The Investment Climate in Brazil, India, and South Africa: A Contribution to the IBSA Debate September 2006 This report was prepared by Andrew Beath under the supervision of Qimiao Fan, Michael Jarvis, and Jose G. Reis. Valuable inputs were received from Priya Basu, Vijaya Ramachandran, and Jennifer Sara. Disclaimer: The views published are those of the authors and should not be attributed to the World Bank. Nor do any of the conclusions represent official policy of the World Bank or of its Executive Directors and the countries they represent. The Investment Climate in Brazil, India, and South Africa INTRODUCTION....................................................................................................................................... 3 SUMMARY OF MAIN CONCLUSIONS............................................................................................... 3 MACROECONOMIC AND TRADE POLICY ....................................................................................... 8 MACROECONOMIC PERFORMANCE................................................................................................ 8 Brazil ............................................................................................................................................................................ 8 India ............................................................................................................................................................................. 9 South Africa................................................................................................................................................................ 9 TAXATION ........................................................................................................................................... 10 FOREIGN TRADE AND EXCHANGE ................................................................................................ 11 MICROECONOMIC FRAMEWORK................................................................................................... 14 REGULATION ...................................................................................................................................... 14 Entry of Firms.......................................................................................................................................................... 14 Labor Regulation ..................................................................................................................................................... 17 Exit of Firms ............................................................................................................................................................ 19 ENFORCEMENT................................................................................................................................... 20 Enforcement of Contracts ..................................................................................................................................... 21 Enforcement of Regulation.................................................................................................................................... 22 ENABLING INFRASTRUCTURE......................................................................................................... 25 ACCESS TO FINANCE ........................................................................................................................ 25 PHYSICAL INFRASTRUCTURE ........................................................................................................ 27 COST AND AVAILABILITY OF SKILLED LABOR......................................................................... 31 CRIME ................................................................................................................................................... 32 CONCLUDING REMARKS ................................................................................................................... 34 ANNEX ...................................................................................................................................................... 34 CONCEPT OF THE INVESTMENT CLIMATE.................................................................................. 35 MEANS OF ASSESSING THE INVESTMENT CLIMATE................................................................ 35 -2- The Investment Climate in Brazil, India, and South Africa INTRODUCTION “The central challenge in reaping greater benefits from globalization lies in improving the investment climate—that is, in providing sound regulation of industry, including the promotion of competition; in overcoming bureaucratic delay and inefficiency; in fighting corruption; and in improving the quality of infrastructure. While the investment climate is clearly important for large, formal sector firms, it is just as important—if not more so—for small and medium enterprises (SMEs), the informal sector, agricultural productivity, and the generation of off-farm employment. For these reasons, the investment climate itself is a key issue for poverty reduction.” – Sir Nicholas Stern (“Investment Climate Assessment.” The World Bank, March 22nd, 2001) Broad-based economic growth is the single most important driving force behind poverty reduction and the improvement of living standards. Such growth, however, only occurs when economic agents are given appropriate incentives to undertake investments in human and physical capacity and to heighten the productivity of factor inputs. This central lesson of economics, although simple, is ill-learnt. Throughout the world, misguided regulations and inadequate infrastructure cause economic resources and human effort to be directed away from productive uses and towards the enrichment of the few. As a result, many sections of the population are hindered from productively contributing to their economy and from sharing in the considerable opportunities opened up by globalization. Changing this situation for the better is only possible through the reform of the investment climate. In this paper, we seek to assess and compare the investment climate of Brazil, India, and South Africa, drawing on the Investment Climate Assessments (ICAs) and Doing Business indicators produced by the World Bank Group. We focus particularly on identifying the commonalities and differences both within and between countries, with a view to highlighting areas in which the three countries may be able to learn from each other and, in a few cases, from within themselves. As noted in the Doing Business 2007 report, Brazil, India and South Africa have all initiated reforms in the past year to improve the investment climate, ranging from reforms to improvement enforcement of contracts in Brazil, to reforms focused on better investor protection and credit access in India, to property registration changes in South Africa. Brazil and India, faced by lower positions in the Doing Business rankings, can build on positive reforms in the past few years. For example, in Brazil, sweeping changes to bankruptcy procedures in 2004 are beginning to help viable enterprises stay afloat and given creditors more influence over their collateral. Meanwhile India’s simplification of a complex tax registration system is helping to halve business start-up time. The challenge is to build on the momentum of such reform, maintain effective dialogue between business and government in shaping improvements to the investment climate, and promote the opportunities for learning within and across countries through dissemination of best practices. SUMMARY OF MAIN CONCLUSIONS Our main conclusions from the analysis can be summarized in the three points: 1. The investment climate in Brazil, India, and South Africa all show substantial scope for improvement (Table 1). The Doing Business 2007 report ranks Brazil and India 121st and 134th, respectively, out of 175 countries surveyed according to the extent to which regulations impede the operation of a hypothetical firm. South Africa performs better, ranking 29th on the list, though it scores below that of business centers in a number of other middle-income countries, such as Thailand, Malaysia, and Chile. The ICA survey results, on the hand, indicate that firms in Brazil see the various components of the investment climate to be a greater constraint on business than their counterparts in India and South Africa.1 1 In Brazil a majority of firms rank the top issues as a severe or extremely severe obstacle to growth, for example 84% respond that tax rates are a severe obstacle. However, for South Africa and India, no one issue is ranked as a severe obstacle by a majority of respondents - the first-ranked constraints in South Africa (skills), and India (corruption) were -3- The Investment Climate in Brazil, India, and South Africa Table 1: Economies Ranked According to the Ease of Doing Business 1. Singapore 50. Jamaica 93. China 134. India 5. Hong Kong 53. Maldives 96. Russia 135. Indonesia 18. Thailand 64. Uruguay 100. Nepal 140. Mozambique 23. Korea 67. Nicaragua 101. Argentina 145. Iraq 25. Malaysia 74. Pakistan 108. Nigeria 146. Senegal 28. Chile 79. Colombia 109. Greece 153. Zimbabwe 29. South Africa 82. Italy 112. Paraguay 164. Venezuela 32. Mauritius 83. Kenya 119. Iran 168. Sierra Leone 34. Armenia 88. Bangladesh 121. Brazil 174. Timor-Leste 42. Namibia 89. Sri Lanka 126. Philippines 175. Congo, D.R. Source: Doing Business 2006 2. There are substantial differences in the investment climate of the three countries, particularly in which facets serve as binding constraints for enterprise. As shown in Table 2 below, the five main constraints identified by managers differ substantially between the three countries. Table 2: Top Five Business Constraints Identified by Managers2 Brazil India South Africa Tax Rates (84%) Corruption (37%) Skills (35%) Macroeconomic Instability (83%) Electricity (29%) Macroeconomic Instability (34%) Policy Uncertainty (76%) Tax Rates (28%) Labor Regulations (33%) Cost of Finance (75%) Tax Administration (27%) Crime (29%) Tax Administration (66%) Policy Uncertainty (21%) Tax Rates (19%) Source: Investment Climate Assessments Firms in all three countries list tax rates as among their top five Table 3: Doing Business in São Paulo concerns, although Brazilian managers are particularly piqued, the reason for which is identified by the Doing Business data.3 Medium-size Ease of . . . World firms operating in Rio de Janeiro face total tax rates which account for Rank Starting a Business 115 201 percent of their gross profits, the highest in the world, while those in São Paulo must spend 2,600 hours per year preparing, filing and Dealing with Licenses 139 paying taxes, also the highest in the world. Although India and South Employing Workers 99 Africa generally seem to have more efficient tax systems than Brazil, Registering Property 124 there nonetheless seems room for improvement. Despite relatively Getting Credit 83 moderate level of taxes, South African firms must spend an inordinate Protecting Investors 60 amount of time - some 350 hours per year - filing 23 annual payments. Paying Taxes 151 Tax rates in India, meanwhile, are even higher than those of Brazil, at Trading Across Borders 53 81.1 percent of gross profits. Indian firms must also submit one-and-a- Enforcing Contracts 120 Closing a Business 135 considered as such by 37% and 35% of the local surveyed firms, respectively. Yet it is difficult to draw any firm conclusions as to the relative impact of the investment climate on firm performance on the basis of such cross-country comparisons, as they may also reflect underlying cultural, economic, social, or political considerations of survey respondents. 2 Percentages represent number of respondents citing characteristic as a “major” or “very severe” obstacle “for the operation and growth of your business.” 3 More than 80% of firms report that taxation severely impedes business growth, while some 65 percent complained about tax administration. -4- The Investment Climate in Brazil, India, and South Africa half times the number of tax payments than their counterparts in other South Asian business centers. Macroeconomic instability is the second-most frequently cited concern in Brazil and South Africa, which is unsurprising given the pronounced volatility of both the Real and the Rand. Although South Africa lacks the history of hyperinflation which haunted the Brazilian macroeconomy, both countries have recently experienced relatively high and volatile levels of inflation, which may also be reflected in the responses. In both of these regards, Brazil and South Africa seem to have something to learn from India, which has experienced remarkable success in maintaining stable price levels over the past five years. A concern related to macroeconomic stability is that of policy uncertainty. Such uncertainty is frequently cited by managers in both Brazil and India, potentially underscoring the perceived threat posed to economic reform by political currents. Lending rates in Brazil are extremely high and the cost of finance was identified as a problem by three- quarters of Brazilian firms. The problem also registered a mention among Indian firms, particularly smaller ones, who have a difficult time getting access to credit. In South Africa, access to and the cost of credit was a lesser concern. Table 4: Doing Business in Jo’berg Indian managers were primarily concerned about corruption, something World which also seemed salient in Brazil, where over half of respondents listed Ease of . . . Rank it as a major constraint on their Starting a Business 57 Table 5: Doing Business in Mumbai business. Such issues, again, were not Dealing with Licenses 45 apparent in the responses of South Employing Workers World 87 Ease of . . . Rank African firms. The power supply was Registering Property 69 Starting a Business 88 another top concern of Indian Getting Credit 33 businesses, ranking second overall, a Dealing with Licenses 155 Protecting Investors 9 finding that reflects the expensive and Employing Workers 112 Paying Taxes unreliable supply of electricity in India. 74 Registering Property 110 The quality of the power supply Trading Across Borders 67 Getting Credit 65 appears to be a problem for firms in Enforcing Contracts 43 Protecting Investors 33 Brazil also, particularly in the northern Closing a Business 65 Paying Taxes 158 regions. Trading Across Borders 139 Among South Africa businesses, the most frequent concern is the Enforcing Contracts 173 availability and cost of skilled workers, although the rigidity of labor Closing a Business 133 regulations and crime were not far behind. Both of these latter two issues were also of concern to of half Brazilian managers. The results of the Doing Business study point to Table 7: Ranking of Brazilian several other specific issues which affect the Table 6: Ranking of Indian Cities States on Ease of Doing Business economic performance of the three countries. on Ease of Doing Business 1. Federal District In both Brazil and India, the judiciary’s 1. Bangalore, Karnataka 2. Amazonas relationship with business is poor. The 2. Jaipur, Rajasthan 3. Minas Gerais problem in Brazil is primarily with procedures 3. Lucknow, Uttar Pradesh 4. Rondônia for bankruptcy, which in turn creates 4. Chandigarh, Punjab difficulties for Brazilian firms in accessing 5. Maranhão 5. Hyderabad, Andhra Pradesh finance. India, meanwhile, has severe 6. Rio Grande do Sul 6. Bhubaneshwar, Orissa problems with the enforcement of contracts, 7. Mato Grosso do Sul 7. Mumbai, Maharashtra although bankruptcy procedures are also 8. Rio de Janeiro inefficient. Regulation also imposes an 8. Chennai, Tamil Nadu 9. Santa Catarina unusual administrative and financial burden 9. Kolkata, West Bengal 10. Bahia on enterprise in both Brazil and India, and, to Source: Doing Business in South Asia 11. São Paulo a lesser extent, South Africa. The rigidity of 12. Mato Grosso labor regulation in Brazil is particularly constraining. India also scores 13. Ceará predictably poorly in terms of the burden of licensing and permit requirements Source: Doing Business in Brazil -5- The Investment Climate in Brazil, India, and South Africa for ongoing business operations and in the time, cost, and administrative procedures required to import or export goods.4 Such regulations raise the cost of doing business, fostering a high level of informality, which in turn deprives both federal and state governments of tax revenue and makes it more difficult for firms to access credit markets and utility services.5 On the plus side, Brazil, India, and South Africa, in particular, do relatively well in protecting minority investors from the misuse of corporate assets. 3. Given the large size of Brazil and India and the authority afforded states, there are significant differences within each country in the quality of the investment climate.6 There is fierce competition between cities in Brazil and India to attract investors through the best regulatory environment. The Doing Business in Brazil 2007 report identifies a positive correlation between the ease of doing business in a state and the level of income; the best performer, the Federal District, is also the wealthiest, while the worst performer, Ceará, is the second poorest state among the 13 surveyed. Nevertheless, there are exceptions. The poorest state, Maranhão, ranks 5th out of 13, as a result of recent reforms, while the two largest business centers, Rio de Janeiro and. São Paulo, rank 8th and 11th respectively.7 Table 8: Top Five Business Constraints Identified by Managers8 Gauteng KwaZulu-Natal Western Cape Eastern Cape Worker Skills (37%) Worker Skills (44%) Macro. Instability (44%) Macro. Instability (36%) Labor Regulations (32%) Macro. Instability (44%) Labor Regulations (39%) Trade Regulation (31%) Crime (31%) Crime (41%) Worker Skills (30%) Worker Skills (19%) Macro. Instability (28%) Labor Regulations (33%) Crime (23%) Cost of Finance (19%) Corruption (19%) Tax Rates (33%) Policy Uncertainty (22%) Labor Regulations (17%) Source: South Africa Investment Climate Assessment In India, an analysis by the Doing Business team found that, of nine cities, Bangalore was the easiest to start and operate a business, while Kolkata was the most difficult. Surprisingly, the relatively prosperous cities of Mumbai and Chennai ranked 7th and 8th, well behind cities such as Jaipur and Lucknow. This evidence is contradicted somewhat, however, by data collected through the ICA, which asked managers to identify the states they thought had a better or worse investment climate than the state in which they were currently 4 In some of these indicators, the India Investment Climate Assessment 2004 reports that substantial progress has been observed. For instance, between 2000 and 2003, the number of factory inspections per year for 2003 was 7.4 compared to 11.7 in 2000 and the average number of days spent on customs clearance for industrial imports has also fallen from 10.3 in 2000 to 7.3 in 2003. 5 According to Doing Business in Brazil 2007, informality “is estimated to have accounted for 42% of Brazil’s output in 2002–03, compared with 33% of Mexico’s, 16% of China’s and 26% of India’s” and estimates that an improvement in “Brazil’s Doing Business indicators to the level of the top 30 countries [would be] associated with a 9 percentage point drop in the share of GDP accounted for by informal activity”. 6 In Brazil, opening a business in the state of Minas Gerais takes only 19 days, compared to 152 days in São Paulo. By way of comparison, the difference between the best and worst performing state in Mexico is only two-fold. The performance of Minas Gerais places it in the top 30 worldwide in terms of the time to start a business. São Paulo ranks 149th out of 155. 7 Doing Business in Brazil 2007 reports that “Maranhão also introduced reforms to facilitate business start ups. Information on new applications is now shared between the board of trade, the state tax authority and the municipality, which evaluate and provide preliminary approvals. This reduces the risk of businesses starting the process of formalization at the board of trade, but not completing it with other agencies. Once the company is cleared for approval, the start up process is faster.” 8 Percentages represent number of respondents citing characteristic as a “major” or “very severe” obstacle “for the operation and growth of your business” -6- The Investment Climate in Brazil, India, and South Africa based. In that analysis, Maharashtra came out on top, with Uttar Pradesh, West Bengal and Kerala scoring poorly.9 Unlike Brazil and India, there is not presently data on variation in the Doing Business indicators within South Africa. However, the business constraints identified by the ICA did vary to some extent across provinces. Firms in the Eastern Cape, for instance, were more concerned about trade regulation than in the other three provinces (18% vs. 31%) and much less concerned about labor regulation (17% vs. 35%), worker skills (19% vs. 37%) and crime (6% vs. 32 %). 9 ICS results indicate that small- and medium-sized enterprises (SMEs) receive factory inspections twice as frequently in the states assessed as having a poor investment climate as in those assessed as having a good climate. Good climate states also have cheaper and more reliable power supplies, and for SMEs in poor climate states the cost of generating power on their own is about twice as high as the price of power for firms from the public grid. -7- The Investment Climate in Brazil, India, and South Africa MACROECONOMIC AND TRADE POLICY When macroeconomic policy goes wrong, few firms are provided with a means to escape its effects. Rampant rates of inflation arbitrarily redistribute income across the economy and create enormous difficulties for all firms wishing to operate with any semblance of normality. Volatile or mis-valued exchange rates similarly generate costs for all those engaged regularly in international trade, either directly through arbitrary Figure 1: Inflation Rates: ’96 – ‘06 revaluations of their international competitiveness or 16% indirectly through the costs of hedging. Poorly managed policies for public finance, meanwhile, inevitably lead to India Brazil ineffective and costly taxation policies, which provide 12% firms with an unwelcome choice between engaging in risky evasion practices or losing a substantial proportion 8% of their profits. In this section, we examine and contrast the macroeconomic history and policies of Brazil, India, and South Africa. We begin with an overview of recent 4% growth and inflation histories, followed by taxation, and finishing up with an overview of the policies towards the South Africa 0% external sector. May-96 May-98 May-00 May-02 May-04 May-06 Source: IMF International Financial Statistics MACROECONOMIC PERFORMANCE Over recent decades, developing countries as a whole have grown quickly relative to historical trends. There has, however, been substantial diversity across different countries and the comparative experiences of Brazil, India, and South Africa demonstrate this diversity well. Brazil, for instance, grew rapidly to middle-income status with dramatically high rates of economic growth in the late 1960s and early 1970s. Since then, however, it has experienced extreme macroeconomic volatility and, over recent years, has recorded negligible rates of economic growth. India, on the other hand, has a relatively low level of per capita income and, for most of the late 20th century, had a disappointing growth performance. Since the early 1980s, however, per capita growth has surged to robustly high levels. South Africa’s growth performance has historically been much less volatile than Brazil’s, although like Brazil, South Africa has recorded negligible rates of growth in real per capita GDP growth over recent decades. Brazil Over the past 25 years, economic Figure 2: Economic Growth in Brazil, 1965 - 2004 growth in Brazil has demonstrated substantial volatility around a 15% relatively low mean. In the wake of 1999 – 04 Annual Avg.: 2.6% chronic inflation which consumed 12% 1969 – 04 Annual Avg: 4.3% Real GDP per capita (2004): $3,565 much of the 1980s and early 1990s, Real GDP per capita (1979): $3,055 the Brazilian economy is still 9% tentatively but steadily finding its way to macroeconomic stability. 6% Throughout the early 2000s, inflation has remained at historically moderate rates. Interest 3% rates too have fallen, although they remain at high levels compared to 0% other countries. Unfortunately, the 1970 1975 1985 1995 2000 recent period of stabilization has -3% not thus far propelled rapid economic growth. Between 1979 -6% -8- The Investment Climate in Brazil, India, and South Africa and 2004, real per capita GDP has grown only $510. Figure 3: Per Capita GDP in Brazil $4,500 Brazil has some of the highest levels of economic South-East inequality in the world, a fact that is reflected in substantial disparities between regions in per capita $3,000 South Center-West income and economic growth. Brazil’s richest area, the Federal District, has a per capita income that is some seven times greater than that of the poorest state, North Maranhão. The Southeastern region – which includes $1,500 the states of Espírito Santo, Minas Gerais, Rio de Northeast Janeiro and São Paulo – is the most prosperous in the country, although the Center-West region, which $0 encompasses the Federal District, has grown much 1985 1989 1993 1997 2001 faster than other regions over the past two decades (see Figure 3). The volatility of growth rates across all Brazilian states is extremely high – the standard deviation of GDP growth rates for Brazilian states between 1986 and 2004 was more than six times the mean. India In the early 1980s, the Indian economy broke from a history of disappointing economic performance and experienced rapid increases in GDP. Between 1994 and 1997, strong private investment spurred economic Figure 4: Per Capita GDP in India growth to levels in excess of 7 percent. Although $600 growth rates lagged somewhat in the years thereafter, North-West 2003 saw the economy grow by 8.6 percent. In total, between 1999 and 2004, the Indian economy grew by $400 South an average of 5.7 percent annually. During this period, inflation has remained at remarkably low levels and the Indian government has experienced considerable success in ensuring a relatively stable exchange rate $200 North-East and low rates of interest. Despite the recent successes in spurring economic growth, per capita income in India in 2004 was only $0 $540, although this is substantially higher than the 1984-85 1988-89 1992-93 1996-97 2000-01 $215 reported in 1979. There are also substantial regional disparities Figure 5: Economic Growth in India, 1965 - 2004 in income and much of India’s recent growth has been concentrated away from the poorer 9% areas in the west and center of the sub-continent. Per capita income in 6% Maharashtra is triple that of Bihar and the rapid growth rates of 3% prosperous states in the far north and south have fast outstripped the 0% negligible improvements of poorer 1970 1975 1985 1990 1995 2000 states such as Madhya Pradesh, Orissa, and Rajasthan. -3% 1999 – 2004: 5.7% 1969 – 2004: 5.0% Real GDP per capita (2004): $540 South Africa -6% Real GDP per capita (1979): $215 Since the transition to democracy, South Africa’s macroeconomic performance has been solid but not spectacular. Between 1995 and 2004, -9- The Investment Climate in Brazil, India, and South Africa annual GDP growth averaged about 3.4 percent. Prior to 1994, economic growth was extremely volatile, but since then it has neither declined nor exceeded 4.5 percent. In this respect, South Africa appears locked into a path of sustained but moderate Figure 6: Economic Growth in South Africa, 1965 - 2004 growth. As South Africa’s population has been increasing, 9% per capita growth has been 1999 – 2004: 3.5% 1969 – 2004: 2.5% slower than total growth and Rea; GDP per capita (2004): $3,310 averaged just 1.3 percent in the 6% Real GDP per capita (1979): $3,325 ten years up to 2004. Since 1979, real GDP per capita has actually 3% declined, albeit only by a small amount. 0% 1970 1975 1980 1995 2000 TAXATION -3% There is no country where businesses do not complain about taxes. Yet, taxes serve an essential purpose in provide funding for public goods such as education, health, the judicial system, infrastructure, and defense. Nevertheless, many governments have, over the years, been guilty of implementing tax policies that are both counterproductive for raising revenue and costly for economic growth. Among the three countries, the administrative and financial burden of taxation is most serious in Brazil. The burden of taxation on firms in India and South Africa, on the other hand, is relatively in line with international norms, although India could work to lessen the number of tax payments made by firms and South Africa could work on reducing the complexity of its system. The Brazilian tax system is among the most complex and burdensome anywhere. In Table 9: Administrative and Financial Burden of Taxes 2005, the tax burden in Brazil reached 37.4 Time Total Tax Payable Payments percent of GDP. A disproportionate (Hours) (% Gross Profit) proportion is raised through taxes on São Paulo 23 2,600 147.9% business.10 In order to fully comply, a Latin America 48 529 52.8% medium-sized company in São Paulo would Mumbai 59 264 43.2% have to pay one-and-a-half times its gross South Asia 26 332 35.3% Johannesburg 32 350 43.8% profits in taxes. Accountants estimate that it Sub-Saharan Africa 41 394 58.1% would consume a full 325 working days to OECD 16 197 Hours 45.4% comply with all tax requirements. Firms in Rio de Janeiro face an even higher financial Source: Doing Business 2006 higher burden, over 200 percent of gross profits, which is the highest rate recorded anywhere by the Doing Business team. In addition, Brazilian firms must cope with frequent changes in tax rates and rules, an onerous process of tax appeals, and extremely severe penalties for underpayment. Furthermore, the high level of financial taxation have further added to the problem of wide spreads on interest rates, which in turn have increased credit costs for firms. For this reason, Brazilian firms consider the level of taxation to be the most serious problem inhibiting their further growth, with more than 80 percent of respondents citing taxation as a severe or extremely severe obstacle. There is substantial variation within Brazil in the burden of taxes. Businesses in Amazonas, for instance, pay a comparatively low 89% of gross profit in taxes, owing to the designation of the capital, Manaus, as a duty free zone. In addition, firms operating in the north of country also generally see tax administration as less of an obstacle to business expansion than their counterparts in the southeast. Doing Business finds that filing taxes is less complicated in the states of Bahia, Rondônia and Mato Grosso do Sul, but is most difficult in Mato Grosso, São Paulo and Minas Gerais. 10The high burden of taxation in Brazil is a relatively recent phenomenon, owing to the growth of the public sector during the 1990s and the unavailability of other means by which to reach the required fiscal balance. - 10 - The Investment Climate in Brazil, India, and South Africa In India, recent reforms have attempted to simplify tax registration procedures, although the administrative and financial burden of tax payments remains high by international standards. Although Indian firms spend less time than their South Asian counterparts in filing taxes, some 264 hours per year, the cumbersome tax regime requires 59 separate payments. More significantly, the financial burden of the tax regime is extremely high by international standards, consuming some 81 percent of Indian firms’ profits, compared with a regional average of just 45 percent. Accordingly, Indian firms cite tax rates and administration as their third and fourth most serious obstacles to business. Small firms are even more likely to complain about the burden of taxation. Recent policy changes, particularly the adoption of a value added tax (VAT) across most of the country in April 2006, should help to lessen such concerns somewhat. However, there is an urgent need to consolidate the sales taxes and VAT collected at various levels of government and thereby eliminate the hassle, both for firms and bureaucracies, of having different taxes on the same tax base collected by separate government agencies. The administrative and financial burden of taxation for firms in South Africa is similar to that of India and considerably less than that faced by firms in other African countries. Corporate taxes have recently been reduced and this has contributed to the relative level of satisfaction expressed by South African firms with their tax burden.11 Of particular interest is that the amount of revenue collected by the South African government through taxation has increased substantially, even as tax rates have fallen. From a base of 100 in 1995, revenue derived from taxes on companies doubled to 200.8 in 2000-2001 and then more than doubled to 410.9 in 2003. The robust growth in tax revenues is a consequence both of increased company profitability Table 10: Total Tax Payable in Brazilian States and improved enforcement and compliance and a (% of Gross Profit) considerable increase in the company register. This Rio de Janeiro 208% experience should be of particular interest to the Rio Grande do Sul 153% government of Brazil, where requirements to generate Minas Gerais 150% public revenue have led to a vicious cycle of burgeoning tax rates, falling compliance, and Federal District 149% increasing informality. São Paulo 148% In summary, the tax system of Brazil is in urgent Maranhão 147% need of reform to reduce the administrative and Mato Grosso 146% financial burden it imposes on firms. Tax policies Mato Grosso do Sul 146% in India and South Africa are less problematic. Rondônia 146% India nonetheless needs to focus on lessening the number of tax payments made by firms and South Bahia 144% Africa must reduce the complexity of its system. Santa Catarina 144% Ceará 137% FOREIGN TRADE AND EXCHANGE Amazonas 89% International trade is universally recognized as the Source: Doing Business in Brazil 2007 engine for growth and development. Imports of capital goods represent an important channel for technology transfer and knowledge adoption, particularly for developing countries which do not have large indigenous capabilities for R&D. The export of goods and services, on the other hand, subject firms to unparalleled competitive pressures and thereby ensures productive use of inputs. Government-imposed barriers to trade, which include not only tariffs and export promotion policies but also the efficiency of port, transportation, and customs infrastructure, can serve a crucial role in determining a country’s overall trade share. While countries have generally lowered tariff barriers in conjunction with global and regional trade agreements, progress in improving trade infrastructure 11 Only 19 percent of enterprises saw tax rates as a serious problem and only 11 percent saw tax administration as a serious problem. This was lower than all but 3 of the 52 investment climate surveys conducted in other countries by mid-2005. Until 1998, the corporate rate of tax was 35%. It then declined to 30% and, in the 2005 budget, a reduction to 29% was announced. - 11 - The Investment Climate in Brazil, India, and South Africa and stabilizing the uncertainty in international exchange has not been as rapid, leaving lingering inefficiencies for trading firms. Table 11: Procedural Requirements for Exporting and Importing a Standardized Cargo of Goods Documents Signatures Time for Documents Signatures Time for for Export for Export Export for Import for Import Import (Number) (Number) (Days) (Number) (Number) (Days) São Paulo 7 8 39 14 16 43 Latin America 7.5 8.0 30.3 10.6 11.0 37.0 Mumbai 10 22 36 15 27 43 South Asia 8.1 12.1 33.7 12.8 24.0 46.5 Johannesburg 5 7 31 9 9 34 Sub-Saharan Africa 8.5 18.9 48.6 12.8 29.9 60.5 OECD 5.3 3.2 12.6 6.9 3.3 14.0 Source: Doing Business 2006 Manufacturing exports from Brazil, India, and South Africa have all grown substantially in recent years, often exceeding the growth in world trade, although at slower rates than dynamic economies such as China.12 Nevertheless, exporting firms in all three countries have found themselves hampered by burdensome customs procedures.13 Such procedures significantly delay the time it takes for firms to receive ordered inputs or deliver exports, increasing the cost of input inventories in the former case and damaging business relationships in the latter. It is of concern thus that customs clearances in Brazil and India are more time-consuming than in most other business centers in the respective regions and, for all three countries, are about triple that of the OECD average (Table 11). Among firms surveyed through the ICAs, median reported times to clear customs were higher in all thee countries than in either China or Indonesia (Figure 7). In Brazil, the reported level was particularly high, exceeding also that of Kenya and Russia. Delays faced by firms in exporting and importing firms Brazil and India also show substantial variation, thereby making it difficult for firms to accurately estimate the time to ship goods to and from abroad, which in turn leads to inevitable risks and/or expenses. Figure 7: Average Time in Days to Clear Goods from Customs 16 Brazil Imports Exports 12 South Russia China Africa 8 India Kenya 4 Indonesia 0 Note: Boxes are 25th - 75th percentile, lines are medians Source: Investment Climate Assessments The costs and uncertainties imposed by the customs regimes of Brazil, India, and South Africa appear to be significant bottlenecks to sustaining the recent expansion in international trade. Simple reforms can have an 12 Between 1999 and 2004, manufacturing exports from Brazil grew at an annual average rate of 13%, compared to just 3% during the previous fifteen years. The share of exports in Brazil’s GDP has recently reached record levels, averaging 14.8% in 2000–2004, compared to 9.7% in 1984–1999. 13 A survey conducted by the Brazilian National Industrial Confederation found that the top four perceived barriers to the expansion of exports are the excessive bureaucracy at customs (41% of the surveyed firms), the high costs of port services (37%), high international transport costs (32%) and difficulties of access to export financing mechanisms (also 32%). In South Africa, about 22% of exporters rated customs and trade regulations as a serious obstacle. - 12 - The Investment Climate in Brazil, India, and South Africa impact, however. Single windows can be established for traders, linking all government agencies involved in the clearance process, and risk management inspection systems can be computerized to allow customs staff to focus on cargo with a higher risk of faulty declaration. General government attitudes towards international trade can matter a lot too. The large discrepancy in delays imposed upon exports and imports in Brazil, for instance, represents embedded incentives to discourage substitute imports for locally-produced manufactures. On the other hand, recent reductions in average customs delays in India are thought to reflect an increasing appreciation among government bureaucracies for the economic value of international trade.14 Since most firms are price-takers in international markets, changes in exchange rates can dramatically affect revenues, particularly when currencies move contrary to expectations. Exporters and importers in Brazil and South Africa have been particularly affected over recent years by the volatility of their respective country’s exchange rates. Since 2001, the Brazilian Real and South African Rand have been among the most volatile of internationally traded currencies (Figure 8).15 The problems such instability has caused for South African firms trading abroad is highlighted by the fact that 44 percent of exporters (and 76 percent of firms that export to the United States) cited macroeconomic instability as a serious constraint on their business, in spite of relatively low and stable rates of inflation and interest.16 As in South Africa, macroeconomic instability is also the second most widely cited concern on Brazilian firms, although unlike in South Africa, such concern also spans high levels of interest rates. Rates of entry into the Brazilian export sector have, however, closely mapped those movements in the real exchange rate. As such, there is some evidence that exchange rate volatility in Brazil has had an undue impact on the structure of the country’s economy. In summary, further reforms are Figure 8: Movement of Exchange Rates, 2001 –2006 required in Brazil, India, and South Africa to ease the burden of customs Rand procedures and to make international 160% trade more efficient for both importers Real 140% and exporters. In addition, the business operations of importers and 120% exporters in Brazil and South Africa Rupees have been impacted by exchange rate 100% volatility. 80% Euro June 2001 June 2003 June 2005 Note: All values are relative to U.S. Dollar 14 The average number of days needed for a shipment of inputs to clear customs fell from 10 days in 2000 to 7 in 2003. 15 A major depreciation between 2000 and 2002 caused the Rand to fall by 27% against the US dollar, 26% against the British Pound and 28% against the Euro. Over the next two years, the Rand then appreciated rapidly, rising 29% against the Euro, 35% against the British Pound, and 67% against the US dollar. 16 57% of exporters that exported to other OECD economies cited macroeconomic stability as a problem. Among exporters to SACU countries, which peg their currencies against the Rand, only 17% of exporters rated macroeconomic instability as a concern. - 13 - The Investment Climate in Brazil, India, and South Africa MICROECONOMIC FRAMEWORK The ability of firms to enter and exit the marketplace, expand and scale back capacity, and operate in an environment in which investors can feel confident that their rights will be upheld and their outlays recouped, is an essential precondition for ensuring the productive use of economic inputs and thereby maximizing rates of economic growth. Although various forms of microeconomic regulation are essential to safeguard the public interest and to protect individuals from exploitation at the hands of unscrupulous operators, regulatory restrictions and bureaucratic requirements frequently transcend basic economic rationality and instead promote perverse outcomes which facilitate exploitation and undermine the public interest. Superfluous restrictions and inspections can also impose severe administrative hassles for management, cause uncertainty in production processes, and result in direct costs in the form of irregular payments to officials. In this section, we examine and contrast the microeconomic frameworks and regulatory environs of Brazil, India, and South Africa and consider means by which policies and regulation could reduce microeconomic distortions and thereby foster productivity and promote capital investment. We begin with a discussion of the specifics of regulation in the three countries before turning to systems for enforcement. REGULATION The fluidity of procedures for market entry and exit are critical in determining the level of competition among producers and, therefore, the microeconomic efficiency. Where market entry is restricted, incumbent firms are able to collect substantial rents through predatory pricing and face little incentive to innovate, undertake efficient investments, or employ their inputs in a productive manner. Similarly, excessive regulation can stifle the operation of factor markets and thereby constrain firms from adjusting their scale to economically efficient levels. Finally, obstacles impeding market exit, such as bankruptcy proceedings and protections of creditor rights, can obstruct the resuscitation of ailing firms and even make lenders wary of supporting entrepreneurs. Entry of Firms Table 12: Bureaucratic and Legal Hurdles to Incorporate and Register a New Firm17 Procedures Cost Min. Capital Duration (Days) (number) (% GNI per capita) (% GNI per capita) São Paulo 17 152 10.1 0.0 Latin America 11 63 56.2 24.1 Mumbai 11 71 61.7 0.0 South Asia 8 35 40.5 0.8 Johannesburg 9 38 8.6 0.0 Sub-Saharan Africa 11 64 215.3 297.2 OECD 6.5 19.5 6.8 41.0 Source: Doing Business 2006 Countries differ significantly in the way they regulate the entry of new businesses. In some, the process is straightforward, quick, and relatively inexpensive, allowing entrepreneurs to easily enter markets in response to profit opportunities. In other countries, firms must complete arduous and time-consuming processes populated by innumerable permit applications, notifications, inscriptions, verifications, and fees, thereby encouraging entrepreneurs to either bribe officials to expedite the process or to enter their informal sector, with attendant consequences for the tax-base, fiscal balance, and economic growth. In most cities in India, registering a firm or a new property is both a lengthy and costly proposition. Brazil performs a little 17 The data on starting a business are based on a survey of the required procedures for a small-medium sized company dedicated to general commercial activities and services. The steps include obtaining necessary permits and licenses and completing inscriptions, verifications and notifications with the authorities to enable the company to start operations. - 14 - The Investment Climate in Brazil, India, and South Africa better, particularly in terms of the cost of registration, although there is nevertheless room for improvement. Overall, South Africa performs better than most developing countries, although a little worse than the OECD average. Table 13: Time and Cost of Starting a Business in Brazilian States 49% Time (Days) Cost (% of Income Per Capita) 33% 31% 20% 49 12% 10% 10% 11% 10% 11% 35 10% 5% 6% 152 68 68 47 44 44 41 41 30 25 19 São Amazonas Rio de Federal Maranhão Ceará Santa Mato Mato Rio Rondônia Bahia Minas Paulo Janeiro District Catarina Grosso Grosso do Grande Gerais Sul do Sul Table 14: Time and Cost of Registering Property in Brazilian States 5.2% 4.6% 4.7% 4.5% 4.0% 3.6% 3.6% 3.2% 3.0% 2.7% 2.4% 2.3% 2.1% Time (Days) Cost (% of Property Value) 88 83 81 75 69 63 58 57 51 47 43 40 27 Bahia Mato Rio Rio de Rondônia Ceará Minas Federal Santa São Paulo Mato Amazonas Grosso do Grande Janeiro Gerais District Catarina Grosso Maranhão Sul do Sul Source: Doing Business in Brazil 2007 In most Brazilian cities, the time and cost of registering a new firm is not particularly high by Latin American standards. In all the 13 cities surveyed, firm registration was less expensive than the regional average and the duration of registration was shorter than the regional average in all but 3 of the cities.18 There does exist substantial regional variation between states, however, reflecting the relatively onerous requirements imposed by some municipal authorities. In São Paulo, the average amount of time spent is the longest in the country, at some 6 months, compared to just 19 days in Minas Gerais. Costs are lowest in the Federal District and Rio Grande do Sul, at between 5 and 6 percent of per capita income, and highest in the North-Eastern states of Maranhão, Bahia, and Ceará, at 49 percent, 33 percent, and 31 percent respectively. Recent reforms have attempted to ease the procedural requirements to start a business and officials at the 18 There is no minimum capital required to start a business in Brazil, which reduces the cost for the entrepreneur. The largest determinants of cost are the printing of receipts for tax purposes, the municipal license, and the registration fees. - 15 - The Investment Climate in Brazil, India, and South Africa federal and sub-national level are now taking measures to unify procedures, share information among agencies and introduce online procedures. Particular success in this regard has been observed in Minas Gerais, where the introduction of a one-stop shop registration-procedure has located various agencies under a single roof and reduced the number of procedures to just 10. Relative to the rest of Latin America, it is relatively difficult to register property in many Brazilian states. In the 12 states and the Federal District, an entrepreneur spends on average 61 days and 3.5% of the property value to register property. This ranks 17 out of 22 countries in Latin America. Even though the procedures for registering property are standardized on paper, costs and time vary considerably, even within regions. For instance, while it takes nearly 3 months and 2.4 percent of the value to register a property in Bahia, it takes under a month but over 5 percent to make a similar registration in Maranhão.19 Overall, the Federal District and Table 15: Time and Cost of Starting a Business in Indian Cities Santa Catarina are considered the easiest places to register property, while Mato Grosso do Sul, - where Time (Days) Cost (% of Income Per Capita) the entrepreneur spends 83 days and 4.6% of the property value - is 62% 62% considered the most difficult. 53% 54% Despite considerable reform of 47% 47% 47% 48% 44% regulation governing Indian 83 79 industry since 1991, the time and 71 68 61 59 cost required to register a business 58 57 57 in the formal sector of Indian cities remains high by regional and international standards.20 Entrepreneurs in Mumbai, for instance, must wait 71 days and pay Kolkata Bhuban. Mumbai Hydera. Lucknow Jaipur Chennai Bangal. Chandi. some 62 percent of national per Table 16: Time and Cost of Registering Property in Indian Cities capita income in order to complete the registration process. By way of 14.9% contrast, similar registration 13.9% procedures in other South Asian 12.3% business centers take only 35 days 11.1% 11.6% 11.4% and 40 percent of per capita income. 10.3% 10.1% Unlike Brazil, the range of variation 7.9% between Indian cities is not particularly large. Of the 9 surveyed cities, procedures in Kolkata took the longest to complete (83 days), while Time (Days) Cost (% Property Value) Chandigarh and Bangalore provided for the quickest registration (57 days). Mumbai and Bangalore were the 132 123 109 67 63 56 43 35 35 most expensive cities to start a Chandi. Bhuban. Kolkata Mumbai Chennai Jaipur Lucknow Hydera. Bangal. business (62 percent of per capita income), while Bhubaneshwar is the Source: Doing Business in South Asia 2006 19 Time is measured in from the start of the transaction to the sale-purchase agreement and finally the registration of the new title with the public registry. 20 Early reforms include the removal of a policy of reservation of certain industries to the public sector, and the abolition of licensing requirements for private investment in many industries. The list of prohibited industries has recently been curtailed from 18 to 3 (atomic energy, railways, and military aircraft and warships), although India has yet to end its long- standing policy of reserving labor-intensive industries to small scale producers. - 16 - The Investment Climate in Brazil, India, and South Africa cheapest (44 percent). During 2004-05, the Indian government undertook reforms to make starting a business easier for entrepreneurs, including automating the tax department’s procedures and outsourcing the assignment of the Permanent Account Number (PAN) for tax payments to a private company. As a result, start-up time fell by 18 days. Further reductions in delays are expected as implementation continues. India’s procedures for registering property, which average some 6 procedures and 67 days, are similar to countries both throughout South Asian countries and the developing world. Costs are relatively high in Indian cities, though, with registrations costing more, in terms of per capita income, than all surveyed Brazilian cities. The duration of registrations in India exhibit substantial variation, but the range of costs is much more limited. The quickest city in which to register property is Bangalore (35 days), while Chandigarh is the longest (132 days). Registrations cost the least in Mumbai (7.9 percent of property value) and the highest in Hyderabad (14.1 percent). The high cost of property registration in India owes much to stamp duties, which tend to discourage formal transactions and promote rampant evasion, lowering government revenues as a result.21 For instance, after halving stamp duties, the state of Maharastra experienced a 20% jump in revenues. Karnataka, meanwhile, has led the way in reducing the duration of registration through the computerization and rationalization of its property registry. A related problem affecting Indian industry is the burden of licensing. To obtain permits and permissions to construct a warehouse costs nearly 700 percent of per capita income, rising up to over 1600 percent in Bangalore. It is also complex, requiring 20 procedures, and time consuming at 270 days, substantially worse than the respective South Asian averages. The difference in the time taken and number of procedures required across states suggests that there are considerable gains to be had from adopting best practices within India. 22 As an example, obtaining land use permission and construction permit takes nearly 150 days across two departments in Mumbai but less than 40 days in Hyderabad with one department. The Doing Business database indicates that barriers to market entry in South Africa are low by standards of developing countries and just slightly above those of the OECD. However, this is in contrast to studies which have suggested that the South African economy is highly concentrated and that there are high barriers to entry for both domestic and foreign firms. Consistent with this is that firms in South Africa appear to be relatively profitable, despite high wages. In summary, entry regulations in Brazil are not particularly cumbersome by Latin American standards, but there is nevertheless scope for substantial improvements if municipal authorities follow the lead of states like Minas Gerais. Registering property is difficult in Brazil relative to the rest of Latin America and this is an area which demands attention. Entrepreneurs wishing to enter markets in India are hamstrung by unusually high costs and lengthy procedures. It is also very expensive to acquire new property in India cities. Barriers to entry and property acquisition in South Africa, meanwhile, are low in comparison to many developing countries. Labor Regulation For firms to be able to innovate and to take advantage of new opportunities, it is important that entry and exit procedures are complemented by fluid factor markets which facilitate the transfer of inputs from low- to high-productivity applications. Owing to the social and political desirability of stabilizing employment levels, labor is one of the most heavily regulated factors of productions and all countries possess some legislation 21 Businesses use cumbersome and less secure ways to avoid taxes—such as replacing deeds with co-operative housing, long-term leases, agreements without possession and transfers under court decrees. 22 The procedures that cause the greatest bottlenecks are obtaining land use permission, building permit, power connection, water and sewerage connection and final occupancy certificate. These are the responsibility of various municipal and state-level institutions. The difference in the time taken and number of procedures required across states suggests that there are considerable gains to be had from adopting best practices from other states. As an example, obtaining land use permission and construction permit takes nearly 150 days across two departments in Mumbai but less than 40 days in Hyderabad with one department. - 17 - The Investment Climate in Brazil, India, and South Africa which purports to guarantee workers certain employment conditions. Labor regulation, however, can have unintended impacts on labor productivity, firm profitability, and broader macroeconomic outcomes. Instruments such as minimum wages, payroll taxes, and worker benefits usually raise the cost of employment, constrain hiring and firing and may impede the movement workers between positions. Labor legislation may also create incentives for workers to maintain or sever employment contracts, which in turn will affect firm labor force investment decisions, with implications for the composition of a firm’s labor force or firm human capital investment and search budgets. All three countries have relatively rigid labor regulations which tend to discourage firms from hiring workers through formal channels, although Brazil’s regulations appear to provide particularly perverse incentives to workers and employers and to promote a high degree of informality in the labor market. Table 17: Flexibility of Employment Rigidity of Firing costs Difficulty of Rigidity of Difficulty of Hiring cost Employment (weeks of Hiring Index Hours Index Firing Index (% of salary) Index wages) São Paulo 67 80 20 56 26.8 165.3 Latin America 41 51 30 40 15.9 62.9 Mumbai 56 40 90 62 12.3 79.0 South Asia 42 35 43 40 5.1 75.0 Johannesburg 56 40 60 52 2.6 37.5 Sub-Saharan Africa 48 63 48 53 11.8 53.4 OECD 30 50 28 36 20.7 35.1 Source: Doing Business Database 2006 Figure 9: Perceived Effect of Labor Regulation on Staff Levels According to the analysis of the 100% Doing Business team, labor 12% 22% 23% 26% regulations in Brazil are the 11 th 30% 80% most restrictive in the world. 22% 54% Unusually burdensome legal regulations 71% impede hiring in the formal sector and 60% 30% create problems for firms wishing to 51% adjust hours of employment. In 40% 65% 13% addition, firms must pay a quarter of a 66% 70% worker’s average salary in hiring costs 44% and pay the equivalent of three years of 20% 29% 32% 27% wages when they fire a worker, three 12% times the regional average. It is 0% unsurprising, therefore, that some 88 Brazil India South China Indonesia Kenya Russia percent of managers report that they Africa would change the size of their labor Causes Understaffing No Effect Causes Overstaffing force if they faced no restrictions on Source: Investment Climate Assessments worker dismissals, severance payments, etc..23 Intriguingly, the overwhelming proportion of those respondents stated that a relaxation of labor rules would cause them to increase the number of workers they employed. Additional evidence indicates that employers are reticent to hire more skilled, and more expensive, workers, since the costs of labor legislation outweigh the benefits of the higher labor productivity. A reduction in costly labor legislation could lead to both an increase in employment and a change in the composition of the labor force toward a more skilled labor force. 23The questionnaire item asked business managers: “Given your current level of output, if you were free to choose without restrictions your current level of employment, what percent of the current level would you choose?” - 18 - The Investment Climate in Brazil, India, and South Africa India’s labor regulations are unusually complex.24 Since independence in 1947, establishments with more than 100 workers have been required to secure state government permission before plant closure or a retrenchment of workers. This permission is rarely granted. The flexibility of firms to adjust employment is also restricted by collective agreements, making it difficult not just to shift workers between plants and locations, but also between different jobs in the same plant. To maintain flexibility in the allocation of manpower, firms commonly resort to a number of circumventions, such as the use of contract workers or, where this is precluded by state governments, the restricting of employment below the threshold level of 100 employees. The Doing Business report confirms that India’s labor regulations are more stringent than the average for South Asian countries in all facets. The “difficulty of firing” workers in India, for instance, is rated 90 out of 100, more than double that of the regional average. Firms must pay 79 weeks of salary in notice, severance and penalties to dismiss a worker—compared with a regional average of 75 weeks and East Asian and OECD averages of 44 weeks and 35 weeks respectively. 30 percent of Indian firms report that they would lay off workers if regulation permitted, with the average firm reporting that they employ 11 percent more workers than they desire. Although this number is high relative to Brazil, it has fallen from 17 percent in the 2000 ICS. The change is thought to be due to increasing government reluctance to enforce the more intrusive provisions of existing laws. Generally, labor regulations in South Africa are less constraining than those in Brazil and India, but more rigid than those of the OECD. Firms in South Africa cite labor regulation as the third most important factor constraining economic expansion, behind worker skills and macroeconomic stability. The Doing Business data confirms that hiring and firing workers in South Africa is more legally complicated than the regional average and significantly more so than the OECD. However, the cost of hiring in South Africa is relatively low, however, at just 2.6 percent of the annual salary. The costs of firing are also in line with that of OECD countries. In summary, labor regulations in Brazil and India are very complex and impose substantial constraints on the ability of firms to adjust their workforces in response to market conditions. In South Africa, regulation appears to be less stringent than in Brazil or India, but more so than the OECD average. The impact of labor regulation is a common concern of firms in South Africa. Exit of Firms Procedures for the exit of firms are Table 18: Time and Cost of Bankruptcy in Indian Cities important both to provide for the resuscitation of ailing companies, 17.3% where appropriate, and to provide 16.4% creditors with speedy and 15.3% 15.3% 14.3% 14.3% inexpensive recovery of their assets 12.8% once firms have irrevocably failed. Where bankruptcy procedures do not fulfill these goals, the function of 8.5% markets can be disrupted. If creditors’ rights are not upheld, for Time (Years) Recovery Rate 5.1% instance, financial institutions will be more reluctant to loan to firms, resulting in high interest rates and 20 15 10 10 10 10 10 9 8 low productivity across the economy. Kolkata Lucknow Hydera. Chennai Bhuban. Jaipur Mumbai Chandi. Bangal. Of the three countries, none have Source: Doing Business in South Asia 2006 24 Doing Business in South Asia 2006 reports that there are currently 47 central laws and 157 state regulations that directly affect labor markets, many of which are inconsistent and overlapping. As a result, it is almost impossible for either firms or workers to be aware of their rights and obligations, or for enforcement authorities to ensure compliance. - 19 - The Investment Climate in Brazil, India, and South Africa particularly exemplary bankruptcy proceedings. The average time to complete procedures and recover assets in South Africa is short, at just 2 years, although the speed is achieved only at significant cost, some 18 percent of the estate, which is more than double that of a similar proceeding in the OECD. The rate of recovery of assets by shareholders afforded by the South African legal system, at 34 percent, is high for developing countries, but around a third that achieved in industrialized economies. In both Brazil and India, the recovery of assets takes, on average, a staggering 10 years, well over double the norm in both of the respective regions and longer than anywhere else in the world. While procedures are reasonably inexpensive in both countries, the rate of recovery achieved by both systems is low. In India, the figure is 13 percent, well below the regional average of 20 percent. In Brazil, creditors can expect to recover just half a percent of the value of their assets, compared to 28 percent across Latin America generally. Table 19: Efficiency of Bankruptcy Proceedings Average Time to Cost of Bankruptcy Recovery of Assets from Complete Procedure Proceedings Insolvent Firms São Paulo 10 Years 9% of Estate 0.5% of Assets Latin America 3.5 Years 17% of Estate 28.2% of Assets Mumbai 10 Years 9% of Estate 12.8% of Assets South Asia 4.2 Years 7.3% of Estate 19.7% of Assets Johannesburg 2 Years 18% of Estate 34% of Assets Sub-Saharan Africa 3.3 Years 19.5% of Estate 16.1% of Assets OECD 1.5 Years 7.4% of Estate 73.8% of Assets Source: Doing Business 2006 Part of the problem in Brazil has been that the law has long prohibited creditors from seizing and selling collateral upon default without the consent of the debtor, unless a lawsuit is filed and the court rules in favor of the plaintiff. Even upon this ruling, the debtor has various options for appeal, during which time they retain control over the assets. In India, defaulting borrowers take refuge under the Sick Industrial Companies Act (SICA) in order to avoid payment to creditors. Insolvency procedures are protracted further by the lack of adequate specialized resources among courts and tribunals and by the requirement that firms employing more than 100 workers to seek the permission of the state government before closing a site or retrenching workers, something which state authorities rarely grant. As a result, bankruptcy procedures in India vary significantly from state-to-state. The least effective system is that of West Bengal, which on average takes 20 years with an average recovery of just 5 percent. Karnataka’s system, on the other hand, takes 8 years and recovers 17 percent of creditor’s assets. Both Brazil and India have undertaken recent reforms of their bankruptcy system. Brazil’s changes, introduced in 2005, created a reorganization procedure which both helps viable enterprises stay afloat and gives secured creditors more influence over the process and priority to their collateral. The reform faced its first test in June 2005, when the Brazilian flag carrier Varig Figure 10: Confidence in Judiciary filed for bankruptcy. In little more than a year, S. Africa Varig’s assets have been sold to a new owner and 80% bankruptcy is near complete. India Brazil Indonesia 60% ENFORCEMENT Kenya The act of enforcing business law and regulation is 40% Russia a fine art. Businesses require supportive, but not intrusive, forms of public administration. Officials 20% inspecting compliance with taxation and regulatory policies must apply the law consistently 0% Source: Investment Climate Assessments - 20 - The Investment Climate in Brazil, India, and South Africa and in a manner which does not lead to exaction of bribes or rents from enterprises, either for real or imagined violations. Similarly, the courts must enforce commercial contracts in an expeditious manner which provides reassurances to investors that their property rights will be upheld. Enforcement of Contracts Almost all forms of legitimate economic activity and exchange are reliant, albeit implicitly, on the enforcement of contracts. Yet in many developing countries, judicial remedies to those seeking enforcement of contracts are slow, costly and often unreliable. An essential step in promoting economic development is thus to enhance the confidence of economic actors in the capability of the judiciary to enforce contracts. The results of ICAs and Doing Business help us to assess the efficiency of contract enforcement by providing information on the complexity of procedures, the time and cost to enforce a contract, and the confidence of firms in the local judiciary.25 Table 20: Burden to Resolve Payment Dispute through Legal System Cost Procedures (number) Duration (days) (% of Debt) São Paulo 24 546 15.5 Latin America 35 461 23.3 Mumbai 40 425 43.1 South Asia 30 386 17.7 Johannesburg 26 277 11.5 Sub-Saharan Africa 36 439 41.6 OECD 20 226 10.6 Source: Doing Business 2006 Of the three countries, managers in South Africa seem most confident that firms would uphold property rights, followed by those in India, and then those in Brazil. The high confidence shown by firms in South Africa is validated by the Doing Business data, which demonstrates that contract enforcement is relatively efficient in South Africa’s main business center of Johannesburg, taking only 9 months, which is close to the OECD average, and costing only 11.5 percent of the total debt value, a level also similar that of courts in developed countries. In Brazil, the duration of contract enforcement is particularly lengthy, around 18 months, compared to less than 8 months in OECD countries. The process is often prolonged by multiple appeals, the inexperience of courts in dealing with commercial cases, and strategies of brinkmanship among claimants.26 As a result of this process, small businesses are particularly keen to avoid judicial processes as much as possible and, in surveys, are much less prone to trust the courts to protect their property rights and adjudicate their contract disputes.27 Substantial variation exists within Brazil, however, as to the efficiency of judicial enforcement. Access to justice is cheapest in São Paulo, where it costs 15.5% of the debt value to enforce a contract, whereas the same process will cost the entrepreneur 48.3% of the debt value in Maranhão. Although contract enforcement is long in São Paulo by international standards, the business center outperforms other major cities in Brazil by a substantial margin. In Rio Grande do Sul, the process to enforce a contract takes over 4 years. 25 The cost of judicial access is comprised of court expenses and attorney fees, whereas the duration indicator measures the time necessary to file a case, obtain a ruling from the judge, and execute a decision. 26 Doing Business in Brazil 2007 reports that in Brazil, 88% of commercial cases are appealed, compared to 13% in Argentina, 17% in Peru, and 30% in Mexico. 27 According to the Brazil Investment Climate Assessment, “Between 25% and 28% of micro firms do not believe that courts will protect their property rights. For large firms, this distrust in courts is of only 5%.” - 21 - The Investment Climate in Brazil, India, and South Africa Table 21: Time and Cost of Enforcing a Contract in Brazilian States 48% Time (Days) Cost (% of Debt) 32% 22% 22% 21% 20% 21% 19% 19% 16% 16% 17% 16% 1,473 1,157 1,068 1,017 942 873 835 813 794 755 730 690 546 0 0 Rio Mato Minas Santa Ceará Bahia Amazonas Rio de Rondônia Mato Federal Maranhão Grande Grosso Gerais Catarina Janeiro Grosso do District São Paulo do Sul Sul Source: Doing Business in Brazil 2007 Indian managers, in general, express a relatively high level of confidence in the judiciary to enforce property rights. However, as with Brazil, the actual process is often lengthy and costly by international standards. In India’s major business center of Mumbai it takes over 14 months to enforce a contract, nearly double that of China. The total cost of enforcement is a whopping 43 percent of the debt value, thereby significantly undermining the rationality of pursuing judicial recourses. Other major Indian cities fare better in terms of the cost of enforcement, but much worse in terms of the duration. In Lucknow (U.P.), it takes over 3 years to get a contract enforced, while in Kolkata and Chandigarh it takes over 2.5 years. The cost of contract enforcement, however, is relatively cheap in Bangalore, Bhubaneshwar, and Jaipur, at around 15 percent of the total debt value. The generally long delays and high costs in getting contracts enforced encourage firms to resolve disputes informally, a fact confirmed by the ICS survey results. In order to resolve this situation, the Doing Business in South Asia 2006 report recommends that “rules of civil procedure can be amended to restrict the adjournments judges can give, and to allow judges to impose strict time limits and a trial calendar on the parties.” In order to expedite enforcement of judgments, which take up the vast majority of time spent attempting to move a case through the courts, Doing Business recommends “scrapping the public monopoly on executing judges’ rulings” and allowing “licensed private enforcement agents” to move into the business. In summary, enforcing Table 22: Time and Cost of Enforcing a Contract in Indian Cities commercial contracts in Brazil and India is generally lengthy and 43% expensive, although substantial Time (Days) Cost (% of Debt) variation exists within both 37% countries. In South Africa, contract enforcement is relatively efficient. 23% 22% Enforcement of Regulation 18% 16% All systems of government regulation 14% 14% 15% require systems of enforcement. However, the officials, bureaucracies, and judicial entities responsible for 1165 942 934 875 765 712 709 683 425 such enforcement do not always do 0 0 so in ways which are efficient, Lucknow Kolkata Chandi. Jaipur Bhuban. Hydera. Bangal. Chennai Mumbai Source: Doing Business in South Asia 2006 - 22 - The Investment Climate in Brazil, India, and South Africa Figure 11: Consistency and Predictability of transparent, predictable, or even honest. Particularly Officials’ Interpretation of Laws where regulation is complex or not particularly 70% accessible, room for discretion is provided to the respective functionaries, leaving business operators in an uncertain and often precarious position. This 50% inevitably raises business costs, both indirectly in terms of preparing for multiple eventualities of 30% interpretation and enforcement, and directly in terms of irregular payments to unscrupulous officials seeking private gain. 10% Both Brazil and India possess relatively complex systems of regulation which tend to encourage Brazil India South Indonesia Kenya Russia Africa rent-seeking by government officials and impose administrative costs for firms in ensuring Source: Investment Climate Assessments compliance. Two-thirds of Brazilian firms, for instance, reported that corruption is a major or severe impediment to business operation, while in India it registered as the number one concern. Furthermore, the proportion of firms in Brazil that report officials’ interpretation of laws to be consistent and reliable is relatively low and well below those reported in India and South Africa (Figure 11). The ICAs also ask firms about the frequency of annual inspection visits and the amount of management time spent complying with regulation and dealing with government officials. Overall, Brazil and India do relatively well on the frequency of inspections, with national averages for both countries at around 7 or 8 visits a year, which is much less than the average 28 visits reported in China. Brazilian managers also spend a relatively minimal amount of time dealing with regulation, less than in China or Kenya. In India, though, the figure is much higher than in Brazil, Indonesia, Russia, or South Africa and displays wide variability. Regulation and its associated enforcement seems to be less of a problem in South Africa than the other two countries, although some managers in the country report spending up to 15 percent of their time dealing with regulatory issues. Firms in the north and southeast of Brazil are exposed to the highest overall inspection burden - some 30 hours on average by federal, state, and municipal authorities, compared to an average of 14 hours in the Center-West region. Overall, managers in the Northeastern states of Paraiba, Bahia and Ceará spend the lowest amount of time in dealing with regulations, followed by those in the South, Southeast and Center- West. Those in the North state of Amazonas Figure 12: Percent of Mgmt. Time Spent on Regulation spend the most amount of time, a fact which may 40% be explained by the widespread use of fiscal incentives in the state of Amazonas. The China frequency of inspections also varies significantly 30% with firm size. Large firms receive, on average, four times as many annual inspections than micro- India Kenya firms. For micro-firms, inspections by municipal 20% environmental authorities are most burdensome, South Africa while, for medium- and large-sized firms, the federal health ministry and labor and social Brazil Russia security agencies make the most frequent 10% Indonesia inspections.28 Indian business regulation is laid out mainly by 0% federal law, although state governments, and the Note: Boxes are 25th - 75th percentile, lines are medians Source: Investment Climate Assessments 28 Federal and municipal health departments were the most frequent inspectors, making an annual average of 1.7 inspections of businesses. Labor and social security followed with an average of 1.3 inspections per year. The Federal Environmental Agency, Fire and Building Safety, and Standards were the least frequent inspectors. - 23 - The Investment Climate in Brazil, India, and South Africa individual inspectors they appoint, are given considerable discretion in enforcement. As a result, the reduction of the “License Raj” at the center has not necessarily had a significant impact on the “Inspector Raj” which presides at the state level. There is accordingly significant variation between Indian states in the burden of compliance with regulation. In Gujarat, which is generally considered to be one of the more investment-friendly Indian states, managers spent nearly a quarter of their time dealing with regulation, compared to just 7 - 8 percent spent by managers in the poorer states of Madhya Pradesh and Uttar Pradesh. Firms in Madhya Pradesh also report the lowest number of inspections (just 2 per year) while firms in West Bengal and Kerala report the most (13and 14 per year, respectively). Table 23: Administrative Burden of Regulation in Indian States 24% Management Time Spent Dealing with Regulations Number of Inspections 21% 18% 16% 13% 13% 13% 11% 11% 10% 8% 7% 13 14 11 9 7 8 6 5 6 5 4 2 M.P. U.P. Haryana A.P. Karnataka Punjab Delhi T.N. Maharashtra W.B. Kerala Gujarat Source: India Investment Climate Assessments In summary, the complex nature of regulation in Brazil and India has led to frequent instances of official corruption. In India, corruption was the number one concern, while two-thirds of Brazilian firms thought it was a problem. Firms in Brazil and India did, however, spend less time dealing with regulation than their peers in China, although substantial regional variation is observed in both countries. Regulation and its associated enforcement seems to be less of a problem in South Africa than the other two countries, although some managers in the country report spending up to 15 percent of their time dealing with regulatory issues. - 24 - The Investment Climate in Brazil, India, and South Africa ENABLING INFRASTRUCTURE A country’s enabling infrastructure consists of the normal set of services, factors, and conditions that firms require to establish operations and engage in production and exchange. As such, it encompasses areas as diverse as the availability of credit, the quality of the country’s transportation network, and public safety. Often, the quality of a country’s enabling infrastructure is impacted by historical and institutional factors exogenous to the orientation of government policy, at least over the short-term. South Africa, for instance, suffers from high crime rates arising from the legacy of apartheid-era policies and the associated socio- economic inequalities; transportation infrastructure in India is still very much reliant on an extensive rail network constructed while the country was still under colonization; and the availability and cost of credit in Brazil has been impacted sharply by the legacy of macroeconomic imbalances. In this section, we examine and contrast the quality of enabling infrastructure in Brazil, India, and South Africa. This section is divided into four parts: Access to Finance, Physical Infrastructure, Cost and Availability of Skilled Labor, and Crime. ACCESS TO FINANCE Finance is a fundamental component of any business operation. Without inexpensive and readily accessible means by which to acquire it, firms will often be precluded from expanding, engaging in research and development, and even surviving during unfavorable economic times. While the availability and cost of credit is often impacted by historical and institutional factors, government policies have a pronounced impact. Financial taxation, inefficient bankruptcy procedures, and directed credit policies all tend to raise interest rates well above what they otherwise would be, thereby making it difficult for firms to grow, and in some cases, even survive. Accessing finance is recognized as a major problem for firms in Brazil; three-quarters of managers cited the cost of finance as a constraint on the growth of their business. Over half of Brazilian firms which claim to need loans opt not to apply, citing reasons such as complicated application procedures, high interest rates, and strict collateral requirements. In China and India, the corresponding figures are just 32 percent and 16 Figure 13: Interest Rates: 1996 – 2006 percent of firms, respectively. Although lending rates in 120% Brazil have fallen over the past decade, they remain above 50 percent, which is extremely high by 100% Brazil international standards.29 Interest rate spreads are also 80% significantly greater in Brazil compared to similar middle-income economies. The wide spreads and high 60% lending rates are commonly attributed to unfavorable macroeconomic conditions, particularly the high level of 40% public sector debt, although weak creditor rights, the South Africa lack of banking competition, and high levels of financial 20% taxation are also a significant part of the explanation.30 India 0% In obtaining finance from banks and other formal May-96 May-98 May-00 May-02 May-04 May-06 financial institutions, firm size clearly matters in Brazil. While three-quarters of large firms which declare Source: IMF International Financial Statistics 29 The median nominal interest rate reported by enterprises surveyed in the Brazil ICS was 40%, higher than in Senegal (12%); Poland (12%), Kenya (15%) and South Africa (11%). 30 Brazil’s Central Bank studies broke down spread into cost of default (17%), taxes (29%), profits (41%) and administrative expenses (13%). High default costs reflect the effects of weak credit rights, poor borrower screening and insufficient creditor protection due to both imperfections of the legal system as well as juridical practice. The large share of profits and administrative expenses express the lack of competitiveness in the credit market and the cost of direct credit to the economy. The high taxation on the financial sector (and on the economy in general) is in large part due to the inability to decrease public expenditure. - 25 - The Investment Climate in Brazil, India, and South Africa a need for credit have bank loans, just 44 percent of small-firms and 36 percent of micro firms have them. The reason for this is that financial institutions tend to view lending to smaller firms as risky proposition owing to the common use of informal procedures and the resulting lack of reliable information on their financial situation.31 This uncertainty is reflected in the wide dispersion of interest rates charged to Brazilian SMEs (Figure 14). Firms that have a bank loan do not appear to be more productive than those the plants that applied for a loan and were rejected, however, underscoring the information asymmetries in the credit market. In order to lower interest rates in Brazil, a continuation of sound macroeconomic policies and reduction of public debt is essential. Creditor rights have been strengthened through the enacting of the new laws on bankruptcy and it is critical that enforcement establishes trust in these new protections. Further measures which would reduce the magnitude of spreads include easing the burden of financial taxation, including indirect taxation, such as reserve requirements and directed credit. In order for smaller firms to gain access to credit, a crucial step is regulatory reform to ease the costs of operating in the formal sector. Figure 14: Interest Rates by Firm Size 40% Brazil 30% Med. Very 20% Large India 10% China Small Large South Africa 0% Note: Upper and lower edges of boxes represent 25th and 75th percentiles. Lines represent medians Source: Investment Survey Assessments Access to external financing is a major issue for firms in India, particularly for small-firms.32 The problem in India is somewhat different than that in Brazil, though, as it relates more to access than to cost. While as many as 75 percent of small businesses in Brazil have bank credit lines or overdraft facilities, the corresponding figure in India is only about 54 percent. Although prior to 1997, Indian SMEs were quite reliant on debt financing both from banks and other financial institutions, policy and regulatory changes have caused the non-bank financial sector to shrink and for bank credit to SMEs to fall sharply. Presently, the limited debt financing available to Indian SMEs is of a short maturity and is relatively costly compared with counterparts in other countries. As with Brazil, much of the financing constraints faced by SMEs seem to arise from credit market and institutional imperfections which raise transaction costs and default risks. Specifically, financial institutions in India lack adequate means of reliably assessing the creditworthiness of SMEs or performing risk management or monitoring and face legal difficulties in using land as collateral.33 As discussed above, the 31 According to several indicators garnered through the ICAs, such as informality, unreported sales, and the use of external auditing, Brazilian SMEs are found to be less transparent than their larger counterparts. As a result, Brazilian micro- firms have the greatest rate of rejected loan applications. 32 Some 27% of respondents rate access to finance as a major to severe obstacle to business operations or growth. 33 According to the Doing Business database, for instance, the scope, access, and quality of credit information available to lenders in India lags that of Pakistan, Sri Lanka, and Nepal. - 26 - The Investment Climate in Brazil, India, and South Africa delays and uncertainties associated with the bankruptcy framework in India hinders exit for troubled firms and fosters low levels of confidence among creditors in enforcing collateral and recovering loans. Nevertheless, the situation does seem to be improving. Several commercial banks and credit information service providers have established the Credit Information Bureau of India Ltd (CIBIL), which should help considerably in deepening credit information. The implementation of the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act (SARFAESI) has also significantly reduced the time to enforce collateral. Further action should nonetheless be taken to assure creditors of the priority to their collateral in and outside bankruptcy and should have the possibility of enforcing collateral agreements without recourse to the judicial system. Compared to Brazil, India, and many other developing countries, firms in South Africa do not view either access to or the cost of finance as serious obstacles to enterprise operations and growth.34 Objective data generally support the perception-based data, particularly with respect to the cost of financing. Real interest rates in Brazil are, at around 5 percent, low relative to many developing countries.35 Firms in South Africa financed less investment through banks than firms in China, Kenya, Senegal, or Poland and fewer firms had access to overdraft facilities than in either Brazil or Kenya. This, however, seems to merely reflect the preferences of South African firms. Most firms that did not have loans did not want or need a loan and very few firms had been rejected for a loan Instead, South African firms rely heavily on retained earnings to finance both investment and working capital and few seem to view themselves as credit constrained.36 In summary, access to credit is a major issue for firms in Brazil and India, particularly those that are small. Interest rates in Brazil are extremely high, particularly for SMEs, and access to finance is often restricted due to the widespread use of informal procedures among small firms. SMEs in India also lack access to credit due to the absence of reliable credit information. Recent innovations, however, will hopefully help to improve this. Access to credit does not seem to be a concern for firms in South Africa. PHYSICAL INFRASTRUCTURE Figure 15: Days to Obtain Electricity Connection 100 Infrastructure services are a key component for India production, affecting the cost and ability to complete 80 production, to receive inputs and deliver goods, and to communicate with suppliers and customers. While Kenya 60 some firms can assume the cost of private provision of a few of these services, they are primarily under the purview of the government – and so can be readily 40 Brazil addressed by reform measures. South 20 Africa Indonesia In Brazil, while it seems clear that the quality of Russia transport and electricity provision is negatively 0 affecting firm performance, firms do not cite infrastructure as an important obstacle to growth.37 Note: Boxes are 25th - 75th percentiles, lines are medians This is probably related to the fact that, despite a Source: Investment Climate Assessments 34 In 17 of 49 low- and middle-income countries, over 40% of enterprises reported that finance was a major or very severe problem. In South Africa fewer than 20% of enterprises rated either as a major or very severe obstacle. 35 The median nominal interest rate reported by enterprises surveyed in the South Africa ICS was 11%, lower than in Senegal (12%); Poland (12%), Kenya (15%) and Brazil (40%). 36 When asked why they had not applied for a loan, most of these firms reported either than they did not need a loan (72%), that they received financing from their parent company (10%) or that they did not want to incur debt (10%). 37 Brazilian firms lose approximately 3.5% of their annual sales as an effect of poor infrastructure services. Firms that experience losses lose around 17% of their annual sales. - 27 - The Investment Climate in Brazil, India, and South Africa major collapse in infrastructure investment,38 Brazil’s infrastructure sector still performs at reasonable levels compared to the rest of Latin America. Firms in India, on the other hand, are clearly very concerned about the effect of deficient infrastructure on productivity. Power supply is clearly identified as the most problematic element, with nearly a third of businesses rating it as a major or severe bottleneck. By way of comparison, only 13 percent of respondents cite transport as a problem. Within India, firms in better investment climate states such as Karnataka tend to be more critical of the quality of infrastructure, although objective indicators suggest that they are generally better served than their counterparts in poorer states. Figure 16: Ownership and Use of Generators in Brazil 40% 7% Mato Grosso Amazonas Firms Owning a Generator (Left Scale) 35% 6% Electricity from Generator (Right Scale) 30% Rio Maranhão 5% Ceará Grande 25% Goiás Santa do 4% Catarina Sul 20% São Paulo Minas 3% Gerais 15% Bahia Paraíba Rio de Janerio 2% 10% Paraná 5% 1% 0% 0% Source: Brazil Investment Climate Assessment The burden imposed on firms in Brazil by Figure 17: Losses to Service Interruptions in Brazil unreliable supplies of electricity appears serious, imposing greater production delays Amazonas than failures in other public utilities. The Ceará reliability of the power supply varies Rio de Janerio significantly within Brazil, however, and Paraíba this is reflected in strong regional disparities in the effects of service failures on firms. Firms Goiás in the North (particularly Amazonas) and Rio Grande do Su; Northeast (particularly Ceará) report Maranhão significant losses to production arising from Mato Grosso power outages.39 To mitigate the problem of São Paulo reliability, around 17 percent of Brazilian firms own power generators. In Mato Grosso Santa Catarina and Amazonas, over 35 percent of firms own Paraná Electricity Phone generators. Although utilities in the North Minas Gerais Transport Water and Northeast are relatively unreliable, Bahia firms in the South and Southeast must wait the longest to get connected to 0 5 10 15 20 mainline services. For instance, while the Note: Mean days lost to service failures per year median delay to supply power to a new firm Source: Brazil Investment Climate Assessment in Rio de Janeiro is some 25 days, a 38 Average investment in electricity generation fell to less than a third of its level during the seventies, while investments in transportation have fallen to about a quarter their level in the 1970s. 39 The regional pattern of outages observed for water, telephone, and transport services is similar to that of electricity, although with a smaller magnitude. - 28 - The Investment Climate in Brazil, India, and South Africa connection takes only 5 days in Maranhão. The cost of transporting goods to market is Figure 18: Time to Connect Utilities in Brazil significant in Brazil, representing one third of Rio de Janerio firms’ average operational costs. To a São Paulo significant extent, this reflects the poor and Minas Gerais deteriorating condition of the 58,000 km paved- Ceará road network which carries some 70 percent of transported goods. More than a quarter of the Mato Grosso network is in poor condition and this is estimated Santa Catarina to add half a billion US dollars annually to vehicle Paraná operational costs. Costs vary systematically Amazonas across Brazilian regions, with firms in the Rio Grande do Sul Center-West region suffering losses of consignment cargo in transit twice as high as those Bahia for firms in the North. Among all regions in 40 Maranhão Telephone Electricity Water Brazil, the highest proportion of firms which Goiás perceive transportation to be a major or very severe problem to doing business is in the North 0 10 20 30 40 50 (43%), followed by the Center-West (33%). In Note : Median reported times to obtain connection contrast, only 13% of firms in the Northeast and Source: Brazil Investment Climate Assessment the South consider transportation to be a major or very severe constraint to their operations. Such results suggest that the supply of transportation services has not yet caught up with higher demand for such services by regional producers. Figure 19: Ownership and Use of Generators in India 25% Chandigarh Kolkata Kanpur 100% Bangalore Firms Owning a Generator (Left Axis) Delhi 20% Lucknow Electricity from Generator (Right Axis) Hydera. Chennai 80% 15% 60% Ahmed. Pune 10% 40% Mumbai Bhopal Vadodara 5% 20% Indore Nagpur 0% 0% Source: India Investment Climate Assessment Firms in India appear seriously constrained by the quality of the country’s physical infrastructure and, particularly, by the unreliability and high cost of electricity. Manufacturers face an average of 17 significant power outages per month, which, through downtime, damage to materials-in-process, and ruin of equipment, collectively cost firms nearly a tenth of total output value. Power supply disruptions are especially frequent in Bangalore, Chandigarh, Delhi, Indore, and Kanpur, while Ahmedabad, Mumbai, and Vadodara experience relatively few. It also takes new firms in India significantly longer than their peers in other major developing countries to obtain a connection to the public grid. On average, the wait is some six- 40These losses are reflective not just the quality of roads and the vehicle fleet of the trucking industry, but also of the security situation and the prevalence of crime in different regions. - 29 - The Investment Climate in Brazil, India, and South Africa and-a-half weeks, compared to three weeks in China or a week-and-a-half in Brazil. To cope with power outages and connection delays, over three-fifths of Indian manufacturing firms own generators.41 The figure is substantially higher in major industrial centers such as Delhi, Hyderabad, Chennai, and Bangalore, where firms rely upon private generation for between 15 and 20 percent of their electricity needs. Overall, India’s combined real cost of power is 74 percent higher than Malaysia’s and 39 percent higher than China’s.42 It is estimated that reliable, affordable energy would increase manufacturing labor productivity by more than 80 percent in high-cost cities. Figure 20: Time to Connect Utilities in India Figure 21: Utility Interruptions in India Vadodara Kanpur Chandigarh Chandigarh Lucknow Bangalore Pune Indore Kanpur Pune Chennai Chennai Ahmedabad Bhopal Hyderabad Delhi Kolkata Hyderabad Nagpur Lucknow Indore Ahmedabad Power Water Telephone Delhi Kolkata Mumbai Nagpur Bangalore Electricity Phone Vadodara Bhopal Mumbai 0 20 40 60 80 100 0 10 20 30 40 50 60 Note: Median time to complete connection Note: Mean number of interruptions per month Source: India Investment Climate Assessment Source: India Investment Climate Assessment Although generation capacities in India are generally considered sufficient to meet the countries needs, there has been serious underinvestment over the years in transmission and distribution infrastructure. In addition, many of India’s State Electricity Boards (SEBs) have long maintained a deliberate policy of cross-subsidizing the supply of electricity to households and agricultural producers by charging excessive tariffs to industry. This and the boards’ growing failure to protect transmission and collect bills, have led to serious underinvestment in maintenance and capacity. India has recently made efforts to attract private investment in generation and distribution, but these efforts have yet to bear fruit partly due to the absence of a regulatory framework in which potential investors have confidence. India’s infrastructure is also severely deficient in the provision of transport services to industry. India currently has no interstate expressways linking its major economic centers and only 3,000 km of four-lane highways.43. Just over half of India’s roads are paved and the average speed of trucks and buses on Indian highways is a paltry 30 – 40 km per hour, owing to both congestion and the low quality of road infrastructure. Although Indian Railways is the second-largest rail network in the world, the service is an inefficient means of transporting goods. The practice of cross-subsidizing passenger fares results in high cargo fares, while 41 This compares to 20 percent in Malaysia, 27 percent in China, and 17 percent in Brazil. 42 India has significant interstate variations in power tariffs. For instance, Uttar Pradesh and Gujarat charge Rs. 6.64 and Rs. 4.39 per KwH respectively, compared to Rs. 3.22 and Rs. 3.00 per KwH in Orissa and Punjab respectively. 43 By way of comparison, China has built 25,000 km of four- to six-lane, access-controlled expressways in the past 10 years - 30 - The Investment Climate in Brazil, India, and South Africa congestion along main lines results in unreliable long-haul delivery times.44 Due to the manifest problems in Indian transport, the government has made the development of the road transport system an investment priority. The Golden Quadrilateral (GQ) project and the North South-East West (NS-EW) highway project will make significant contributions to the time and cost required to travel between India’s main centers. However, even assuming these projects are completed on schedule by the end of 2008, reasonably well surfaced, four-lane national highways will account for just 22 percent of India’s national highways and none of the state highways. Table 24: Effectiveness of Public Power Supply Days to Connect to Percent of Output Generator Share of Power from Public Grid Lost to Outages Ownership Gen. Brazil 10 Days 2.5% 17.0% 1.6% Peru 7 Days 3.2% 28.2% 5.9% India 45 Days 10.0% 63.5% 19.1% China 6 Days 2.0% 20.1% 1.6% South Africa 4 Days 0.9% 9.4% 0.2% Kenya 21 Days 9.1% 69.7% 14% Notes: Data is for manufacturing firms only. “Days” represent median values. Source: Investment Climate Assessments In South Africa, losses due to power outages are modest and the cost of power in low by international standards. Overall, manufacturing firms in South Africa lose less than 1% of output to electricity outages. As a result of reliable electricity supply, less than 10 percent of South African firms see the need to own a generator. Of the three countries, India suffers the greatest problems with the quality of its physical infrastructure. Power supplies are extremely unreliable, due to inadequate transmission facilities, and the transportation infrastructure is primitive. Some regions of Brazil also have serious infrastructural issues, with firms in the North and Northeast losing significant portions of production due to power failures and firms in the Center-West losing goods in transit due to the inadequacy of transport infrastructure. COST AND AVAILABILITY OF SKILLED Figure 22: Weeks to Fill Vacancy for Skilled Technician LABOR 12 As firms attempt to increase the amount of value added during production and to compete with firms of overseas, the availability of skilled 9 labor can be a crucial determinant of performance. Where it is difficult to find or hire such labor, market opportunities may go amiss 6 and production runs may suffer disruption. Excessive skill premiums similarly raise the cost 3 of production and render firms uncompetitive in the international market. The availability of skills was the most 0 commonly cited constraint on firm Brazil India South Russia China Indonesia Africa operations and growth in South Africa, with Note: Boxes are 25th - 75th percentile, lines are medians Source: Investment Climate Assessments 44In a situation of zero cross-subsidization, the ratio of passenger earning per passenger km to freight earning per metric ton of freight km should be 1. For India it is 0.3. - 31 - The Investment Climate in Brazil, India, and South Africa some 35.5 percent of surveyed managers regarding it as a “major” or “very severe” obstacle for their business.45 Consistent with such perceptions, skilled workers attract an extremely high premium in South Africa: an additional year of education in South Africa is associated with an 11 - 12 percent increase in wages, compared to 5 - 7 percent in most developed economies. This is further reflected in a high level of wage inequality in South African industry. While the median monthly wage for an unskilled production worker in South Africa in 2002 was about $240 per month, a manager in South Africa commands about $1850 per month. In Brazil, unskilled workers average about $167 per month and managers $540 per month. This translates into significant additional costs of production, which render South African firms uncompetitive relative to firms in other developing countries. South African firms also require a median time of 4 weeks to fill a skilled vacancy, compared to just two weeks in India and China. In Brazil, however, firms require a median of nearly 6 weeks to fill a skilled vacancy and some 25 percent of hiring firms report spending 12 weeks or longer. Table 25: Median Monthly Wages by Worker Type (USD) Skilled Unskilled Managers Professionals Production Production Total Workers Workers Brazil $542 $568 $241 $167 $224 China $128 $120 $72 $76 $131 South Africa $1,848 $803 $487 $241 $675 Poland $738 $369 $320 $246 $408 Source: South Africa Investment Climate Assessment Table 26 - Frequency of Firm-Based Training Despite the concerns that South Africa managers Skilled Unskilled Workers Workers express about the availability of skills, relatively Brazil 77% 68% few firms in South Africa have training programs. Poland 80% 86% While around four out five workers in Brazil, China, India 55% 33% and Poland undergo firm-level training programs, China 69% 63% under half of South African firms offer such training. South Africa 45% 46% The figure is also low in India, where 55 percent of skilled workers and only a third of unskilled workers Source: South Africa Investment Climate Assessment receive training. In summary, both the cost and availability of skills in South Africa seems to be a significant problem. Firms in South Africa have to pay significantly more to hire skills than do firms in other developing countries with which they compete. South African firms must also spend longer looking for skilled workers to hire than in some competitors. The time to fill a skilled vacancy is even more problematic in Brazil, however. In both of these respects, India seems to perform particularly well. CRIME The incidence of crime can add significantly to the costs of doing business, both directly through the loss of plant equipment and produce to vandalism or theft and indirectly through the cost of employing security agencies to protect the firm’s property. In Brazil and South Africa managers expressed particular concern about the effect of lawlessness on their ability to conduct business. Over half of Brazilian managers, for instance, rated it as a “major” or “very severe” constraint. In South Africa, crime ranked fourth overall among concerns of managers, cited by just under 30 percent of respondents. Objective indicators indicate that Brazil and South Africa are representative of countries where crime and security may be considered important, though not critical, problems. Nevertheless, compared to other middle-income countries, the security environment harms 45 This compares to 33.5 percent for macroeconomic instability and 33 percent for labor regulation. - 32 - The Investment Climate in Brazil, India, and South Africa competitiveness and makes Brazil and South Africa less attractive destinations for foreign investment. In the ICA survey, approximately 23 percent of Brazilian managers reported that their firm had suffered losses due to arson, theft, or vandalism during the past year, with some 81 percent of firms reported employing outlaying additional costs for security. Such costs seem to be lower than experienced by firms elsewhere in Latin America. Three quarters of Peruvian firms, for instance, reported experiencing direct costs from crime. Within Brazil, firms in the North seem to bear the highest direct costs of criminal sales, averaging some 1.5 % of annual sales.46 Security costs and costs of prevention are highest in the Center-West, which is also the region with the highest value of consignment cargo lost during transport, and the high costs of security possibly reflect firms’ needs to secure cargo in transit. Security costs are lowest in the south of Brazil. The incidence of property crime in South Africa has increased over markedly since 1994 and this has raised the costs of doing business.47 Over half of South African firms reported direct costs as a result of arson, theft, or vandalism in the past year and four out of five firms also incurred extra costs for securing their property. The incidence of direct losses to crime, although not particularly unusual for firms in Africa, was nonetheless significantly higher than in Kenya or Senegal. Direct losses account for a third of the total costs of crime, which is more than in most countries, and seems to imply that the means by which firms protect themselves from crime are less effective in South Africa than in other countries. Although the reporting of crime to the police is relatively high in South Africa (58 percent), nearly three quarters of firms report that none of the reported incidents were solved. The burden of crime is not evenly distributed across firms. In general, manufacturing firms faced fewer losses than firms involved in retail and wholesale trade or construction.48 Large firms also tended to face higher losses than smaller firms. After controlling for other factors, firms in Durban faced the heaviest losses, while firms in Johannesburg faced relatively modest losses. Brazil and South Africa have a reputation for being especially afflicted by violent crime. The data collected through the ICA survey, however, indicates that while Brazilian and South African firms suffer quantifiable costs from crime, both directly and indirectly, the incidence of crime in both countries is not unusually high for either of the respective regions. Table 27: Percent of Firms Experiencing Crime Costs Incidence of Incidence of Extra Crime in Security Past Year Costs Brazil 23% 81% Ecuador 37% 93% Peru 74% 66% India - 73% China 10% 48% Pakistan 8% 59% South Africa 53% 81% Kenya 35% 92% Senegal 42% 76% Source: Investment Climate Assessments 46 Concern over crime was particularly high in the Southeast and Center-West, where it was cited by 58% and 56% of respondents respectively. Firms in the North and Northeast were less concerned, cited by only 32% and 44% of firms. 47 Between 1994 and 2000, common robbery increased by 168 percent and aggravated robbery increased by 31 percent 48 About 52 percent of manufacturing firms experienced losses from crime in 2003, compared to 54 percent of construction firms and 64 percent of wholesale-retail firms. - 33 - The Investment Climate in Brazil, India, and South Africa CONCLUDING REMARKS The above analysis demonstrates that Brazil, India, and South Africa are far from reaching their full economic potential. In all three countries, aspects of the investment climate which could be improved through reform constrain firms, resulting in lower levels of investment, misallocation of factor inputs, and disincentives to engage in innovation and employee training. In Brazil and India, in particular, changes to tax policy and regulation and improvements in physical infrastructure and public administration will, with a good probability, result in heightened firm-level productivity, increased investment, and higher levels of economic growth. South Africa, meanwhile, has achieved mostly favorable tax and regulatory policies. Firms nevertheless continue to face constraints due to the high cost of skilled labor, the high level of criminal activity, and uncertainty concerning the value of the exchange rate. The nature of the investment climate in Brazil, India, and South Africa is significantly different in each case and, as such, there is substantial scope for learning between the three countries. Taxation in Brazil, for instance, is extremely burdensome, both in administrative and financial terms, a fact that has stemmed from the rigid revenue needs of central and state government. South Africa’s experience, where tax revenue was dramatically increased even as tax rates were reduced, is instructive for Brazil. The experience of Brazil in reforming bankruptcy procedures could be instructive to India. Similarly, Brazil and India have much to learn from South Africa in areas of public administration, in improving access to finance and upgrading the quality of physical infrastructure, and in reducing the burden of regulation governing market entry, exit, and the employment of labor. In a number of areas, India has much to impart to Brazil and South Africa. Skilled labor in India is both readily available, which it isn’t in Brazil, and relatively inexpensive, which it certainly isn’t in South Africa. The stability of India’s exchange rate contrasts sharply with the volatility of those of Brazil and South Africa, which again provides another area for mutual learning and assistance. While there is scope for learning from each other, all three countries can also learn from themselves. In Brazil and India, in particular, substantial differences exist between regions in different aspects of the investment climate. In a large share of cases, substantial improvements in the overall investment climate would be observed if all of the states within a country mimicked the policies and performance of the best domestic performer in each category. Thus, while it is important for countries to benchmark themselves against regional and global competitors and set targets accordingly, it is important for them to also look inward and to encourage state and municipal authorities to adopt reforms that have worked particularly well in specific parts of the country. - 34 - The Investment Climate in Brazil, India, and South Africa ANNEX CONCEPT OF THE INVESTMENT CLIMATE The investment climate in a country is the collective set of incentives which establish the “rules of the game” to which economic actors must adhere. Set by a wide variety of sources, including government policies, cultures of public administration, and institutional, social, and physical infrastructure, the investment climate determines the level and uncertainty of returns expected by economic agents and consequently impacts the quality and quantity of investment and the incentives to productively employ inputs. The investment climate can be broken down into the following three main areas: (1) Macroeconomic and Trade Policy - The capacity of domestic institutions and economic policy (e.g. fiscal, monetary, trade, and exchange rate policy, administration of customs and ports, security of property rights, strength of rule of law, and political stability) to reduce costs of international trade and finance and ensure a consistent and non-distortionary basis for investment, production and exchange; (2) Microeconomic Framework - The contribution of microeconomic regulation (e.g. rules governing market entry and exit and factor markets) and enforcing agencies to efficient, expeditious, and predictable processes of production and exchange; (3) Enabling Infrastructure: - The cost, availability, and reliability of key public factors of production and exchange (e.g. credit, electricity, land, knowledge, physical security, skilled employees, transport). None of these sectors, or the components that comprise them, exist in isolation, however. Indeed, there is a high degree of complementarity across domains of public policy, regulation, and provision of public goods. The systems dynamics of the investment climate can be complicated accordingly. A change in policy in one facet, for instance, may lead firms to heighten their productivity, releasing binding constraints on growth by seemingly unrelated policies. When drawing reform implications from investment climate analysis, it is important therefore that policy makers be aware of these interrelationships and the potential for indirect, even unintended, effects. A given set of reforms may, for instance, deliver quite different results depending on the sequence by which those reforms are implemented. Where political constraints restrict the scope of reform, as is often the case, identifying the most effective sequence of policy changes is often critical to sustaining the political case for reform. MEANS OF ASSESSING THE INVESTMENT CLIMATE Information on the state of a country’s investment climate is provided by two separate but complementary instruments published by the World Bank, the Investment Climate Assessment (ICA) and the Doing Business report. While both publications provide invaluable information on the state of the investment climate across the world, they each adopt a different approach and provide a distinct assessment of the ease of investment, production, and exchange in the respective economies: • Investment Climate Assessments (ICA) are based primarily on firm-level surveys of managerial perceptions concerning the impact of the regulation, institutions, and infrastructure. Surveys cover a stratified random sample of manufacturing firms spread across the country and a core set of survey questions, asked of firms in every country, ensures reports are at least partially comparable across countries; • The Doing Business report seeks to objectively analyze existing laws and regulations through a common methodology and to consider their effect on a hypothetical firm. Much effort is expended by the Doing Business team to ensure cross-country comparability of results and a ranking of 155 countries according to the ease of doing business is published annually. The ICAs and the Doing Business reports complement each other in a number of ways. Doing Business enables a transparent and simple comparison of the administrative and financial burdens of complying with regulation - 35 - The Investment Climate in Brazil, India, and South Africa across a wide span of countries. Yet the analysis, done by legal experts in surveyed countries, relies very much on de jure regulation and thereby may not provide an accurate assessment of effective constraints on productivity and investment where enforcement is lax or where firms operate through informal channels.49 The Doing Business analysis also focuses on a hypothetical firm, defined in a very specific manner and located only in the country’s main business center. As such, the ascribed administrative burdens and costs may not be applicable to firms with different characteristics. ICAs directly survey managers as to their perceptions of the effective constraints on firm-level expansion and on the administrative and financial burdens of complying with government regulation.50 Accordingly, they can potentially provide a more realistic assessment of the effective constraints on firm-level growth. However, cross-sectional comparisons of survey results are fraught with difficulty and ordinarily provide little basis for assessing the magnitudes of problems.51 Another concern is whether survey responses accurately reflect reality, as respondents may adjust their responses in view of certain outcomes, particularly if they believe their responses can impact policy.52 Furthermore, managers of extant firms in the formal sector represent a biased sample, in so far as they have already “succeeded” in establishing their business, and are unlikely to be able to provide an adequate diagnosis of the problems faced by those who the investment climate condemned to entrepreneurial failure. Notwithstanding such cautions, the data obtained by the ICAs and Doing Business reports collectively represent the most insightful evidence available on the impediments to investment and productivity in developing countries. Provided that the objective cardinal measures of the Doing Business database are used in a complementary fashion with the perception-based indicators of the ICAs, useful summary comparisons can ordinarily be drawn across countries and conclusions and policy recommendations made accordingly. 49 One salient example mentioned below relates to the total taxation burden in the city of Rio de Janeiro. The Doing Business analysis finds that medium-sized firms in Rio are required to pay a total of 201% of their gross profits in tax, the highest of any city in the world. Obviously, given the wide range of businesses operating in Rio, this cannot be an accurate description of the de facto tax burden. 50 At time of writing, the World Bank had conducted ICSs across 76 countries since 2001. 51 Respondents in prosperous Indian states such as Karnataka tend to view their state’s investment climate in a much critical light than their counterparts in poorer states such as Bihar, a the difference which more likely reflects the differing expectations of managers in the two regions. 52 As an example, managers may overstate the amount of time spent dealing with regulation in an effort to encourage the government to reduce the regulatory burden on businesses. - 36 - The Investment Climate in Brazil, India, and South Africa REFERENCES In compiling this note, we drew upon the following resources: • The Investment Climate Survey for Brazil, conducted between July and October 2003 and covering 1,642 manufacturing firms in 13 Brazilian states (available here and here); • The Investment Climate Survey for India, conducted between March and July 2003 and covering 1,860 manufacturing firms sampled from 40 cities in 12 of India’s major states (available here and here); • The Investment Climate Survey for South Africa, conducted between January and December of 2004 and covering 800 firms, 75 percent of which were in the manufacturing sector, 14 percent in the construction industry and 11 percent in the wholesale and retail trade (available here and here); • The Investment Climate Assessment for Brazil, published December 2005 (available here and here); • The Investment Climate Assessment for India, published November 2004 (available here and here); • The Investment Climate Assessment for South Africa, published 2004 (available here); • State-Level Investment Climate Policy Note - Uttar Pradesh, India, published March 2006 • Doing Business in Brazil 2007 (available here and here); • Doing Business in South Asia 2006 (available here); • Doing Business 2006 (available here) • Doing Business 2007: How to Reform (available here) - 37 -