Investment Climate Drivers: Does Governance and Corruption Matter? An Empirical Framework with Practical Applications Daniel Kaufmann, World Bank Institute www.worldbank.org/wbi/governance Presentation at the University of Wisconsin Business School, Madison, December 17 th, 2004 1

Key Themes 1. Improving the Investment Climate: Fundamental Challenge for Emerging Economies WDR 2005 2. All Firms: Key Actor in Driving Growth and Responding to Investment Climate 3. Some Firms: Not Passive Investment Climate Takers? 4. How Governance affects the Investment Climate 5. Learn from Variation across countries & Institutions 6. Implications and Challenges ahead 2

world development report 2005 A Better Investment Climate for Everyone 3

The investment climate: The opportunities and incentives for firms to invest productively, create jobs, and expand Private firms of all types are key actors in growth and poverty reduction Create more than 90 percent of jobs. Provide goods & services consumed in society Pay taxes for public service provision Size of contribution depends largely on the investment climate But who shapes the investment climate? 4

Accelerating Growth and Reducing Poverty Growth closely associated with poverty reduction 10 8 6 Percent per annum, 1992-98 GDP per capita growth rate Poverty reduction 4 2 0 Pakistan Bangladesh India Vietnam China Main sources of long-term growth are investment and productivity improvements -- a good investment climate drives both, and protects other social interests But also need to account for direct impacts -- jobs and self-employment are main paths out of poverty 5

Policy and Institutional costs Taxes are rarely the biggest burden in emerging economies Governance, Institutional factors are key 6

Variations within countries & across firms 25 20 Conditions vary within countries Days to obtain a mainline telephone connection % of production lost due to power outages 7 6 Small firms often suffer most Percentage of firms 75 Large 5 50 Days 15 10 4 Percent 3 2 25 Medium Small 5 1 Informal 0 Shanghai Beijing Chengdu China 0 0 Have a loan from a formal financial institution Confident that courts will uphold property rights Believe regulations will be interpreted consistently 7

Persistence, not perfection, is key No country has a perfect investment climate. Focus on important constraints, and sustain a process of ongoing improvements. Priorities need to be determined in each case Big differences across, and within, countries. Maintaining momentum is essential Public communication Consultation bodies Mechanisms to review existing constraints Processes to review new regulatory proposals. 8

Focus on delivering the basics To benefit all firms and activities in the economy Stability and security -- Peace & macroeconomic stability: fundamental -- Secure property rights; control of corruption; link effort to reward Regulation and taxation --Better regulation and taxation, not necessarily less Finance and infrastructure Workers and labor markets Skilled and healthy workforce Regulate to benefit all workers Help workers cope with change 9

Going beyond the basics? Selective interventions Many rationales, but no sure-fire strategies. More ambitious the goal, and the weaker the governance, the longer the odds of success. Not a substitute for broader improvements. Can be a distraction, and can go spectacularly wrong. International rules and standards Committing to enhance credibility Forgone flexibility; Possible legitimacy concerns. Harmonizing to reduce costs Institutional fit; competition between standards. Cooperating to address policy spillovers Common priorities; capacity constraints. 10

The international community can help Growth from better investment climate can dwarf value of aid flows Manufacturing value-added vs. global aid flows International community should do more Reduce distortions in developed countries Strengthen aid for investment climate improvements 11 Tackle substantial knowledge agenda.

Key Lessons from WDR 2005 Improving the investment climate critical to faster growth and poverty reduction. Reduce policy-related risks, costs, and barriers to competition Persistence, not perfection, key to progress International community should do more Much more than changes in formal policies the challenge of informality 12

Explosion of activities: Examples of major programs launched across countries Albania (public admin.) Latvia (anticorruption) Ukraine (tax admin) Russia (customs/treasury) Kyrgyz Republic (governance reform) Jordan (civil society) Cambodia (PE; forestry) Guatemala (diagnostic to action program) Colombia (diagnostics & civil society) Bolivia: (public admin.) Ghana (PE accountability) Gabon (water/electricity) Uganda (PRSC; education) Tanzania (PSR) Pakistan (devolution) Ethiopia (decentralization) Bangladesh (civil society) Philippines (transport) Indonesia (local governance) India Andra Pradesh (power; e-gov); Karnataka (right to info) 13

Empirical Approach to Governance 1. Macro : Worldwide Aggregate Governance Indicators: 200 countries, 6 components, periodic. 2. Mezzo : Cross-Country Surveys of Enterprises 3. Micro : Specialized, in-depth, in-country Governance and Institutional Capacity Diagnostics: Includes surveys of: i) user of public services (citizens); ii) firms, and iii) public officials On Aggregate/Macro Level first 14

The Governance Macro Level Defining and unbundling succintly The 6 dimensions of Governance: how conceptually derived, how measured The governance worldmap, & web interactivity What the Macro can and cannot do 15

Governance: A working definition Governance is the process and institutions by which authority in a country is exercised: (1) the process by which governments are selected, held accountable, monitored, and replaced; (2) the capacity of gov t to manage resources and provide services efficiently, and to formulate and implement sound policies and regulations; and, (3) the respect for the institutions that govern economic and social interactions among them 16

Operationalizing Governance: Unbundling its Definition into Components that can be measured, analyzed, and worked on Each of the 3 main components of Governance Definition is unbundled into 2 subcomponents: Democratic Voice and (External) Accountability Political Instability, Violence/Crime & Terror Regulatory Burden Government Effectiveness Corruption Rule of Law We measure these six governance components 17

Governance can be measured an illustration Control of Corruption, Selected Countries (K&K, 2002) 2.5 Good Control Corruption 0 Bad Control Corruption -2.5 Source for data: Kaufmann D., Kraay A., Mastruzzi M., Governance Matters III: Governance Indicators for 1996-2002, WP #3106, August 2003. Units in vertical axis are expressed in terms of standard deviations around zero. Country estimates are subject to margins of error (illustrated by thin line atop each column), implying caution in interpretation of the estimates and that no precise country rating is warranted. 18

Governance World Map: Rule of Law, 2002 Source for data: http://www.worldbank.org/wbi/governance/govdata2002 ; Map downloaded from : http://info.worldbank.org/governance/kkz2002/govmap.asp Colors are assigned according to the following criteria: Red, 25% or less rank worse ( bottom 10% in darker red); Orange, between 25% and 50%; Yellow, between 50% and 75%; Light Green between 75% and 90% ; Dark Green above 90% 19

Governance World Map : Government Effectiveness, 2002 Source for data: http://www.worldbank.org/wbi/governance/govdata2002 ; Map downloaded from : http://info.worldbank.org/governance/kkz2002/govmap.asp Colors are assigned according to the following criteria: Red, 25% or less rank worse ( bottom 10% in darker red); Orange, between 25% and 50%; Yellow, between 50% and 75%; Light Green between 75% and 90% ; Dark Green above 90% 20

Dividend of Good Governance 90 80 70 60 Infant Mortality and Corruption 12,000 10,000 Per Capita Income and Regulatory Burden 50 8,000 40 30 20 6,000 4,000 x 100 75 10 0 Development Dividend Weak Average Good Control of Corruption Literacy and Rule of Law x 2,000 0 Development Dividend 10000 9000 8000 Weak Average Good Regulatory Burden Per Capita Income and Voice and Accountability 7000 50 6000 5000 25 4000 3000 2000 0 1000 0 x Development Dividend Weak Average Good Rule of Law x Development Dividend Weak Average Strong Voice and Accountability Note: The bars depict the simple correlation between good governance and development outcomes. The line depicts the predicted value when taking into account the causality effects ( Development Dividend ) from improved governance to better development outcomes. For data and methodological details visit http://www.worldbank.org/wbi/governance. 21

Governance Improving Worldwide? -- Mixed On average, over the past 8 years: some progress on Voice and Democratic Accountability, but little if any on the quality of rule of law and control of corruption However, the variation across countries is very large: For instance, some countries in Eastern Europe have improved. In each region there is significant variation across countries. Good: Chile, Costa Rica, Botswana Important to unbundle governance and corruption: improvement in some dimensions, deterioration in others Where corruption is systemic, unrealistic to expect that Bank projects/lending could be totally immune 22

Judiciary Independence (EOS survey resuls 1998-2004) High Independence 7 4 1 No 1998 1999 2000 2001 2002 2003 2004 Independence Independencia de la Judicatura OECD East Asian NICs Latin America NON OECD 23

Key Constraints to Business: OECD vs. emerging economies EOS 2004 % firms report constraint is in top 3: 60 Emerging Economies OECD 40 20 0 Financing Labour Foreign Currency Infrastructure Bureaucracy Educated Workforce Work Ethics Policy Instability Government instability Source: EOS 2004. Question: From the following list (including all constraints depicted in the figure) please 24 select the five most problematic factors for doing business in your country, and rank them from 1 to 5. Crime Corruption tax regulations Tax rates Inflation

Impact on Global Competitiveness Index (GCI) Rank of Improvement in Constraint to the Firm 30 Competitiveness Gain in Number of Rankings (Change in Rank Positions) 25 20 15 10 5 0 Financing Labor Regulations Foreign Currency Regulations Infrastructures Bureaucracy Education of the Workforce Workforce Ethics Policy Instability Constraint Government instability Crime Corruption Tax Regulations Source: Constraints to Business data based on EOS 2004 (Question: From the following list, please select the five most problematic factors for doing business in your country, and rank them from 1 to 5. ); GCI based on GCR team calculations for 2004/2005 Report; GDP per capita from World Bank. Calculations based on regression estimates of the impact on the GCI of an improveme nt in the constraint by one standard deviation. Tax Rates Inflation 25

Unbundling Governance some illustrations: View of the Firm, 102 countries (EOS 2003) 100 Percent of firms rating constraints as dissatisfactory Administrative Bribery Bribery to Influence Laws Illegal Political Financing 50 0 OECD East Asia (NIC) East Asia dev. Former Soviet Union Eastern Europe South Asia Sub-saharan Africa Latin America / Caribbean Source: EOS 2003. Each region has the following number of countries: OECD: 23; East Asia (Developing): 6, East Asia (NIC): 4; Eastern Europe: 14; Former Soviet Union: 2 (Russia and Ukraine); South Asia: 4; Sub-Saharan Africa: 21; Middle East North Africa: 7; Latin America and Caribbean: 21. 26

Defining, Measuring and Analyzing Legal Corruption Old, traditional definition of corruption: Abuse of public office for private gain Problems i) interpreted in terms of legality of act (illegal = corrupt; legal = non-corrupt?); ii) onus is on the public official (asymmetry), and, iii) measurement bias towards petty corruption Alternative: Privatization of public policy (e.g. undue influence by private interests on public policy actions ) This implies that some actions may be legal strictly speaking, but illegitimate, inconsistent with standards and/or corrupt These legal forms of corruption can be measured 27

% Firms report corruption type (1-4) Corporate Corruption, 2004 % Firms report 'corruption' 80 60 40 20 0 Corporate Bribery Corporate "Legal Corruption" Nordic Countries G-7 Southern Europe East Asia NICs Non-OECD Source: Author s calculations based on EOS 2004. 28

Frequency of bribery at home and abroad, EOS 2004 % Firms Report Bribery Takes Place 100 80 60 40 20 Within OECD Countries MNC in OECD, HQ in another OECD MNC outside OECD, HQ in OECD Domestic Firms in Non-OECD 0 Bribes for Taxes Bribes in procurement Source: EOS 2004. The percentage of firms that report bribery takes place within its group in the country is depicted in each case. EOS Question on which these calculations are based: In your industry, how commonly would you estimate that firms make undocumented extra payments or bribes connected with the following: public utilities, tax payments, awarding of public contracts? very common (1) / never occur (7). Any firms reporting answers 1 through 5 were considered to be reporting at least some frequency of bribery, while answers of 6 and 7 were not. 29

Percentage Firms Report High Cost Global vs Domestic Governance Challenges: % Firms Report High Cost of Terrorism and Crime, EOS 2004 80 70 60 50 40 30 20 10 0 OECD Nordic Countries Cost of Terrorism Organized Crime Common Crime State Capture Cost G7 East Asia NICs East Asia Developing Former Soviet Union Eastern Europe % Firms Report High Cost of: South Asia Latin America Source: EOS 2004. A firm is considered as reporting high cost when rated the question as unsatisfactory (1,2, or 3) in the scale of 1 to 7. Questions were, respectively: The threat of terrorism in your country, incidence of common crime and violence (e.e. street muggings, firms being looted), organized crime (mafia-oriented racketeering, extortion) in your country impose / does not impose significant costs on business? ; In your 30country the diversion of public funds to companies, individuals or groups due to corruption is common / never occurs.

Firm s Cost of Terrorism threat and Organized Crime (% Firms Report High Cost, selected countries) 100 80 Cost of Terror Threat Cost of Organized Crime Percentage firms (%) 60 40 20 0 Algeria Belgium Canada Colombia France Germany Greece Israel Italy Kenya Latvia Netherlands Norway Philippines Portugal Russia Spain Sri Lanka 31 Source: EOS 2002/03. Question: The threat of terrorism in your country imposes significant cost on business Turkey United Kingdom Uruguay United States

High 6 Money Laundering through Banks and Diversion of Public Funds Money Laundering through Banks FIN ISR URY CHE HKG IRL ESP PRT DEU BEL NORAUT BWA NLD CHL SVN SWE CAN USA AUS SGP GBR NZL TUN DNK ISL GRC KOR HUN MYS JOR HRV TWN ZAF EST FRA NAM UKR ARG RUS COL IDN PRY PHL HTI NIC HND BOLECU GTM ROM MEX BGD BGR LVA PERPAN TTO JAM CZE POL TUR IND DOM ZWE LTUTHA LKA SVK CRI BRA MAR SLV MUS ITA VNM CHN JPN r = 0.85 VENNGA Low 1 1 7 Diversion of Public Funds High 32

Key Features of Governance Diagnostic Tools Multi-pronged surveys of: households, firms and public officials [ triangulation ] Experiencial questions (vs. opinions /generic) Specially designed and tested closed questions Conceptual framework: Incentive Structure behind Governance; focus on development Rigorous technical requirements in implementation Local Institution Implements, with WB Collaboration Recognizing Multidimensionality of Governance Focus on Service Delivery: Input for Action and Change 33

High Public Officials Survey: Meritocracy in the Public Service Can Help Reduce Corruption 5 4 3 Prov. Council Electoral Supreme Tribunal Undersec. Of Gov't Congress Comptroller Undersec. Of Social Welfare National Council of Transit Telephone company M of Fin - Budget Courts M of Energy and Mines Universities and schools y = -0.05x + 6.05 R 2 = 0.50 r=-0.71 Real Estate Bank Low 2 1 Attorney General M of Fin - Income M of Fin - Treasury Municipality Presidency National Fin. Corp. Cent. Bank Electricicy company Public Prosecutor 40 50 60 70 80 90 100 Meritocracy in Hiring and Promotion 34

Citizen Voice Improves Accessibility of Public Services to the Poor 100 Accessibility to the Poor 80 60 40 20 r = 0.54 Controlled Causal Link 0 10 20 30 40 50 60 70 80 90 Voice / External Accountability Based on Public Officials Survey. The sample of institutions includes 44 national, departmental, and municipal agencies which are a prior anticipated to be accessible to the poor 35

Deserving particular attention 1. External Accountability Mechanisms (voice) 2. Transparency Mechanisms (e*governance, data) 3. Incentives as drivers, Prevention (e.g. Meritocracy) 4. The Role of the Firm and Elites (influence, capture) and Multinationals can play a key pro-good governance role 5. Governance: linking security & development 6. For Donor Countries, IFIs: i) Aid Effectiveness; ii) Trade; iii) access to World Econ. Clubs 36

On the growing gap between EU-accession countries and the rest of transition --Rule of Law Over Time, Selected Regions, 1996-2002 High 1 Rule of Law Low 0-1 1996 1998 2000 2002 EU Accession Countries Other Transition Countries Source for data: http://www.worldbank.org/wbi/governance/govdata2002. Each region has the following number of countries: OECD: 28; East Asia (Developing): 35, East Asia (NIC): 4; Eastern Europe: 16; Former Soviet Union: 12; South Asia: 8; Sub-Saharan Africa: 47; Middle East North Africa: 21; Latin America and Caribbean: 38. 37

Governance Indicators: Chile 2002 vs. 1998 Source for data: http://www.worldbank.org/wbi/governance/govdata2002 ; Colors are assigned according to the following criteria: Dark Red, bottom 10 38 th percentile rank; Light Red between 10 th and 25 th ; Orange, between 25 th and 50 th ; Yellow, between 50 th and 75 th ; Light Green between 75 th and 90 th ; Dark Green above 90 th.

Illustration of Concrete Projects and Programs promoting Transparency and Accountability Transparency & reform in political/party finance: e.g. new methods for disclosure (expenses), etc. E*disclosure (web) of votes of parliamentarians Public Disclosure of Assets/Incomes by public officials and legislators and their dependents E*procurement; e*data.governance; diagnostics In-depth Institutional Country Diagnostics for Agency and Budgetary transparency Delisting Firms Publicly Country takes the lead, participatory approach The Governance CAS Strategic Approach 39

Data for Analysis and informing Policy Advise, not for Precise Rankings Data in this presentation is from aggregate governance indicators, surveys, and expert polls and is subject to a margin of error. It is not intended for precise comparative rankings across countries, but to illustrate performance measures to assist in drawing implications for strategy. It does not reflect official views on rankings by the World Bank or its Board of Directors. Errors are responsibility of the author(s), who benefited in this work from collaboration with many Bank staff and outside experts. www.worldbank.org/wbi/governance 40