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UNLEASHINGEN TREP REN EU RSH IP

M A K I N G B U S I N E S S W O R K F O R T H E P O O R

Commission on the

Private Sector &Deve lopment

R E P O R T T O T H E S E C R E TA RY - G E N E R A L O F T H E U N I T E D N AT I O N S


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UNLEASHINGENTREPRENEURSHIPMAKING BUSINESS WORK FOR THE POOR

Commission on thePrivate Sector &Development

REPORT TO THE SECRETARY-GENERALOF THE UNITED NATIONS


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1 March 2004

The analysis and policy recommendations of thisReport do not necessarily reflect the views of theUnited Nations Development Programme, itsExecutive Board or the United Nations MemberStates. The Report is an independent publication byUNDP and reflects the views of the members of theCommission on the Private Sector and Development.

Copyright 2004United Nations Development ProgrammeOne United Nations Plaza, New York,NY 10017, USA

All rights reserved. No part of this publicationmay be reproduced, stored in a retrieval systemor transmitted, in any form by any means,electronic,mechanical, photocopying or otherwise, withoutprior permission of UNDP.


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COMMISSION MEMBERSC O - C H A I R S

The Right Honourable Paul MartinPrime Minister, Canada

Ernesto ZedilloDirector,Yale University Center for the Study of GlobalizationFormer President, Mexico

M E M B E R S

E X -O F F IC I O M E MB E RS

Maurice Strong (Canada)Special Adviser to the Commission

Mark Malloch Brown (United Kingdom)Administrator, United Nations Development Programme

A LT E R N AT E S

Debra Dunn for Carleton Fiorina (United States)Senior Vice President of Corporate Affairs, Hewlett-Packard Company

Michael Froman for Robert Rubin (United States)President and CEO, CitiInsurance

C O M M I S S I O N S E C R E TA R I AT

Executive Director: Nissim Ezekiel

Core Team: Jan Krutzinna, Naheed Nenshi,Yann Risz and Sahba Sobhani

Eduardo Aninat (Chile)Former Deputy Managing Director,

International Monetary Fund

Jorge Castaeda (Mexico)Former Minister of Foreign Affairs, Mexico

Distinguished Professor of Politics &Latin American Studies, New York University

Luisa Diogo (Mozambique)Minister of Planning and Finance,Mozambique

Carleton Fiorina (United States)President and CEO, Hewlett-Packard Company

Rajat Gupta (India)Senior Partner Worldwide,

McKinsey & Company

Anne Lauvergeon (France)Chairman of the Executive Board, Areva Group

President and CEO, Cogema

Jannik Lindbaek (Norway)Chairman, Statoil ASA

Peter McPherson (United States)President, Michigan State University

Alan Patricof (United States)Vice-Chairman and Founder,Apax Partners

Kwame Pianim (Ghana)CEO,New World Investments

C.K. Prahalad (United States)Harvey C. Fruehauf Professor of BusinessAdministration,University of MichiganBusiness SchoolRobert Rubin (United States)Director and Chairman,Executive Committee,CitigroupFormer Secretary of the Treasury, United States

Miko Rwayitare (South Africa)President and Executive Chairman, Telecel InternationalOwner Mont Rochelle Winery

Juan Somavia (Chile)Director-General,International Labour Organization

Hernando de Soto (Peru)President, Institute for Libertyand Democracy, Peru


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nding poverty, the aspiration of the MillenniumDevelopment Goals, is the overriding developmentalobjective of the 21st century.Despite great progressin the past 50 years,1.2 billion peopleone-fifth of

the people on Earthlive on less than US $1 a day, without access to manyof the social services basic to a decent human life.Their plight requires a globalresponse making full use of all the financial, intellectual and organizationalresources that we can muster.

It is against this urgent background that Secretary-General Kofi Annanasked us to convene the Commission on the Private Sector and Developmentto answer two questions. How can the potential of the private sector andentrepreneurship be unleashed in developing countries? And how can theexisting private sector be engaged in meeting that challenge? This report isour responses to these questions.

The report offers recommendations on how the major actorsgovernments,public development institutions, the private sector and civil society organizationscan modify their actions and approaches to significantly enhance the ability of the private sector to advance the development process.The objective of

FOREWORD

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poverty alleviation leads us to focuson developing businesses that createdomestic employment and wealthby unleashing the capacity of local entrepreneurs.

We set an ambitious time limit for

our work, which has been completedin a little more than half a year sinceour first meeting in June 2003. Ourintention was not to carry out basicresearch. Much work on the subjectis already under way, and majordevelopment agencies, privatefoundations and academic institutionsare already focusing their energieson the private sectors contributionsto development. Instead, our approach

has been to understand and assimilatethe work already carried out by allparts of the development coalition,including business, civil society andlabour organizations, and to integratethat thinking in the framework presented here.

The Commissions work has beenheavily influenced by the voices of entrepreneurs, expressed through

their actions and through theirresponses to wide-ranging surveyslaunched to understand what mostaffects their ability to be productiveand to grow. It is the capacity, driveand innovation of entrepreneursthat increase the impact of abroadly constituted private sector.Entrepreneurship encompasses theactions of small, informal, village-

based individuals as much as it doesthat of the managers and innovatorsin multinational corporations andlarge local companies. It is their voicesthat we have heard the loudest.

The Commission has also

attempted to highlight a broadrange of good practices that show how the capabilities of the privatesector can best be harnessed for thecause of development and poverty alleviation. The cases includesuccessful approaches that originate with the traditional developmentplayers, such as the multilateraldevelopment institutions andbilateral aid agencies. But more

often they include lesser known butinnovative approaches implementedby the private sectorboth by companies and civil society organizations. Those approachesrely on market mechanisms andprivate sector incentives and thuslend themselves much more to thereplicability and scalability that we believe needed. One of our key observations is the lack of knowledge

about best practices and the greatneed for more sustained researchand analysis of what works and what doesnt.

We concluded at the outset thatit would not be enough for thisCommission to produce a traditionalreport voicing opinions and urgingothers to take action. Instead, we

believe that it is critical to developa set of pilot actions and initiativesthat would test the main observationsand conclusions of our workso that their relevance to the real

world of development could bedemonstrated on the ground. Thatis why the report ends with anillustrative portfolio of actions that

will be developed in greater detailover the next few monthsactionsthat could be implemented on apilot basis shortly thereafter. Someof them could be driven by the UNsystem, and some by other partnersand stakeholders.

These initiatives are far from

enough. We put them out to all of you as indicative of the types of actions that we believe can andshould be replicated for the widestpossible impact. Nor do we believethat each of them is a perfect model.Country differences require modifyingthe initiativesas well as some of our overall recommendationstofit particular circumstances. Ourideas and conclusions are presented

as directional, to elicit reaction andconstructive dialogue. The intent isto catalyze a renewed coalition of the major stakeholdersfocusedmore clearly on the challengesoutlined here. Such a coalition isessential to unleashing the capacity of the private sector, to achievingthe Millennium DevelopmentGoals and to alleviating poverty.

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Paul Martin Ernesto ZedilloCo-Chair Co-Chair


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he Commissions work would not have beenpossible without the input and assistance of manyindividuals and organizations.We are deeplygrateful to all those listed here.

A SPECIAL THANKS

To McKinsey & Company, who provided input and counsel to the Commissionand its Secretariat throughout the project. The team of Maria Blair, Michael

Monson and Mark Templeton was led by Tilman Ehrbeck, Diana Farrell, Jeremy Oppenheim and Les Silverman.

To Jennifer Barsky, Prabal Chakrabarti and Irene Philippi who also provided vital inputs to the work of the Secretariat.

READERS AND EXPERTS

Our work has been informed by many who have gone before, and a numberof them generously gave of their time and expertise to help shape our thinking. These include: Adrian Hodges, International Business Leaders Forum;

ACKNOWLEDGEMENTS

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Lalita Gupte, Mahdav Kalyanand K. V. Kamath, ICICI Bank;Nandan Nilekani and Sanjay Purohit,Infosys Ltd.; Percy S. Mistry,Oxford International Group;Richard Frank, Bob Graffam, JulioLastres and Alexander Schwedelheim,Darby Overseas Investments Ltd;Michael Barth, NetherlandsDevelopment Finance Company;Nancy Bearg, Enterprise Works;Gary Bond, Noreen Doyle andMichael McCullough, the EuropeanBank for Reconstruction andDevelopment; Cameron Rennie,the World Business Council forSustainable Development; EnriqueFerraro, Jim Kaddaras and MariaOtero, Accion; Jide Zeitlin,Goldman Sachs; Masood Ahmed,David Stanton and Adrian Wood,the U.K. Department forInternational Development;Professors Michael Chu, Calestous Juma, Tarun Khanna, GeorgeLodge, Michael E. Porter, IqbalQuadir and Deborah Spar, HarvardUniversity; Michael Fairbanks,On the Frontier; Craig Wilson,DeltaPearl; Elli Kaplan; BenjaminKrutzinna; Neysan Rassekh; AlexShakow; George Ivanov; EleonoreKopera, Business HumanitarianForum; Barbara Samuels, SamuelsAssociates; Donald Snodgrass,Development Alternatives, Inc.;Elizabeth Littlefield, CGAP;

Bill Kramer, Water Research Institute;Hugh Locke, Locke Associates;Bill Draper, DraperRichards; Joaquim Boborquez; Maria CattauiLivanos and William Stibravy,the International Chamber of Commerce; Robert Litan, RobertChernow, The Ewing MarionKauffman Foundation; Professors John McMillan and Paul Milgrom,Stanford University; Christopher Woodruff, University of California,San Diego; Professor JonathanMorduch, New York University; Jeb Brugman and Craig Cohon,GlobalLegacy; Bob Fitch,Enterplan; Daniel Zelikow, JP Morgan; Kenny Pegram andRay Smilor, the Foundation forEnterprise Development; SunilSinha, Emerging Market Economics;Roland Dominic and Jean-Philippede Schrevel, BlueOrchard;Professor Roger Leeds, JohnsHopkins University; Professor Ted London, the Base of thePyramid Learning Laboratory atthe University of North Carolina; John Richardson and SevdalinaRukanova, the European FoundationsCentre; Kenneth Borghese, JohnE. Wasielewski, the United StatesAgency for InternationalDevelopment; S. Aftab Ahmed,Sabine Durier, Mariann Kurtz,Guy Pfeffermann, Harold Rosen, Thomas Schipani, Bernard Sheahanand Udayan Wagle, the InternationalFinance Corporation; Gerard Byam,

Cesare Calari, Gerard Caprio,

Arvind Gupta, Jemal-ud-dinKassum, Michael Klein, KhalidMirza, Francois Nankobogo, NeilRoger, Marilou Uy and Dileep

Wagle, the World Bank; Gerald T. West, the Multilateral InvestmentGuarantee Agency; JonathanFiechter and Prakash Loungani,the International Monetary Fund;Karen Decker and Arvind Mathur,the Asian Development Bank;Nancy Boswell, Transparency International; Antonio Vives, theInter-American DevelopmentBank; and Ric Cameron andArthur Saper, the CanadianInternational Development Agency.

CONSULTATIONS

The Commission Secretariatconducted four formal consultations

with international labour represen-tatives; European foundations,academics, and Canadian civilsociety organizations. Our thanksto the hosts of these consultations,including the International LabourOrganization and the EuropeanFoundations Centre, as well as toparticipants of these consultations,

who included: Bob Kyloh, workersrelations branch, the InternationalLabour Organization; Raul Requena,Union Network International;

Wendy Caird, Public ServicesInternational; Carla Coletti, theInternational MetalworkersFederation; Esther Busser, theInternational Confederation of Free Trade Unions; Sndor Kles,the Carpathian Foundation;

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TABLE OF CONTENTSC O M M I S S I O N M E M B E R S

F O R E W O R D i

A C K N O W L E D G E M E N T S i i i

H I G H L I G H T S 1

C H A P T E R 1 . W H Y T H E P R I VAT E S E C T O RI S S O I M P O RTA N T I N A L L E V I AT I N G P O V E RT Y 5

Deep poverty remains intractable 6

The private sector is important for the poorand often is the poor 7

Who are all the entrepreneurs? 8

A focus on the domestic private sector 9

C H A P T E R 2 . C O N S T R A I N T S O N T H EP R I VAT E S E C T O R I N D E V E L O P I N G C O U N T R I E S 1 1Widespread informality for microenterprises 1 2

Few competitive small and medium size enterprises 1 3

Lack of competitive pressure on large companies 1 4

Foundations for entrepreneurshipnot yet in place 1 4

Three pillars of entrepreneurshiptoo often missing 1 7

C H A P T E R 3 . U N L E A S H I N G T H EP O T E N T I A L O F T H E P R I VAT E S E C T O R 2 1

Building the foundations 2 3

Erecting the pillars 2 4

C H A P T E R 4 . E N G A G I N G T H EP R I VAT E S E C T O R I N D E V E L O P M E N T 2 9

Serving markets at the bottom of the pyramid 3 0

Forming ecosystems and building networks 3 0

Fostering public-private partnerships for sustainable development 3 3

Improving corporate governance 3 4

Advancing responsible business practicesand corporate social responsibility standards 3 4

C H A P T E R 5 . R E C O M M E N D E D A C T I O N S 3 7

Actions in the public sphere: create an enabling environment 3 8

Actions in the public-private sphere:partner and innovate 4 0

Actions in the private sphere:mobilize capabilities and resources 4 1

Looking forward 4 2

B I B L I O G R A P H I C N O T E 4 3

B I B L I O G R A P H Y 4 5


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B O X E S

Box 1.1 The Millennium Development Goals 7

Box 3.1 Costa Ricas private sectorunleashed 2 7

Box 4.1 Resources under the radar screen for private sector development 3 0

Box 4.2 Showing whats possible at the bottom of the pyramid 3 2

F I G U R E S

Figure 1.1 More investmentmore growth 7

Figure 1.2 Four billion people at the bottom of the pyramid 8

Figure 2.1 Informality thrives in poorer countries 1 2

Figure 2.2 Small and medium enterprises become more importantand informality less important as countries become wealthier 1 3

Figure 2.3 Foundations for the private sectorand pillars of entrepreneurship 1 5

Figure 2.4 Enterprises in low income countries facemany more burdens when registering 1 7

Figure 3.1 Strengthening the effectiveness of traditionalprivate sector development activities 2 2

Figure 4.1 Private sector contributions to private sector development 3 0

Figure 5.1 Actions in the three focus areas 3 8


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he Commission believes that any approach to privatesector developmentand the policy and actionrecommendations that accompany itshould begrounded in the realization that the savings, investment

and innovation that lead to development are undertaken largely by privateindividuals, corporations and communities.

The private sector can alleviate poverty by contributing to economicgrowth, job creation and poor peoples incomes. It can also empower poorpeople by providing a broad range of products and services at lower prices.

Small and medium enterprises can be engines of job creationseedbedsfor innovation and entrepreneurship. But in many poor countries, small andmedium enterprises are marginal in the domestic ecosystem. Many operateoutside the formal legal system, contributing to widespread informality andlow productivity. They lack access to financing and long-term capital, thebase that companies are built on.

The Commission believes that the primary responsibility for achievinggrowth and equitable development lies with developing countries. This

HIGHLIGHTS

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responsibility includes creating theconditions that make it possibleto secure the needed financialresources for investment.

Those conditionsthe state of governance, macroeconomic and

microeconomic policies, publicfinances, the financial system andother basic elements of a countryseconomic environmentare largely determined by the actions of domestic policymakers. Theirchallenge is to capitalize on advancesin macroeconomic stability anddemocracy and to launch reformsthat bring about further changes ininstitutional frameworks to unleash

and foster the private sector.Most of the recommended actionsinvolve more than one of theactors working together. Wheregovernments are implementingpolicy change, it is often with thedirect support and involvement of multilateral development institutions. Where the private sector is taking amore active stance on sustainable

development, it is often with civilsociety raising the profile of thisissue. Where governments areimplementing regulatory reform,it may be in direct consultation with representatives of the privatesector. The individual actionsidentified here should be seen inthe framework of this broadercooperationneeded even moreto reduce poverty.

Our interest lies in three areas:

1. In the public sphere, promotingthe reform of laws, regulationsand other barriers to growth.

2. In the public-private sphere,facilitating cooperation andpartnerships between public andprivate players to enhance accessto such key factors as financing,skills and basic services.

3. In the private sphere,encouraging the developmentof business models that can bescaled up and copied and thatare commercially sustainable.

ACTIONS IN THEPUBLIC SPHERE:CREATE AN ENABLINGENVIRONMENT

Creating an enabling environmentinvolves steps to reduce the share of the informal sector in an economy,through reform of the overallenabling environment for theformal economy.

For developingcountry governmentsReform regulations and strengthenthe rule of law. Developing country governments have to make a strong

and unambiguous policy commit-ment to sustainable private sectordevelopmentand combine that with a genuine commitment toreform the regulatory environmentby eliminating artificial and policy-induced constraints to strongeconomic growth.

Formalize the economy.Developing country governmentsneed to focus on creating theconditions to reduce informality and change the composition of theprivate sector ecosystem over time.

Engage the private sector inthe policy process. Governmentsneed to create a real partnership

with representatives of the domesticprivate sector to implement changesand ensure that the voice of the privatesector includes small and mediumenterprises and microenterprises.

For developed

country governmentsFoster a conducive internationalmacroeconomic environment andtrade regime. Increasing the flow of development aid and reforming theglobal trading system to provide faireconomic opportunities to producersfrom developing countries areessential for promoting rapid growthin domestic private investment.

Redirect the operationalstrategies of multilateral and bilateral development institutionsand agencies. In encouragingsustainable private sector develop-ment developed countries need toensure that the collective actionsof these agencies are bettercoordinatedto improve theirefficiency and to reduce the pressureson the administrative capacity of

developing country governments.Untie aid. Changes in theadministrative rules controllingtied funds would permit moreeffective use and delivery of technical assistance to stimulateprivate sector development.

For multilateraldevelopment institutions Apply the Monterrey recommen-

dation of specialization andpartnership to private sector development activities. Theextent of overlapping activities iscounterproductive and needs tobe urgently addressed.

Address informality in developing countries. Some pioneering work is underway to map the structure of the informal sector, and a global

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effort to expand the coverageof this work is likely to yieldsignificant benefits.

ACTIONS IN THEPUBLIC-PRIVATE

SPHERE: PARTNERAND INNOVATE The Commission believes that allstakeholders need to make concertedefforts in finance, skills and public-private partnerships for the delivery of basic services.

Facilitate access to broader financing options. We envisioncontinuing development of domestic

financial markets coupled withskill-building for regulators andprivate financial institutions.

Assist skill and knowledgedevelopment. Skill-buildingactivities could range fromprograms for top public andprivate leadership to trainingmicroentrepreneurs to joint efforts with public authorities and unionsto improve workforce skills.

Make possible sustainable delivery of basic services,particularly energy and water. The Commission seesthe need to develop innovativemodels for partnerships of governmental service providers,multinational companies andlocal companies.

ACTIONS IN THE

PRIVATE SPHERE:MOBILIZE CAPABILITIESAND RESOURCES The Commission believes that theprivate sector, particularly largelocal companies and multinationalcorporations, must realize thatit can contribute to acceleratedeconomic development and topoverty alleviation.

For the private sectorChannel private initiativeinto development efforts. Webelieve that the private sector hastremendous potential to contributeto development through itsknowledge, expertise, resourcesand relationships.

Develop linkages withmultinational and large domesticcompanies to nurture smaller companies. Linkages betweendifferent types of firms indeveloping countries provide aneffective channel for local companiesto gain access to markets, financing,skills and know-how.

Pursue business opportunitiesin bottom-of-pyramid markets.Recognizing the needs of bottom-of-the-pyramid markets (the 4 billionpeople who are earning less than$1,500 a year) and creating innovativesolutions to meet these needs areother vital actions required fromthe private sector, both domesticand international.

Set standards. The privatesector needs to make a genuinecommitment to sustainabledevelopmentwith a sharpfocus on corporate governanceand transparency.

For civil society andlabour organizations The Commission believes that civilsociety and labour organizations

have to continue as criticalobservers of the developmentagendaand as facilitators andsupporters of innovative approachesfor meeting the MillenniumDevelopment Goals and improvingthe quality of life for poor people.

Increase accountability in thesystem. This is a core part of the

work of civil society organizations,as is their leadership in pushingforward the concept of sustainabledevelopment. This work shouldbe strengthened.

Develop new partnerships andrelationships to achieve commonobjectives. Civil society organizationsare closest to the base of the pyramid.

They also are often proxies forexperimenting with new technologiesfor solving problems.

LOOKING FORWARD

To promote progress, the Commissionrecommends that the United Nationssponsor the tracking of privatesector development. An annualprogress report would maintain theprominence of the Commissionsoverall recommendations and ensurethe commitment to addressing themany issues identified here.

The Commission is assemblinga first set of actionable initiativesto facilitate transformations inindividual countries and to providethe tools for governments andthe private sector to supplementavailable resources and begin rapidly implementing a programme of change. These first actions areintended to stimulate a collaborativeresponse from potential partners

who read this report. Our messageto all of you is: join us.

H I G H L I G H T S 3


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his report is about walking into the poorest villageon market day and seeing entrepreneurs at work.It is about realizing that the poor entrepreneuris as important a part of the private sector as the

multinational corporation. It is about acknowledging that the private sectoris already central to the lives of the poor and has the power to make thoselives better. It is about using the managerial, organizational and technologicalinnovation that resides in the private sector to improve the lives of the poor.It is about unleashing the power of local entrepreneurs to reduce poverty intheir communities and nations.

The Millennium Development Goals, ambitious in scale and scope, can beachieved only through committed application of best knowledge and practice. The problem is huge, with a fifth of the planets people living on less than$1 a day. But some encouraging examples show how private enterprise canalleviate poverty. Consider garment exports in Bangladesh, information

C H A P T E R 1

WHY THE PRIVATE SECTORIS SO IMPORTANT INALLEVIATING POVERTY

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technology in Costa Rica and cutflowers in Kenyanew industriescreating jobs, boosting incomes,lifting hopes. And consider thefollowing successes, ranging frommodern multinationals to domesticentrepreneurs, demonstratingthe potential of private returnto boost development.

I Cemex, the Mexican cementfirm, has become one of the

worlds leading producers andinnovators in the industry,employing thousands.

I Casas Bahia in Brazil hasdeveloped a unique businessmodel providing efficient retail

services aimed at poorer customers.I Infosys, an Indian information

technology services firm, grew from less than $10 million insales in the early 1990s to becomea leading global player withalmost $800 million in salestoday. Along the way, it has alsobeen setting international standardsfor corporate governance andcreating a new partnership for

development with local andcentral government.

I ICICI Bank, also in India, isapplying technology and acomprehensive approach to thefull range of its client baseparticularly in rural markets andto small and medium enterprisesand microentrepreneurs.

I In Cambodia hundreds of smallprivate providers offer servicesranging from battery rechargingto fully metered electricity provision for entire communities.

These providers now serve anestimated 115,000 customers

more than one-third of electricity customers nationwide.

I Fierce competition betweenprivate locally owned mobilephone companies in Somalia hasdriven costs on internationalphone calls to less than $1 aminute, about a sixth that inmany other African countries. This, in a country where thereis no official banking or postalsystem and where many donot have regular running wateror electricity.

I In Guatemala the Confederationof Agricultural Cooperativesformed a joint venture with aCanadian firm. The enterprisenow exports vegetables worthmore than $3 million a yearto Canada, providing steady income for 100 indigenous women and supporting morethan 1,000 farmers.

I In Mozambique a farmer boughtan oilseed press on credit. Now as the owner of four presses, hehas organized nine other pressoperators into a small cooperativeassociation, bargaining with localbanks and customers as a group.

I In India small-scale soybeanfarmers use a village Internetkiosk to check spot prices fortheir products on the ChicagoBoard of Trades website,bypassing local intermediariesand getting better prices.

These examples are not just successstoriesthey are stories about thesuccesses of the domestic privatesector. They are what this report isabout. But moving from exampleto broad achievement requiresthinking freshly about development,unconstrained by ideology, unhingedfrom tired debate.

DEEP POVERTYREMAINS INTRACTABLE

Despite great progress in somecountries and regions, deep poverty remains a stubborn and intractableproblem across much of the world.

Substantial gains in some countrieshave been accompanied by deeplosses in others, and far too many people still earn less than $1 a day,suffer from hunger and lack accessto water, sanitation and energy.

The latest Human Development Report of the United NationsDevelopment Programme reportsthat the proportion of people inextreme poverty fell to 23.2% in1999 from 29.6% in 1990. But thenumber of people living on $1 aday slipped only to 1.17 billion from1.29 billion a decade earlier. Moreover,if the dramatic improvement inChinas poverty indicators is excluded,the number of people living inabsolute poverty actually increased.

In recent years poverty alleviationhas moved to the centre of the global

dialogue as the primary overridingobjective of developmentnot aderived outcome. The MillenniumDeclaration was an unprecedentedexpression of solidarity and determi-nation to rid the world of poverty,committing countries, rich andpoor, to eradicate poverty, promotehuman dignity and equality andachieve peace and environmentalsustainability. It led to agreement

on the Millennium DevelopmentGoals (box 1.1).

Yet progress is more than possibleand it occurs with regularity under theright conditions. Economic growthhas lifted hundreds of millions of people out of subsistence agricultureinto manufacturing and serviceemployment, increasing wealthand reducing poverty. Witness the



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dramatic improvement in the livingstandards in East Asian countries,including Indonesia, The Republic of Korea, Malaysia and Thailand, and

the sizable reduction in the numberof people in poverty in China.

The impact of economic growth,overall, on poverty depends on arange of factors that influence thenature of this growth,but the empiricalevidence is compelling. In East Asiaand the Pacific, the region with thestrongest growth in the 1990s,annual per capita GDP growth of

6.4% resulted in a 15% decline inthe rate of poverty (using the $2 aday criterion), and in South Asia3.3% annual growth led to an 8.4%decline. In contrast, the slow growthof 1.6% in Latin America and theCaribbean and 1.0% in the MiddleEast and North Africa caused amarginal deterioration in poverty rates. More dramatically, negativegrowth rates increased poverty ratesby 1.6% in Sub-Saharan Africa and13.5% in Europe and Central Asia.

The message is clear: sustainedeconomic growth reduces poverty. The link is equally clear betweeneconomic growth and strong privateinvestment. A study of 50 developingcountries from 1970 to 1998 examinedthe relationship between private

and public investment and growthand incomes. Countries with highergrowth featured higher privateinvestment (figure 1.1).

But for output growth to contributeto poverty alleviation, it must translateinto incomes of the poor. For wagelabourers and salaried workers, the

quantity of employment and therate of pay are crucial. For the self-employed, productivity and returnsare important, influenced by technology, inputs and prices.Employment is thus the key link between output growth andpoverty alleviation.

THE PRIVATE SECTORIS IMPORTANT FORTHE POORANDOFTEN IS THE POOR

The private sector is central to thelives of the poor. First, all poorpeople are consumers. Across the

world the story is the samepoorconsumers pay more than richconsumers for basic services. InMumbai, slum-dwellers in Dharavipay 1.2 times more for rice, 10 timesmore for medicine and 3.5 timesmore for water than do middle classpeople living at the other end of the city on Bhulabhai Desai Road.

C H A P T E R 1 :W H Y T H E P R I VAT E S E C TO R I S S O I M P O RTA N T I N A L L E V I AT I N G P O V E RT Y7

1. Eradicate extreme poverty andhunger: reduce by half the proportionof people living on less than $1 a day;reduce by half the proportion of peoplewho suffer from hunger.

2. Achieve universal primary education:ensure that all boys and girls completea full course of primary schooling.

3. Promote gender equality andempower women: eliminate genderdisparity in primary and secondaryeducation by 2005,and at all levels of education by 2015.

4. Reduce child mortality: reduce bytwo-thirds the mortality rate for childrenunder five.

5. Improve maternal health: reduce

by three-quarters the maternalmortality ratio.

6. Combat HIV/AIDS,malaria and otherdiseases:halt and begin to reverse thespread of HIV/AIDS; halt and begin toreverse the incidence of malaria andother major diseases.

7. Ensure environmental sustainability:integrate the principles of sustainabledevelopment into country policiesand programmes;reverse the loss of environmental resources; reduce byhalf the proportion of people without

sustainable access to safe drinking waterand basic sanitation;achieve significantimprovement in the lives of at least100 million slum dwellers by 2020.

8. Develop a global partnershipfor development.

B O X 1 . 1 T H E M I L L E N N I U MD E V E L O P M E N T G O A L S

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14

12

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0< 3% 35% > 5%

Growth rates, 197098

I Private I Public

I n v e s t m e n

t a s p e r c e n t o

f G D P , 1 9 7 0

9 8

Source: Bouton and Sumilinski (2000)


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Fully 4 billion people in the worldthose who earn less than $1,500 a yearmake up the bottom of thepyramid markets (figure 1.2).

The quality of goods that poorpeople purchasewhether food,

water or financial servicesisalmost always substandard. Often,an informal private sector fills thegaps with goods of higher pricesand varying quality. It serves animportant need, for informaleconomies sustain the majority of poor families in many countries. Yet the advantages of economiesof scale and scope are missingfrom the lives of people at the

bottom of the pyramid. Some of the barriers are poor marketingand poor distribution.

The private sector is already meeting the needs of poor peoplein places governments do not reach.In some countries, for example,the government has little impact onthe poor. In the slums there are nohealth services, no public education

and no infrastructure. This story repeats itself across the developing world. In many cases, where servicesexist, they are provided by privatesources. Anywhere from 15%to 90% of primary education isprovided in private schools. Some63% of health care expenditures inthe poorest countries are private,almost twice the 33% in highincome countries that belong to

the Organisation for EconomicCo-operation and Development.

With the right attention andregulatory requirements, privately provided services can help meetthe needs of poor people. Recent

data on the distribution of new water connections by incomequintile from three countries inLatin America show that 2530%of the network expansion wastargeted at the lowest fifth of the income profile.

Put simply, an innovative privatesector can find ways to deliverlow-cost (even sophisticated)goods and services to demandingconsumers across all income ranges.It can sell to the urban distressedarea as well as the poor rural villageor town. It can develop distributionlinks to the consumer in the villageand so be better able to harnessknowledge about the actual needsof this segment of the market.It can keep costs low throughoutsourcing, for greater flexibility.

The private sector can thus alleviatepoverty by:

I Contributing to economic growth.I Empowering poor people by

providing them with services andconsumer products, increasingchoices and reducing prices.

The first creates employmentand income growth. The secondimproves the quality of life for thepoor. And the greater interactionbetween those at the base of thepyramid and the private sector createsopportunities for direct involvementin the market economy.

WHO ARE ALL THEENTREPRENEURS?

The Commission takes an expansive view of the private sector. Largecompanies are a vital part of theprivate economy, but the poor arean equally important part. They areoften entrepreneurs themselvesfrequently of necessity, operatinginformally, trapped in subscaleenterprises. We endorse the view

that market-oriented businessecosystems comprise many formsof private enterprise coexistingin a symbiotic relationship. Theecosystem generally includesmultinational corporations, largedomestic companies, cooperatives,small and medium enterprises andmicroenterprises, with formal andinformal players. It thus encompasses


F I G U R E 1 . 2 F O U R B I L L I O N P E O P L E AT T H E B O T T O M O F T H E P Y R A M I D

> $20,000

$1,50020,000

< $1,500

Tier 1

Tiers 23

Tier 4

75100

1,5001,750

4,000

Purchasing powerparity in dollars

Populationin millions

Source: Prahalad and Hammond (2002)


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the farmer in the field as much asthe multinational company.

Agriculture is of particular interestbecause 75% of the people livingon less than $1 a day are in ruralareas, with livelihoods dependent

on mostly subsistence production.In Africa agriculture supportsmore than 70% of the population,contributing an average of 30%of GDP. Providing inputs to theagricultural sector and the valueadded processing and marketingof agricultural goods are importantparts of private sector development. The critical importance of agriculturein alleviating poverty reinforces

the need for urgent progress oneliminating subsidies for producersin developed markets, and ontrade reform.

In many developing countries, women constitute the majority of microentrepreneurs in the informaleconomy and a significant percentageof the formal sector. Many of themare illiterate and live in poor ruralcommunities. And setting up

their own enterprisesgenerally microenterprisesis usually theonly possibility for them to beemployed and earn an incomeon their own. In Latin Americaand the Caribbean between 25%and 35% of formal sector micro-enterprises and small and mediumenterprises are owned and operatedby women. In the Philippines womenown 44% of the microenterprises,

more than 80% in rural areas.In Zimbabwe women run themajority of microenterprises andsmall enterprises (67%), whileenterprises run by men tend toprovide proportionally more of the household income and havemore employees.

Entrepreneurship exists in largecompanies, where individual

executives take the initiative toinnovate and expand the business. This report highlights many instances of large companies thathave targeted bottom-of-the-pyramidmarkets and developed productsand processes to serve the poorprofitably or to operate sustainably in very challenging environments.Entrepreneurship by individualengineers and executives is oftenat the root of such moves by bigcorporations, which can have a majorpositive impact on development.

Entrepreneurship also drives many civil society organizations, and itexists in government and public

administrations. Individuals in theseorganizations have the drive toinnovate and pursue opportunities with the passion and dedication of an entrepreneur, albeit with littleif any pecuniary reward.

Entrepreneurship flourishesperhaps most in small and mediumfirms with significant potential togrow and innovate. This dynamicsegment is typically the hotbed of

entrepreneurship and innovation.It can drive economic growth,create jobs and foster competition,innovation and productivity.

A FOCUS ONTHE DOMESTICPRIVATE SECTOR We focus here on the domesticprivate sectorfor three main

reasons. First, domestic resourcesare much larger than actual orpotential external resources.Domestic private investmentaveraged 1012% of GDP in the1990s, compared with 7% fordomestic public investment and25% for foreign direct investment(FDI). Second, when informalresources are examined, such as

the potential value of land, thedomestic assets that can be tappedare significantly larger than thecumulative FDI or private portfolioflows.Third,unleashing the domesticresources in an economybothfinancial and entrepreneurialislikely to create a more stable andsustainable pattern of growth.

Estimates of the informal assets indeveloping countries range as highas $9.4 trillion, many multiples of cumulative portfolio flows or of FDI flows to developing countriesover the past 15 years. Thesecomparisons are illustrative only,comparing flows and stocks of assets.

Converting informal assets intofinancial resources will require abroad programme of reform that

will enable these assets to be usedas collateral in the banking system.But keep in mind the size of theseassets. Recent work in Egypt, forexample, concludes that the country has a large and vibrant extra-legaleconomy that employs over 8million people (about 40% of the

workforce) and has assets of almost$250 billion, 30 times the market

value of all companies registeredon the Cairo Stock Exchange.

This focus on the domesticprivate sector does not diminishthe importance of FDI. Beyond thefinancial resources that FDI brings,its infusion of a corporate culturecan change the way business isdone, bring managerial know-how and best practices, provide accessto international markets, transfertechnology and innovation, introducecompetitive pressures in previously closed markets and be the principaldriver for the growth of local business.In these situations, FDI can improvethe overall investment climate.

C H A P T E R 1 :W H Y T H E P R I VAT E S E C TO R I S S O I M P O RTA N T I N A L L E V I AT I N G P O V E RT Y9


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eveloping countries have remarkable energyand assets,and all segments of the private sectorhave demonstrated the ability to respond whenempowered. But the Commission finds that three

major structural challenges confront the private sector in all developingcountries, to varying degrees.

I Microenterprises and many small and medium enterprises operate informally.I Many small and medium enterprises have barriers to growth.I A lack of competitive pressure shields larger firms from market forces

and the need to innovate and become more productive.

C H A P T E R 2

CONSTRAINTS ON THE PRIVATE SECTOR INDEVELOPING COUNTRIES

D


P h o t o :

U N D P C u

b a


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WIDESPREADINFORMALITY FORMICROENTERPRISESMicroentrepreneurship is a commonform of employment in many developing countries (figure 2.1).Almost all microenterprises operateoutside the formal legal system,contributing to widespread informality.

Informality provides some benefitsin some circumstances. It can act asa form of employment substitutionfor labourers who have difficulty finding jobs. For example, urbandwellers in Thailand who lost their jobs during the economic crisis of the late 1990s supported themselvesby turning to informal street-vendingopportunities. In societies that limitthe economic role of women, home-based enterprises provide women

with opportunities to earn money.If the formal rules, enforcementsystems and cultural conditions in acountry are so restrictive that mostentrepreneurs cannot use theirtalents, the economy may benefitif they operate informally.

Difficulties in getting finance alsotrap developing country entrepreneursin subscale operations. Entrepreneursand enterprises that operate informally cannot borrow at a reasonable costbecause they do not have legal statusor title to the land they occupy.Frequently, the only option foraccess to capital is through illegalmoneylenders who charge highrates and who may be able to lendonly small sums relative to theneeds of a growing enterprise.

The access of businesses thatoperate informally to the formallegal system and its benefits arelimited. In general, the formal legalsystem should enforce contracts andprotect property rights more fairly than informal enforcement systems do.Predictable rules and dispute

resolution mechanisms are essentialfor entrepreneurs to engage in thelong-term arrangements that enablethem to innovate, to scale up andto diffuse their knowledge andbenefits. Side payments to officialsthat increase predictability in anuncertain world reduce income that

could otherwise be invested in makingoperations more productive.

Cruel and arbitrary informalenforcement systems limit the ability of entrepreneurs to be productiveas well. Local debtor prisons and

mafia-like punishments can hurtan entrepreneurs full access tocrucial human inputs. According toHernando de Soto, a third of debtors

who obtained credit informally inEgypt spent some time in private

jails because they did not pay back what they owed.

Entrepreneurs who operate formally are hurt by the implicit subsidiesthat informal enterprises receivethrough uneven enforcement andby poor mechanisms for protectingproperty and contracts, both of whichdistort competition. Both aspectscreate an uneven playing field andreduce formal entrepreneurs accessto inputs and markets, discouragingentrepreneurs who operate formally from making investments toincrease productivity.

Informal firms can charge lessbecause they avoid paying taxes orcomplying with other regulations.More productive formal firms havedifficulty capturing market sharefrom informal firms because theformal firms pay taxes and othercontributions, which increases theircosts significantly. More productivefirms are less able to drive the lesscompetitive informal firms outof business. So, poor enforcementpermits the informal firms tocontinue to exist, holding back theproductive firms from reachingmaximum scale. Yet, given thesignificant productivity advantageheld by formal firms, the inability to compete may reflect an unwill-ingness to serve some parts of the market rather than the costadvantages offered by informality.


F I G U R E 2 . 1 I N F O R M A L I T Y T H R I V E S I N P O O R E R C O U N T R I E S

Portugal

Chile

Mexico

Thailand,Turkey,Brazil

India, Indonesia,Pakistan,Philippines

Sub-Saharan Africa

Estimated share of nonagriculturalworkforce that is informal

30

38

40

50

70

80

Source: World Bank and International Labour Organization


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Moreover, worker rights andprotections in the informal sectorstand up poorly to those in theformal sector. And consumersable to purchase only goods of inappropriate quality and safety standardsdo not have access to thegreater choice and lower prices intruly competitive consumer markets.

There are many constraints onentering the formal sector.The over-arching issue is one of costs versusbenefits for the individual entrepreneur who has to choose between formaland informal operations.

In most developing countries it iscostly to be formal. Formal playersare often overtaxed (a vicious circle,since they are overtaxed because afew formal companies carry mostof the tax weight). Registering abusiness can be a long and expensiveproposition (in Angola it takes 146days and more than 8 times the percapita income). Regulations andgovernment requirements arecomplexand compliance costs

high. The opportunities for bribery increase with the complexity of regulations, exposing smaller players who lack the legal resources todefend themselves.

Entrepreneurs also see little benefitin going formal. While formalbusinesses in developed countriescan raise capital by mortgaging theirassets, this is often not possible inmany developing countries wheremortgage laws are weak and banksprove reluctant to finance smallplayers. In theory, being formal would facilitate selling beyondgeographic boundaries, but poorlocal infrastructure and customsabuse limit the opportunities.And bankruptcy laws, whichprotect formal players in developedcountries, are often ineffective in

developing countries, exposingformal entrepreneurs to even morerisks (due to more visibility) thanif they remained informal.

FEW COMPETITIVE

SMALL AND MEDIUMENTERPRISES

Small and medium enterprises tendto be engines of job creationseedbeds for innovation andentrepreneurship. By providingnew entry and competition, they can boost efficiency and growthand lead to economic development.

Indeed, recent research indicates

that economic growth in poorcountries is accompanied by amore than proportional growth inthe share of the formal small andmedium enterprise sector. In low income countries the share of formalsmall and medium enterprises inemployment is about 30% and inGDP about 17%, while in highincome countries the shares areabout 60% and 50%. Indeed, richer

countries see far less informal andmuch more small and mediumenterprise activity (figure 2.2).

The reality in many poor countries,especially in Sub-Saharan Africa,is that the small and mediumenterprise sector is relatively marginal in the domestic ecosystem. Why are small and mediumenterprises not able to graduateto the ranks of larger companies?

For this evolution to be possible,it is essential that a reasonably level playing field and supportinginstitutional structures existbetween (often larger) incumbentsand (often smaller) new entrants.

Rules that constrain market entry andexpansion have a chilling effect on

small and medium enterprises at theexpense of established larger firms.Small and medium enterprisesoften could compete effectively inniche markets, but the advantagesthat accrue to established largeplayers fend off competition fromthe small and medium enterprisesector. Without the reasonablecompliance costs that exist only in afairer system of competition, small

and medium enterprises cannotgrow and become more productive.Ineffective or arbitrary tax laws,onerous business regulations andother restrictions penalize them.

C H A P T E R 2 :C O N S T R A I N T S O N T H E P R I VAT E S E C TO R I N D E V E L O P I N G C O U N T R I E S13

Lowincomecountries

Middleincomecountries

Highincomecountries

I Informal activityI Small and medium enterprise activityI Remaining activity

Source: Ayyagari, Beck, and Demirguc-Kunt (2003)

Percentage of GDP

FIGURE 2.2SMALL AND MEDIUMENTERPRISES BECOME MOREIMPORTANT AND INFORMALITYLESS IMPORTANT AS COUNTRIESBECOME WEALTHIER

47

16

37

31

39

30

13

51

36


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Widespread informality and thelack of skills also affect the ability of entrepreneurs to scale up abusiness. While often animatedby innovative ideas or addressinguntapped markets, small andmedium enterprises suffer fromlower total factor productivity,by using older technologies oremploying inferior workforcepractices. The cost of businessservices is often more than smalland medium enterprises can pay,or is not in tune with their needs.Lower export sales from smalland medium enterprises comein large part from lack of accessto knowledge about foreignstandards of quality.

Perhaps most important, small andmedium enterprises lack access tofinancing and long-term capital,the base that companies are builton. High risks associated withsmall and medium enterprises, whether real or perceived, exist inthe absence of financial instrumentsthat manage and diversify the risk.

Banks also face high costs orcannot acquire information thatthey can trust, even when smalland medium enterprises are credit- worthy. These factors raise interestrates and reduce lending volumes,setting up price and quantity barriers to small and mediumenterprise growth. Small and mediumenterprises have to resort to financingfrom networks of family or friends,from retained earnings, or fromshort-term credit from other smallbuyers or suppliers, rather thanfrom larger institutions providingdedicated long-term financing vehicles for specific purposes.

LACK OF COMPETITIVEPRESSURE ON LARGECOMPANIES

Large companies form the hub of networks and clusters and, by the virtue of their size and range of

business activities, provide the spark for the private sector ecosystem.But in many developing countrieslarge incumbent companies can alsostifle entrepreneurial energy andinitiative. Too often, they can takeadvantage of weak institutionalenvironments to raise anticompetitivebarriers and protect their dominantposition. While local informalmarkets can often function withoutmuch regulation, more mature andcomplex markets need appropriateregulations to function effectively.

A dynamic financial sector, in whichnew entrants and incumbents canget finance under competitive terms,is also important for creatingcompetitive pressures in the market.But companies with a protectedposition in these markets often

have strong incentives to use theirlobbying power to slow governmentprogress in improving the institutionalinfrastructure for markets.

Such practices directly hurt poorpeople, through higher pricesand lower quality products. Poorpeople benefited from the openingof competitive markets in India inthe early 1990s. Until then thepopulation was effectively subsidizinga large part of the private sector, which was selling low quality products at high pricesmadepossible by controls on entry by domestic competitors and severequotas and high tariffs on imports.Such anticompetitive policies areoften perpetuated by an unlikely

alliance between large protectedincumbents and poor people,

who fear a loss of jobs incompetitive markets.

Corruption combined with weak and arbitrary legal enforcement

buttresses incumbent firms atthe expense of potentially morecompetitive ones. Specifically,incumbents might receive subsidies,special licenses or other privilegesthat preserve their position anddampen the incentive to innovateand reduce prices. Such firms may respond to perverse incentives tostrip assets or dole out contracts touncompetitive suppliers even when

more efficient providers exist. Thepoor domestic macro environmentencourages wasteful rent-seeking andretards the growth of competitivefirms based on productivity.

These firms might also indirectly starve competitors from receivingcapital by contributing to anenvironment that keeps financeunderdeveloped. Large firms

thus command the lions share of resources in an underdevelopedfinancial system.

FOUNDATIONS FORENTREPRENEURSHIPNOT YET IN PLACE

Building a sound private sectorrequires a strong foundation inthe global and domestic macroenvironments, physical and socialinfrastructure and rule of law (figure 2.3).

Global macro environment The foundations for growth inthe private sector start with a well-functioning global macro businessenvironment involving a dynamicglobal economy that providesmarkets, as well as adequate trade



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rules that enable competitive accessto market opportunities. The openexchange of goods, capital andinformationand the transfer of technology and ideasstimulatesprivate sector development. Thisoccurs through several mechanisms:open markets, good-quality foreigninvestment, effective development aidand efficient transfers of technology and knowledge. It requires suchreforms as dismantling the agri-cultural subsidies and other formsof protection that so evidently impede export-oriented privatesector development in the ruralareas of developing countries.

There is broad agreement that openmarkets have supported economicgrowth. The advantages, while well catalogued, merit repeating.An open trade policy fostersproductivity growth by openingthe private sector to competition.Free trade helps countries allocatetheir resources towards their mostproductive areas of comparativeadvantage. Cheaper imports raise

the domestic standard of livingand allow for the use of lower costinputs as the private sector producesfor domestic or foreign customers.Such a regime provides open marketaccess through lower tariff andnontariff barriers.

Domestic macro environment The central elements of a strongdomestic macro environment forbusiness include peace and politicalstability, good governance with policy predictability, transparency andaccountability, and sound macro-economic policies. For businesses,internal or external conflict increasescost and uncertainty, deterring bothdomestic and foreign investment. Worse, conflict forestalls privatesector development, because it oftenleads to the tragic destruction of

human capital, the misallocation of scarce public funds, the devastation of land, the seizure of natural resourcesand the elimination of market access.

Physical and

social infrastructureA countrys physical and socialinfrastructure includes roads, power,ports, water and telecommunicationsas well as basic education and health.Building up these basic services hasa dual benefit: improving the livesof poor people directly and enablingthe growth of businesses.

Technical inefficiencies in roads,

railways, power and water alonecaused an estimated $55 billion a year in losses in the early 1990san amount equal to 1% of theGDP of developing countriesor twice the annual budget forfinancing infrastructure in thedeveloping world.These losses fallon firms large and smalland onindividuals, especially the poorest.

Low quality roads can shut smallproducers off from regional marketsand encumber large producers withshortages of critical inputs.

Well-maintained infrastructureimproves commerce by speedingthe transport of goods and raw materials, sustaining energy-intensive production and makinginformation readily accessibleand communication timely. Poorphysical infrastructure oftenprecludes business activity.

Ensuring connectivity throughtelecommunications and information

technology has become particularly important in recent years, helpingto overcome some of the barriers of inadequate physical infrastructure.Efficient access to information isclearly a vital part of the basic infra-structure need of modern economies.


Pillars of entrepreneurship

Foundations forthe private sector

Levelplaying

field

Access tofinancing

Access toskills and

knowledge

Rule of law

Physical and social infrastructure

Domestic macro environment

Global macro environment

Private sector growth

F I G U R E 2 . 3 F O U N D AT I O N S F O R T H E P R I VAT E S E C T O RA N D P I L L A R S O F E N T R E P R E N E U R S H I P


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Maintaining high quality physicalinfrastructure is largely, but notsolely, a matter of capital investment.Efficient contracting, open bidding,regulatory credibility and privateand public managerial capability carry weight as well.

Studies demonstrating the socialand private returns from investmentsin education and health spotlighttheir efficacy. High levels of investment in human capital,especially in education and health,lay the groundwork for privatesector growth. A healthy, educated workforce is a productive workforce.One need look only at countries

ravaged by poor health or diseaseto see the deleterious effects of an underfinanced or inadequatehealth infrastructure on previously productive economies. Private firmsprofit from investments in education,from primary to university, fromuniversal to targeted. Ensuring thatsuch education is appropriate for afuture workforce is a core task of a well-functioning education

infrastructure. Educating womenhas particularly positive effects ontheir future earningsand societys.

Investments in health and educationinvolve both the public and privatesectors, and counter to conventionalbelief, many education and healthservices in developing countries aredelivered through private initiatives,including cooperatives and mutual

health insurance organizations. Insome systems 7080% of health careexpenditures are through privateactors. Often, but not always,private involvement is a responseto government underinvestments.

Improving the social infrastructureand ensuring that those survivingon the lowest incomes have accessto affordable and high quality health and education services is animportant foundation for privatesector development.

The rule of law The rule of law means thatgovernment decisions are madeaccording to a set of written laws andrules, to be followed by every citizen. The rules are applied consistently,administered by a professionalbureaucracy and adjudicated by afair and transparent judiciary that isadequately compensated. In nearly

all cases, courts provide reasons fortheir decisions based on the law,through some form of due process.Countries may subscribe to differentlegal systems arising from differentpolitical and social cultures, but thefair administration and enforcementof a just system of laws is a cardinalprinciple. Both elements matterlaws and their administration.

Laws form an intrinsic layer of the foundation for a robust privatesector. Without a transparent legalframework and a fair judicial andadministrative system, other effortsto foster private sector developmentcannot work as intended, and may even do harm. Home governmentsmust establish the rules of the game,a system that reduces transactioncosts by making them predictable

and enforceable. Legal and admin-istrative systems influence whetherand how transactions take place.

The rule of law manifests itself inthe private sector with commerciallaws, customs laws and contractlaws, among others. Critically,the assignment and protection of

property rights circumscribe privatesector behaviour. Confusing andcontradictory legal systems makeformal business practices difficultand push businesses to become orremain informal. Poor legislationbuttresses oligarchic and corruptfirms against competitive forces,often at the expense of smalland medium enterprises. Cosy relationships between business and

regulator impair the developmentof open, free market competition.

The poor are likely to be the first victims of lawlessness.

Even though a written set of lawsmay exist, the legal system in many

developing countries works informally.In the shift from informal to formalsystems, many countries have oldand new systems coexisting, often inconflict. The loser is often the moreformal new system, implemented ina shallow and ineffective manner.One estimate suggests that as many as 80% of the legal issues facing thepoor are addressed through customary or informal systems.

Corruption and confusion over theenforcement of rules are often toblame for high compliance costs.Bureaucratic red tape, backlogs,arbitrary decisionmaking and otheronerous requirements and inefficientpractices hamper private activity.Arbitrary or corrupt enforcementsubvert laws intended as benevolentprotections, including laws for worker

safety, environmental protectionand consumer safety. And corruptpractices distort prices and markets,and hinder free and fair competition.

The World Bank estimates thatcorruption can reduce a countrysgrowth rate by 0.5 to 1.0 percentagepoints a year.Transparency Internationals CorruptionPerception Index could, with



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very few exceptions, almostbe ordered by incomepoorercountries are almost universally rated more corrupt, though thereis plenty of recent evidence thatcorruption is not limited to lowerincome categories.

THREE PILLARS OFENTREPRENEURSHIPTOO OFTEN MISSING

Even with strong macroeconomicand institutional foundations, threeadditional factors are indispensablefor entrepreneurship and the privatesector to flourish in an economy: alevel playing field, access to finance,and knowledge and skills.

A level playing fieldwith fair rules, fairly enforcedPerhaps most important in allowingentrepreneurship and the privatesector to blossom is a level playingfield for firms competing in thedomestic market. That can becreated only by a system of rulesand enforcement mechanisms that

is fair, trustworthy and effective.Predictable rules ensure thatentrepreneurs have open accessto markets and can do businessefficiently. And basic trust in thesystem encourages entrepreneurshipand attracts talent (local, foreignand diaspora) to embark onentrepreneurial ventures.

Good rules are a critical element in

creating a level playing field, andeffective regulations are essentialfor the market economy. Rules, if excessively complex and incorrectly applied, can turn into significantbarriers for enterprises and hamperbusiness growth. This applies to rulesfor entry, operating, market and exit.

Entry rules. Excessive proceduralrequirements for business registration

and licensing procedures raise thecost of entry into the formal sectorand tilt the playing field in many developing countries (figure 2.4).For example, the World Banks Costof Doing Business survey estimatesthat starting a business requires

$5,531 in Angola (more than eighttimes the per capita income) andabout $28 in New Zealand (far lessthan 1% of the per capita income).Cumbersome entry regulationsare directly correlated with lowerproductivity. When countries areranked by ease of starting a business,the top quartile of countries haslabour productivity of about $40per worker, almost twice that of the

bottom quartile. Longer registrationprocesses are directly associated with higher levels of corruption.

Operating rules. Disclosurerequirements can have a positiveimpact at the industry and businessenvironment by giving consumersand investors the information they

need to make choices about theproducts they purchase and thecapital they allocate. Labour marketrules are critical to protectingemployees from exploitation. Buta number of developing countrieshave excessively complex labour

rules, more than wealthier countries.For laying off employees, companiesin middle and low income nationsface higher barriers on average thantheir counterparts in developedeconomies. The mechanisms forsocial dialogue to find ways of mitigating the effects of layoffs,and safety nets to protect the poorare often weak or non-existentin most developing countries.

Moreover, rigid employmentregulations are associated withhigher female unemployment.Note, however, that few of theserules are regularly enforced,makingthe case for simpler rules with


F I G U R E 2 . 4 E N T E R P R I S E S I N L O W I N C O M E C O U N T R I E SFA C E M A N Y M O R E B U R D E N S W H E N R E G I S T E R I N G

Number of procedures

Duration(days)

Note: Low and lower middle-income countries had GDP per capita (purchasing powerparity) of less than $2,976 in 2001, upper middle-income countries were between

$2,976 and $9,205, and high income countries were above $9,205.

Source: World Bank (2003a)

Income

Low andlower

middle

Uppermiddle

High

11

11

8

70

58

42

115

29

17

Cost (% of GNI per capita)

I Enterprisesin low andlower middleincomecountries facethe longestduration andthe highestcost (as apercent of GNIper capita).


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better enforcement. Complex taxrules and structures also imposehigh costs that fall more on smalland medium enterprises than onlarge enterprises, which can affordtax experts.

Credit rules. Many countries lack rules for sharing credit information, which makes it virtually impossiblefor creditors to check how indebted apotential client already is. In addition,creditors have limited protection inthe case of default, significantly lessening their willingness to assumethe risks associated with small andmedium enterprise lending.

Tax rules. High tax rates andcomplex tax administration is asignificant constraint for small andmedium enterprises and can leadthem to the informal sector if taxburdens become excessive.

A large informal economy canmean lower government revenuesand higher taxes for firms in theformal economy, creating moreincentives for informal operation.For example, in Brazil the informaleconomy grew as tax revenuesincreased from 24% of GDP in1991 to 29% in 1999.

Market rules. Barriers in the landmarket are high in many nations.For example, it takes about 168steps, involving 53 public and privateagencies and 1325 years to acquireinformal land and receive legal

title to it in the Philippines. Thisarduous process discourages peoplefrom formally purchasing land,making it impossible to use landas collateral for getting credit, oneof the main sources of capital indeveloped countries.

Product market barriers alsostifle growth. Subsidies and tradebarriers in the developed worldare the biggest culprits. But many developing countries also raisebarriers to entrysay, by forbiddingsmall companies to distributeelectricity in rural areas, even when state monopolies do notserve those areas.

Restrictions on pricing can alsocloud the business environment.For example, many governmentscharge excessively high prices forfixed-line domestic and internationaltelecommunications services. Themonopolies that operate in these

conditions are highly profitable as aresult, but their capital and labourproductivity are low. The highprices provide few incentives fortelecommunications players to usetheir resources more effectively.

Exit rules. Inadequate bankruptcy rules and protections can createadditional hurdles for financingenterprises. Countries with better

insolvency regulations tend to havemore and cheaper lending.

Poor enforcement by formalinstitutions permits enterprisesto avoid some or all of these rules,advantaging some of them overothers. Breakdowns in formalinstitutions occur when officialsdo not have the skill or will tocarry out their oversight functions.Government officials may not havethe will to enforce the laws becausethe institutions they work for donot provide the right incentives. The institutions may not rewardofficials for applying the law fairly and equally, and the organizationsmay lack transparency and may notsupervise officials sufficiently. Inaddition, government officials may

not have the skills and resourcesthey need to enforce the laws.

They often require additionaltraining or tools.

Access to financing While foreign direct investment

has had an essential role in thedevelopment process, it is impossiblefor a country to progress withoutdomestic investment based ondomestic savings. This requiresdomestic financial institutionsthat can efficiently manage risk and allocate capital to productiveinvestments. Many developingcountries have had weak, state-dominated financial sectors unableto act as a catalyst for development.But where genuine reform has beenimplemented, the benefits havebeen quick and evident, even if creating and restructuring anefficient domestic financial sectoris a long task.

Large companies are well servedby existing banking systems, andthere has been good progress inmicrofinance over the last 10 years

with 41 million poor people servedin more than 65 countries. But theprogress on small and mediumenterprise financing has been slow at best. It is not only about money needed, though. Small and mediumenterprises are risky ventures. They require risk capital, but the sourcesof such capital are difficult to tap.So small and medium enterprisesgenerally have to turn to classic debtfinancing. This can be difficult forthem, because few entrepreneurs indeveloping countries can leverageassets as collateral the way they do indeveloped countries. Why? Mainly because of informal property rightsand the lack of mortgage markets.Collateral requirements act as ascreen that selects wealthy borrowersand crowds out many entrepreneurs

with high growth potential.



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Most emerging markets finance upto 90% of their investments locally,although for Sub-Saharan Africathe figure is closer to 65%(and most productive enterprisesgenerate revenue in local currency,so the reliance on local financingis sustainable). Private credit as apercentage of GDP rises from12% in low income countriesto 25% in lower middle-incomecountries, 30% in upper middle-income countries and 85% inhigh income countries.

A web of factors is at work, morethan just the lack of capital.

I Rules and their enforcement areoften at the core. Most countrieshave weak property rights,making the use of assets ascollateral difficult. Even whenproperty rights are well defined,the enforcement of mortgagecontracts is often impossible,for both political and judicialreasons. In addition, bankruptcy laws are typically lacking,

increasing the risk to creditorsand further deterring themfrom investing in small andmedium enterprises.

I Poor financial institutionsare also a problem. Domesticfinancial institutions can operatein oligopolistic or monopolisticconditions, with limited share-holder pressure to enter new andmore difficult markets, such as

lending to small and mediumenterprises. Added to the lack of incentives is the publicborrowing that crowds outprivate borrowing.

I Even when financial institutionshave the will, they often lack the skills for small and mediumenterprise lending. Banks are

accustomed to full-blown risk assessments working with largeclientstoo costly for smalland medium enterprises.At the other end of the spectrummicrofinance institutions lend with very limited analysis, relying mostly on social networks for repayment. This does not work well for thelarger amounts that small andmedium enterprises require.

I A lack of reliable credit informationalso hampers the growth of small and medium enterpriselendingusually because thereare no credit information agenciesand disclosure requirements are weak or not enforced.

I Investors lack exit opportunities.Capital markets are absent orhighly illiquid in many poorcountries, making public offeringsimpossible. Private offeringscan work, but most markets arefar from liquid, with very few transaction opportunities.

I Entrepreneurs often lack the skilland the will for receiving risk capital. On skill, managementtalent is limited. On will,private equity investors reportthe reluctance of small andmedium enterprises to opentheir books to outsiders inenvironments where parallelaccounting is widespread.

Access to skills and knowledge Technological innovations and theshift towards knowledge-basedeconomies make human capitalinvestment a prerequisite forsustained economic growth andcentral to the start-up, growthand productivity of firms. Humancapital can determine the potentialfor a firms growth and survival.

It contributes directly to a firmsproductivity by enabling theadoption of innovative technologiesand processes. A firms competitiveadvantage comes from itsentrepreneurial capabilities;its management and technicalknow-how, including labour-management relations; and theskills, education and adaptability of its employees.

The level of education matters,and the skills of employees need tobe continually upgraded throughon-the-job training to increase thefirms productivity and its ability toabsorb new technologies. In Costa

Rica, Mauritius and Singapore theprivate sector has benefited from a

virtuous cycle with formal educationreinforced by on-the-job learningand training. Costa Rica has themost software exports per capitain Latin America, making it atechnological hub in the region,thanks to its investments in bothbasic education (producing oneof the highest literacy rates) and

technical education.Many developing countries sufferfrom low levels of human capitalinvestment, aggravated by theoutward migration of highly skilledprofessionals. The cumulativebrain drain since 1990 has beenestimated at 15% for CentralAmerica, 6% for Africa, 5% forAsia and 3% for South America.

The International Organizationfor Migration estimates that some300,000 professionals from theAfrican continent live and work in Europe and North America.



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By some estimates up to a thirdof R&D professionals fromthe developing world reside inOECD countries.

This persistent brain drain deprivesdeveloping countries of the know-how

of thousands of their most talentedpeople. It reduces the stock of human capital at home, erodes thedomestic tax base and shrinks theeducated middle class, a stabilizingfactor in most societies.

The migration of talented risk-seeking entrepreneurs from thedeveloping world seeking opportu-nities in more entrepreneurially minded societies spotlights theobstacles to starting and scaling upbusinesses in their native countries. The underlying cause is a disablingsocial environment that limits boththe number of potential entrepreneursand the degree to which they canunfold their potential.

I I I

This diagnosis of the structureof the private sector and theconstraints to its rapid growthapplies in differing degrees across a wide range of developing countries.

The balance among the differentfactors varies with income,institutional development andthe composition of the privatesector. Addressing the constraintsto unleash the potential of the private sector will requireprogrammes tailored to the needsof individual countries, but theunderlying approaches will bebroadly similar. We turn to

them now.



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P h o t o :

E v a n

S c h n e

i d e r /

U N D P

he Commission acknowledges that the constraintson developing a sustainable private sector are widelyknownand generally accepted. So are the keyelements of policies for addressing them.The big

challenge is moving from an understanding of the broad constraints toputting together specific, country packages. Now the focus must shift fromdetermining what the constraints are to how they are to be lifted andwho is to lift them. Here we examine the policies and administrative stepsthat can alleviate these constraints and help create the capacity needed togovern transactions, capacity that is vital to the development of the privatesector and to the efficient functioning of a market economy.

The Commission has emphasized that the private sector is important to thepoor in many ways. If the benefits of reform are clearly articulated and theresults of reform are quickly evident, constructive approaches to private sectodevelopment can translate into greater political support. And the momentumand consensus for change that this creates can provide the springboard fora comprehensive programme of reform and change.

C H A P T E R 3

UNLEASHING THE POTENTIAOF THE PRIVATE SECTOR


I


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Some broad lessons of experience:

I Successful policy reforms havegenerally been those in whichconcerned governments andpolicymakers have made strongand voluntary commitmentsto change.

I

Reforms linked to conditionality rarely succeed when implementinggovernments are not committedto them.

I Significant changes often occur when countries are faced withmajor economic crisis (India in1991, East Asia in the late 1990s),and the response to these changescan be rapid. Of course, it is betternot to wait for a crisis to reform.

I

Changes can also follow major shifts in basic economicphilosophy (China, Vietnamand Eastern Europe).

I New governments that replaceprevious regimes with a history

of poor governance (Kenya,Nigeria in the past few years)can often use the impetus of change to implement reforms.

I Changes almost alwaysinclude new roles for the localprivate sector and civil society organizations, including employerand worker organizations.

I Technology is the agent for muchof the needed change, and new technology enables change to beimplemented much faster thanmight generally be expected.

Support to private sectordevelopmentboth global andnationalcan involve economicresearch, macro and sector policy

advice, technical assistance anddirect financial support to specificprivate sector projects. Barringthe latter, the bulk of theseinterventions involve governmentsand public institutions directingtheir support to governments andpublic institutions in developingcountries (figure 3.1).

The main public players in thisfield are the World Bank Group(including the InternationalFinance Corporation and theMultilateral Investment GuaranteeAgency) and the InternationalMonetary Fund. The regionaldevelopment banks, including theAsian Development Bank, theAfrican Development Bank, theEuropean Bank for Reconstructionand Development and the Inter-American Development Bank, arealso focused on helping to createthe enabling environment forentrepreneurial development intheir respective regions. Importantroles are also being played by the Organisation for EconomicCo-operation and Developmentin research and policy, and by themajor UN specialized organizationssuch as the United Nations IndustrialDevelopment Organization, theUnited Nations Conference on

Trade and Development, theInternational Labour Organizationand the United Nations Development

Programme. Bilateral agencies andinstitutions (such as the UnitedStates Agency for InternationalDevelopment, the U.K. Departmentfor International Development, theCanadian International DevelopmentAgency and the NetherlandsDevelopment Finance Company)are also focused on importantelements of the task, includingenhancing access to capital and

supporting the development of micro entrepreneurs and smalland medium enterprises.

The Commission believes thatany approach to private sectordevelopmentand the policy and action recommendations thataccompany itneeds to be groundedin the realization that the savings,investment and innovation that


F I G U R E 3 . 1 S T R E N G T H E N I N G T H E E F F E C T I V E N E S S O FT R A D I T I O N A L P R I VAT E S E C T O R D E V E L O P M E N T A C T I V I T I E S

Driven by privatesector playersI CompaniesI Civil society

organizationsI Foundations

Driven by publicsector playersI Local

governmentsI Donor

governmentsI Development

agencies

Targeted at publicsector players

I Setting broader standards(industry norms,sustainability,corporate governance)

I Lobbying for policy changesI Promoting participatory

processes throughsocial dialogue

I Policy reformI Policy adviceI Funding and delivering

technical assistance forpublic sector reforms

I Financial transfers(aid, loans)

Targeted at privatesector players

I Business linkages andpartnerships

I Investment, includingforeign direct investment

I Mentorship forentrepreneurs

I Public-private partnerships,for example, for basicservice delivery

I Public-privateconsultative bodies

I Privatization or contractingI Investment promotionI Direct business

development servicesI Direct financing


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lead to development are undertakenprimarily by private individuals,corporations and communities.Governments should thus actas facilitators of private sectordevelopment and avoid actionsthat impede it. Governments andintergovernmental agencies canfacilitate private sector developmentonly by fostering properly functioningcompetitive markets.

unleashing entrepreneurship

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