71513 v1 Zambia: Second Investment Climate Assessment Business Environment Issues in Diversifying Growth (In Two Volumes) Volume 1: Summary Final December 2009 1 Contents Acknowledgment 3 Preface 4 Executive summary 5 1 Introduction 11 2 Productivity and Export Diversification 15 3 Productivity, Market Distortions and Business Environment 22 4 Direct Regulation of Entry and Competition 27 Competition and trade policies 27 Direct entry regulation 28 Entry regulation, informality and competition 30 5 Indirect Barriers to Entry and to Factor Mobility 31 Access to finance 31 Taxation 37 Power shortages 39 Trade facilitation and transport costs 43 6 Other business environment issues 45 7. Conclusion 48 References 49 2 Acknowledgement The Second Investment Climate Assessment of Zambia was written by a team comprising Taye Mengistae (AFTFE, team leader), Sina Joy Grasmann (DECVP), James Habiyarimana (University of Georgetown), Inessa Love (DECRG), Manju Shah (AFTFE), and Colin Xu (DECRG). Marie Sheppard (AFTFE), Alvaro Gonzalez (AFTFP) and Gerardo Corrochano (AFTFE) provided overall guidance and support throughout the duration of the work. Magdi Amin (CEADR), Pablo Fajnzylber (LCSPR), and Jos Verbeek (AFTP2) kindly served as peer reviewers. The 2008 Enterprise Survey on which the report is based was carried out by the survey firm EEC Canada. 3 Preface The objective of the Second Investment Climate Assessment of Zambia is to provide firm level analyses of some of the key business environment factors influencing manufacturing employment and exports in the country. The report builds on an earlier investment climate assessment of Zambia that the World Bank issued in 2004. That report was based on the Productivity and Investment Climate Survey of 2003. The main data sources of the second assessment are the Zambia Enterprise Survey of 2008 and the 2003 survey itself. The report has two self-contained volumes, of which this is the first, and summarizes the main findings of the assessment without going into detail on underlying arguments and methodologies. The full report is presented in the second volume and provides, in addition to the main findings, details of the arguments and the evidence behind them. 4 Executive Summary This is the second World Bank assessment of Zambia’s investment climate. Its objective is to highlight some of the impediments to growth and export diversification in the current business environment in the country. It is also a sequel to an earlier assessment (World Bank, 2004), which also addressed this same issue. Like the first assessment, it is based on an analysis of enterprise survey data specifically collected for the purpose, namely, the World Bank’s Zambia Enterprise Survey of 2008, which the report analyzes along with data from the Zambia Investment Climate Survey of 2003 and similar data on a group of comparators selected from the World Bank Enterprise Survey (WBES) cross-country database. The comparators are drawn from the region and from high performing middle income economies in other parts of the world. Productivity and export diversification Zambia needs to diversify its exports into manufactures and services. At present it is not as much of an exporter of labor intensive manufactures as its low wages should have made it to be. This is partly because the effect of low wages on unit labor costs is more than offset by Zambia’s labor productivity shortfalls relative to larger exporters of the products. The labor productivity shortfall itself is in part explained by underinvestment in equipment. However, even if Zambian manufacturing were as capital intensive as any of the comparators used in the report, Zambian workers would still not be as productive as their counterparts in those countries. A large part of the labor productivity shortfall is in fact a total factor productivity (TFP) gap. Some of that gap reflects Zambia’s comparatively low ‘within-firm’ TFP, meaning that, relative to those in the comparators, Zambian manufactures operate, on average, further below the global technological frontier of their respective industries. The rest of the TFP gap is due to the fact that there is greater allocative inefficiency in Zambia’s industries. As a result, the correlation between within-firm TFP and market shares is comparatively weak in Zambia so that low-productivity firms tend to have higher market shares in Zambia than they would have in the comparators. Zambia’s business environment in an international perspective A key message of the report is that Zambia’s business environment has improved dramatically since the first investment climate assessment in 2004. However, there are also major business environment problems that need to be addressed as they are a large part of the reason why manufacturing productivity is as low as it is. The problems have reduced productivity and employment in manufacturing and other tradable sectors in two ways. One of these is that they have 5 raised the cost of doing business in Zambia relative to that in other countries. This aspect of the effect of business environment problems on productivity and employment is analogous to that of an implicit tax imposed on all activities of all producers in Zambia at a flat rate thereby making them that much less competitive in world markets. In order to provide a sense of how much the country could be losing in jobs and productivity when business environment problems raise the cost of doing business in this way, the report compares averages of key business environment indicators between Zambia and other countries. Business Environment and Domestic Market Distortions The second way in which business environment problems are costing Zambia in terms of manufacturing jobs and output is by distorting domestic markets. In practice a business environment problem does not affect all firms to the same degree. It is more likely to affect some firms more than others for a variety reasons, and is therefore unlikely to add to the cost of doing business by the same amount for everyone. The effect of the problem from this point of view resembles not that of a flat tax applied uniformly to everyone, but that of a system of discriminatory tax rates that vary across sectors, locations, and, indeed, firms. Just as taxes of this kind would, differences between firms in the cost of doing business generate losses in employment and productivity by preventing factor productivity from equalizing at the margin across activities and producers, that is, by generating allocative inefficiency. The size of the loss involved here is determined, not by how grave the business environment problem in question is on average in Zambia, but by the variation in the incidence and intensity of the problem across domestic firms, the rule being that the greater is the dispersion across firms, the larger the loss in aggregate employment, productivity and exports. The basic point is that even if Zambia had the best set of average indicators of business environment on all dimensions by international standards, it could still in theory be less productive and poorer than comparators if there is too much disparity across firms within Zambia in terms of those indicators relative to the disparity in the other countries. In order to provide some sense of the extent of the loss in manufacturing employment and productivity due to the allocative inefficiency arising from the disparity of business environment within Zambia, the report describes the extent to which key business environment indicators vary across business size and age groups, sectors, and regions. Zambia’s overall business environment has improved drastically According to the 2008 Enterprise Survey Zambia’s business environment has improved drastically on every major indicator since the 2003 survey. Business managers were asked in the 2003 survey to rate 17 potential business environment problems as obstacles to the growth of their businesses on a scale ranging from being ‘no obstacle’ to being a ‘severe obstacle’. The outcome was that ten of those potential problems were rated as major or severe obstacles by at least a third of survey respondents. Many problems were in fact rated in that way by 50 to 80 percent of respondents. These included, in that order of importance, macro-economic instability, high taxes, access to finance, power supply, crime, corruption, competition from informal firms, and skills shortage. 6 By contrast, none of those ten potential obstacles was rated as major or severe by a third or more of respondents in the 2008 survey. Indeed, no other potential business environment problem was rated as such by more than a third of respondents. While much of the change in the average ratings has to do with changes in the composition of the sample between the two surveys in terms of size and sector distribution, a sizeable portion of it holds in most cases when comparisons are made controlling for shifts in sample composition. Moreover, the changes in ratings are matched by consistent improvements in hard indicators. Despite the improvement overall, serious business environment issues were also identified by respondents to the 2008 survey. These included (in more or less in that order of importance): (a) access to finance, (b) taxation, (c) product market competition and (d) the provision of physical infrastructure, particularly of power supply and transport. Competition and trade policies That low productivity firms tend to have larger market shares in Zambia than they would have in more advanced and better performing economies suggests that there should be some scope for increasing productivity through competition policy reforms. Indeed, the government is already considering some specific proposals for such reforms. The proposals include expanding the mandate of the ZCC beyond the regulation of mergers to the detection, prosecution and prevention of cartels and the abuse of dominant market power. These are commendable measures that could lead to significant allocative efficiency gains by reducing entry barriers to domestic industries. However, they are all measures for influencing the behavior of incumbent large players, which behavior is only one among several influences on entry and exit rates and on factor mobility between incumbent in domestic industry. Key among the other influences is the international integration of the economy in terms of the export orientation of domestic industries and the level of import penetration of domestic markets. At least as important are also a range of other business environment factors affecting the ability of potential entrants to respond to new investment opportunities. Some of these relate to the direct regulation of entry by government. Some pose indirect barriers to entry, of which group the most notable are problems of access to finance and taxation and power shortages. Issues in the direct regulation of entry In Zambia, as in other countries, business licensing and the requirement of construction permits constitute the most common forms of direct regulation of entry by government. Since the first assessment, the time and pecuniary costs associated with meeting these requirements have fallen substantially. At the same time FIAS’ latest assessment is that Zambia can increase firm formation and entry rates by cutting the number of days needed to set up a business from the 18 days where it stands today to 8, and by reducing the time needed for obtaining construction permits. 7 Access to Finance According to the Enterprise Surveys, inadequate access to finance is the most widespread indirect barrier to entry and to factor mobility in the current business environment in Zambia. More businesses had access to formal external finance in 2008 than did at the time of the 2003 survey, and therefore far fewer of them were complaining of lack of access in 2008. However, nearly a third of respondents in 2008 survey considered inadequate access to be a serious growth bottleneck-an assessment that is backed by several hard indicators of access. Moreover, as is the case in almost every other country, smaller and start up business have poorer access than larger and longer established ones. This distorts the distribution of factors and market shares between small and large firms, not only directly by impeding the mobility of resources among incumbent operators, but also indirectly by reducing entry and firm formation rates. The loss in employment and productivity resulting from the distortion adds to the loss due to Zambian businesses not having as good access to finance as their counterparts in many of the comparators used in this report. In Zambia the problem of inadequate access to finance is inseparable from that of macroeconomic instability. One of the most important steps the government can take to improve businesses’ access to finance is therefore to achieve lasting price and exchange stability, and to bring down government borrowing under control over the long term. In addition, there are major institutional gaps in the current financial system that need to be filled. To address one of the gaps, Zambia needs to promote the development of microfinance institutions at least to the point that these meet as much of the credit needs of microenterprises as similar organizations are doing in many other countries in the region. A second institutional gap is the lack of a workable credit information system, in which Zambia is being advised to invest in order to encourage commercial banks to participate in the SME credit market. SME’s demand for external finance for investment would continue to go largely unmet if commercial banks continue to stay out of the SME market because of lack of the minimum infrastructure needed for their participation. A reliable credit information system is a key part of that infrastructure. Business taxation Another indirect barrier to entry and to factor mobility relates to small business taxes. Zambia is not a high tax economy by international standards, and the Enterprise Surveys suggest that the average business tax burden has fallen significantly since the 2004 assessment. But one in four business managers still think that the growth of their businesses is being seriously hampered by taxes that are too high. The report argues that the contrast between the relatively high complaint rate against high taxes and Zambia’s relatively low average tax rates is explained by the fact that the complaints have nothing to do with average tax rates, and are driven primarily by the marginal effective tax rate being way higher for SMEs than for large enterprise. Just like the disadvantage that SMEs have in terms of access to finance this is also a source of distortion that protects the market shares of larger firms among incumbents while reducing entry and firm formation rates. Like the disparity in access to 8 finance between the two groups of firms, higher tax burdens on SMEs ultimately means less aggregate employment and lower aggregate productivity. Power shortages Despite unmistakable improvement in the situation in recent years, Zambian industry continues to suffer from serious power shortages. The shortages have meant frequent outages and long queues to get connected to the public grid for start ups and expanding businesses. The outages and connection delays have added significantly to the cost of doing business in Zambia relative to other countries. They are also a major source of allocative inefficiency, not only because they affect smaller and younger firms more than others among businesses already in operation, but also because they reduce firm formation and entry rates. To give a sense of the extent of the shortages, businesses reported to have lost 3.6 percent of yearly revenue to outages on average in 2008 while a business needed 80 days on average to get a new connection to the public grid that year. An indication of the magnitude of the allocative inefficiency associated with the shortages is that losses to outages were significantly higher in manufacturing businesses than in services. Within manufacturing, smaller businesses reported higher losses on average than larger one. The waiting period for getting connected to the public grid was also several times longer for small businesses than for large ones. Ultimately the shortages will be tackled only with the help of large investments in new generating and transmission capacity. The government is trying to facilitate these investments using institutional reforms designed to encourage private sector participation in the power sector. However, for needed investments to materialize in the long term, more rational electricity tariffs need to be instituted in the short term. The tariffs that are currently in force fail to cover the full cost of supply. This has undermined the financial viability of ZESCO. It is also a disincentive for private sector participation in future investment programs. Other measures needed for improving ZESCO’s finances include reducing transmission and distribution losses and resolving the long standing issue of build-up of payment arrears by ZESCO’s public sector customers. 9 Trade facilitation and transport costs Yet another potential source of productivity gains in Zambia relates to trade facilitation and transport costs. The trade liberalizing reforms that Zambia has carried out since 1991 are likely to have led to significant productivity growth in several ways. First, they are likely to have induced a reallocation of market shares from low productivity firms to high productivity ones within domestic industry. Secondly, they are likely to have increased the incentives for innovation by domestic firms. Third, they probably have provided opportunities for greater economies of scale in industries where exports have grown significantly. All indications are also that Zambia can realize more of these gains since there is significant room for opening up its economy even more through further trade facilitating measures and by reducing transport costs further beyond the remarkable achievement of the past decade in that regard. 10 1. Introduction Issues This is an extended summary of the World Bank’s second assessment of Zambia’s investment climate. The full report is available in a separate volume. Building on an earlier assessment (World Bank 2004), it highlights some of the impediments to growth and export diversification in Zambia’s current business environment. Like the first assessment, it is based on an analysis of enterprise survey data specifically collected for the purpose, namely, the World Bank’s Zambia Enterprise Survey of 2008, which the report analyzes along with the Zambia Investment Climate Survey of 2003 used in the first assessment and similar data on a group of comparators selected from the World Bank Enterprise Survey (WBES) cross-country database. The comparators are drawn from Sub-Saharan Africa and from high performing middle income counties from other regions. Included in the first group are Angola, Botswana, Kenya, Mozambique, Nigeria, Tanzania, Uganda, and South Africa. The middle income comparators from other regions are China, Malaysia, Thailand, Chile and Colombia. Zambia’s GDP needs to grow at more than 7 percent a year if the country is to attain middle income status by 2030 as is envisaged in the Fifth National Development Plan (FNDP). The closest that Zambia ever got to that kind of growth was in the five years leading up to the current global recession, when output grew at 5-6 percent a year largely on the back of a copper price boom and a major debt relief. That growth episode reversed decades of persistent decline in per capita incomes that was also happening all over Sub Saharan Africa, but bore a sharp contrast to the explosive growth of South East Asia’s economies, many of which began the sixties much poorer than Zambia (figure 1). The fact that the decline occurred very much in sympathy with a similar trend in the price of copper (figure 2), and the deceleration in growth that the sudden collapse in the same price led to in 2008 underscored the enormity of the risks involved in the excessive dependence of the economy on copper exports. Both the post 2000 upturn and the consequences of the recession have been strong reminder that diversification of exports and the attraction of FDI particularly into non- mineral sectors are necessary conditions for sustaining growth in what has been a low-income, low- savings economy since independence. As a low income economy, Zambia is characterized by extensive poverty and high unemployment, for which part of the blame lies in the concentration of exports, infrastructure and public services in the relatively capital intensive mining sector. 11 Figure 1 GDP per capita in 2000 US dollars The Enterprise Surveys of 2003 and 2008 As the main source of the data for this report, the 2008 Enterprise Survey of Zambia was carried out by the survey firm, EEC Canada, and took place in the last quarter of 2007 and the first quarter of 2008. Full description of the sample design is provided in an annex to the full report. The total sample consisted of 603 enterprises selected from the cities of Lusaka (64 percent), Kitwe (13 percent), Ndola (13 percent), and Livingston (10 percent) and from about half a dozen two-digit manufacturing industries, retails and wholesales trade and other services (table 1). One hundred nineteen observations of the full sample were micro enterprises, which we define as establishments employing less than five workers. The remaining enterprises employed five workers or more. 12 Figure 2 Source: World Bank Competitiveness Study Mission to Zambia, July 2009 Of the total sample of the 2008 Enterprise Survey, 87 businesses were revisits to a part of the sample of the Investment Climate Survey of 2003, on which the first assessment was based. We thus have repeat observations on a range of business environment and business performance variables in a four-year interval over a sizeable number of enterprises. The Investment Climate Survey of 2003 itself covered 207 manufacturing establishments. These too were drawn from the cities of Lusaka, Kitwe, Ndola and Livingston and from more or less the same industries as those covered by the 2008 survey (table 1). The instrument of each of survey was a written questionnaire that enumerators administered to enterprise managers through face to face to interviews, with significant variation in the instruments used for the survey of micro enterprises from those applied to larger manufacturers, which, in turn, differed from the survey instrument for retail businesses. Each variant of the instrument generated information on four broad areas with comparable observations across the two waves: managers’ ratings, on a common scale, of different aspects of their business environment; objective indicators of the various dimensions of same environment; financial, production, employment, assets, sales and technological information needed for the measurement of business productivity and growth; and key business characteristics such as business age, forms of business organization, and other entrepreneurial characteristics. 13 Table 1 : Distribution of Enterprise Survey Sam ple by Business Characteristics 2008 sam ple 2008 and 2003 pooled Number Percent Number Percent Distribution by industry groups: Food 117 19% 175 22% Textile and garments 80 13% 97 12% Machinery and metal products 40 7% 48 6% Chemicals and plastics 29 5% 41 5% Other manufactures 71 12% 87 11% Retail and w holesale trade 213 35% 214 26% Other services 44 7% 54 7% Other 9 1% 30 4% Total 603 100% 810 100% Distribution by location: Lusaka 383 63.5 487 60.2 Kitw e 81 13.4 106 13.1 Ndola 77 12.8 124 15.3 Livingston 62 10.3 93 11.4 Total 603 100 810 100 Distribution by em ploym ent size groups : Few er than 5 w orkers ("micro") 119 20% 119 15% 5-49 w orkers ("Small") 366 61% 453 56% 50+ w orkers ("Large") 118 20% 238 29% Total 603 100% 810 100% Distribution by age groups : 1-9 years since established ("Young") 372 61.7 457 56.4 10 years or more since established ("Established") 231 38.3 353 43.6 Total 603 100 810 100 Distribution by exporting status: Non-exporter 533 88.4 656 81.0 Exporter 70 11.6 154 19.0 Total 603 100 810 100 Distribution by foreign equity participation: No foreign share in ow nership 479 79.4 625 77.2 Some foreign ow nership 124 20.6 185 22.8 Total 603 100 810 100 Organization of the summary This summary broadly follows the structure of the full report. Like the full report it opens with an analysis of manufacturing productivity and labor costs in an international perspective as proximate determinants of manufactured exports. It then discusses key business environment variables as deeper factors in the growth of manufacturing employment and exports. 14 2. Productivity and Export Diversification Exports and productivity Zambia’s economy is fairly open to trade and its exports are far more diversified today than they were in the mid 1990s. This is largely thanks to the reforms the country has made since then to liberalize its trade and exchange rate policies. However, Zambia’s manufacturing industries are not as export oriented as their labor intensive nature and the low wages they face (figures 4A and 4B) should lead us to expect. They certainly are not as export oriented as similar industries in the middle income comparators used in this report. In the Enterprise Surveys this shows up as the export participation rate of the Zambian sample being lower than those of samples from all upper middle income comparators shown in figure 3, and those of samples from countries such as Kenya and Senegal within the region. Indeed, the surveys show that the export market participation rates of Zambian manufacturers have been falling in recent years since well before the onset of the global recession. There were also indications that they would probably have continued to fall even if the recession did not happen. One of these indications was that the rate of return in exporting was declining relative to that in production for the domestic market. A major contributing factor to this development undoubtedly was the steep appreciation of the Kwacha between 2003 and 2008 (figure 4). However, even controlling for exchange rate movements, export market participation rates could have been higher than shown in figure 3, given that Zambian wages have always been low compared with those of middle income comparators, and did not rise significantly over the period in question (figures 5A and 4B). Zambia’ exports of manufactures are as low as they have been because the country’s advantage over middle income countries in terms of lower wages is more than offset by its disadvantage in terms of labor productivity (figures 6A and 6B). Indeed Zambia’s unit labor costs are higher than those in countries like China, Brazil and Colombia, and have been so at least since the 2003 survey (figure 6A). 15 Figure 4. Zambia: Real Effective Exchange Rates (2000=100), 1980-2008 16 Within Africa, Zambia’s unit labor costs are significantly higher than those of Kenya, Swaziland, Botswana and Namibia (figure 6B). These countries and nearly all of the middle income comparators in fact have far higher average wages than Zambia. They therefore owe their lower unit labor cost shown in figure 7A to their average labor productivity being even higher than Zambia’s (figures 6A and 6B). 17 Proximate causes of low labor productivity Part of the reason why labor productivity is so much lower in Zambia relative to East Asia and the other middle income comparators is that Zambian workers are not as well equipped with fixed assets. Thus the value of fixed assets per worker in Zambia is lower than that in all middle income comparators shown in figure 8A except those of Malaysia and Thailand. Within Africa, production is more capital intensive than in Zambia in countries where labor productivity is also higher than Zambia’s. This group includes Kenya, Botswana and Namibia. It also turns out that Zambia’s labor productivity shortfalls with respect to any of those comparators would not vanish even if Zambia’s capital to labor ratios were as high as the comparators’. In other words, part of the reason for the shortfall is that the average total factor productivity (TFP) is lower in Zambia (figure 9). 18 19 Productivity and allocative efficiency in domestic industry Aggregate TFP is lower in Zambian manufacturing than in middle income comparators in part because average within-firm TFP is lower in Zambia (figure 10). This means that the typical Zambian enterprise operates further away from the world technological frontier than its counterparts in middle income countries because of poorer know-how or poorer work organization and management at the factory floor and beyond. A second explanation is that there is greater allocative inefficiency in Zambian industry compared to industries in middle income comparators, as a result of which low productivity firms tend to have a larger market shares in Zambia than they would have in the comparators (figure 11). 20 Misallocation of capital between the SMEs and large firms Productivity shortfalls due to allocative inefficiency tend to be higher in industries exposed to relatively little competition because of barriers to domestic entry or because of insufficient import penetration. The shortfalls originate in distortions in domestic factor markets arising from problems of business environment and lead to the misallocation of capital, land and labor between sectors and 21 groups of firms.1 While there is no evidence of (persistent) inter-industry or inter-regional misallocation of capital in Zambia at the moment, it is clear from the survey data that smaller and younger firms are subject to more capital shortages than others. The shortages have made manufacturing employment and productivity lower than they would otherwise be. By young enterprises we mean those that have been in business for less than 10 years. And by small enterprises we meant those employing less than 50 workers. Although total factor productivity does not vary by business size in the 2008 Enterprise Survey data, both the average rate of return to capital and the marginal revenue productivity of capital do. In particular, both indicators are significantly higher for young small enterprises than for larger enterprises of the same age group. Significantly, the pattern in the marginal productivity of capital holds up in the 2003 survey data as well, which suggests that the comparative shortage of capital for smaller firms has been a persistent phenomenon. 1 The distortions lead to a misallocation in the sense that employment and productivity would both be higher in the absence of the distortions. In the case where the misallocation is between smaller and larger firms because smaller firms suffer from capital shortages, society would increase employment and productivity by removing the distortions so as to facilitate the reallocation of capital in favor of small firms to the point where the rate of return on capital would be the same for both small and large firms. 22 That the marginal revenue productivity of capital is always higher in smaller firms means that aggregate output and productivity would have been greater if some of the investment made in the larger firms had been made by the smaller firms instead. In that sense the fact that smaller firms operate subject to greater capital shortages is costly to society. Part of the gap in expected rate of return to capital between small enterprises and larger businesses no doubt reflects differences between the two groups of firms in risk exposure and in attitude to risk and does not therefore necessarily represent misallocation of capital. On the other hand, it is also clear that part of the difference in risk exposure between the groups reflect differences in business environment rather than in inherent capabilities of firms. This part does signify misallocation of capital from society’s point of view. In the rest of the summary, we discuss some of the business environment problems that contribute to this and other instances of misallocation by impeding the mobility of labor and capital from units, sectors or locations where their respective returns are low to where the returns are higher. 3. Productivity, Market Distortions and Business Environment Zambia’s business environment in international perspective Business environment problems have reduced manufacturing employment and productivity in Zambia in two ways. One of these is by raising the cost of doing business in the country relative to other countries. This aspect of the effect of business environment problems is analogues to that of an implicit flat tax imposed on activities of all producers in Zambia, which would make them that much less competitive in world markets. The report provides a sense of how much Zambia could be 23 losing in manufacturing employment and productivity when business environment problems raise the cost of doing business in this way by comparing averages of key business environment indicators between Zambia and the group of international comparators listed earlier Business Environment and Domestic Market Distortions The second way in which business environment problems have cost Zambia in terms of manufacturing jobs and productivity is by distorting domestic markets. Typically, a business environment problem does not affect all firms to the same degree. It does not therefore add to the cost of doing business by the same amount for everyone. The proper tax analogy from this point of view is therefore, not one with a flat implicit tax rate, but one with that of a system of discriminatory tax rates that vary across firms, sectors and locations. Just as taxes of this kind would, differences between firms in the cost of doing business generate losses in employment and productivity by preventing factor productivity from equalizing at the margin across activities and producers, that is, by generating allocative inefficiency. In this case the magnitude of the loss involved is determined, not by how much the business environment problem in question adds to the cost of doing business on average in Zambia, but by the dispersion in the added cost across firms and sectors within Zambia, the rule being that the greater is the dispersion, the larger the loss in aggregate employment and productivity. The basic point here is that, even if Zambia had the best averages of all business environment indicators, it could still in theory be less productive and poorer than comparators if there is too much disparity in business environment across firms within Zambia that leads to greater allocative inefficiency than in comparators. In order to provide a sense of the loss in manufacturing employment and exports due to the allocative inefficiency arising from the disparity of business environment within Zambia, the report describes the extent to which key business environment indicators vary across business size and age groups, sectors, and regions. The gravity of many business environment problems often varies significantly between business age groups in part because entry cohorts often differ in terms of technical know and capability. Often established businesses respond differently from younger ones to the same problems because they have already incurred some (sunk) costs. There are also scale economies in dealing with some business environment problems, which also puts larger businesses at an advantage over smaller ones. On the other hand, larger firms may be more exposed to predatory behavior by corrupt officials. Inter-industry technological differences could also translate to differences in how firms are susceptible to or cope with certain business environment problems. Moreover, such key aspects of business environment as physical infrastructure and governance often show significant regional variation. Lastly, it is common for some firms to find themselves in a better business environment 24 than others as the outcome of a deliberate government policy-as beneficiaries of export promotion schemes or of special investment incentive, for example. Zambia’s overall business environment has improved drastically In trying to identify the main business environment influences on employment and productivity, the 2003 and 2008 Enterprise Surveys asked business managers to rate items on a list of 17 potential obstacles to business expansion. The ratings were on a scale of 0 to 4, 0 being no obstacle and 4 being severe obstacle, with 2 for moderate obstacle, and 3 for major obstacle in between. In addition, both surveys collected data from each responding enterprise on hard indicators of the state of most of the 17 potential obstacles. The purpose of collecting data on these ‘hard’ or ‘objective’ indicators was to get some concrete sense of the problems that managers would be “complaining� about in providing the ratings. The hard indicators have the added advantage of being objectively measurable and can be useful in monitoring the outcomes of specific business environment reforms. In figure 12 we compare the proportion of manages who rated problems in the indicated aspects of the business environment as major or severe obstacles as reported in both the 2008 and the 2003 surveys. The chart shows that the private sector’s view of Zambia’s business environment has become far more favorable than it was in 2003. Of the fifteen items displayed in the chart, 10 were rated as major or severe obstacles by at least a third of respondents of the 2003 survey. These included problems relating to macro-economic instability, high taxes, access to finance, power supply, crime, corruption, competition from informal firms, and skills shortage. It is thus a measure of the success Zambia has had in improving its business environment since then that none of those 10 obstacles were rated as major or severe by at a third or more of respondents during the 2008 survey. Indeed, no other potential business environment problem was rated as such in 2008 by more than a third of respondents. While much of this discrepancy between ratings from the two surveys has to do with changes in the composition of the sample in terms of size and sector distribution, a sizeable portion of the change holds in comparisons controlling for shifts in sample composition. In addition, the change in perceptions is matched by improvements in hard indicators in almost every case. 25 Outstanding issues Figure 12 also indicates that there are at least four major business environment areas that should continue to be of serious concern to policy makers. These relate, more or less in that order of importance, to: a) problems of access to finance b) issues of taxation c) barriers to entry and problems of product market competition more generally, and d) problems of provision of physical infrastructure, particularly of power and transport Tables 2 and 3 describe how managers’ ratings of these and other issues vary within Zambia by sector and by business size and age groups. As already noted, it is in as far as business environment problems affect different groups of firms to different degrees that they generate allocative inefficiency in domestic industries. The inefficiency arises not only in as far business environment problems influence the mobility of resources among incumbent operators in a given set of industries, but also because they often affect firm formation and entry rates. In discussing the problems we note that some of them affect firm formation entry rates directly while the influence of 26 others on the same is often indirect. We should also note that the distribution of resources and market shares among domestic produces depends on how far domestic industries are integrated internationally through trade as much as it does on business environment factors not directly related to trade. We have therefore grouped business environment issues into three categories in the rest of the summary: those relating to the direct regulation of entry and competition, problems posing indirect barriers to entry and factor mobility, and factors impeding trade integration. We include in the first of these categories issues relating to competition policy and business regulation via licensing and permit requirements. Problems of access to finance, access to reliable power supply, and taxation form the second category. Table 2: Repondents rating factor as major or sever business obstacle (%)- Enterprise Survey 2008, Full Sample Full sample SMEs and Large Micro Manufacturing Retail Other industry/ Enterprises Services Number=603 Number=304 N=122 Number=58 Number =119 Acccess to finance 27.7 27.2 15.5 30.3 41.2 Competion from informal firms 26.4 21.8 24.7 26.5 37.8 Tax Rates 25.5 25.9 23.2 25.3 27.7 Court System 17.8 18.8 12.5 26.3 13.0 Access to Land 15.8 12.4 15.5 14.1 24.4 Corruption 14.6 15.2 9.2 7.1 26.1 Electricity 13.8 20.2 5.6 11.1 12.6 Crime 12.9 12.8 12.0 6.1 20.2 Macro Instability 12.3 11.9 10.6 11.1 16.0 Transport 10.3 10.7 9.2 10.1 10.9 Tax Administration 10.1 7.0 9.9 8.1 18.5 Customs and Trade Reg. 9.6 9.5 10.6 8.1 10.1 Skills shortage 6.6 9.1 5.6 7.1 2.5 Licensing and permis 6.5 4.1 5.6 7.1 11.8 Telecommunications 3.7 4.9 0.7 4.0 4.2 Labor Regulation 3.7 3.3 4.9 5.1 1.7 Political Instability 1.5 0.8 2.1 2.0 1.7 27 Table 3: Percent of respondents rating problems as a major obstacle to growth Size group: Access to finance and to infrastracture: Unreliable power Problems of Poor access Skills shortage supply transport to finance 2003 2008 2003 2008 2003 2008 2003 2008 Young and small 30% 14% 20% 10% 62% 26% 38% 7% Established and small 34% 11% 43% 12% 69% 25% 40% 6% Young and large 39% 24% 39% 0% 37% 14% 25% 7% Established and large 46% 14% 25% 12% 51% 22% 38% 12% Total 39% 14% 30% 10% 54% 24% 36% 8% Taxes, macro economic stability, and regulation: High taxes Macro economic Competition from Problems of tax instability the informal sector admin 2003 2008 2003 2008 2003 2008 2003 2008 Young and small 63% 25% 78% 6% 28% 19% 28% 9% Established and small 66% 22% 89% 13% 17% 33% 29% 9% Young and large 61% 29% 61% 12% 33% 12% 31% 7% Established and large 50% 29% 75% 22% 25% 28% 27% 5% Total 57% 25% 75% 11% 26% 24% 28% 8% Labor regulation, corruption and crime: Labor regulation Corruption Crime 2003 2008 2003 2008 2003 2008 Young and small 8% 3% 53% 9% 53% 13% Established and small 20% 5% 54% 15% 46% 10% Young and large 14% 5% 33% 17% 42% 10% Established and large 21% 5% 45% 13% 55% 9% Total 17% 4% 46% 12% 50% 11% 4. Direct regulation of entry and competition Competition and trade policies The fact that low productivity firms tend to have larger market shares in Zambia than they would in a typical middle income economy suggests that there could be some scope for increasing productivity through competition policy reforms. Zambia has had a competition law since 1994, when it enacted the Competition and Fair Trading Act, primarily as a safeguard against anti- competitive behavior by the large players in domestic markets that emerged from the privatization and FDI deregulation programs of the early 1990s. The Competition and Fair Trading Act mandates the Zambian Competition Commission (ZCC) to regulate mergers and acquisitions. However, it is not clear how far this power has in fact been used by the ZCC to regulate the 28 evolution of the structure of Zambian industry since its establishment, and whether it has the right tools and resources needed for exercising that kind of influence. There are now proposals in the MCTI for expanding the ZCC’s mandate into the pursuit of a more activist competition policy beyond the regulation of mergers (GOZ, 2009). Specifically, it is being proposed that the ZCC expand its scope to the detection, prosecution, and prevention of abuse of dominant market power and cartels, that it be provided with the authority and resources commensurate with the expansion of the mandate, and that a Competition and Consumer Protection Tribunal be established to provide for due process in the implementation of the new policy. These are measures which, if successfully implemented, could generate significant allocative efficiency gains in as far as they could lower entry barriers to domestic industries. However, it is also important to recognize that competition policy is only one of several complementary tools for promoting competition in domestic industry. Competition policy is essentially about influencing the behavior of larger players in specific industries and in the economy as a whole. Such behavior is often a critical determinant of entry and exit rates and of the distribution of market share among incumbents, especially in a country such as Zambia, where, as the MCTI’s latest policy statement on competition and consumer protection points out, industries tend to be concentrated to a greater degree than in an advanced economy because of the smallness sof national markets (GOZ, 2009). But the behavior of potential entrants and the constraints conditioning it is also as critical. There are also important influences other than competition policy on the behavior of potential entrants just as there are on the market power and behavior of incumbents. Of these influence by far the most important is foreign trade. Indeed, it is the trade liberalizing measures that Zambia has carried out since 1991 that have influenced the most the competitive pressure under which domestic firms and industries operate. It is clear that the economy can be opened up even more to trade through a range of trade facilitation measures that could significantly reduce trade costs and non tariff barriers to trade. At least as important determinant of entry and exit rates, and hence ultimately of the market structure and productivity of domestic industry, as openness to trade and competition policy, are also a range of determinants of the ability of potential entrants-big and small- to respond to new investment opportunities. We include among these determinants the direct regulation of entry as well as indirect barriers to entry including lack of access to finance and to other basic services such as power supply. Direct regulation of entry Business licensing and the requirement of construction permits are probably the most ubiquitous forms of direct regulation of entry by government in most countries. In Zambia anyone setting up a new business needs to have an investment certificate from the Zambia Investment Center (ZIC). They also need to obtain operating licenses from the local and central government, and have the business registered with the Patent and Company Registration Office (PCRO). Because the costs associated with getting license and legal status are incurred prior to the start of operations, 29 established businesses rightly treat them as sunk costs. They are therefore unlikely to put those costs high on their lists of “business obstacles�, as responses to the 2003 and 2008 enterprise survey showed. Less than one in 10 of the managers of non-micro enterprises rated the requirements as a major or serious obstacle to business operations in the 2008 survey (table 2). This was not much different from the proportion of respondents who thought likewise in the 2003 survey. It was also true of all business size groups and industry groups. Yet, a 2004 World Bank study (World Bank 2004b) showed that the time and pecuniary costs associated with licensing and permit requirements were formidable enough to have substantially reduced rates of new entry and firm formation at the time. The study noted that the basic business licenses alone took five to six weeks to get for Zambians and nine to 16 weeks for foreigners, and made a series of recommendations aimed at shortening the time needed for both groups. Chief among the recommended measures were that the discretion that the ZIC exercised in issuing investment certificates be eliminated, the number of licenses required be reduced, the frequency of renewals be cut, and that the registration process be regionally decentralized by opening regional and local offices of the PCRO. Thanks largely to the implementation of some of these recommendations, Zambia today counts as one of the countries in Sub-Saharan Africa where it is easiest to set up a business. The total time needed to set up the standardized Doing-Business company was estimated at 40 days at about the time the FIAS recommendations were made in 2004. This was the time needed to complete the 6 procedures that the standardized company was expected to go through. According to the 2009 Doing Business report, the number of required procedures is still the same as it was six years ago, but the number of days needed to complete them has dropped to 18. Most of the saving in time occurred in 2008 and 2009, when the time needed for registration was cut from 7 days to 3 and the number of days needed for VAT registration fell from 21 to 10 (World Bank, 2008). These are large improvements, especially given the shortness of the time interval in which they were made. However, they are not good enough compared to more than 60 better performing countries outside of the regions. More importantly, FIAS’s assessment is that Zambia still can and should cut the number of days needed to set up a business from 18 days to 8 by reducing the number of licensing and registration procedures from six to five, by cutting the number of days needed for VAT registration even further and by setting up a one-stop service center for business registration (World Bank 2009b). The need for greater improvement is clearly evident in two related areas that are probably as important determinants of entry rates as the cost of business registration and licensing. These are the time needed to secure permits for business construction projects and the ease of access to land for business premises. Unlike business registration and business licensing, construction permits have been an area in which things have worsened in recent years. The number of days needed to obtain the Doing Business standardized construction permit was first measured in 2006, when it was estimated to be 165. The number of procedures involved then was 16. The number of procedures increased to 17 in 2008 and has remained unchanged since then. The number of days needed to 30 complete all procedures increased to 196 in 2007 and then to 254 in 2009 and has not changed yet since. FIAS is recommending that the number of procedures be cut to 14 in order to bring about significant reduction in the total number days needed to secure permits. The 2004 FIAS report found that obtaining land for business premises was a major problem for any investor in Zambia. The report traced the problem to the fact that very little of available was titled and registered, which made the process of identifying suitable plots exceedingly difficult and time consuming. It also found the land registration and acquisition process to be over centralized but poorly coordinated, and called on the government to improve the situation by establishing, codifying and publicizing procedures and service delivery standards for land administration agencies. The 2004 FIAS report also made specific recommendations for facilitating FDI including some that required amendments to the Immigration and Deportation Act or to the Investment Act with a view to making it easier for foreigners to make obtain work permits and business licenses and make it easier for their businesses to hire and fire workers. Entry regulation, competition and informality Being licensed by and registered with authorities imposes costly norms of technology and transactions on firms in return for benefits in the form of cheaper access to key business services and to publicly provided goods. The decision whether or not to get a license is based on how a particular entrepreneur evaluates the balance between those benefits and the explicit and implicit costs of being licensed and registered. Other things being equal, higher costs of registration, licenses and routine compliance with rules would increase the number of firms operating informally by avoiding both the registration and the licenses. By making it easier and less costly for businesses to register, get a license and keep one, government helps reduce the size of the informal sector thereby helping boost overall economic growth. The government can also make registration and licenses more attractive by increasing its effectiveness in excluding the unregistered and the unlicensed from the services that licenses entitle their holders to. Moreover, the more diverse are those services and the higher they are in quality, the less attractive is it for a firm to operate unregistered and unlicensed. A reasonable indicator of how high the cost of registration and licensing are relative to the benefits they entitle firms to is the proportion of survey respondents who think that being registered and licensed puts them at a competitive disadvantage relative to the unregistered and the unlicensed. Both the 2003 and 2008 surveys provide information on that proportion based on a question which asked respondents to rate the competition that they faced from unregulated businesses as an obstacle to their growth on a scale ranging from 0=no obstacle to 4=severe obstacle. The evidence based on the ratings provided is that the costs of registration and licensing have come down 31 significantly since 2003, that operating informally is a less attractive proposition of Zambian firms today than it was then. For, in the 2008 survey, the proportion of respondents that rated competition from informal firms as a major obstacle to growth was about 26 percent as compared to the 39 percent of respondents who felt likewise in 2003. Although some of this change reflects a shift in sample composition in terms of distribution by size and industry, a significant share of the drop in the complaint rate remains after accounting for those changes. Despite the drop in the complaint rate between the surveys, the fact that more than one in four of business covered by the 2008 survey felt that they were held back by competition from the informal sector means that there is some room for raising business formation and business formalization rates by reducing further the cost of registration and licensing. As is to be expected, high licensing and registration costs deter the formalization of smaller enterprises more than that of larger ones. For the cost of being formal is higher for smaller businesses than for larger ones for any given business age group, and higher for older established business more than relatively new entrants younger ones for any size group. For example, in the 2008 survey, the complaint rate about competition from informal firms was 33 percent for established small firms as compared to 28 percent for large businesses of the same age group, 19 percent for young small businesses, and o 12 percent for young large businesses (table 3). 5. Indirect barriers to entry and to factor mobility Problems of access to finance A major source of distortion that Zambia’s economy shares with others is that smaller and start up business do not have as much access to external finance as larger and longer established ones. One aspect of the distortion pertains to the allocation of resources and market shares between operating small firms and existing larger businesses. A second aspect is that that business entry rates are lower than what they would be if smaller and younger businesses had as good access to finance as larger and longer established businesses. An indication of the relative importance of this distortion is that inadequate access to finance was the factor that the largest percentage of businesses in the 2008 Zambia Enterprise Survey rated as a major obstacle to their growth from the list shown in figure 12. We use the term “inadequate access to finance� to designate situations in which businesses find interest rates too high to borrow as well as those in which lenders would not extend credit to them under any terms. Understood in this broad sense, access to finance has always been a major business environment issue in Zambia, and is one of the consequences of a long history of high inflation and currency fluctuation. As the 2004 assessment argued, the key access problem in 2003 was indeed 32 that these factors of macroeconomic instability pushed real lending rates to prohibitive levels, the average Kwacha loan rate standing as high as 50 per cent at one point. Perhaps as importantly, the uncertainty that large and growing budget deficits and the external debt problem created made bankers very reluctant to extend long term loans to anyone. Figure 13 Percent with overdraft or line of credit Thailand 86 Mauritius 84 Kenya 73 Malaysia 72 Malawi 68 South Africa 64 Zambia 43 Namibia 40 Botswana 36 China 31 Tanzania 28 Ghana 22 0 10 20 30 40 50 60 70 80 90 Percent of firms Figure 14 Value of Collateral as Percentage of Loan Value Kenya 182 Namibia 147 Tanzania 146 Zambia 141 Botswana 124 Ghana 117 Mauritius 112 Malawi 109 South Africa 103 Thailand 88 China 83 Malaysia 77 0 20 40 60 80 100 120 140 160 180 200 Percent of firms Improvement in small business access to finance One of the main finding of the 2008 Enterprise Survey is that firms’ access to credit had improved a great deal compared to what it was in 2003. Some 27 percent of respondents to the 2008 Enterprise Survey rated inadequate access to finance as a major obstacle to business growth. This compares with the more than 60 percent of respondents to the 2003 survey who gave the same rating to the 33 same problem (figure 12). While some of the drop in the complaint against inadequate access to finance reflected changes in the composition of the sample in terms of business size, age, industry, and location, much of it holds up when we control for those attributes. The change is also backed up by improvement in hard indicators of access between the two surveys. Many of these indicators improved sharply between the surveys as key indicators of macroeconomic stability improved in the wake of a debt relief program and a copper price boom. Thus as the inflation rate fell from 21 percent in 2003 to under 10 percent in 2008, the average nominal interest rate dropped from 28 percent to 19.3 percent while the average value of collateral to loan ratio fell from 324 percent to 141 percent. As a consequence, the percentage of small businesses that had active bank loans rose from 19.5 percent to 28 percent. Significant as these improvements are, the values of indicators for 2008 themselves do not compare well with those in other comparatively successful African economies. In particular, nominal and real interest rates are quite high in Zambia by the region’s standards while the share of bank financing in firm level fixed investment and working capital in Zambia is one of the lowest in the region (figure 13). The value of the collateral to loan value ratio is higher in Zambia in many other countries in the regions while the proportion of small businesses that have active bank loans and the share of SMEs that have active bank credit lines are both lower in Zambia (figure 14). The problems of access to finance that these comparisons point to generate losses of employment and productivity at two levels. At one level, the fact that Zambian firms do not have as good access to finance as their counterparts, say in Kenya or Thailand, because they face higher finance charges and higher collateral requirements makes them invest less and employ less than their counterparts in those countries. In turn, the lower investment and hiring rates often make Zambian firms less productive than those counterparts in as far they mean that Zambian firms use inferior technology or fail to exploit economies of scale that their counterpart do. At a second level, disparities in access within Zambia generate allocative inefficiencies that reduce aggregate employment and productivity by lowering firm formation and entry rates and by impeding the mobility of resources among incumbent firms. Access to finance and firm level employment and productivity The mechanics of the first level of influence of inadequate access to finance on employment and productivity is that firms that do not have sufficient access to finance suffer from capital shortages, which force them to operate at suboptimal scales or operate suboptimal technologies. In the Enterprise Survey data, the link between capital shortages and inadequate access to finance is finds expression in firms that have poorer access having a higher marginal revenue productivity of capital. Inadequate access to finance often forces a firm to be less capital intensive than it would otherwise be, which in practice means that it has to use less or outdated equipment. It also often makes a firm operate at a lower scale than it would with better access, that is, it forces the firm to reduce both 34 equipment and manning levels at a given ratio of fixed assets to employment. This often means that the firm has to forgo economies of scale that those with better access to finance exploit.2 The Enterprise Survey data show that both of these firm level outcomes of inadequate access to finance have been at work in Zambia. Specifically it turns out that businesses that have better access to trade credit and to bank credit tend to have higher labor productivity, not necessarily because they are inherently more productive, but often because they have access to better technology as a consequence of their better access to finance. This is indicated by the fact that the marginal revenue productivity of capital and the average rate of return on fixed assets are both consistently lower in enterprises that have better access to finance but only because the value of equipment per worker is higher for such enterprises Access to finance and allocative efficiency The effects on employment and productivity of the average Zambian firm having poorer access to finance than international comparators are reinforced by the allocative efficiency losses arising from the fact that the ease of access to finance also varies between firms within Zambia, notably between SMEs and large firms, and between start-ups and established businesses. Those allocative efficiency losses add to Zambia’s international productivity and employment shortfalls if the variation in access within Zambia is greater than that between firms within international comparators. For example, a higher cost of borrowing for the average Zambian firm than for the average firm in another country, would reduces employment and productivity in Zambia relative to that other country, Zambia’s employment and productivity shortfalls vis-à-vis the other country being even larger if, in addition, the dispersion in the cost of borrowing also happens to be larger in Zambia.3 To get some sense of the significance of potential allocative efficiency losses due to such dispersion it is useful to examine the variation in access indicators across firms within Zambia. 2 Thirdly, when the number of firms affected by inadequate access to finance is large enough, the problem will translate into higher prices as it restricts market supply by reducing entry and by forcing incumbents to produce less on aggregate. This too should mean higher marginal revenue productivity of capital but, unlike the other two effects, applies to all firms in an industry including those with adequate access to finance and is therefore an aggregate effect and not a firm level one. 3 Greater dispersion in the cost of borrowing would add to the loss in employment and productivity in Zambia by making the dispersion in the marginal productivity of capital and labor in Zambia to be higher than it would be in the other country. 35 Looking at the 2008 survey data, we see in tables 2 that manufacturers were more likely to report access to finance as a major or severe obstacle (27 percent) than those in retail trade (16 percent). But this variation is does not seem to be as consequential as that between small enterprises and larger ones. As pointed out above, although there is no significant TFP difference between these two groups of enterprises, it is clear that smaller enterprises underinvested in equipment relative to larger since the marginal revenue productivity of capital is significantly higher in smaller enterprises than larger ones, as indeed is the average profitability of fixed assets. Table 3 indicates that at least one explanation for the underinvestment by smaller businesses is poorer access to finance. Thus we see in the 2008 data that the proportion of those rating problems of access to finance as a major or severe obstacle to business growth was significantly higher for smaller firms (32 percent) than larger one (23 percent) and for micro enterprises (41 percent) than small businesses. Complaint rates were also significantly higher for younger businesses. Table 3 also suggests that the difference between large firms and small firms in terms of the rate of complaint about access to finance has not changed much between the two surveys, although the difference between established large firms and young large firms has come down drastically. What needs to be done Access to finance and macroeconomic stability In Zambia the problems of access to finance is inseparable from that of macroeconomic stability. For the extremely high cost of borrowing and tight credit that Zambian business faced at the time of the 2004 assessment was an immediate consequence of the high rates of inflation and the currency volatility of the time. Similarly, the fall in real interest rates and the expansions in business lending that was captured in the 2008 survey came about thanks to a sharp drop in the rate of inflation to a single digit and the stabilization of the Kwacha that a large debt relief program and a copper price boom brought about by helping drastically reduce government borrowing. Things had improved so much by the time of the 2008 survey that less than 15 percent of survey respondents thought of macroeconomic instability as a major obstacle to business growth as compared to the 80 percent of respondents to the 2003 survey who thought likewise. However, as the consequences of the global recession showed, and as indeed should be apparent from the role that arguably fortuitous factors played in the comparative stability of the 2005 to 2008 period, Zambia is far from having mastered the forces of macroeconomic instability inherent in its economic structure.4 Achieving lasting price and exchange stability and bringing government 4 Even at the time of the 2008 survey macroeconomic instability was of serious concern to larger businesses, some 20% of which rated it as a major or severe obstacle to their growth, the preoccupation this time being more with the appreciation of the Kwacha than anything else (table3). Apart from its influence on the cost of borrowing macroeconomic instability can harm employment and growth in exporting industries when it generates exchange rate volatility or appreciation, which impacts investment decisions directly to the extent these increase the uncertainly of 36 borrowing under control over the long term is therefore probably the most important step Zambia can take to improve businesses’ access to finance. Access to finance and credit information SMEs and microenterprises complain so much of lack of access to finance because most commercial banks do not extend loans to them as a matter of policy. Micro finance institutions that meet a significant part of the credit needs of microenterprises in other African countries and low income economies more generally are nowhere near as common in Zambia, and currently serve at most 50,000 clients (Martinez, 2006). And although there are non-bank financial institutions designed to lend to SMEs, experts believe that the loan products that they offer are not attractive enough to such businesses, either being of too short a cycle to provide investment finance or carrying prohibitively high interest charges. There is thus an urgent need in Zambia for the development of micro finance institutions, on the one hand, and, on the other, for providing the commercial banking sector with the infrastructure it needs to participate in the SME credit market. A missing key component of this infrastructure is a workable credit information system. For one of the reasons why interest charges are often too high at present when Banks do lend to SMEs occasionally is the extremely high risk premiums that they attach to the return on lending to small borrowers. A large part of this premium reflects Banks’ lack of reliable information on this particular group of borrowers, which is a problem that well developed credit information systems have helped mitigate in advanced economies. Zambia’s credit information system is rudimentary at present, the first credit reference bureau, Credit Reference Bureau Africa Limited (CRBAL), having opened only in 2007. A recent FIAS assessment ( World Bank 2009) stresses that Zambia has a long way to go before it can build on this a reliable credit system that will have measureable influence on bank lending to SMEs. At the moment the CRB covers a tiny fraction of potential borrowers, and more importantly, collects data only from Banks and other financial institutions, and has yet to expand its sources to retailers, trade creditors and utility companies in order to capture a larger share of the population of potential borrows, and generate more reliable information on those already in its database. returns to investment. The Enterprise Survey data suggest that macro economic instability reduces total factor productivity, not only through its influence on access to finance, but also by generating excess capacity more directly. The excess capacity may in turn have reduced manufacturing employment, not only by discouraging further investment in fixed assets, but also in as far as it means lower manning levels of equipment. 37 Taxation Yet another source of distortion in Zambian industry is that the marginal effective tax rate is higher for SMEs than it is for larger businesses. Just as the disadvantage of SMEs in terms of access to finance does, this distortion protects the market shares of larger firms among incumbents while reducing firm formation and entry and entry rates. As we say this, we should stress that Zambia is not a particularly high tax economy by international standards. For example, the Doing Business database shows that the ‘standard’ Zambian firm pays a much smaller percent of its profits in total taxes than its counterparts not only in middle income countries but also in low income comparators such as Kenya, Ghana, Malawi and Tanzania (figure 15). Indeed, the average business tax burden may have fallen significantly since the 2004 assessment, of which one indication is that a far smaller proportion of business managers complained of high taxes in the 2008 survey than did in the 2003 survey. Specifically, about 26 percent of respondents to the 2008 survey thought high taxes were a major obstacle to the growth their businesses as compared to more than 60 percent of respondents who thought likewise in the 2003 (figure 10). The change in the complaint rate applies to all groups of firms. Nonetheless, the proportion of business which felt held back by high taxes in 2008 was quite high in absolute terms, and nearly as high as the proportion of those who complained inadequate access to external finance as a growth obstacle. Figure 15 38 Marginal effective tax rates are higher for the non-corporate sectors The reason that so many businesses are complaining of high taxes despite Zambia’s standard tax rates not being high relative to other countries is that survey respondents’ ratings are not based on standard tax rates. The ratings are more likely to reflect mangers’ assessment of the effective marginal tax rate, that is, the amount by which the sum total of direct taxes and other fiscal obligations net of subsidies and other incentives increases for every dollar of fixed investment made by the business. Stern and Barbour (2005) calculate that the effective marginal tax rate in Zambia falls in the 20-25 range for small businesses. This is very high compared to the 5 to 10 percent range they calculate for other sectors of the economy. Zambia’s effective marginal tax rate so calculated would be significantly lower than South Africa’s (about 32 percent) and of Rwanda’s (30-50 percent), but most Zambian small businesses would probably compare their tax burden with larger businesses within Zambia in responding to the survey question, and are quite unlikely to benchmark rates internationally.5 Just like the differences in tax burdens between the corporate and non-corporate sectors, differences in tax burdens that may exist among various groups of firms reduce productivity and employment due to the allocative inefficiency they generate. The Enterprise Survey data indicate that those complaining of high taxes are employing fewer workers than others either because they invest less or employ more capital intensive technology.6 Power shortages Although the situation has improved drastically in recent years, Zambian industry has suffered from chronic power shortages for quite a while now. The shortages have meant frequent outages and long queues to get connected to the public grid for start ups and expanding businesses. Like many other business environment problems, the shortages have added significantly to the cost of doing business in Zambia relative to other countries. They have also been a source of significant allocative inefficiency in the economy. Again the inefficiency occur, not only because the shortages affects 5 We should stress here that the small business category used in Stern and Barbour (2005) includes many businesses that would count as “large� according to the classification used in tables 2 through to 4. This is important when we try to interpret the differences between business groups in terms of ratings of high taxes as an obstacle to growth. 6 Although there were no significant differences between sectors of activity in complaint rates against high taxes in the 2008 survey (table 2), larger enterprises (by our classification) were more likely to rate high taxes as a major or severe obstacle to growth than smaller ones within the manufacturing sector. Foreign invested manufacturers were also more likely to rate high taxes likewise than others, although the difference between exporters and non-exporters was not very large in this regard. 39 smaller and younger firms than the larger and the more established among businesses already in operation, but also because they are likely to reduce firm formation and entry rates. One indication that the shortages have lessened recently is that the average time taken to get connected to the public grid dropped from 120 days in the 2003 survey to about 80 in the 2008 survey (figure 16). Although the frequency of outages did not change much, average revenue losses due to outages also fell from 4.5 percent a year to 3.6 percent (figure 17). As a result the share of managers who considered power shortages to be a serious obstacle to business growth dropped from 40 percent to 20 percent (figure 10). Moreover, the complaints rate fell for all business size groups, industries and locations. Still, an 80-day waiting time to get an electrical connection has to indicate a serious supply shortfall as should an average revenue loss of 3.6 percent due to outages. The Enterprise Survey data suggest that the shortages reduce employment by lowering the rate of investment overall, and by making production more capital intensive within each industry. The second of these effects occurs when firms are forced to switch funds from their wage bills to capital expenditures on backup generators and other equipment related to mitigating the effects of the power fluctuation. Over the long term power shortages can reduce the rate of fixed investment across the board because of the high degree of complementarity between capital and energy as inputs. Figure 16 40 Figure 17 Outages and long queues to getting connected There were nearly 36 outages in the year leading up to the 2008 survey, which works at an outage every 10 days. Outages often lead to loss of sales by forcing downtime. They can also cause wastage of material in-process at the point of the power interruption and damage equipment thereby adding to routine maintenance costs. These costs should not be confused with the investment costs that frequent outages may also lead to in the form of outlays on backup generators, and surge protection devices, or with the additional investment costs of substituting existing equipment with alternatives less susceptible to damage due to power fluctuations. The sharp drop in managers’ concern with power shortages between the two surveys seems to have more to do with steep declines in such investment costs and in the waiting time to getting connected to the public grid, than it had with the relatively small drop in recurrent losses to outages. This conclusion is supported by the fact that the proportion of businesses running backup generators dropped from 38 percent in 2003 to 11percent in 2008 (table 4). 41 Table 4: Indicators of provision of infrastructure Infrastructure Indicators 2008 Other Full sample small Large Lusaka cities Frequency of power outages (times last yr) 36.28 37.01 34.83 42.77 25.76 % of production lost due to power outages 3.46 3.61 3.16 4.57 1.66 Have own generator (%) 11% 8% 17% 12% 9% % of production lost in shipment 1.93 1.50 3.70 2.64 1.61 No. of days to obtain a telephone connection 19.86 19.62 20.00 20.55 17.00 No. of days to obtain a electricity connection 79.56 164.17 52.84 98.88 45.22 Infrastructure Indicators 2003 Other Full sample small Large Lusaka cities Frequency of power outages (times last yr) 37.2 29.8 44.9 37.8 36.7 % of production lost due to power outages 4.5 5.6 4.3 5.2 3.9 Have own generator (%) 38.2 27.3 60.6 33.3 42.3 % of production lost in shipment 2.68 4.7 2.3 – – No. of days to obtain a telephone connection 132.5 135 21.7 183.6 13.3 No. of days to obtain a electricity connection 120.7 47 162.8 90 123.8 Power shortages as a source of allocative inefficiency To the extent that outages are more frequent and waiting queues to getting connected are longer in Zambia than those in comparators (figure 16), they make doing business in Zambia more costly than in the other countries, which in turn reduces Zambia’s aggregate employment and productivity. To these losses of employment and productivity should be added those stemming from the allocative inefficiency caused by the fact that outages are more frequent in some sectors than in others and for some firms than others, while longer queues for getting connected are likely to mean lower firm formation and entry rates. It is significant that the pattern of variation in these shortage indicators did not change between the two surveys. In both surveys, the most striking contrast in revenue losses due to outages was that between manufacturing businesses and those in retail and other services. As should be expected those losses were significantly higher in manufacturing businesses than in services. Within manufacturing, smaller businesses reported higher losses on average than larger ones for each business age group. Similarly, the waiting period for getting connected to the public grid was several times longer for small businesses than for large ones(table 4). These patterns in hard indicators are also reflected in those in rates of complaint about the shortages (table 2). Thus in the 2008 survey only about 6 percent of retail businesses rated power shortages as a serious obstacle to growth (as opposed to 20 percent in manufacturing). Although the rate did not 42 differ much between small enterprises (17 percent) and larger ones (19 percent) within manufacturing (table 2), complaint rates become higher for larger businesses when we control for the age of businesses (table 3). In particular, relatively young and large enterprises –meaning those that have been in business for less than 10 years but employing 50 workers or more-were more likely to rate power shortages as a major or severe obstacle to business in the 2008 (24 percent) than small enterprises of the same age group (14 percent). A similar pattern is also seen in the 2003 data, in which the complaint rate among relatively young large businesses was about 30 percent as compared to about 39 percent for large businesses of the same age group. What needs to be done The root cause of power shortages in Zambia is that there has not been any major addition to generating capacity since 1970, while demand for electricity is estimated to have increased by 4 percent a year since then with notable acceleration since the 1990s.7 The ultimate solution to the shortages will therefore require large investments in generating and transmission capacity. Indeed, the government has a five year plan for such investments. It has also undertaken a series of institutional reforms since the mid 1990s in order to make the plan viable. The reforms include the legalization of private investment in the power sector by the Electricity Act of 1995, the establishment of the Energy Regulation Board in 1995, and the 1999 government policy framework for encouraging private sector participation in power generation and transmission development. In the short-term, the government should increase the prospects of success for its long term investment plans even more by helping institute a more rational pricing system for the sector. At the moment the electricity tariff does not cover the full cost of supply. For example, a recent ERB commissioned study indicates that the tariff is on average 45 percent below the cost of service. Underpricing has direct implications to the prospects of long term investments in additional capacity, not only because it is undermining the financial viability of ZESCO, but also because no other new or potential player would be willing to make such investments at the current tariff rates. Here also there are already important initiatives with the government taking steps to revise tariffs. However, low tariffs are not the only factor behind ZESCO’s weak financial position. Other perhaps equally important issues that need to be addressed in order to improve ZESCOs performance include excessively high transmission and distribution losses, the build-up of payment arrears by ZESCO’s public sector customers, and financial losses arising from operating inefficiencies one would not expect in a commercial enterprise. 7 As a result the country has been experiencing load shedding since the early 2000. For example, in 2005, the total installed capacity was 1,732 MW, mostly hydro generation, and the peak demand was 1,330 MW, while total generation was 8884 GWh. 43 Trade logistics and trade facilitation To date arguably the most important competition enhancing policy developments in Zambia have been the trade liberalization measures the country has implemented since 1991. While there is no formal study of the impact of those measures on the structure of domestic industry in Zambia, recent studies based on data from developing and OECD economies show that the kind of trade policy reforms that have taken place in Zambia help lower domestic prices and mark up rates not least of all by influencing the behavior of large players in the domestic economy. There is also solid evidence that increased openness to trade leads to large productivity gains in two complementary ways. On the one hand, it generates allocative efficiency gains by inducing a reallocation of market shares from low productivity firms to high productivity ones. It also raises average within-firm total factor productivity by providing firms with greater incentives for innovation. To these forms of trade induced productivity growth should be added a third one, which is the economies of scale that export markets often help domestic firms realize. It is quite likely that Zambia has benefited from one or more of the three forms over the last decade, especially in light of the fact that data from the Enterprise Surveys suggest that aggregate manufacturing TFP went up between 2003 and 2008 as a result of allocative efficiency gains (figures 9 and 11). All indications are also that Zambia can realize similar gains in the future to the extent that there is room for opening up its economy even more by improving its customs administration in the short term, and by reducing transport costs in the long term. Trade Facilitation The Doing Business standard cargo takes 53 days and 64 days respectively to export from and import to Zambia by ocean transportation at a cost of USD 2664 for exports and USD 3335 for imports. This puts Zambia’s 2009 global rank for the ease of trading across borders at 157 in a field of 183 countries, and at a clear disadvantage with most of the comparators used in this report. Although adverse geography has a lot to do with why it is more difficult to trade with Zambia than with so many other countries, there is also scope for opening up Zambia’s economy further to trade through trade facilitating reforms, given that more than two thirds of the time needed to export from Zambia, and about half of what is needed to import to it, is taken up by document preparation and document handling (World Bank 2009b). FIAS has therefore been recommending reducing the number of customs documents and streamlining their handling as major trade facilitation measures (World Bank 2009a).8 One of the specific recommendations for simplify and quicken document handling is to extend the Customs Accredited Client Program to SMEs. This is a scheme whereby 8 World Bank (2004) made 15 recommendations for streamline importing and exporting procedures some of which required amendment to the Customs and Excise Act. 44 businesses go through a comprehensive accreditation process the completion of which would allow them to bypass most inspections at entry and exit points. At the moment only the largest exporters and importers are eligible for the program. Other measures that FIAS has recommended for streamlining customs clearance include the use of inland clearance facilities, better clarification and codification of customs valuation rules, and improved staff training. Transport costs Although transport accounts for the largest share of trading costs in Zambia, it is also an area where it is not necessarily obvious that there is a great deal of room for cost saving. This is not only because Zambia’s geography can hardly be more adverse from the point of view international trade.9 It is also because, as Raballand et al. (2008) point out, Zambia has among the lowest transport costs for landlocked countries in Sub-Saharan Africa. Raballand et al. (2008) attribute Zambia’s comparatively low transport costs to two factors. One of these is the investment that Zambia made over the past decade in improving road conditions, which is of crucial importance given that more than two-third of the volume Zambia’s trade relies on road transport and is with neighboring countries. The second is that Zambia has succeeded in cutting freight tariffs by making its transport sector highly competitive through deregulation measures that opened it to up to foreign competition and to foreign direct investment. As a result of those measures the share of Zambian operators in the domestic market has dropped to no more 40 percent, which share, however, those operators are maintaining at competitive tariff rates matching those of much larger foreign competitors without any form of direct or indirect support from the government. At the same time, Raballand et al. (2008) point out that Zambia can reduce freight transport costs significantly further by lowering fuel costs and by reducing delays involved in “border-post operations�. Costs would be even lower if it had not been for adverse spillovers of South Africa’s banning of imports of secondhand trucks to protect its motor industry against foreign competition. The assessment that there has been rapid improvement in road transport in Zambia is borne out by the differences between the 2003 and 2008 surveys in how managers thought of transport problems as a business environment issue (figure 12). In 2008, barely 10 percent of managers rated poor transport as a major drag on business growth as compared to 35 percent who thought that way in the 2003 survey. Much of the complaint about transport in 2003 was against the poor condition of roads on account of which business estimated to have lost 2.7 percent of annual sales at the time. 9 Current ports serving Zambia are Dar es Salaam (1970 Km away from Lusaka), Durban (3000km from Lusaka and Beira (1400 km from Lusaka). Apart from long transit time of up to 10 days by road and 25 days by rail, the use of either of these ports is said to be expensive ranging between 50 USD per ton and 160 USD per ton (Raballand et al. 2008). 45 The lower complaint rate in the 2008 survey was matched by businesses reducing estimated losses of shipment in transit to less than 2 percent. Yet another indicator of the improvement in the availability and quality of transport services between the surveys is the change in the levels of precautionary stocks of materials that firms maintained. The stocks fell significantly from a 40 day inventory in 2003 to 20 days in 2008. 6. Other business environment issues In this section we discuss, very briefly, four business environment issues that were seen to be major growth obstacles by large proportions of respondents to the 2003 survey, and were treated at some length in the 2004 assessment, but were no longer as high on the priority lists of respondents to the 2008 Enterprise Survey. The issues are corruption, crime, skills shortage and labor regulation. Corruption The 2008 Enterprise Survey indicated that Zambian firms faced far less corruption than they did five years earlier. About 15 percent of respondents to the survey saw corruption as a major growth obstacle, which, while quite high a complaint rate in absolute terms, was also large improvement over the 46 percent of respondents to the 2003 survey who thought of corruption that way. The complaint rate was even higher among small enterprises in 2003 at about 55 percent. This change in subjective ratings applied to all business size groups and to all sectors of activity. It was also consistent with the drop between the surveys in the proportion of business managers who thought they were expected to pay bribes to government officials (figure 18). Figure 18 46 While a major improvement over the situation observed in the last assessment, that 15 percent of respondents to the 2008 survey complained against should make corruption an important business environment problem that merits policy makers’ attention. Crime Crime is another area in terms of which Zambia’ business environment improved significantly between the 2003 and the 2008 surveys. In the 2003 survey 49 percent of respondents thought that crime was a major or severe obstacle to the growth of their businesses, the proportion being even higher for large firms at 53 percent. In the 2008 survey the proportion of businesses who complained of the problem to the same degree was about 13 percent. This is obviously drastic improvement. But the complaint rate in the 2008 survey is high enough to make crime still an important area of concern. The complaint rate for 2008 is even higher than the overall average for exporters (19 percent) and microenterprises (20 percent). As importantly, the explicit cost that Zambian businesses incur as victims of crime and as spending on crime prevention is quite high. In 2008 these costs were 5.1 percent of the annual sales revenue on average, which is a relatively small drop from the average for 2003 (figure 19). Figure 19 Skills shortages and labor regulation Ten percent of respondents to the 2008 survey rated skills shortage as a major constraint to their expansion. Again this is a large enough complaint rate to make skills development a significant policy issue, especially given that the rate is even higher among exporters (14 percent) and large firms more generally (12 percent). At the same time the rate was a welcome contrast to responses to 47 the 2003 survey in which some 36 percent rated skills shortage the same way. Moreover, the change in ratings applied to all business size groups and sectors, and seems to have little to do with the change in the composition of the sample between the two surveys. Labor regulation was never near the top of the list of constraints respondents identified in the 2008 survey or the 2003 survey. Nonetheless there was a large drop in the number of businesses who saw labor regulation as major growth obstacle between the two surveys, namely, from 17 percent in 2003 to less than 4 percent 2008. Again the change applied to all size groups and sectors, the drop being most pronounced in the case of exporters (22 to percent to 10 percent) and large firms more generally (21 percent to 7 percent) . The changes in the perception of labor regulation as a growth obstacle coincided with the decline in unionization between the two surveys, although unionization rates remained high among large enterprises of all age groups, ranging from 26 percent among young businesses to just below 40 percent among longer established ones. The decline occurred across the board including all business size groups and all sectors of industry. 7. Conclusion Zambia’s exports are far more diversified today than they were prior to 1991. This is thanks in large part to the reforms the country has made to its trade and exchange rate policies since then. The starting point of this report has nonetheless been that the country needs to diversify its export even more into manufacturing and other non-mineral tradables. The report has highlighted some of the impediments to this diversification in the current business environment in the country. The most immediate reason why Zambia’s low wages have not translated into more exports of labor intensive manufactures is that labor productivity in Zambia has been too low compared to that in more successful exporters of those goods within the region and beyond. Part of the reason for this labor productivity shortfall is underinvestment in equipment relative to current manning levels in the manufacturing sector. A second reason is that Zambia’ manufacturing total factor productivity is relatively low, in part because within-firm TFP is comparatively low, and in part because there is greater allocative inefficiency in Zambian manufacturing industries than in similar industries middle income comparators. The former means that the typical Zambian manufacturer operates further below the world technology frontier than the typical manufacturer in comparators. The second means that the correlation between within firm TFP and market shares is weaker in Zambia than in the comparators in the sense that low productivity firms tend to have larger market shares in Zambia than they would have in the other countries. This suggests that there could be some scope for increasing productivity through competition policy reforms, for which some specific proposed measures are being considered already by the government. 48 The proposed competition policy reform measures are commendable as they will probably lead to significant allocative efficiency gains by reducing entry barriers to domestic industries. However, they are also inevitably all about influencing the behavior of incumbent larger players. There are also other equally important influences on entry and exit rates and on factor mobility among incumbent in domestic industry that deserve the attention of policy makers. One such influence is the degree of international integration of the economy in terms of the export orientation of domestic industries and the degree of import penetration of domestic markets. Zambia has been successfully strengthening this influence through its trade and exchange rate policy reforms. A second influence is the business environment within which domestic firms operate in all its dimensions. Some of the dimensions relate to the direct regulation of entry while others, such as ease of access to finance, the provision of physical infrastructure, and taxation influence entry rates indirectly but directly affect the mobility of resources among incumbents. The report has shown that Zambia’s business environment has improved drastically in those areas as well as in all others in which the 2004 assessment found it to be seriously lacking. At the same time, it has highlighted that inadequate access to finance, excessive tax burdens on small businesses, and power shortages have been significant barriers to export diversification as they are holding back the growth of manufacturing employment and productivity. The problems reduce employment and productivity at two levels. On one hand, they raise the cost of doing business in Zambia relative to that in other countries. On the other hand, they generate allocative inefficiency in as far as they affect different sectors of the economy and different firms within each sector to different degrees. The report has discussed a number of measures that the government is being advised to address each of the three problem areas and those in the areas of entry regulation and trade logistics and trade facilitation. References Africa Finance Private Sector Development Unit.2009. ‘Second Investment Climate Assessment of South Africa,’ World Bank: Washington DC Martinez, J. de Luna. 2006. ‘Access to Financial Services in Zambia,’ World Bank Policy Research Working No. 4061. Raballand, G., C. Kunaka, and B. Giersing. 2008. “The Impact of Regional Liberalization and Harmonization in Road Transport Services: A Focus on Zambia and Lessons for Landlocked Countries,� World Bank Policy Research Working Paper No. 4482. Washington DC. 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