WORLD BANK GROUP AFRICA REGION, PRIVATE SECTOR UNIT 33672 Summary of 2005 Business Environment and Comparative Advantage in Africa: Evidence from the Investment Climate Data EPTEMBER S Introduction High Cost in Africa (Macro Analysis) 2 is note is based on the paper entitled "Business Envi- When examining Africa's inability to develop a more ro- ronment and Comparative Advantage in Africa: Evidence bust manufacturing sector, one must consider the theory UMBER N from the Investment Climate Data," by Benn Eifert, Alan of comparative advantage. e authors evaluate three sepa- E OT Gelb, and Vijaya Ramachandran, presented at the An- rate approaches to comparative advantage. First, Chenery N nual Bank Conference on Development Economics held and Syrquin (1975) put forth the theory that development in Dakar, Senegal in January 2005. e analysis delivers and structural change are closely associated,so that growth the clear message that high indirect costs and losses are largely involves the introduction of new, higher-value-add- dampening the productivity and competitiveness of man- ed activities and products rather than simply the expansion ufacturers across Africa. e paper focuses on three direct of old ones. Trade theory is central to understanding eco- messages. First, costs in Africa are higher than in compar- nomic structure and structural change because countries ator countries relative to income and productivity. ese will tend to export goods that they can make most cheaply conclusions are based on macro evidence. Second, using and efficiently relative to other countries. firm-level data gathered in the investment climate surveys, Second, Wood and Berge (1997) and Wood and the authors confirm that costs are high at the firm level Mayer (2001) compare Africa's factor endowments with as well. ese data specifically identify indirect costs and those of other regions. ey show a strong relationship business-related losses as higher in Africa relative to com- with the relative endowments of skills and land (resources) parator countries. ese costs are degrading profitability and composition of exports. us, countries with greater for the region's manufacturers. ird, cleavages exist along skills and land per capita export more manufactured goods ethnic lines and firm size in the private sector across Af- than primary goods. However, these theories alone do not rica. e investment climate survey evidence confirms fully account for Africa's low income level. that firm size and foreign ownership are highly correlated. e third theory, advanced by Paul Krugman (1980, Large firms and those with foreign ownership tend to be 1981, 1983), demonstrates that comparative advantage more productive and have formed alliances with politi- not only may arise from relative factor abundance but also cal elites to reduce competition and the likelihood that is a function of differences in productivity and costs. e dynamic economies of scale will develop as firm density effects of this theory are demonstrated through two basic remains sparse. Based on these clear findings, the authors approaches: business environment factors and dynamic recommend a series of six reforms that are intended to economies of scale. e business environment is defined as weaken the alliances between private sector and politi- the nexus of policies, institutions, physical infrastructure, cal elites, erode the potential rent seeking that fuels these human resources, and geographic features that influence collusive relationships, convince private sector elites that the efficiency with which different firms and industries higher profits can be enjoyed in a more open market, and operate. Its impact is more heavily felt in traded sectors finally encourage new entrants into the market, which will that are not natural-resource intensive. Even efficient man- increase density and eventually fuel dynamic economies ufacturers can be driven out of business by a poor busi- of scale. ness environment. e second approach is that of dynamic economies of scale. Such economies of scale are generated by learning processes, network effects, and industry specific High Cost in Africa (Micro Analysis) spillovers that go beyond classical production and trade theories. However, individual firms do not internalize the Having the established macro-level analysis, it is important benefits of these effects when making entry or investment to evaluate the question at the micro level. Firm data col- decisions, and so quality of the business environment drives lected by the World Bank's investment climate firm surveys decisions on entry, investment, and expansion. from 2001 to 2004 are used. e authors focus their analy- With these three theories setting the context,we will re- sis on technical efficiency. ey first estimate Total Factor consider why most African firms are not productive enough Productivity (TFP). ese estimates support the conten- to export manufactured goods. eir factor endowments are tion that TFP is lower on average in most African countries consistent with competitiveness in a variety of labor-inten- than in higher-performing competitors in the developing sive, natural-resource processing industries. Most African world. e analysis is then taken a step further by broad- countries, however, have been unable to take even this step ening the measure of productivity. A measure for net TFP toward higher value-added processing. Using Krugman's is developed by netting out known indirect costs. As high approach to comparative advantage, the authors evaluate the indirect costs inherent in a poor business environment can cost level in Africa to determine if Africa's inability to de- degrade comparative advantage, netting out the impact of velop a robust manufacturing sector may be linked to high poor power infrastructure or poor transport infrastructure costs rather than factor endowments. should provide a more accurate measure of firm productiv- With the caveat that purchasing power parity (PPP) ity controlling for the business environment. For the sample conversion factors are imprecise, they do help to evaluate ag- used, most of the African countries (excepting Morocco and gregate price levels across comparator countries. As shown Senegal) have the highest indirect costs as a share of the in Table 1, Africa's poor economies have only four-fifths the cost structure, ranging from 15 percent to nearly 30 percent. income of South Asia and one-half that of East Asia; their ese cost structures are demonstrated in Figure 1. costs, however, are 75 percent and 35 percent higher, respec- ese high indirect costs squeeze profits for firms that tively, than these two regions. When considering predicted are operating in the countries and serve as a barrier to entry costs (based on a Balassa trend line relating income level to for those considering new investment. Figure 2 shows that PPP ratios), Africa's poor countries have higher actual costs even moderate reductions in indirect costs would increase than predicted, and China and South Asia have lower costs. the viability of African manufacturing firms, by pushing When evaluating country-level data, the best performing them out of the red and making those firms that are profit- countries (including South Africa and Mauritius, which able even more so. have shifted from primary to manufactured exports) have Figure 3 presents several alternative scenarios juxta- costs that are close to predicted values and higher export lev- posed against actual profitability. e first scenario depicts els. e poor performing countries, including many in Sub- a 13 percent reduction in indirect costs. With the exception Saharan Africa, have costs higher than predicted values and of Zambia, all comparator countries in this scenario would negligible export levels.If costs facing manyAfrican firms are have positive profit levels, bringing Ethiopia, Nigeria, and close to these estimates, competitiveness will be affected. Bolivia out of the red. In this scenario, both Mozambique Table 1: Ratio of Exchange Rate to PPP Conversion Factor, by Region, 1993­96 LAC South Central Carib- EAP SSA OECD Am. Am. bean MENA ECA All China SAR All Poora Costs 1.19 0.64 0.46 0.55 0.42 0.42 0.29 0.23 0.22 0.37 0.31 Ratio of costs to predicted costs* 1.07 1.16 0.93 1.07 0.93 0.90 0.91 0.80 0.87 1.07 1.28 Income per capita (market prices) 26,500 4,000 2,850 3,200 2,200 2,450 750 550 375 550 300 a. Excluding Botswana, Cape Verde, Mauritius, Namibia, and South Africa, all of which are middle-income well-managed countries. b. A value of 1 implies that cost levels are equal to those predicted by the Balassa trend line relating income level to PPP ratios. Regions with costs or prices higher than predicted have values above 1 Figure 1: Cost Structures, Firm-Level Average by Country to ethnic minority ownership. ese large, foreign, and minority-owned MOZAMBIQUE Materials firms tend to have higher productiv- ERITREA Labor KENYA ity than indigenous firms and tend to Capital TANZANIA export more than their smaller indig- ZAMBIA Indirect COSTS enous counterparts. On average, small UGANDA AL BOLIVIA to medium enterprises in China have TOT NIGERIA productivity levels at about 80 per- OF ETHIOPIA CHINA cent of larger firms. In Africa, the ra- NICARAGUA tio is closer to 50 percent. ese firms SHARE MOROCCO INDIA all face some of the same constraints SENEGAL related to business environment, yet BANGLADESH 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 the share of large firms with access to credit is much higher than that of small firms. Large firms also have and Tanzania would have profit margins on par with China. more interaction with the government, which may provide With the exception of Morocco and Senegal, a one-third opportunities to exchange favors,although rent seeking here reduction in indirect costs would have a greater impact on is also likely. e role of networks in the African private sec- profit margin than would a one-third reduction in the cost tor is crucial in understanding the nature of the cleavages. of labor. For most African countries, achieving an indirect Biggs and Shah (2004) link access to credit and other per- cost level equal to Senegal would have a greater impact on formance variables to ethnicity in their research. ese often profit margins than halving labor costs. is comparison ethnic networks help firms to overcome the limitations of demonstrates that high indirect costs in Africa are acting as markets but also function to exclude outsiders.Small,sparse a damper on economies with much potential. industrial sectors dominated by a few firms with high mar- ket share are likely to see less dynamic competition arising. Cleavages in the African Private Sector Without competition, fewer incentives arise for these net- works and entrenched business interests to push for better Political analyses of Africa describe twin problems of slow regulation and business services. growth and only partially successful reforms. Both Tangri (1999) and Van de Walle (2001) find that minority com- Policy Reforms munities within the private sector tend to be closely aligned with the political elite. e political elite implement partial e main message of the paper is the importance of includ- reforms with little impact on the private sector and their way ing losses and indirect costs in firm-level analysis. By evalu- of doing business. us, their alliances with the minority ating net TFP, rather than gross TFP, a broader evaluation groups within the private sector remain undisturbed. Al- of firm costs can be considered, which allows for a more ac- though the World Bank and other donors focus their dia- curate comparison of firm productivity. Based on the find- logue on technical solutions to private sector development, ings in this analysis, six reforms are put forth: such as better roads, more power generation, and reduction of the regulatory burden, dialogues in the domestic African 1. Reduce most severe indirect costs: As demonstrated by press focus on the proposition that the persistence of the pri- the scenarios of reduced indirect costs, firm-level prof- vate sector elite (whether foreign, ethnic minority, or Black) itability can be seriously enhanced by improvements in has prevented economic empowerment of the majority of the business environment. For most African countries, Black Africans. e long-standing rent-seeking arrange- power, transport, and telecommunications are of great- ments that have benefited the private sector and political est concern. elites must be confronted for true reform to take place. 2. Level the playing field: Extend to indigenous firms pro- e firm-level surveys support this perception of cleav- grams such as tax incentives and training that are al- ages within theAfrican private sector.In almost all countries, ready benefiting minorities and foreigners. there is a strong relationship between foreign ownership 3. Encourage enclave growth to increase business density: and firm size, but in Africa, this relationship also extends Because improving services countrywide may be diffi- cult and costly, creating enclaves Figure 2: Cost Structures and Profits in Manufacturing for business, such as the export processing zones (EPZs) of Materials Labor Capital Indirect Profit Mauritius and Madagascar, may 1.4 1.2 be more feasible. ey can also 1 help to attract new entrants. 0.8 4. Build constituencies for reform: 0.6 0.4 Demonstration effects can weak- 0.2 en old perceptions. Business 0 enclaves can serve this purpose, -0.2 -0.4 as well as advertising the gains A achieved in other countries. KENY INDIA CHINA ZAMBIA NIGERIA BOLIVIA ERITREA ETHIOPIA UGANDA SENEGAL 5. Enhance the profile and credibility MOROCCO NZANIAAT NICARAGUA MOZAMBIQUE BANGLADESH of reforms: Business-related re- forms should receive the same attention as social sector reforms. Figure 3: Profitability, Actual and Counterfactual Focusing on measurement may Actual With indirect costs 13% of total With 1/3 reduction in labor costs help to enhance the profile and 0.3 credibility of these reforms. SALES 0.2 6. Capitalize on the concern over do- OF nor dependence: Some African % 0.1 countries are beginning to discuss 0 the need to lessen dependence on -0.1 MARGIN, the donor community. Linking -0.2 development in the private sector PROFIT -0.3 to reduction of donor dependence A INDIA may increase support for reforms. KENY CHINA ZAMBIA NIGERIA BOLIVIA ERITREA ETHIOPIA UGANDA MOROCCO NZANIAAT SENEGAL NICARAGUA BANGLADESH MOZAMBIQUE is note is part of a series of summaries of analytical work of the Africa Private Sector Unit. e note is authored by Michael Igram based on a paper entitled Business Environment and Com- parative Advantage in Africa: Evidence from the Investment Cli- mate Data, by Benn Eifert,Alan Gelb, and Vijaya Ramachandran, presented at the Annual Bank Conference on Development Eco- nomics held in Dakar, Senegal in January 2005. e views con- tained in this paper are the authors' own and do not necessarily represent the views of the institutions that they are affiliated with. For more information, contact Vijaya Ramachandran via email at vramachandran@worldbank.org. A copy of the report is also available from www.worldbank.org/afr/aftps