from four of the
New Types of Institutions                             fourteen that it has set up. The remainder are per-
forming satisfactorily, except for two where a deteri-
Although recently its activity with respect to DFIs has  oration in general economic conditions has cut off
been limited, IFC has been active, given the resources  business opportunities.
at its disposal, in other areas. In the past ten years or  Perhaps the most adventuresome part of IFC'S capi-
SO IFc has been involved in the creation of forty-eight    tal market institutional activity has been the estab-
financial institutions outside the traditional DFI field.    lishment of venture capital companies. IFc has
iFc has tried to identify new types of private sector  helped to establish nine such companies; the main
institutions that could deepen the financial structure  mission of these companies has been to take substan-
in a country, while concurrently dealing with spe-    tial stakes of risk capital in relatively small compa-
cific policy issues that affect the depth of the institu-  nies, with close and continuous inputs by the
tional structure. The objective has not been to       venture capital company to the companies financed.
maximize investment levels (such IFC investments      Two have been unsuccessful in volume and earnings,
account for only about $ 100 million) but to create    five seem to be on their way to reasonable success,
first-of-a-kind institutions that, in many cases, can  and two are brand new. The overriding determinant
then be replicated by others. The current portfolio   of success, once again, is management. In Spain,
includes nineteen leasing companies, eight housing    where a venture capital company might be expected
finance institutions, two commercial banks, ten mer-    to do well, the project failed. In Kenya, where a
chant banks or securities companies, nine venture     more difficult environment exists, the project suc-
capital companies, two insurance companies, and       ceeded because of outstanding management.
one mutual fund. The critical element in bringing
new institutions and products into a financial market    Direct Financing
is experienced, vigorous management, and thus in      What the Bank Is Doing
almost all cases IFc helps to find, and conditions its
investment on, an active partner-investor, often for-    There was no expansion of Bank direct financing in
eign, who will take on managerial responsibilities.   productive sectors in fiscal 1983-87; indeed approv-
31



Table 4-2. Direct Bank Lending to Industry,                Nonetheless, there may still be large, important
Fiscal 1983-88                                          projects that could not be completed without Bank
Oil, gas, and coal      Other industry        support in addition to that of IFC. In such cases,
Number of    Billions    Number of    Billions   assuming government support in guaranteeing the
Year    projects    of dollars    projects    of dollars  Bank loan is forthcoming, the Bank and IFC would
1983      19          1.0         13         0.7        cooperate to finance the project jointly. The Dikheila
1984      16         0.9          12         0.5        Steel joint venture in Egypt is a historical example,
198       16          1.3          9         0.6        and this type of joint Bank-IFc effort could well be
1987       8         0.7           7         0.4        replicated more frequently in the future in large
1988       2         o.4          11         0.9        infrastructure projects to be developed by private
Source: World Bank data.                               investors under build-operate-transfer principles (see
chapter 3). If IFC were not in a position to finance a
als fell in 1986 and 1987 as indicated in table 4-2.    significant private sector project because of con-
Virtually all the oil, gas, and coal projects recently  straints related to exposure or risk, and a govern-
financed by the Bank were state enterprises; half of    ment considers it important enough to provide a
this program  over the past five years has been         guarantee, then the Bank could proceed without IFC.
absorbed by China and India. The same is true of
"other industry," where the vast majority of funds      What IFC Is Doing
have gone to state enterprises. About one half of that
program  has been in China, Hungary, and India.         IFC'S mandate is the private sector; all its energies are
Only three of some sixty industrial operations          directed to making a difference in the private sector
involved a significant private sector component, and    in its member countries. JFC'S principal goal is not to
these were largely related to subsector restructuring   transfer resources but to catalyze private sector
operations. In many cases the public sector projects    activity. In bare volume terms the recent history is
financed have not met with great success in reaching    shown in table 4-3.
their objectives. The problems surrounding public         IFC is normally exposed to full project risks, a use-
management are often more intractable than had          ful but demanding discipline in allocating scarce
been anticipated.                                        resources in rather risky environments. The health
This raises a legitimate question as to whether the   of IFC'S portfolio is discussed at length elsewhere;
Bank should simply withdraw from parastatal financ-     suffice it to say here that there has been a marked
ing. This report argues that there certainly have been  improvement in recent years, both in regard to
cases, and there will be cases in the future, where it  equity returns and the loan portfolio. IFC'S collection
makes sense for the Bank to finance such projects,      rate is now slightly above 90 percent, and the portfo-
provided the parastatal (a) is or is likely to become an  lio affected by nonaccruing loans has been reduced
efficient producer and (b) fosters or at least does not  from  19 percent in fiscal 1986 to 12.5 percent in
curtail competition, so that efficient private sector   fiscal 1988, based on conservative accounting treat-
activity is not crowded out by a less efficient parasta-  ment. The expectation is that the improving trend
tal. There will also be cases where Bank help for       will continue, despite rather difficult macroeco-
restructuring a parastatal may be a desirable step      nomic conditions in many of the markets in which
toward privatization. Consequently, the established     IFC operates.
and logical pattern in recent years has been for IFC to    Actually IFc has a dual mandate: to do business that
handle larger private sector projects, while the Bank
supported relatively smaller private sector projects     Table 4-3. IFC Investment Activity, Fiscal 1983-88
through DFI lending and directly financed public sec-    (millions of dollars)
tor projects that merit support.                                       Total investment       Equity portion of
The use of the government guarantee capacity           Year            approved             total investment
should be minimized for private sector projects. For     1983               426                     55
enterprises that can appropriately be financed pri-      1984               391                     62
vately without recourse to government guarantees         1985               609                     61
and that meet IFC'S ownership guidelines, IFC is the     1987               790                     80
appropriate Bank Group financier. In this regard IFC's   1988a             1,050                   197
enlarged capital enables it to make commitments           a. Estimate.
that, in terms of size, were beyond its earlier scope.    Source: IFC data.
32



is both financially sound and of economic impor-       nation of these sectors. However, IFC is now finding
tance. Unfortunately, there is a significant amount of    that many governments are increasingly open to pri-
activity in developing countries that is financially   vate investment in sectors long dominated by the
attractive but is of questionable value economically   state, if efficiencies can be achieved. At the moment
or vice versa, given distorted pricing signals.        private sector proposals are under discussion in IFC
IFc's lending strategy is based on the fact that its    for power projects in C6te d'Ivoire, Mexico, Paki-
more remunerative investments (because of their    stan, Turkey, and Venezuela; telecommunication
size and risk profiles) have to carry the costly efforts  operations in Argentina and Sri Lanka; ports in
to meet private sector needs in its smaller and least  Colombia and Turkey; and pipeline storage projects
developed member countries. About 28 percent of    in Mexico. Expectations are that the list will continue
IFC'S staff effort goes to benefit Africa (not including  to grow. MIGA can be directly supportive by insuring
special African initiatives), although this region is    the foreign investment component of such projects
likely to produce only 17 percent of short-term        against noncommercial risk. The Bank can also
investment volume.                                     directly help IFc by making its technical skills avail-
The availability of long-term  loans for project     able to IFC in examining such projects, and IFc can be
finance is still a problem  for the private sector in  helpful in lending its financial packaging skills to the
many developing countries. In many others, how-        Bank when a collaborative effort is required.
ever, the issue is not how to load additional debt on
to a country or enterprise but how to capitalize or    Facilitating Flows of Foreign Capital
restructure enterprises so that sound growth can       and Know-How
take place. This suggests that IFC should place
increasing emphasis on (a) providing equity or quasi-  Foreign Direct Investment
equity finance, (b) bringing critical technical, mana-
gerial, and marketing skills into enterprises, (c)     A broad consensus is emerging that, to prosper in an
advising and assisting on restructuring opportunities,  increasingly competitive, fast-changing world mar-
(d) facilitating privatization where that is appropri-  ket, developing countries can benefit from and may
ate, and (e) supporting private sector involvement in  indeed require an increased flow of foreign direct
infrastructure activities. In these areas it is know-  investment. This attitude (new to many) rests on sev-
how, ideas, and international contacts, as much as     eral tenets. First is the rccognition that outward-
capital, that IFC can uniquely contribute.             looking enterprises need up-to-date technical,
IFc recently reviewed its equity policy, not primar-  managerial, and marketing know-how, which often
ily to assess its scope (although IFC'S program calls for  is not available locally. With strong local manage-
an increase in the relative share of equity instruments  ment, technical know-how can sometimes be pur-
in the total), but to assess its quality and catalytic  chased; managerial know-how, however, usually
power. The framework has now been set for that         cannot be purchased. Moreover, in many countries it
effort.                                               is the combination of technology and management
In regard to its advisory services, IFc has begun    that is critical.
systematically to break down its effort into normal      Second, risk capital, rewarded by results, is seen as
project-related advice and advisory efforts that go    an attractive alternative to debt, particularly as for-
beyond the norm in complex projects, or advisory       eign commercial bank lending, never available in
services not related to project finance. The mix of IFC  many countries for long-term  project finance, has
business is thought to be shifting to include more     dried up in others. Third, there is growing confi-
idea-brokering in areas where IFC'S accumulated        dence in the ability of developing countries to avoid
knowledge can benefit private sector investors. As     the abuses (most prevalent in highly protected sec-
this work develops, IFc needs to focus on how it can   tors) and secure the advantages of foreign direct
channel the special skill mix required to maximize its    investment. Foreign investors increasingly recognize
impact.                                               the need to be "good corporate citizens" within the
Chapter 3 discussed private delivery systems for     host country. As a result, dozens of countries have
'public" services. This is a developing market for IFC  made efforts in recent years to revise their invest-
and an area for increasing collaboration between the   ment codes and regulations to facilitate foreign
Bank and IFC, as well as MIGA. Although IFc has always  direct investment.
been ready to finance such projects, there have been     Unfortunately, as the need and desire on the part
few opportunities to do so, given the past state domi-  of developing countries for foreign direct invest-
33



ment has increased, the flow has decreased-from       on assignments, FIAS coordinates with the Bank to
$15 billion net in 1981 to about l 10 billion a year in  ensure that its work does not duplicate other on-
1983-87. And even that amount has been concen-        going programs.
trated in a rather narrow band of countries. The
decline is due to foreign investors' perceptions of    Settlement oflnvestmient Disputes
the opportunities and risks of investing in many
countries, given such factors as political instability,    In 1966 the International Centre for Investment Dis-
debt overhang, macroeconomic policies, rigid trade    putes (ICSID) was established under the auspices of
problems, and foreign exchange allocation schemes.    the Bank. Administratively integrated into the Bank
However, the critical issue for foreign investors in  and fully funded by it, iCSID provides a forum for
many countries is the macroeconomic environment.      conciliation and arbitration of investment disputes
Consequently, the Bank's greatest impact in facili-    between states and foreign investors. Eighty-nine
tating foreign direct investment will come through    countries have joined IeSID, and twenty-five cases
supporting structural adjustments that deal with      have been submitted to it for arbitration; increasing
macroeconomic instruments and through encourag-       use is being made of this facility. ICSID's activities
ing countries to move from  inward- to outward-    include research and information on investment
oriented strategies. These efforts will also tend to  arbitration and law. It publishes materials and orga-
reduce internal opposition to foreign direct invest-    nizes symposiums on these topics.
ment. Increasingly, structural adjustment operations
(about half of them at present) contain specific con-    Investment Guarantees
ditions related to foreign direct investment, such as
improvements in investment codes. As part of its      The newest member of the Bank Group, the Multilat-
economic sector work, the Bank has also, on occa-     eral Investment Guaranree Agency (MIGA) has
sion, looked specifically at a country's foreign invest-    recentlv come into being. It too is a response to the
ment policies (Mexico is a case in point), where those  need for a new mechanism  to encourage foreign
policies loom as a development issue.                 direct investment. MIGA will specialize in the reduc-
One of iFC's original and basic roles is to facilitate    tion or elimination of noncommercial risks, espe-
the flow of foreign direct investment. About 40 per-    ciallv political risk, and will carry out this mandate
cent of IFC's operations are joint ventures between   through guarantee, consultative, advisory, and pro-
foreign and local sponsors; in many more there is     motional activities. Specifically, MIGA will provide
foreign involvement in providing  technological,    guarantees against (a) restrictions on the repatriation
managerial, or marketing know-how. Indeed IFC'S    of investment proceeds in convertible currency
role is truly catalytic in situations where the foreign  (transfer and inconvertibility risk), (b) expropriation
investor simply would not invest unless IFC was an    and similar measures, (c) breach of contract by a host
involved coinvestor. In recent years about half of the  government in certain defined cases of denial of jus-
lFc-financed joint ventures fall into this category.    tice, and (d) war, revolution, or civil disturbance.
This is particularly true in countries that have      (The breach of contract coverage, not normally pro-
recently opened their doors to foreign investors (for  vided as such by national investment guarantee
example, Hungary) and in those that have always had   agencies, can be important in encouraging build-
a difficult time attracting them (for example, African  operate-transfer contracts, which were discussed in
countries).                                           chapter 3.) Coverage may be extended to other non-
commercial risks, except currency devaluation.
Foreign Investment Advisory Services                    In addition to equity investments (including
equity-type loans), coverage will encompass
Responding to increasing requests from  member        production-sharing contracts, profit-sharing con-
countries for advice on foreign direct investment, IFC  tracts, management contracts, franchising agree-
launched the Foreign Investment Advisory Service      ments, licensing agreements, leasing agreements,
(FIAS) in 1986. FIAs advice centers on the content and  and turnkey contracts, if they have a term of at least
administration of investment policies and on the      three years and the contractor's payment is substan-
stratcgies for promoting investment. As of fiscal    tially linked to the operating results of the projcct.
1988, work has been done in seven countries, and        MIGA is coming upon the scene with a strong man-
projects are under way or planned in ten additional   date in its charter to provide a broad range of advi-
countries. Thus the demand is significant. In taking  sory services that will aid the protection and
34



promotion of foreign direct investment. Both IFC      country funds that IFC or other institutions have pro-
(including FIAS) and MIGA have unique contributions   moted. As of fiscal 1988, IFc has managed or co-
to make to member governments seeking foreign         managed ten such funds with a total capitalization of
investment advice. IFC'S capability in this respect   about $1 billion.
flows principally from its activities as a direct inves-  Considerable effort goes into establishing the
tor and from its experience in forming joint ventures  appropriate legal and regulatory framework for such
and promoting investment projects in developing       investment funds, arranging independent manage-
countries. MIGA'S capability will in time be built upon  ment for them, and putting together the underwrit-
the business experience resulting from  its invest-    ing of each transaction. Although the capital flows
ment guarantee operations and its particular focus on  represented by these funds are still limited and the
investment protection. In order to take advantage of  short-term growth rates were no doubt reduced by
these potential contributions, it is recommended      the worldwide stock market decline in 1987, they
that the managements of IFc and MIGA develop an       are an important new capital-raising mechanism for
advisory service jointly managed and supported by     some developing countries. IFC is expected to play a
both institutions.                                    catalytic, market-leading role in more country funds;
In the area of guarantees, there is a question of the  it is now examining proposals from Argentina, Brazil,
division of labor between MIGA and IFC. MIGA envis-   Chile, Mexico, the Philippines, and Turkey. One
ages providing guarantees under carefully designed    impetus to this type of activity is the debt-equity
arrangements against noncommercial risks in invest-   conversion plans being developed in Chile and other
ments for productive purposes. MIGA'S program         countries, which specifically link the country fund
would initially focus on equity investments and       to debt conversion. In many cases the country funds
other forms of foreign direct investment. In contrast,    set up with the help of IFc have been established after
IF(. has occasionally provided repayment guarantees   the country has undertaken extensive adjustment
for lending activities, and only in a few special situa-  programs with the help of the Bank. This sequence
tions has it guaranteed equity-type arrangements.     underscores the connections between macroeco-
IFC'S program  for a guaranteed return of invest-   nomic policies and conditions conducive to deepen-
ment principal (GRIP) is in essence designed as an    ing financial markets and increasing international
investment partnership, sharing risks and rewards,    capital flows.
rather than as a protection scheme for political risk.
Consequently, IFC'S guarantee activities entail little, if  Debt Flows
any, overlap with MIGA'S, and there is little need at
this time to further delineate MIGA'S and IFC's respec-  Commercial bank lending and export credits have
tive guarantee functions. If particular cases arise   undergone a major reversal. In 1981 commercial
where an overlap is anticipated, the two institutions  lending to developing countries totaled $52 billion;
should consult to ensure the complementarity of the   by 1986 it fell to $5 billion. Export credit finance
two programs.                                         declined from $18 billion to $2 billion in the same
interval. The overwhelming amount of commercial
Foreign Portfolio Investment                          long-term  credit has gone to meet public sector
needs, as has almost all export credit finance.
As more developing countries deepen their financial     The picture varies somewhat from  country to
systems, the potential grows to build links between   country. In those markets where the credit risk is
their markets and foreign portfolio investors. iFc's  perceived to be low, as it is in some Asian countries,
Emerging Market Data Base tracks securities markets    loans from foreign commercial banks to strong pri-
in eighteen developing countries and covers about     vate sector borrowers are common. For the bulk of
8,500 stocks. Although only some 300 of these secu-   the Bank Group's member countries, however, for-
rities now meet the liquidity and "visibility" require-  eign commercial bank financing is hardly available to
ments of international portfolio managers, the        the private sector. When available, it is usually lim-
market is growing. Capitalizations of each of the five  ited to short- or medium-term trade financing for the
largest developing markets are already comparable     most solid exporters.
to those of a medium-size European country.             Against this backdrop, IFC's efforts to sell participa-
In 1984 IFC pioneered the listing of a country fund  tions in IFC loans to commercial banks (averaging
on the New York Stock Exchange. This fund-which       about $300 million a year) account for a sizable share
was for Korea-has served as a model for other         of commercial bank finance for projects in the pri-
35



vate sector. Properly structured loans based on       Others will need only the kind of policy reforms that
project cash flows avoid the dangers of the pre-1982  affect all intermediaries (for example, banking regu-
lending boom, which was based instead on easily    lation, audits, and accounting transparency; liberal-
available government guarantees. IFC should con-    ized interest rates and the reduction of directed and
tinue to emphasize this aspect of its activity.      subsidized credit; the removal of barriers to new
Although commercial bank lending is currently       financial instruments and institutions; and the exit of
depressed, in some countries the Bank Group can       loss-makers).
encourage, in conjunction with financial sector         The Bank, through its macroeconomic and finan-
reform, the introduction of foreign banks into tradi-    cial sector work, has the capacity to take the lead in
tional, protected banking systems. Foreign banks can  the overall assessment and programming of neces-
play a valuable role in financial sector reform  by   sary reforms and systemic improvements. This will
introducing modern techniques and standards and       be reflected in increased lending to the financial sec-
by increasing competition.                            tor in the coming years, as well as increased focus on
Both the Bank and IFC can also encourage the flow  financial sector issues in other adjustment lending
of export credit finance to the private sector. Except  operations.
for the Export Credit Guarantee Department in the       As countries achieve success in implementing
United Kingdom, which has initiated a limited         some of the basic reforms needed to improve inter-
project finance program, the large export credit      mediation, opportunities will emerge for deepening
agencies still insist on government guarantees; this    financial structures by further development of capi-
tends to drive their financing toward the public sec-    tal markets. It is in this area that the Bank and IFC
tor. However, the Bank Group, through its involve-    should fully collaborate. IFC'S work in developing
ment in build-operate-transfer schemes, for example,  securities markets, establishing and strengthening
can raise the willingness of these agencies to finance  nonbank financial institutions, introducing new
private sector infrastructure projects.               financial instruments, and developing links to inter-
national capital markets effectively allows the Bank
Conclusion: The Need for Collaborative Effort         Group to cover the full range of issues affecting the
financial sector.
In many of the Bank's member countries deficiencies     Private sector development requires a great variety
in financial institutions and policies limit the poten-  of efforts and skills. Here are some of the most
tial for private sector growth. The Bank Group,    important that have been explored in this report: to
because it has so many ways to influence the means    establish an adequate regulatory framework for pri-
by which private sector firms secure the resources    mary and secondary markets, so that a wider variety
they need for their growth, is well placed to help its  of debt and equity instruments can be sold, based on
members develop their financial sectors, and a start    adequate disclosure and protection conditions for
has been made. Still, a more concerted effort is    investors; to make tax policies more neutral to differ-
needed, based on country-specific long-term strate-  ent types of securities, especially by removing tax
gies for financial sector development.                deterrents to the use of long-term debt and equity
Such strategies should balance macro (sector) and  instruments; and to promote institutional develop-
micro (institutional) issues. Financial sector adjust-  ment, so as to provide liquidity in the financial sys-
ments will have to parallel adjustment policies in the  tem for new instruments.
economy as a whole and will depend on the degree        The Bank Group encompasses many of the skills
of financial distress encountered in the particular    that can help member governments implement these
country. Some systems will require massive restruc-   reforms. With greater cooperation and commitment,
turing and loss-taking, as well as changes in the own-    the members of the Bank Group can create a syner-
ership or management of major banks and firms.       gism in support of private sector development.
36



Appendix.- Summary
of Recommendations
This report has made a number of recommendations    cedures, reforming investment and labor regula-
for the Bank Group. These are summarized below.  tions, protecting the public interest, fostering
competition, clarifying property rights, and remov-
The Enabling Environment                          ing limitations on the ease of entry and exit of large
and small enterprises.
A major contribution of the Bank will continue to be  Recommendation 3: That the Bank Group expand
the assistance it offers governments through policy    and intensify its support for privatization of state-
analysis and advice and through adjustment lending  owned enterprises. The Bank should expand its
to ensure that the enabling environment and busi-    research and advisory capacity on privatization,
ness climate are supportive of PSD, as noted in the    especially as regards the institutional and incentive
following recommendations.                       framework. It should also increase its supportive role
Recommendation 1: That the Bank's adjustment    in the analysis of the legal and regulatory environ-
and public sector restructuring loans give increased  ment for privatization and its capacity to provide
attention to the creation of a macroeconomic, regu-    technical operational support in the design of com-
latory, and public sector environment conducive to    ponents for country economic and sector work and
PSD. Adjustment operations are the natural vehicle    for structural and sectoral adjustment loans dealing
for translating analytical insights on the enabling  with privatization.
environment into effective policy dialogue and     IFC should expand its capacity to provide technical
financial support. A recently published report on  assistance and advice to governments and to the
adjustment lending reviewed the design and imple-    Bank in this area, as well as its capacity to finance and
mentation of structural and sectoral adjustment    underwrite particular privatization transactions. IFC
operations (including macroeconomic management,    should explore the possibility of setting up a special-
reform of incentives, and public sector restruc-    ized staff unit for this purpose. At the request of
turing).I This report therefore concentrates on those  member governments IFC should be eligible to pro-
aspects of the enabling environment most directly    vide advisory services (in this and other areas)
dealing with PSD (especially regulatory controls and    funded under Bank loans and IDA credits. MIGA can
privatization).                                   also provide guarantee coverage to foreign invest-
Recommendation 2: That the Bank Group, led by   ment in support of privatization.
IBRD and IDA, give greater attention to the legal and
regulatory constraints to PSD. More research,    Supporting Services
country-specific economic and sector work, and
lending activity should be devoted to this area,    Support to public agencies for the efficient provision
including such issues as streamlining regulatory pro-    of supporting services (infrastructure, education,
health, and so forth) remains an essential component
of the Bank Group's support for growth, develop-
1. World Bank Country Economics Department, Adjustment   of the  ptivate sector,    reutio opverty.
Lending: An Evaluation of Ten Years of Experience, Policv and    ment of the private sector, and reduction of poverty.
Research Series I (Washington, D.C.: World Bank, 1988).  In addition, the Bank Group can expand and inten-
37



sify its activities to ensure that the potential contribu-  ported by efforts to develop operational staffing
tion of private enterprises in the efficient provision  capacity, by increased research, and by country eco-
of such services is fully realized.                   nomic and sector work.
Recommendation 4: That the Bank undertake             Recommendation 8: That the Bank and IFc extend
research and policy work on the appropriate role of    and intensify their support for the development of
the private sector in providing infrastructure and    capital markets in developing countries to mobilize
social services. The Bank already has undertaken      both domestic and external resources in support of
studies on this question for some sectors (for exam-    productive activities, especially in the private sector.
ple, housing and urban bus transport), but the scope  The Bank's involvement in this area is related to its
of such research and policy work should be            efforts to reform the policy and regulatory environ-
extended to all major sectors.                        ment of capital markets. IFc is also active in this area,
Recommendation 5: That the Bank prepare policy      often in collaboration with the Bank. IFc has
papers for each sector to provide operational guide-  extended its support for capital market development
lines on how the Bank Group can ensure that the       through innovative initiatives supporting new pri-
private sector becomes more involved in financing     vate institutions that provide various types of capital
and operating infrastructure and social services. This  market instruments (new types of debt securities,
work would also draw on IFC'S limited involvement     equity), services (securities companies and merchant
in the infrastructure and social services sectors and  banks), and funds providing linkages with foreign
in turn would seek to provide guidance for an expan-  markets.
sion of IFC's activities in these areas.
Recommendation 6: That the Bank in its public
expenditure or investment reviews for particular
countries explicitly consider ways to increase private
sector participation in the provision of infrastructure  The Bank has financed the private sector primarily
and social services. Increasing private sector involve-    through a variety of development finance institu-
ment in the provision of services offers an opportu-    tions (DFIS). IFC is a shareholder in some of these, but
nity not only to increase efficiency within the sector,    in recent years the Bank has been the main source of
but also to reduce government spending during         funding and support for these institutions, the large
periods of fiscal austerity.                          majority of which are government-owned. The
record of the 130 or so institutions supported by the
Financial Sector Development                          Bank or IFC is, at best, mixed. There are some notable
successes, but many are in serious trouble and of
questionable viability and vitality. Another form of
The development of the financial sector and capital   Bank financing for DFIS is the so-called apex loan (a
markets in developing countries is one of the most    loan to one institution that in turn on-lends the funds
important ingredients for successful and healthy      to other domestic financial institutions). Although
growth of private enterprise. The economic crises of  apex loans have achieved some sectoral objectives,
the 1980s in many developing countries have dem-      they have also distanced the Bank from basic prob-
onstrated the weaknesses in the financial sector.    lems and deficiencies in some participating interme-
Unless these weaknesses are addressed in a synchro-   diaries.
nized way with macroeconomic reforms, the effec-        Recommendation 9: That the Bank Group, led by
tive contribution of the private sector will be       the IBRD and IDA, undertake an in-depth review of DFI
limited.                                              lending. This review would draw on and update the
Recommendation 7: That the Bank, supported by       1985 internal policy paper on DFI lending. It would,
the IFC staff, expand and extend its program  of      among other things, be designed to reassert stan-
adjustment lending in support of financial sector     dards that put more focus on the financial integrity
reform. Basic financial reform is essential for a return  of the DFI, the capability of its management, the link-
to solid growth. It typically involves the reform of  ages of the DFI to domestic capital markets, the suit-
inefficient banking systems, directed and subsidized  ability of its structure to adapt to rapidly changing
credit streams, poor disclosure and audit require-    environments, and its sustainability in the long term.
ments, and locked-in lending institutions unable or   This review is all the more urgent in view of the
unwilling to take losses. The expanded initiatives in  current forecast of increased Bank lending through
financial sector adjustment lending need to be sup-   financial intermediaries.
38



Recommendation 10: That the Bank, with inputs     Direct Financing
from iFc, develop a country-specific strategy for
Bank Group support to intermediaries. This strategy  Direct financing of industry by the Bank has declined
would be developed as part of the overall country   substantially, and most of what is currently done
strategy for PSD. It would lay the basis for turning,    involves restructuring operations in the public sec-
over time, government-dependent intermediaries      tor. This trend is appropriate in view of IFC'S increas-
into more self-sufficient market-based entities, par-    ing capacity and the Bank Group's general policy
ticularly in countries where the financial sector is    stance that the public sector should minimize its
maturing. Within such a strategy, DFI lending by the  direct involvement in the productive activities of the
Bank should typically aim to address the systemic    industrial sector if there are more efficient alterna-
financial or institutional problems that impede the  tives available.
country's financial intermediaries-those directly     Recommendation 12: That IFc be the appropriate
supported by the Bank, as well as others-from play-  Bank Group vehicle for the direct financing of pri-
ing a more effective and self-sustaining role in mobi-    vate industrial projects. The Bank may be called
lizing and intermediating financial resources. As a  upon, together with iFc, for some direct financing of
complement to Bank intervention, IFC should con-    large private projects where both institutions are
tinue to press forward with its program of diversifi-  needed. The Bank would also continue selective
cation that supports a variety of specialized capital  direct financing and restructuring of public industrial
market institutions. iFC's role is particularly impor-    enterprises. Bank involvement should normally be
tant in assisting capital market development and in    restricted to cases of significant restructuring of
supporting intermediaries that are maturing and     public industrial enterprises, especially those in
approaching private markets, that do not have access  which eventual privatization is a possibility. In
to government guarantees and finance, or that are    financing state enterprises more care is needed to
permitting IFC to serve a market segment that would    limit such financing to those cases where the entity
not otherwise be served. The IFC'S skills and experi-  will become an efficient producer and where more
ence in this area should be made available to the   efficient private sector activity is not crowded out.
Bank when they are helpful in resolving particular  Occasionally it will also make sense for both the
problems relating to Bank-financed intermediaries.  Bank and IFC to be involved in a private sector
Recommendation  11: That the Bank Group           project that could not effectively be put together
develop a systematic and consistent approach to sub-  without both institutions, and policies should be
loan pricing in DF1 lending. Present Bank policy is    flexible enough to support such collaboration.
either that sub-borrowers assume the foreign
exchange risk on Bank funds or that the pricing in  Support for Small Entrepreneurs
local currency reflect the real marginal cost of those  and Technological Development
funds. Increasingly in DFI lending by the Bank, gov-
ernments cover all or part of the foreign exchange  The scope for effective direct intervention by the
risk. Depending on how subloans are priced, there   Bank Group in support of small entrepreneurs and
can be a difference in the terms of Bank-sourced and  technological development so far appears to have
commercially sourced funds to end-users. In some    been limited. Research and operational experience
cases, lenders that are not government-guaranteed   indicate, however, that the enabling environment-
may be crowded out by government-guaranteed,        particularly the business climate, the openness of the
Bank-sourced funds. Care should be taken that such  economy, and the absence of burdensome regula-
crowding out does not occur. This requires that    tory restrictions-is the major factor that determines
within the context of market-based pricing, appro-  whether or not small enterprises and domestic tech-
priate country-specific methodologies be developed  nological development can thrive.
and applied for dealing with the foreign exchange     Recommendation 13: That the Bank seek to
risk of-DFI lending. The policy review of DFI lending  strengthen the enabling environment for small entre-
(recommendation 9) should provide the general    preneurs and technological development as part of
methodological framework and options, while the     its research, policy, and operational work and that
country-specific strategies for DFI lending (recom-  both the Bank and the IFC continue to explore ways
mendation 10) should reflect agreement within the   to strengthen their direct support in these areas.
Bank Group on the particular subloan pricing        Direct support for small entrepreneurs should build
options appropriate for the country concerned.      on an analysis of what has and has not worked in the
39



past and on the evolving experience of iFc with leas-     Recommendation 14: That the Bank Group, espe-
ing companies, venture capital operations, and its      cially through IFc and MIGA, strengthen its efforts to
initiatives in Africa and the Caribbean designed to     promote the flow of foreign direct investment to
help small firms. Intensification of the dialogue with  developing countries. These efforts would bring into
nongovernmental organizations in this area is also      play a wide range of support functions including
needed. As for technological development, there is    loans, investments, and guarantees, as well as advi-
scope for the Bank to continue to support the           sory and informational activities directed both to
improvement of research and scientific capabilities     host countries and to foreign investors. The Bank
in the developing world through lending that bene-      can also play a more effective supporting role by
fits institutions of higher learning and research. IFC  promoting a macroeconomic environment that will
should also continue to explore ways to assist its      encourage and give confidence to foreign investors.
clients to locate, evaluate, and acquire new  or        Its adjustment lending in particular should give
mature technologies.                                    increasing attention to policy constraints to foreign
direct investment in specific countries.
Foreign Direct Investment                                 Recommendation 15: That IFC and MIGA develop a
single, jointly managed delivery system for advising
In many member countries the need and desire for        governments on the broad range of issues related to
foreign direct investment has grown, especially as      encouraging foreign direct investment. IFC, through
the availability of foreign commercial bank financing   FIAS, already has an advisory capability in this area
has been severely curtailed. The advent of IFC's For-   stemming from IFc's long history of work with for-
eign Investment Advisory Service (FIAS) and MIGA is a   eign investors in its member countries. At the same
direct response of the Bank Group to this develop-      time, MIGA has a broad mandate in this area. Develop-
ment. Foreign direct investment brings risk capital,    ment of a joint advisory service would be most
management, and technology, and in a number of          appropriate.2
countries the process works well. In others, how-
ever, although policymakers want the benefits of
such investment, the framework and environment
for it are poor, and the amount of foreign direct        2. This recommendation has been implemented since the
investment has been limited.                            Review Group submitted its report.
40



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