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«Policy Research Working Paper 5313 Public Disclosure Authorized Growth Identification and Facilitation The Role of the State in the Dynamics of ...»

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 Sixth, the government may also provide limited incentives to domestic pioneer firms or foreign investors that work within the list of industries identified in step 1 in order to compensate for the non-rival, public knowledge created by their investments. The incentives should be limited both in time and in financial cost. They may be in the form of a corporate income tax holiday for a limited number of years,40 directed credits to cofinance investments, or priority access to foreign reserves41 to import key equipment. The incentives should not and need not be in the form of monopoly rent, high tariffs, or other distortions. Therefore, the risk of rent seeking and political capture can be avoided.42 For


  2006). Ethiopia’s success in cut flowers exports is another example. Before the government’s identification of cut flowers export and provision of supports in its industrial policy in the 1990s, a local pirate firm had exported cut flowers to the European market for over 10 years. Asparagus in Peru is also a good example. The possibility of growing asparagus, a foreign crop, was self-discovered by Peruvian farmers in the 1950s. However, the industry and export did not take off in earnest until 1985 when USAID provided a grant for a farmers’ association to obtain advice from a specialist from University of California, Davis, who had recently invented the UC-157 variety that was suitable for the U.S. market, and from another expert who showed members of the association’s experimental station how to set up seedbeds for large scale production and package the products for export. The state also supported cooperative institutions such as the Peruvian Asparagus Institute and Frio Aereo Associacion Civil for engaging in research, technology transfer, market studies, export drives, and quality promotion. Furthermore, the state invested in the freezing and packing plants that handled 80 percent of fresh asparagus exports. With these interventions, Peru has overtaken China and become the largest asparagus exporter in the world (O’Brien and Rodriguez 2004).

In addition to infrastructure, many African countries, for instance, also face the constraint of rigid labor regulation. To overcome that constraint, Mauritius has allowed labor employment to be flexible in the export process zone while maintaining the existing regulation for the domestic economy (Mistry and Treebhohun 2009).

40 The commonly used measure in China to attract foreign direct investment is to exempt the corporate income tax for the first two years and reduce the tax by half for additional three years.

41 Direct credits and access to foreign reserves are desirable measures in countries with financial depressions and with foreign exchange control.

42 The likelihood of capture is proportional to the magnitude of protection and subsidies. If the targeted industries are consistent with the country’s inherent comparative advantages, the protection and subsidies are used to compensate the pioneer firms for their positive information externalities, the magnitude of protection and subsidies should be small, and the elites will not have the incentives to use their political capital to capture the small rent. In addition, once the pioneering firms are successful, many new firms will enter and the market will be competitive.

That will further reduce the danger of capture by elites. Alternatively, if the government’s goal is to support the development of industries that go against the country’s comparative advantages, the firms in the targeted industries will not be viable in competitive markets and the required subsidies and protections for the firms will be large, which are likely to become the target of rent-seeking and political capture (Lin 2009).

20    firms in step 4 that discovered new industries successfully by themselves, the government may award them with special recognition for their contributions to the country’s economic development.43 The industries identified through the above process should be consistent with the country’s latent comparative advantage. Once the pioneer firms enter successfully, many other firms will enter these industries as well. The government’s facilitating role is mainly restricted to provision of information, coordination of hard and soft infrastructure improvement, and compensation for externalities. Government facilitation through the above approach is likely to help developing countries tap into the potential of the advantage of backwardness and realize a dynamic and sustained growth.

Possible Ways of Identifying Binding Constraints

The facilitation of industrial growth has been the subject of a rich body of research and several approaches have recently been suggested by various authors.44 While all these suggested approaches are likely to yield useful results, none of them focuses specifically on the identification of industries in which a developing country may have latent comparative advantage. The intellectual legacy of the failure of industrial policies based on development strategies that were inconsistent with comparative advantage has certainly led many economists to conclude that it may be impossible for any government to successfully “pick winners”.

In the absence of a framework for industrial identification, the existing literature has been limited to exploring ways of improving the business environment and infrastructure, which indeed affect firms’ operations and transaction costs. There is a robust empirical knowledge based on quantitative data on firm performance and perceptions-based data on the severity of a number of potential constraints facing firms in the developing world. It points out that in most of SubSaharan Africa, firms, for instance, tend to consider many areas of the investment climate major obstacles to business development and the adoption of more sophisticated technology. Finance and access to land seem to be areas of particular concern to smaller firms; larger firms tend to perceive labor regulations and the availability of skilled labor as the main constraints to their activity; firms across the board are concerned about corruption and infrastructure—especially network utilities such as electricity, telecommunications, transportation, and water (Gelb et al.


Despite their usefulness, investment climate surveys, which try to capture the policy and institutional environment within which firms operate, can be misused or misinterpreted. Just as individual perceptions of well-being are subjective and do not necessarily correlate with objective measures such as income or consumption, firms’ perceptions of binding constraints to their development often differ from actual determinants of performance. This limitation is due to the very nature of the investment climate data and the way it is often used. In a typical survey, the managers of a sample of firms are asked to rate each dimension of the investment climate (such as “infrastructure,” “access to financing,” “corruption,” etc.) on a scale of 1 to 4,

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corresponding to the degree to which it is an obstacle to firm performance.45 High mean reported values for particular dimensions of the investment climate are then interpreted as evidence of the severity of obstacles to growth.

However, this may not be the case. Perceptions of the degree to which some investment climate variables differ from the actual effect of these variables on firm productivity, business performance, or firm growth. Despite their intimate knowledge of their business processes and operating environment, firms may not fully recognize the true origin of their main problems and mistakenly identify as a constraint something which is in fact a symptom of another less obvious problem. Because of these shortcomings, investment climate constraints are increasingly complemented by the World Bank “Doing Business” indicators, which are based on expert surveys (not just firm-level perceptions) and provide a more comparable cross-country perspective across a detailed range of regulation.

The problem remains, as survey results often vary depending on whether respondents are asked to rate their most important constraints, or to rank them. While ranking appears to be favored by researchers who have examined different methodologies, as it forces stronger expression and relationships (Alvin and Krosnick 1985), it may not be entirely reliable: firms or experts who are asked to rank constraints may not have a good basis for determining whether their top-ranked constraint is serious or not. Ranking without a solid and meaningful benchmark against which local firms in a given country can rate the severity of a particular constraint may not provide useful information. In addition, there are instances where picking any single quantitative criterion could be misleading, as firms often face several constraints simultaneously. Ranking all of them as important may not be very helpful for policymaking. In order to account for the major role of firm heterogeneity in growth analysis, one must go beyond extracting means of investment climate variables from firm-level surveys. Careful econometric modeling of firm performance is therefore needed to identify which particular variable has the biggest effect on growth. In other words, the policy variables with the greatest economic impact can be quite different from the policy variables with the highest perceived values.46 Investment climate surveys have two more limitations: they do not provide information about industries that do not yet exist, but in which a country has latent comparative advantage.

Moreover, the existing industries that are surveyed may not be consistent with the country’s comparative advantage, either because they are too advanced (as a legacy of a development strategy that defied comparative advantage), or because they have become fundamentally uncompetitive (as a result of a general wage increase that accompanied the country’s development). These two additional limitations make it highly desirable for investment climate


Ayyagari et al. (2005) present the mean reported values for a number of investment climate variables in a sample of over 6,000 firms in 80 countries. In the overall sample, taxes and regulation, political instability, inflation, and financing are reported as being the greatest obstacles to firm growth.

Bourguignon (2006) observes: “‘Extracting means’ is the way I would characterize the Investment Climate Assessment exercises that the Bank is now carrying out. Like the ‘Doing Business’ indicators, these are undoubtedly useful. However, what they give us is essentially new and better right hand side variables in cross-country regressions, not necessarily better data for country-specific analysis. The goal should be to use investment climate surveys to measure the sensitivity of firms of different types to investment climate variables, as another way of determining exactly which variable corresponds to a major obstacle to growth.” 22    surveys to only cover a sample of firms that meet the criteria of viability, and can represent the true economy’s potential.

Another important problem with the recognition of obstacles to growth is the fact that many other constraints to business development are endogenous to the industries that might be targeted by a developing country. Good examples are specific types of human capital, financing instruments, or infrastructure that may only be needed by firms moving to specific industries.

Identifying and removing them may require the use of several complementary analytical tools.

One useful tool is the Growth Diagnostics Framework suggested by Haussman, Rodrik and Velasco (2008). It is based on the observation that when presented with a laundry list of needed reforms, policymakers either struggle to try to solve all of the problems at once or start with reforms that are not critical to their country’s growth potential. Because reforms in one area may create unanticipated distortions in another area, focusing in the one that represents the biggest hurdle to growth is the most promising avenue to success. Therefore, countries should figure out the one or two most binding constraints on their economies and then focus on lifting those.

The Growth Diagnostics approach provides a decision tree methodology to help identify the relevant binding constraints for any given country. It starts with a taxonomy of possible causes of low growth in developing countries, which generally suffer from either a high cost of finance (due either to low economic and social returns or to a large gap between social and private returns), or low private return on investment. The main step in the diagnostic analysis is to figure out which of these conditions more accurately characterizes the economy in question. The use of that framework highlights the fact that in some countries, the growth strategy should identify the reasons for the low returns on investment, while it must explain why domestic savings do not rise to exploit large returns on investment in other countries. While the Growth Diagnostics Framework attempts to take the policy discussion of growth forward, its focus and the specification of its model remain quite macroeconomic. This is understandable, after all, growth is a macroeconomic concept and taking the analysis to a sector level would raise issues of sector interactions and trade-offs.

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