WORLD DEVELOPMENT REPORT 2002 22826 v WUSeptember 2001 OVERVIEW Building Institutions for Markets T' HE WOj'R D A NK BUILDING INSTITUTIONS FOR MARKETS World Development Report 2002 O verview The World Bank Washington, D.C. C) 2001 The International Bank for Reconstruction and Development / The World Bank 1818 H Street, N.W., Washington, D.C. 20433, U.S.A. Cover design by Debra Naylor, Naylor Design, Inc. Cover photographs: top, ©) 2001 Stephen Simpson/FPG; middle, ©D200 1 Stone/Paul Chesley; bottom, Yosef Hadar, World Bank. Inside design and typesetting by Barton Matheson Willse & Worthington, Baltimore. Manufactured in the United States of America First printing September 2001 This document summarizes World Development Report 2002, published by Oxford University Press for the World Bank. It is a product of the staff of the World Bank, and the judgments made herein do no necessarily reflect the views of its Board of Executive Directors or the countries they represent. The World Bank does not guarantee the accuracy of the data included in this publication and accepts no responsibility whatsoever for any consequence of their use. ISBN 0-8213-5016-1 Contents of World Development Report 2002 PART I INTRODUCTION 1 Building Institutions: Complement, Innovate, Connect, and Compete How do institutions support markets? How do institutions support growth and poverty reduction? How do you build effective institutions? Organization and scope of the Report Conclusions PART 11 FIRMS 2 Farmers Building more secure and transferable rural land institutions Building effective and accessible rural financial institutions Building effective institutions for agricultural technology and innovation Conclusions 3 Governance of Firms What firms around the world look like Private governance institutions for firms Laws and formal intermediaries Conclusions 4 Financial Systems Should policymakers promote bank-based or market-based financial systems? What form should financial regulation take? Enhancing efficiency in the financial sector: the role of ownership and competition How foreign entry and e-finance can change the nature of financial markets How to enhance access to financial services Conclusions 111 IV OVERVIEW PART III GOVERNMENT 5 Political Institutions and Governance Political institutions and policy choices Corruption Politics, institutions, and taxation Conclusions 6 The Judicial System Comparison of legal and judicial systems New evidence on two aspects of judicial efficiency: speed and cost Judicial reform efforts Fairness Conclusions 7 Competition Domestic competition International competition Conclusions 8 Regulation of Infrastructure Competition in infrastructure sectors Structure of regulatory system Designing infrastructure regulation to deliver services to poor people Conclusions PART IV SOCIETY 9 Norms and Networks Informal institutions in markets: their utility and shortcomings Building and adapting formal institutions Integrating informal and formal institutions Conclusions 10 The Media Independence Quality Broadening the media's reach Institutions to complement the media Conclusions Bibliographic Note Selected World Development Indicators OVERVIEW Building Institutions: Complement, Innovate, Connect, and Conpete How do we accountfor the persistence ofpoverty in the trying to start new businesses, run into political obsta- midst ofplenty? If we knew the sources ofplenty, why cles from established firms and the state. don'tpoor countries simply adoptpolicies that make For these people, and others like them, markets forplenty? ... We must create incentives for people to don't work. That is, markets don't give them the incen- invest in more efficient technology, increase their skills, tive to engage in wider trade, the ability to use their and organize efficient markets. Such incentives are skills and resources fully, or the opportunity to increase embodied in institutions. their incomes and accumulate assets. -Douglass C. North, 2000 Despite the problems, many people in rich countries and poor are engaged in productive-and rewarding- market activity. As World D)evelopment Report 2000/ J n the 11th century the Maghribi traders of North 2001 argued, income from participating in the market Africa had a problem. They wanted to expand across is the key to boosting economic growth for nations and the Mediterranean, but uncertainties hindered their to reducing poverty for individuals. This Report is plans-uncertainties about the prices in distant lands, about enhancing opportunities for poor people in mar- the possibility of theft in transit, and the quality of goods kets, and empowering them. What makes market ac- on arrival. tivity rewarding and possible for some, and not others? Over time they came up with a solution. They set Why are some market systems inclusive and integrated, up a network of Maghribi agents in the major Mediter- allowing benefits to flow to the poor as well as the rich, ranean trading centers to represent their interests and the rural people as well as the urban? And why are exchange information about markets. Bound by social other markets localized and segmented? ties, they had information flowing freely among them. Markets work if they have rules, enforcement mech- Theft and deceit were rare, because each member's anisms, and organizations promoting market transac- interests were best served by staying in the network tions. Extremely diverse, these institutions transmit in- of traders. And membership was self-enforcing, even formation, enforce property rights and contracts, and though there were no written rules.' manage the degree of competition. And in so doing, A millennium later, people everywhere face simi- they give people opportunity and incentives to engage lar problems in striving to improve their well-being in fruitful market activity. Where do such market in- through market activity. African entrepreneurs cannot stitutions come from? States or communities can build expand their opportunities because they lack informa- them, and they can be formal or informal (table 1). tion about potential business partners. Poor farmers in This Report is about people building institutions Latin America cannot use assets they own as collateral that support the development of markets. The 2000/ for bank loans. Budding entrepreneurs in Central Asia, 2001 Report underscores the importance of institutions I 2 OVERVIEW Table 1 nations teaches us that building institutions takes time Examples of market-supporting institutions and that the process within each country may stall or reverse because of political conflicts or economic and Public Private social conditions. It teaches us about the process of * Judicial systems * Chambers of commerce change and the importance of leadership, norms, and * Competition laws * Credit registries culture in particular countries. Institution building is * Bank supervisory * Moneylenders authorities * Reciprocity among generally a cumulative process, with several changes In * Disclosure requirements business partners different areas building up to complement and support on companies * Land inheritance norms one another. It is important to find areas in which to * Formal land titles and go forward; changes in one area can build pressures for laws governing inheritance change in another. Not all reforms are politically diffi- cult for all countries. And the nature of what is difficult changes over time. The key is to move forward, and this Report identifies elements of such a strategy. The whole in affecting poor people's participation in markets. This is greater than the parts, and even moderate progress in Report discusses both institutions that support growth the parts can contribute to a better system to promote and those that directly affect access of people left out of growth and poverty reduction. many market activities. It considers those institutions Four main lessons emerge for institution building. that provide opportunities for people and that empower The first two are about supplying effective market-sup- them. It goes beyond the 2000/2001 Report by analyz- porting institutions. But supplying institutions is not ing what institutions do to promote growth and facili- enough. People must want to use them too. Thus, the tate access and by suggesting how to build effective in- second two lessons are also about creating the demand stitutions. And it emphasizes how institutions can help for such institutions and about promoting the forces people make better use of the assets they own and how for change. to accumulate more. In focusing on institution build- To ensure effective institutions: ing, it does not devalue the importance of policy. But good policies are not enough. The details of institution * Design them to complement what exists-in terms of building matter for growth and poverty reduction. other supporting institutions, human capabilities, and The Report contributes to the work on institutions available technologies. The reason? The availability and markets in several novel ways. It provides a diag- and cost of supporting institutions, existing levels of nostic framework for understanding how institutions corruption, the degree of transparency, and underly- support market activity. Bridging the gap between the- ing human capacity and technology determine the ory and evidence across disciplines, it also builds on ex- impact of a particular institution. That is why insti- isting evidence about the role of institutions and insti- tutions that achieve their goals in industrial countries tutional change. It confirms that one size does not fit may not do so in developing ones. Much of the im- all in considering institutional design. But the Report portant work in building institutions lies in modify- does more than that. It suggests how to proceed in ing those that already exist to complement other in- building more effective institutions. It considers both stitutions, and in recognizing what not to build or how policymakers can design more effective institu- transplant in a particular context, as much as recog- tions and how to bring about forces for change. It ex- nizing what to build. "Best" practice in institutional tends previous empirical work on institutional change design is a flawed concept. to developing countries and presents a framework for * Innovate to identify institutions that work-and those institutional change. And it provides policy guidance, that do not. Even in countries with similar incomes by taking a pragmatic approach. The aim is not to de- and capacities, innovation can create stronger insti- fine what should be done in an ideal world, but what tutions because of differences in local conditions- can be done in today's world. differences ranging from social norms to geography. In understanding what drives institutional change, Experimentation, which has some costs that must be the Report emphasizes the importance of history. Many recognized, can nevertheless help identify new insti- developing countries have been nation-states for a short tutional forms. Countries can gain from expanding time relative to industrial countries. The evolution of successful innovations and adopting innovations OVERVIEW 3 from the private sector. But they must also have the Figure 1 courage to drop failing experiments. The concentration of ownership varies * Connect communities of market players through open tremendously across countries irnformation flows and open trade. Exchanging goods and services outside networks creates demand for Ownership concentration market-supporting institutions. Exchanging infor- + mation through open debate creates demand for in- 0.58 - stitutional change by holding people to account, by changing behavior, and by supplying ideas for change 0.48 - . from outside the community. Linking communities of people in networks of information and open trade 0.38 giving access to markets is thus a priority for policy- makers building market-supporting institutions. 0.28 - * Promote competition among jurisdictions, firms, and individuals. Greater competition modifies the effec- 0.18 t I I I * IX tiveness of existing institutions, changes people's in- 5.5 6.5 5 Income8.5 9.5 10.5 centives and behavior, and creates demand for new (logarithm of per capita income) institutions. Developing country actors often face Note: Ownership concentration is measured by the combined stakes too little competition, often because of current insti- of the three largest shareholders in the 10 largest privately controlled firms. tutional structures. Changing this will improve the Source. La Porta, Lopez-de-Silanes, Shleifer 1999. quality of other institutions. Competition among ju- risdictions highlights successful institutions and pro- motes demand for them. Competition among firms and individuals does the same. Yet not all institutions promote inclusive markets. The Maghribis lowered transaction costs among them- selves but in so doing excluded other communities. Small vendors engage in simple spot-market transac- Institutional designs that evolve through historical cir- tions, with buyers and sellers dealing face to face to cumstances or are directed by policymakers are not trade fairly standard products whose quality is easy to necessarily the best for all of society-or for economic verify. Large multinational firms exchange more differ- growth and poverty reduction. For instance, state ag- entiated products, face greater difficulties in verifying ricultural marketing boards, instead of helping farm- quality, and must span greater separations in time and ers, have often resulted in lower incomes for them in space between one part of the transaction and the other. Africa. And institutions that once supported market Most economies have both types of markets. But the transactions can outlive their usefulness-for example, first is relatively more common in developing countries, privatization agencies and bank restructuring agencies. the second in industrial economies. The challenge for policymakers is to shape institu- Developed markets-more global, more inclusive, tional development in ways that enhance economic and more integrated-offer more opportunity and development. choice. Underdeveloped markets, more likely in poor Institutional structures vary tremendously across countries, tend to be more local and segmented. So, countries and over time. Banks, firms, and farmers compared with farmers in Canada, poor farmers in organize themselves and deal with one another in di- Bangladesh have fewer opportunities-and far fewer verse ways. In some countries bankruptcy laws favor formal institutions (such as banks and formal courts) creditors-in others, indebted firms. In industrial to reduce their risks and increase their opportunities. countries, some firms have concentrated ownership; What limits market opportunities? The transaction others, dispersed ownership (figure 1). Some farmers costs stemming from inadequate information and market their goods through cooperatives; others use incomplete definition and enforcement of property contracts with traders. rights.2 And barriers to entry for new participants. What The institutions of the state are equally diverse. In increases them? Institutions that raise the returns from some countries governments are highly centralized; in market exchange, reduce risk, and increase efficiency. others, much power is devolved to local governments. 4 OVERVIEW Figure 2 change.3 And politics within countries shaped the na- Sources of borrowing, 1995-96: ture of their formal legal systems. In many of the poor- all households in Nepal est areas of the world today, productive institution building has been retarded by political and social con- Other flicts. And in many of these countries formal institu- 6% Formal tional structures were transplanted by foreign settlers. Yet a key feature of all industrial market systems is a strong state that can support a formal legal system that complements existing norms and a state that itself re- spects the law and refrains from arbitrary actions. Building effective market institutions is the central challenge for communities and economies-and that challenge is what this Report is about. It provides a framework for understanding how institutions support Informal markets, what these institutions do, and how effective 81% institutions to support markets can be built. Note: "Other" includes microcredit nongovernmental organizations, The Report's approach is pragmatic. It provides a rotating savings and credit associations, reiief agencies, and other guide for policymakers, by assessing the current re- unspecified sources. The paper from which this figure was drawn also search on institutional change and analyzing the expe- shows that poorer households access informal sources more often than richer ones. riences of contemporary historical institutional devel- Source: Besley and others, Wor)d Development Report 2002 opment across countries. It also provides new empirical background paper. opent on intns alsoiutonl ne incde evidence on institutions and institutional change in de- veloping countries. Market-supporting institutions do much to promote And social norms and attitudes toward market transac- growth and reduce poverty (box 1). This Report builds tions are diverse as well. In some countries, bankruptcy on past Reports, especially World Development Report means an unshakable stigma; in others, it is business as 2000/2001, which called attention to how market ac- usual. tivity is central in promoting growth and providing op- Institutions do not need to take the form of formal portunity for poor people. This year's Report focuses laws or regulations. They can be informal arrange- on what institutions do to promote market develop- ments, based on norms. These are important in busi- ment that provides benefits for all-inclusive and inte- ness transactions in both rich countries and poor. In- grated markets-markets that provide equal opportu- formal institutions are relatively more important than nity, that reduce risk, and that enable investment in formal ones in poorer countries, and particularly in higher-return activities. poorer areas. In Nepal, for instance, informal sources A growing body of research links institutional suc- of finance predominate (figure 2), although richer cess (and failure) to development over time and across households are more likely to use formal financial in- countries. And a wide range of indicators captures the stitutions. This reflects the typical situation of poorer performance of different, often overlapping sets of in- countries, where most people operate outside the pub- stitutions. For example, the success of the state in pro- lic or formal institutional framework. In such situations viding laws and the performance of the judiciary and informal networks promote exchange. police reflect how citizens and investors perceive the Clearly, there is no unique path to growth and state as respecting property rights. Access to financial poverty reduction. The diverse institutional forms that services and the sophistication of financial markets re- exist in developed markets today have evolved in re- flect how institutions protect the property rights of bor- sponse to each country's particular history. Political, rowers and lenders. High levels of corruption reflect the economic, and social forces mold public and private types of incentives that exist for politicians and civil ser- institutions. For example, in 19th century Japan the vants to pursue their self-interest over the public good. Meiji restoration brought with it a wide range of new Positive relationships between economic development ideas and new institutional forms. In Europe competi- and these indicators of institutional success have been tion among states was a strong force for institutional widely documented. But most studies do not establish OVERVIEW 5 Box 1 Figure 3 Weak institutions hurt poor people Financial depth generates growth Through their powerful effects on economic growth, the Ratio of liquid liabilities to GDP, 1960 institutions that support markets are an important force for poverty reduction. There is also growing evidence that Deep (greater the costs of institutional failure are often felt most by the than 0.5) poorest in society. Corruption is an especially regressive tax, with the poor hit hardest by even small demands for bribes or fees when they want public services. 0.25 to 0.5 In far too many cases, the legal systems and the judi- ciary do not serve the poor well, as illiteracy and the inabil- ity to pay for legal representation put legal institutions beyond their reach. The failure of the state to protect 0.15 to 0.25 property often hurts the poorest disproportionately be- cause they cannot afford to take measures to protect themselves from crime. The failure of the institutions of public policy to deliver a stable macroeconomic environ- Shallow (less ment also places greater burdens on the poor. than 0.15) The poor are often most vulnerable to macroeconomic - crises, and cross-country surveys indicate that poor peo- 0 1 2 3 ple disproportionately rate inflation as one of their great- est economic concerns. And inadequate access to finan- cial institutions that would enable the poor to save in good Note: Figure based on partial scatter from the instrumented cross- times and borrow in bad leaves them more vulnerable to sectional regressions in Beck, Levine and Loayza 2000. economic downturns. Nor do private institutions always serve the interests of the poor or disadvantaged in society. Private monopo- lies often charge high prices for essential goods, where businesses identify partners and high-return activi- competition would allow broader segments access to ties-and assess their creditworthiness. They also help these goods. Local informal dispute resolution mecha- nisms may be biased against some groups. And networks governments regulate well. So institutions can affect or associations based on social connections exclude those the production, collection, analysis, verification, and who are not members. dissemination (or withholding) of information and Source: World Bank 200 1. knowledge to participants in and among communi- ties and markets. Examples of institutions that affect information sharing include accounting firms, credit registries, and government regulations on the media links between specific institutions and specific outcomes. to restrict the dissemination of information.4 Instead, they highlight the wide variety of institutions * They defi ne and enforce property rights and contracts, that support markets. For example, income and the rule determining who gets what and when. Knowing the of law-encompassing the collective importance of rights one has to assets and income and being able to property rights, legal institutions, and the judiciary-are protect those rights are critical for market develop- highly correlated. For another example, the development ment, including the rights of the private sector in re- of financial institutions predicts growth (figure 3). lation to the state. Institutions can reduce the poten- tial for disputes and help enforce contracts. Examples include constitutions, judicial systems, and the full To provide a framework that applies across the range array of social networks. of market-supporting institutions, this report cuts a They increase competition in markets-or decrease it. through the complexity of institutional structures by Competition gives people incentives to do better, pro- focusing on what they do. Understanding what they do moting equal opportunity. In competitive markets is the first step to building effective institutions. In- resources are more likely to follow the merits of a proj- deed, institutions do three main things: ect than the social or political connections of an entrepreneur. A degree of competition also spurs in- * They channel information about market conditions, novation and economic growth. But while some insti- goods, andparticipants. Good information flows help tutions facilitate competition, others impede it. By 6 OVERVIEW overregulating the entry of new business, governments When governments have built new institutions they can impede competition. And by organizing market have met with varying success. Contrast Poland and activities around a closed group of participants-recall Russia in the 1 990s. To promote market development, the Maghribis-opportunities for those in the group Poland's government moved quickly to clarify property may increase, even though competition is stiffer, while rights between the state and private actors. It imposed the opportunities for outsiders decline. hard budget constraints on state enterprises and pro- moted a dynamic class of entrepreneurs. Russia's gov- Through these three functions, all institutional ernment did not develop a clear delineation between structures affect the distribution of assets, incomes, and private and public institutions-revealed by the contin- costs as well as the incentives of market participants and uing soft budgets for firms and widespread tax arrears. efficiency of market transactions. By distributing rights Private interests can build institutions too. They can to the most efficient agent, institutions can enhance push for-or impede-institutional change, individu- productivity and growth. By affecting the incentives to ally or in partnership. Banks, for instance, have lobbied invest, for example, through strengthening property for tougher financial supervision in Mexico. Interna- rights, they can affect investment levels and adoption tional investors worked with local groups to push for a of new technology. By delineating market rights, such commercial court in Tanzania in the 1990s. as through competition law, they limit producer rents International organizations can also be a force for and protect consumers from high prices. And by clari- institutional change. They too have had varying success frying rights for the disadvantaged in markets, insti- in helping to build institutions well-suited to develop- tutions can directly affect the lives of poor people. For ing country needs. For instance, they have been instru- example, giving formal titles to poor people whose mental in transmitting knowledge about different in- occupancy rights were not recognized by lenders allows stitutional designs across countries. But they have also them to borrow and invest. advised on institutional reforms that have not been ap- Effective institutions are those that are incentive propriate for a given country context. compatible. Institutions with internal enforcement mechanisms are effective because there is a mutually How do you build effective institutions? recognized system of rewards and penalties. An impor- Recalling the framework of information, enforcement, tant issue in the design of public institutions is ensur- and competition, policymakers building institutions ing that the incentives that are created actually lead to need to assess what is inhibiting market development desired behavior. Take the example of deposit insur- or leading to particular market outcomes. The key is to ance, which is designed to protect depositors from the identify what type of institution is needed, rather than risks inherent in financial institutions (chapter 3). Ex- to assume that a particular structure is needed. Policy- perience has shown that deposit insurance can weaken makers need to ask: the incentives of financial managers to lend depositors' funds prudently and can lead to excessive risk taking. * Who needs information on what? For example, do In circumstances like this, complementary regulations bankers lack information on the creditworthiness of are required to realign incentives, such as regulations to potential borrowers? ensure that bank managers have a significant financial * Are everybodv' property rights-and contracts-clearly stake in bank performance. defined and enforced? For example, do farmers have enforceable rights to land they use? * Is there too little competition-or too much? For exam- As economies develop, to support increasingly sophisti- ple, is an infrastructure monopoly inhibiting entry, cated transactions, institutions must also evolve. This or are firms not undertaking high-return research be- evolution can come from changes in existing institu- cause they lack safeguards on intellectual property? tions, but it can also come from building or transplant- ing new institutions. Who builds such institutions? Gov- Once the institutional gap is identified, the next step ernments, but also business and community actors and is to design the appropriate institution. Both supply and players in international markets. demand factors are important. Moreover, as countries OVERVIEW 7 change and develop, so will the appropriate institution. Figure 4a To be effective, an institution must be designed so that Cost of business registration (as percentage of the incentives of market actors are aligned to achieve GNP per capita) is higher for lower-income the desired outcome. Four key approaches toward insti- countries tution building hold across all sectors and countries: Cost of registration 1%) complement what exists, innovate to identify institu- 140 - tions that work, connect communities through infor- 120 - mation flows and trade, and promote competition. 100 - 80 - Conplemnent what exists 60 - Institutions that are effective in achieving their goals in 40 - industrial countries can have quite different outcomes 20 - in developing countries, which have fewer complemen- 2 0 - , tary institutions, weaker administrative capacity, higher 1st 2nd 3rd 4th per capita costs, lower human capital levels, different Income quartiles technology, and different levels and perceptions of cor- ruption. By knowing how to adapt institutional design Figure 4b to these differences between industrial countries and de- veloping countries when building or transplanting new Average per capita GDP (thousands of U.S. dollars) 25 - institutions, or modifying existing ones, policymakers can increase the effectiveness of their institutions. 20 - Regulations for business entry are a good example. _ In some developing countries, the cost of business reg- istration is very high relative to GDP per capita (figure 10 - 4a).5 The number of procedures required to register a business is also higher relative to that in industrial 5 - countries (figure 4b). Such high costs deter entryrinto 0 -5 I 1 , a mor the formal sector and reduce competition. Overregula- 1-5 6-10 11-15 16 and more tion of business activity is another cost that may add to Number of procedures corruption in developing countries (figure 4c). For in- stance, a recent study finds that in many African coun- Figure 4c ' . . . . ~~~~~~~More procedures are associated with higher tries, restrictive regulations and practices are often corruption aimed at generating rents for officials and favored pri- Index of corruption (higher worse) vate agents or groups, constraining business in both 90 - agriculture and industry.6 80 - In richer countries, by contrast, enforcement ca- 70 - 60 - pacity is stronger, and information processing systems 50- are better. So greater accountability for regulators 40- means that regulations do not incur as many addi- 30 - tional costs. As another example, judicial procedures 20 - for debt collection are very complex in poorer coun- 10 - tries, on average, even wvithout adjusting for enforce- 0 J I ' ' ^,, , . , , . 1-5 ~~~~ ~~6-10 11-15 16andmore ment capacity. Although some industrial countries also have complex procedures, they also tend to have Number of procedures complementary institutions that foster judicial effi- Note: Costs are defined as official fees as a percentage of 1999 GNP ciency. These are institutions, for example, that pro- per capita. Source: Djankov and others, forthconling, World Development Report mote transparency, or incentives that judges and other 2002 background paper. parties in litigation face to resolve disputes efficiently. 8 OVERVIEW Box 2 experimenting with institutional forms and these need Private innovation supported by formal to be recognized when making choices. institutional change Because innovation can come from many sources, collaboration by the different actors in society is vital. In Bangladesh an economics professor had an idea-to I oecssgetrlclatnm n atcpto help poor people help themselves, by giving them small In some cases greater local autonomy and participation loans to start businesses despite their lack of collateral or can foster experiments that lead to innovation. Aguas credit histories. He started the Grameen Bank in 1976 Argentinas, a privatized monopoly that provides water using his social connections in government to manage a and sanitation services in Buenos Aires, worked with village branch of a government bank. The success of these local government, a low-income community, and a endeavors led the government to successively change the laws governing Grameen Bank, establishing it first as an nongovernmental organization to create a new organi- independent entity with government control, then as an zational form. The community was experimenting with effectively private bank run by a public official, and finally two systems: a low-cost sewerage system and a double as an effectively private bank run by an independent board water system (with one connection to the network for of directors. Today Grameen Bank has branches in more than half the villages in Bangladesh, with over 2 million small volumes of potable water, and another drawing borrowers. on groundwater sources too salty for drinking but good In Peru another innovative individual began with an ex- for washing and bathing). The double water system was periment. He found that in Lima, it took 728 bureaucratic dropped at the experimental stage because it was too steps for a person with an informal right to housing to get legal title. He followed up with a 1 0-year public informa- expensive to develop, while the sewerage system was tion campaign, proving to politicians that there was a "hid- maintained. And to expand its network for water, den consensus for reform" for simplifying the procedures Aguas Argentinas took over those systems built at lower for formalization. Faced with overwhelming public support costs by the community, giving customers a discount for simplification, the Peruvian congress unanimously on the price in exchange. In effect, it contracted out passed legislation to formalize titles. Today, a simple legal o procedure for establishing land titles for poorer people part of its work to consumers.' works in parallel with the formal system. Innovation and experimentation occur on at least These two stories show how the state can work with three levels: national public policy, private commercial private actors to promote institutional innovation by di- practices, and local action by communities and civil so- rectly supporting experiments-or at least by allowing them to proceed and be tested and then, if they are suc- ciety leaders. Local innovations have the advantage of cessful, by encouraging their growth. The stories also being able to try many experiments simultaneously- show the importance of other factors in promoting inno- with the successful ones replicated and the failures con- vation. Social connections and networks reduce barriers taied. But not all innovations can be left to local or to experimentation. Openness in information sharing pro- decentralized lcommunities-since loca to may vides the impetus to adopt successful experiments. ecentralized communities-since locat actions may have consequences across communities. And local elites Source: De Soto 2000; Yunus 1997. may capture gains at the expense of others through new institutional forms. In developing countries, this suggests that simplifica- Connect comnmunities through iniformation flows tion of existing procedures may be a way to enhance and trade judicial efficiency. Open information exchanges and open trade create de- mand for market-supporting institutions. Open trade Innovate to identify institutions that work does more than enhance allocative efficiency, the ad- Even at similar levels of development, countries differ vantage typically cited. It exposes: in many ways-in their norms, geography, and endow- ments. Innovation is often needed to accommodate * Market participants to a larger, more diverse group those differences in the design of effective institutions. of trading partners, increasing the demand for for- Policymakers need to support the innovations of pri- mal institutions by domestic and foreign players to vate agents, replicating local successes and abandoning provide information and enforce contracts.8 failures (box 2). Experimentation can help identify ef- * Firms to new technology and new organizational and fective institutions-but there are also costs related to managerial forms. OVERVIEW 9 Figure 5 Box 3 Greater openness and quality of institutions Institutional evolution of rice markets and standardization in Japan, 1600-1920s Rule of law index 0.6 - (a) In Japan's Tokugawa period (1600-1868), local private traders collected and marketed the rice shares of both the da,myo (feudal lord) and the peasant. The traders had to 0.4 - be big, since poor inland transport meant that rice was shipped in large sailing vessels and later steamships-a costly and risky venture. When the network of railroads 0.2 - was extended to local areas, locally segmented markets began to form a nationwide market. And with the econo- mies of scale in transport and related risks, small traders 0__ could market their rice, using small shipments from many 1st 2nd 3rd local centers. Openness Itercilesl The competition among small traders from different rice-producing regions increased the pressure to standard- ize rice grades. Better and more stable quality and stan- Government effectiveness index dards ensured higher prices in urban markets. Groups of farmers and traders began taking the initiative by labeling the quality of rice in various regions. By 1900 these volun- 0.4 - tary efforts were transformed into official regulations by local government agencies, which began to set standards for the packaging of rice shipped to other regions. By 1910 there were 33 rice-grading warehouses (beiken sokol, 0.2 - managed by private companies or cooperatives, serving several purposes-inspecting, grading, repackaging, and _I I _storing. Innovations in finance followed. As farmers and traders ° - brought ungraded rice to the warehouse, it issued a "rice 1st 2nd 3rd exchange note." The precursor to today's inventory credit, Openness (terciles) these notes were also used as collateral for loans from Note: The figures show the partial relationsh p lafter accounting for the banks and pawnshops, easing capital constraints for farm- effect of differences in the legal systems, ethnic diversity, GNP per ers and traders. capita, years that the country in queston has beer independent, More trade among different communities led to the de- country size, and inequality of income) between an ind cator of rule of velopments of standards, first adopted by private traders law/ government effectiveness and openness for over 100 countries and later by government. These early institutional changes in 1997-98 The countr es have been divided into three groups of promoted new institutions to support market exchange. equal size. Source: Islam and Monteniegro forthcoming, WDR 2002 background paper. Source: Kawagoe 1998. * Markets to greater competition, inducing institu- clarification of land tenure rights and the development tional change. of land registries so that land could be used as collat- * Countries to a different set of risks, possibly creating eral. Possibilities for developing countries to export the need for additional institutions to manage the goods, agricultural and other, to developed country new risks. markets can strengthen institutions in the former and create the demand for new institutions. Openness to trade and the exchange of ideas within Japan's experience in rice markets shows a similar countries and between countries has served as a catalyst pattern of institutional development (box 3). Open for institutional change throughout history. Open trade among communities stimulated the development countries also tend to have better institutional quality of marketing institutions. The early institutional devel- (figure 5). For example, at the turn of the last century, opment originated in the private sector, but govern- Thailand became a rice exporter, and the value of rice- ment later intervened to further expand the use of these producing land shot up. This spurred demand for the standards and to facilitate trade. IO OVERVIEW Box 4 caused more land disputes and increased the demand The media's role in reducing corruption in Peru for more formal procedures for recording transactions. Firms competing in product markets, forced to in- Even in a country with regulatory and informal controls on crease efficiency, have the incentive to lobby policy- the press, the media can expose corruption and increase k pressure for better governance. In September 2000 a local makers to Implement istitutional changes that can television station broadcast a video that showed the lower their costs. But many existing structures limit or national security chief bribing an opposition member of prevent competition. Rules governing entry in markets Congress in return for voting for the incumbent govern- can limit competition. Competition also affects the dis- ment. The story spread rapidly in other publications, com- pounded by reports that the security chief was smuggling triburion of gais among market players, and so in- arms to Colombian guerrillas. The revelations led to his creases the demand for institutional change among dismissal and in November 2000 to the resignation of the those who want to maintain their gains in the light of president. Following these events, the newly elected pres- changing economic factors. dent announced his intentions to fight corruption. This shows how the media can change the in- I centives for corruption for public officials. By providing essary and reduce the burden on regulators. Municipal information to the public, the media increase trans- and large industrial users of power in Argentina, Brazil, parency of government action. The risk of exposure of Chile, and Peru enjoy competition from long-distance corruption is therefore higher with effective media. The transmission lines carrying power from different gener- media also help build the public consensus required to fight corruption-creating the public disapproval that ators-and thus require less regulatory protection. But presses corrupt agents to resign-raising the penalties competition can also complicate the regulation of in- for corruption. frastructure services. Before privatizing state monopo- lies in many countries, state infrastructure monopolies cross-subsidized poorer customers. After privatization The open exchange of ideas also drives institutional their governments have struggled to balance regulation change. Consider the media's exposure of a corruption to protect poorer customers while maintaining the scandal in Peru, leading to pressure for institutional profitability of large providers. New initiatives, wel- reforms to combat corruption (box 4). By providing coming smaller, sometimes informal, entrants into the checks and balances on government and private agents, market can help to reach poorer consumers. the media is an active force for change. In some cases the simple provision of information or sharing of knowledge What affects the pace of change? can lead market participants to modify institutional Institutional changes come from a shifting web of polit- structures. Policymakers play a large role in affecting the ical and social forces. Supporting the existing institu- quality and flow of information in economies. tions are constituencies that benefit from the status quo, and the politics of institutional reform demand that Promote competition-among jurisdictions, firms, these constituencies be compensated for institutional and individuals change. Equally important, the effectiveness of institu- Competition among firms in product markets, among tional designs adopted by governments will be affected individuals, and among jurisdictions creates demand by the political distribution of power. For example, for institutional change.9 It changes the effectiveness of strong local governments can support regulatory agen- existing institutions by affecting relative returns and cies at the local level. changing the incentives of agents. For example, as com- Sometimes policymakers wishing to embark on re- petition in markets increases, traditional norm-based forms may have to create new institutions rather than institutions may become inadequate or obsolete.t0 modify existing ones. Even though institutional change Competition can also reduce the effectiveness of closed may be desirable, the costs of collective action-includ- groups, such as guilds or business networks, whose ex- ing those of information collection, enforcement, and istence and effectiveness depend on superior access to competition-may be so great relative to perceived ben- such inputs as information. This can create the demand efits that they would frustrate the formation of a new for new institutions or improve the quality of existing political coalition that would push for institutional institutions by changing behavior. In places as varied as change. But not all reforms are equally difficult politi- Thailand and Uganda, greater competition for land cally. Some ineffective institutions may exist in part be- OVERVIEW II Box 5 changing relative returns to activities, also generates de- Institutions for markets and the comprehensive mand for new institutional forms. development framework As with the Comprehensive Development Frame- work (box 5), this Report takes a long-term view of de- Since 1999 the World Bank has had a new approach to al- vopment, and f eson the ior-te of p e- leviating poverty: the comprehensive development frame- velopment, and focuses on the Importance of partner- work. The framework seeks to improve development ships and cooperation in the development process. It effectiveness by balancing macroeconomic require- also emphasizes the responsibility of country govern- ments with the structural, human, and physical aspects of ments and citizens in the development process. development. Market-supporting institutions are a big topic, for Four interrelated principles underlie the framework: they are everywhere and varied. So much remains to be * A long-term, comprehensive vision of development re- learned about them. This Report offers some guidance quirements and solutions. for policymakers distilled both from the history of * Greater country ownership of development strategies, institutional evolution and from the lessons of recent based on participation and inclusion. . . . * Increasing the strategic partnerships and coordination experience-the varied experiences of the transition among stakeholders. economies in the last decade, the struggles in many * Accountability for development outcomes through mea- poor countries around the world, and the successes of surement of results. some of the emerging economies in the past decades. Taking a holistic approach, the framework explicitly The Report does not addlress all possible institu- recognizes the centrality of institutions in the development tional problems in all possible fields. Instead, it focuses process. Structural aspects of development-an effective on sets of these institutions from many fields to show governance framework, a legal and Judicial system, a fi- that the framework (inform, enforce, compete) and nancial regulatory system, and social safety net-are inseparable from macroeconomic, physical, and human messages (complement, inovate, connect, and (again) factors. Emphasis on this interdependence means that compete) can be applied, regardless of the sector. It identifying institutional bottlenecks and intersectoral link- does not cover in detail issues that past World Devel- ages are a core part of sustainable development. opment Reports have covered, unless there is new evi- The framework extends to how institutions work. dence in the field. This Report, one in a series looking Ownership shifts responsibility for development from in- ternational agencies to country governments and their at critical development issues, is a natural continuation people. Greater coordination between internal and exter- of World Development Report 2000/2001, which dis- nal stakeholders means that institutions must have more cusses the central role of markets in the lives of poor consultative processes and more selective intervention, people. It leaves some important issues for World De- velopment Report 2003, which will focus on the devel- opment of human, natural, and environmental capi- cause there are no interest groups pressing for change- tal, as well as social cohesion and social stability. not because some interest groups oppose change. Or it may be that those who would oppose change do not have much political sway. Whatever the reason, reforms 1. Greif 1997. in these areas could be accelerated. And as these reforms 2. North 1994; Coase 1937; Williamson 1985. breed new constituencies and forces, they can create de- 3. North 1993; Pistor and others 2000. mand for greater change. 4. The World Development Report 1998/1999. Knowl- The structure of society-such as its inequalities and edge for Development discusses the importance of infor- ethnic diversity-can also affect the pace of institu- mation-sharing institutions. tional reform. More polarized societies may find it more 5. Djankov and others forthcoming. difficult to establish institutions that benefit broad seg- 6. World Bank 2000. ments of society. However, these are also the cases where 7. Baker and Tremolet 2000. formal public institutions are needed to bridge the gaps 8. Scholars, including North and Weingast 1989, between groups with different norms. And in many in- have written about the importance of trade in general stances, economic crises engender institutional reforms in promoting institutional change. because they change the impact of political and social 9. North 1993. forces in the economy. Technological innovation, by 10. Andre and Platteau 1998. 12 OVERVIEW References tion of Countries." World Development Report 2002 back- Andre, Catherine, and Jean-Paul Platteau. 1998. "Land Rela- ground paper, World Bank, Washington, DC. tionsun:Rwanda Caught in the Kawagoe, Toshihiko. 1998. "Technical and Institutional Inno- Mathosinder Unbearahie Sturen s ofEconomicBebviorandOrga- vations in Rice Marketing in Japan." in Yujiro Hayami (ed.) nization 34(T): 1-47. Toward the Rural-Based Development of Commerce and Industry. Education Development Institute Learning Re- Baker, W., and S. Tremolet. 2000. "Utility Reform: Regulating sources Series. World Bank, Washington, D.C. Quality Standards to Improve Access for the Poor." World sortas rael, Forenci Lasin an, adnr Bank Private Sector Note 219. October 2000. World Bank, leiPer. 1999. "Corporat LOw erSiparound teWrl. Washington, D.C. Available on-line at: www.worldbank.org/ Journaleof Financeo54(2):47 1-517. html/fpd/notes. JunloFnne5()4157 Lex Mundi, Harvard University, and The World Bank. "Judi- Beck, Thorsten; Ross Levine, and Norman Loayza. 2000. "Fi- cial Project." World Development Report 2002 background nance and the Sources of Growth." Journal ofFinancial Eco- paper, World Bank, Washington, D.C. nomics 58(1-2):261-300. North, Douglass C. 1993. "Competition and Values in the Rise Besley, Timothy J, Sanjay Jain, and Charalambos Tsangarides. of the West." Swiss Review of World Affairs 11:23-24. "Household Participation in Formal and Informal Institu- _. 1994. "Integrating Institutional Change and Techni- tions in Rural Credit Markets in Developing Countries." cal Change in Economic Historv: A Transaction Cost Ap- World Development Report 2002 background paper, World proach." Journal of Institutionaiand Theoretical Economics Bank, Washington, D.C. 150(4) 609-624. Coase, Ronald H. 1937. "The Nature of the Firm." Economica, North, Douglass C., and Barry Weingast. 1989. "Constitutions Vol. 4, 386-405. and Commitment: The Evolution of Institutions Govern- De Soto, Hernando. 2000. The Mystery of Capital. Why Capi- ing Public Choice in Seventeenth-Century England." Jour- talism Triumphs in the West and Fails Everywhere Else. New nal of Economic History 49(4):803-832. York: Basic Books. Pistor, Katharina, Yoram Keinan, Jan Kleinheisterkam, and Djankov, Simeon, Rafael La Porta, Florencio Lopez-de-Silanes, Mark West. 2000. "The Evolution of Corporate Law." and Andrei Shleifer. Forthcoming. "Regulation of Entry." World Development Report 2002 background paper, World Quarterly Journal of Economics. World Development Report Bank, Washington, D.C. 2002 background paper, World Bank, Washington, DC. Williamson, Oliver E. 1985. "Reflections on the New Institu- Greif, Avner. 1997. "On the Social Foundations and Historical tional Economics." Zeitschrift fur die gesamte Staatswis- Development of Institutions the Facilitate Impersonal Ex- senschaft 141(1):187-95. change: From the Community Responsibility System to In- World Bank. 2000. Can Africa Claim the 21st Century? Wash- dividual Legal Responsibiliry In Pre-Modern Europe." Stan- ington D.C. ford University, Economics Department Working Paper, 12 . 2001. World DevelopmentReport2000/2001:Attack- June 1997. ing Poverty. New York: Oxford University Press. Islam, Roumeen, and Claudio E. Montenegro. "The Determi- Yunus, Muhammad. 1997. Banker to the Poor: Micro-Lending nants of the Quality of Institutions: A Study in a Cross Sec- and the Battle against World Poverty. New York. Public Affairs. This report is about building institutions that support markets which promote growth and reduce poverty. It analyzes the myriad of institutions-formal and informal, public and private-that people build and use to undertake activities that maximize returns and to manage risk in markets. These institutions range from unwritten customs and traditions to complex legal codes that regulate international commerce on the cutting edge of technology. Some developing countries have been able to harness such market-supporting institutions to improve the welfare of their people, but others have not yet achieved the same degree of success. Drawing on a wealth of research and experience from inside and outside the World Bank, this 24th edition of the World Development Report moves toward a deeper understanding of market-supporting insti- tutions and a better appreciation of how people can build such institutions. Building Institutionsfor Markets takes a two-step approach to institutional development. First, it contends that what is critical is focusing on the functions that market-supporting institutions provide and how they provide it rather than on particular structures. Looking at institutions in terms of the functions they provide rather than in terms of their structures helps identify institu- tional gaps. All market-supporting institutions affect both efficiency and distribution by doing three main things: *Channeling information about market participants and goods * Defining and enforcing property rights and contracts * Increasing or decreasing the level of competition in markets. Second, after identifying the institutional gap, the next step is to build the needed institution. The report goes beyond the recognition that one size does not fit all to develop an understanding of how to think about designing effective institutions in a particular context. There are four main lessons on building effective institutions. The first two are mostly about supplying institutions, while the second two are mostly about first creating the demand for such institutions: * Design them to complement what exists-other supporting institutions, human capabilities, and available technologies * Innovate to identify institutions that work-and drop those that do not * Connect communities of market players through open information flows and open trade * Promote competition among jurisdictions, firms, and individuals. Building Institutionsfor Markets also includes Selected World Development Indicators, an essential reference on recent trends in development. Altogether, the report offers valuable insights and vital guidance for policymakers, researchers, and anyone with an interest in development. H The World Bank 1818 H Street N.W. 5016 Washington, D.C. 20433 USA 1516 Telephone: 202-477-1234 Facsimile: 202-477-639197821306 Internet: www.worldbank.org E-mail: feedback@worldbank.org 0-8213-5016-1