House of Commons - International Development

Select Committee on International Development Fourth Report

2 UNDERSTANDING PRIVATE SECTOR DEVELOPMENT

8. We sought first to understand what and whom constitutes the 'private sector'. This is a wide-ranging term covering all private actors engaged in economic activity, from the market stall-holder and family farmer to large domestic and foreign corporations.[12] It is estimated that 90% of people in sub-Saharan Africa are in the private sector[13]; the Secretary of State for International Development recently stated, "Poor people are the private sector, they are the farmers and small businesses that we are trying to help".[14] The enduring stereotype of the international private sector as consisting primarily of multinational corporations is a false vision. 80% of investment in Africa, for example, is domestic.[15]

9. The links between the private sector and poverty reduction are manifold. The rate of economic growth necessary to accelerate progress towards the MDGs — for Africa, 7% by 2010, an increase from current levels close to 3%[16] — will only be achieved with major increases in profitable investment by the private sector. Private sector investment generates jobs and higher wage income; it boosts national savings; enhances the national tax base, permitting higher public spending on basic services such as education and health, and it strengthens civil society and popular participation in national development.[17]

10. Private sector development underlines the central importance of economic growth in reducing poverty. Robust growth rates generate the crucial financial resources to meet education, health, water and poverty targets. Higher growth rates are correlated with increased poverty reduction (see Figure 1). Indeed, approximately 75 to 80% of the variations in poverty reduction across countries over the last 20 years are explained by differing growth rates.[18] Asia's high growth economic model has seen a number of 'tiger economies' burst into the international business scene over the last 20 years, simultaneously pulling millions of people out of poverty. Vietnam, for example, saw annual per capita growth rates of 6% contribute to poverty reduction of 8% a year over the 1990s.[19] China's 10% growth rates are estimated to have lifted 400 million people out of poverty over the last 20 years.[20]

Countries with higher overall growth rates also saw higher growth in incomes of poor people. Points above the 45-degree line indicate incomes of poor people rising faster than average incomes.

DFID, 'What is Pro-Poor Growth and Why Do We Need to Know', Pro-Poor Briefing Note 1 (London: DFID, 2004)

Pro-poor growth

11. However, it is increasingly acknowledged that growth is a necessary, but not sufficient, condition for reducing poverty. Quality of growth is as important as the pace of growth: high quality growth is "grounded in human rights and justice [...] and builds upon participation, transparency and human empowerment".[21] Countries can have similar levels of growth yet achieve poverty reduction at different speeds. Dr. Claire Melamed of Christian Aid gave the Committee the example of Tunisia and Senegal, whose poverty reduction rates have differed by a factor of two to Tunisia's advantage, despite having almost exactly the same growth rates.[22] This variance is partly due to inequalities within countries and government policies for addressing poverty. But the rate and redistributive nature of growth are also pivotal. Over the last decade, the term 'pro-poor growth' has emerged to reflect a new way of looking at how growth and changes in inequality together affect poverty reduction.[23]

12. So what exactly differentiates 'pro-poor' growth? There are two key reasons why growth may not be pro-poor. Firstly, growth rates may be too negligible to affect poverty — especially if they are lower than population growth — and secondly, inequality levels may compromise growth's ability to engage all sectors of society.[24] There is a triangular relationship between growth, inequality and poverty[25], as is being borne out in China, where, despite a high growth rate, rising inequality has slowed the rate of poverty reduction since 2000.[26] Inequality, however, is not the only determinant affecting growth's ability to be 'pro-poor'. Countries afflicted by the 'resource curse'[27] demonstrate that the pattern of growth is also significant. Such countries — including Nigeria, Chad, Equatorial Guinea and the Democratic Republic of Congo — tend to experience short periods of high growth that is not sustained and fails to benefit the poor because of a damaging combination of economic dependency, corruption and conflict.[28]

Constraints to private sector development

13. The private sector has the ability to deliver pro-poor growth through driving entrepreneurship, job creation and rising incomes. The private sector's capacity to do this, however, is shaped by the environment set for it.[29] The climate in which investment takes place varies from country to country and in many contexts the private sector will be subject to a number of constraints. Countries wishing to attract foreign investment must, for example, have appropriate laws, regulations and institutions in place.[30] There is evidence that if these 'macro-level' constraints are addressed — that is, the rule of law is enhanced, regulation eased (but, where it is necessary, rigorously implemented), tax revenue collected efficiently and corruption reduced — new business entry and growth will be encouraged.[31]

14. Macroeconomic policy (especially monetary policy), plus public spending and taxation levels, exert a profound influence on the preparedness of companies to invest.[32] The World Bank estimates that as a result of investment climate improvements in the 1980s and 1990s, private investment as a share of GDP nearly doubled in China and India; in Uganda it more than doubled.[33] A poor investment climate and weak regulation will tend to push private sector activity into the informal economy, thereby blocking potential tax revenues and limiting returns and opportunities for growth for entrepreneurs. Developing countries often have a reputation for cumbersome bureaucracy, red tape and inefficiency, and changing this image (and reality) will take sustained efforts.[34] Conflict is also a major obstacle to PSD at the macro-level.[35]

15. Micro-level constraints also act as serious obstacles to investment. Access to finance — often microfinance where the Small and Medium-sized Enterprise (SME) sector is concerned — especially credit, is clearly crucial in order for the private sector to flourish, especially for SMEs and for potential business start-ups. Evidence suggests that prosperous areas have higher levels of business start-ups than poorer regions.[36] Analysis of the challenges facing SMEs in China, for example, has tended to focus on credit constraints, generally relating to the low levels of finance provided by the banking sector to private companies.[37]

16. Major impediments to private sector development also exist at the 'meso-level'.[38] The primary issue here is inappropriate, low-quality or non-existent infrastructure. Efficient transportation, telecommunications and energy infrastructure can help open new markets and encourage them to work for poor people.[39] Conversely, weak infrastructure can greatly inhibit markets: in Uganda, for example, transport costs add the equivalent of an 80% tax on clothing exports.[40] In addition to infrastructure, other resource inputs that may be constrained include human resources, especially skilled personnel, business development services and market intelligence.

Donor approaches to private sector development

17. We considered how donors can best stimulate and sustain private sector development. This has been a subject of debate over the past two decades. Donors' interest in PSD was triggered by a number of factors: the pre-dominance of the market-economy system after the end of the Cold War; the process of globalisation and concomitant growth in international trade; increasing evidence of the links between growth and poverty reduction; rising migration flows — all these factors have contributed to a growing recognition of the role of growth in poverty reduction, and of the private sector in driving growth.[41]

18. In the 1980s and 1990s, donor policies on PSD tended to centre on direct intervention in markets. Development agencies attempted to provide and implement market inputs — finance, technical advice, contacts, business development strategies — themselves. Yet acting as a direct player within the market proved largely not to work, possibly because this approach involved addressing the symptoms of dysfunctional markets (for instance, business problems and access to finance) rather than the causes (systemic weaknesses such as the macro-economic framework and the investment climate).[42]

19. A number of major surveys at the end of the 1990s responded to these problems and highlighted the distortions and dependencies that can develop in markets following direct donor intervention.[43] Market intervention by the public sector risks crowding out the indigenous private sector in developing countries and even jeopardising public provision of goods and services — for instance, within healthcare — by supporting private providers.[44] The late 1990s reviews indicated that more effective donor strategies focused on market development (as opposed to intervention) — focusing on providing business development services, facilitating systemic changes to improve market conditions and providing inputs where appropriate.

20. A theoretical framework for a new approach to PSD began to develop, a strategy that became known as Making Markets Work for the Poor (MMWP). A MMWP approach is based on the need to understand market systems, looking at systemic factors from the perspective of poor people.[45]The Approach retains a degree of the interventionist strategy of the 1980s and 1990s but learns from previous mistakes: for instance, offering business support services such as accountancy, training and technology advice instead of entering the market as a direct player. The Approach involves donors seeking to facilitate and catalyse, rather than intervene in, markets.[46] Disciples of the MMWP Approach include the Swedish International Development Cooperation Agency (SIDA), which gave substantial prominence to MMWP ideas in one of its three recent agency-wide Policy Guidelines papers.[47] Germany's development agency, GTZ, has also afforded considerable importance to the MMWP approach[48], as has USAID, particularly regarding business development services and strategies for the avoidance of market distortions.[49]

21. This brings us to the current situation vis-à-vis donor approaches to PSD, and an emerging split in donor thinking on 'what works'. A parallel stream of work to MMWP — represented by another active donor working group on the Donor Committee for Enterprise Development — is the investment climate approach (sometimes known as the 'enabling environment' approach). The World Bank and International Finance Corporation (IFC), under their Vice-President for Private Sector Development, Michael Klein, have led this school of thought. The approach focuses very clearly on cementing the building blocks for economic growth through improving investment climates — the broad business environment in which investment takes place. Measures for achieving such improvements include microfinance[50], support for entrepreneurship, addressing property rights, regulatory and taxation reforms, competition policy, infrastructure investments and anti-corruption strategies.[51] There is evidence that some developing countries engage actively and even compete with each other to promote their rankings on the league tables for attracting investment — especially in the World Bank's 'Doing Business' Reports.[52] Although the World Bank is now involved in a wide range of enabling environment reforms, it is difficult to detect a coherent strategy as yet for moving from analysis to implementation. Similarly, there is, as yet, little discussion about the measurable impacts on poverty.[53]

22. A number of bilateral donors have aligned themselves with the investment climate approach. For example, AusAID has published a White Paper that lists "improving the policy environment for growth" as its first priority in promoting growth.[54] The Canadian International Development Agency's Private Sector Development Policy also advocates the investment climate approach, together with a range of other strategies.[55]

DFID's approach to private sector development

23. So where does DFID sit on this spectrum? The Department's current approach seems to straddle both the MMWP and investment climate approaches — with an additional preference for budget support as a major conduit for DFID's support to PSD. DFID currently uses Poverty Reduction Budget Support (PRBS) in 16 countries and views this approach as particularly useful for PSD: in its written evidence, DFID told us, "Budget support is well suited to supporting macro stability (key for the private sector to thrive), and potentially also to building capacity of government agencies to support PSD."[56]

24. The merits of using budget support for PSD are contested, however: a multi-donor joint evaluation of General Budget Support, published in March 2006, tested the effects of budget support on growth and income poverty reduction and was critical in its conclusions: "A forceful critique of PRBS is that [...] it neglects growth and the development of the private sector on which growth and poverty reduction depend [...] There should be more explicit attention paid by governments and international partners to the income poverty and growth implications of public policy and expenditures."[57] Written evidence from Alan Gibson of the Springfield Centre for Business in Development also emphasises that DFID should not to rely on budget support for PSD: "Budget support [...] has limited efficacy in relation to PSD outcomes [...] DFID needs to restore greater balance to its work and complement its budget support focus with other interventions related to market development."[58]

25. But the hybrid approach currently favoured by DFID by no means favours sole reliance on budget support. DFID's submission to this inquiry and its most recent policy paper on PSD, published in December 2005, indicate commitments to both the Making Markets Work and investment climate approaches.

26. Indeed, this balanced approach is the only logical one: generating and sustaining growth, through improvements to the investment climate, and then using this growth to provide opportunities for poor people to participate in markets. DFID's policy paper uses a MMWP framework as a unifying theme for the different strands of its PSD approach (agriculture, financial services reforms, developing infrastructure etc).[59] DFID's leadership of the Investment Climate Facility and its commitment of $30 million to this nascent initiative demonstrate strong faith in the investment climate approach. Sunil Sinha, of Emerging Market Economics, saw no problem in combining these approaches:

27. We consider that DFID should retain its focus on both market development and investment climate approaches to PSD. Indeed, this balanced approach is the only logical one: generating and sustaining growth, through improvements to the investment climate, and then using this growth to provide opportunities for poor people to participate in markets. To increase the role of budget support in PSD would risk neglecting the systemic development of the private sector and markets. DFID has a real opportunity to provide intellectual leadership on a hybrid approach incorporating both market development and investment climate work. DFID should be aware of changing donor 'fashions' within PSD and attempt to carve out a sustainable, long-term model for its PSD policies.

12 Ev 326 [World Business Council for Sustainable Development] Back

13 Q 278 [Ann Grant] Back

14 Hilary Benn, First White Paper speech, 19 January 2006. Available online at http://www.dfid.gov.uk/news/files/Speeches/wp2006-speeches/growth190106.asp Back

15 World Bank, World Development Indicators (Washington: World Bank, 2004) Back

16 Commission for Africa Report, p.221. It is worth noting that the Commission calculated this projected growth rate using figures from 2000, hence the rate is likely to be higher now. Back

17 Ev 187 [Professor Keith Palmer] Back

18 Q 21 [Professor Adrian Wood] Back

19 World Bank, 'Pro-poor growth in the 1990s: Lessons and Insights from 14 Countries' (Washington: World Bank on behalf of the Operationalising Pro-Poor Growth Research Programme, 2005), p.2 and p.20. Back

20 Heather Stewart, 'All they need is a fair chance to compete', The Observer (Business), 22 January 2006. Back

21 Ev 320 Back

22 Q 463 [Dr. Claire Melamed] Back

23 For discussions of pro-poor growth, see, for instance, 'World Development Report 2006: Equity and Development' (Washington: World Bank, 2005) or DFID Pro-Poor Growth Briefing Note 1, 'What is pro-poor growth and why do we need to know?' (DFID Policy Division internal paper, February 2004). Back