Report No. 35424-CR Costa Rica Investment Climate Assessment February 6, 2007 Finance, Private Sector and Infrastructure Central America Country Management Unit Latin America and the Caribbean Region Document of the World Bank PROCOMER Center for Promotionof ForeignTrade (Promotora del Comercio Exterior de Costa Rica) PROPYME Support Program for Small- and Medium-Sized Businesses(Programa de Apoyo a la Pequefiay Mediana Empresa) R&D Researchand Development SEN National Electric System(Sistema Electric0Nacional) SETENA Environmental Technical Secretariat(Secretaria Tecnica del Ambiente) SIECA Secretariat of Central American Economic Integration(Secretaria de Integraci6n Econ6micaCentroamericana) SUGEF Superintendency of FinancialIntermediaries in CostaRica (Superintendencia General de Entidades Financieras de Costa Rica) SMEs Small and MediumEnterprises TFP Total Factor Productivity UCCAEP Costa Rican Chamber o f Private BusinessAssociations (Uni6n Costarricense de Cfimarasy Asociaciones de la Empresa Privada) VAT Value-added tax UNCTAD UnitedNations Conference on Trade and Development WCIS World Cellular Information Service Vice President: Pamela Cox Country Director: Jane Armitage Sector Director Enersto May Sector Manager: Aquiles Almansi (Acting) Sector Leader Manuel Sevilla InvestmentClimateUnitManager Simeon Djankov ResearchManager Luis Serven Task Team Leader: Susana M.Shnchez CostaRica Investment ClimateAssessment - Table of Contents SUMMARYREPORT................................................................................................................................... i Background General Findings..................................................................................................................................... ................................................................................................................................................ ...i 111 Finance.................................................................................................................................................. ................................................................................................................. ..vii ... Infrastructure.. ...................................................................................................................................... Policy Recommendations xiii ..xiv Infrastructure-Related Constraints and the Competitiveness of Costa Rica's Firms. ........................ ..................... xvi Innovation.............................................................................................................................................. Key Policy Options for Enhancing Infrastructurefor Growth and Competitiveness xviii Why Government Policy Matters..................................................................................................... xxi .xxi Governance ........................................................................................................................................... How Much Does Costa Rica Innovate?............................................................................................ xxii xxv Business Regulations ........................................................................................................................ xxv Contract Enforcement ..................................................................................................................... .xxvi Crime & Violence ........................................................................................................................ Corruption ..................................................................................................................................... .xxvii Policy Recommendations .................................................................................................................... xxviii ... Business-Government Relations ..................................................................................................... xxix Contract Enforcement andthe Judiciary .......................................................................................... xxix Corruption ....................................................................................................................................... xxx xxxi Crime and Violence ......................................................................................................................... xxxi ......................................................................................................................................... DETAILEDFINDINGSAND RECOMMENDATIONS............................................................................ References. .xxxii 1 Chapter 1, Introduction......................................................................................................................... 1 1.1 Costa Rica's General Economic Trends ...................................................................................... 3 1.2 Data Sources ................................................................................................................................ 7 1.3 Impact o f the Investment Climate in Growth and Competitiveness: Econometric Estimates............11 The Perspective of Firms...................................................................................................................... Main Investment Climate Constraints ......................................................................................... 8 9 Chapter2. Finance.............................................................................................................................. 15 2.1 Introduction ................................................................................................................................ 15 2.2 Costa Rica's Financial System .................................................................................................. 16 Financial Sector Infrastructure .......................................................................................................... .19 Lending to SMEs ................................................................................................................................ 20 2.3 Results of the Investment Climate Survey (ICs) ....................................................................... 22 Use of Credit Services to Finance Working Capital andNew Investments ....................................... Characteristics o f Formal Sector Credit ............................................................................................ 22 ............................................................................................ .26 Firmsas Creditors .............................................................................................................................. Credit Constraining by Formal Lenders .29 31 2.4 Policy Recommendations .......................................................................................................... 33 Chapter 3. ..................................................................................................................... 3.1 Introduction.,............................................................................................................................. Infrastructure 35 .35 3.2Transport Infrastructure Endowment ................................................................................................ The Endowment of Costa Rica's Infrastructure......................................................................... 39 -40 3.3Quality o f the Transport Network ...................................................................................................... The Quality and Efficiency o f Costa Rica's InfrastructureServices......................................... 56 57 Quality of Telecommunications Services........................................................................................... 70 Quality of Electricity Services............................................................................................................ 64 3.4 InfrastructureFinancing ............................................................................................................ -82 Private Financing................................................................................................................................ ..................................................................................... 87 89 Legal and RegulatoryFramework...................................................................................................... Private Participationinthe Electricity Sector 90 The Lack of Clarity on LegalRightsto Be a Generator..................................................................... 90 Gaps and Preferential Treatments inthe Legal Systemto Allocate Rightsfor the Use of Hydro Resources............................................................................................................................................ 90 Uncertain Futureof PPA after Their Expiration ................................................................................ Integration to Central America Electricity Marketand CAFTA ........................................................ 91 91 3.5 Recommendations for Policy Action Related to Infrastructure Trade and Growth InvestmentDecisions ......................................................................................................................... ...................93 93 3.5.1 Transportation Recommendations.. ....................................................................................... 95 Chapter 4.Introduction The Role of InnovationinCosta Rica's Development ................................................... 103 4.1 .............................................................................................................................. 103 4.2 Innovation Framework ............................................................................................................. 104 Market Failures inthe Creationand Diffusion of Innovation .......................................................... 105 4.3 How Much Does Costa Rica "Innovate"? ............................................................................... 106 4.4 MacroeconomicEvidence on the Role of Innovation inPromoting Economic Development 116 Does Patenting Activity Improve a Country's Prospectsfor Development? What Are the Social Rates of Returnto R&DInvestments Across Countries?............................... ................................... 117 Do Market Failures HinderInnovation Inside the Global TechnologicalFrontier?......................... 121 123 4.5Empirical Strategy............................................................................................................................ Costa Rica's Current Innovation Structure, Policies, and Programs ...................................... 126 126 4.6 The Costa RicanExperience with InnovationPolicies............................................................ 129 Matching Grants and PROPYME .................................................................................................... 129 FutureMonitoring and Evaluation ofthe MatchingGrants Program ............................................... 135 Chapter 5.Summary 4.7 and Policy Recommendations ................................................................................. 137 Governance ..................................................................................................................... 141 5.1 141 E-Government .................................................................................................................................. Business-Government Relations.............................................................................................. Introduction.............................................................................................................................. 5.2 141 Inspections........................................................................................................................................ 145 146 Labor Regulations ............................................................................................................................ 148 Tax Regulations ................................................................................................................................ 150 5.3 Recommendations on Business-Government Relations .......................................................... 152 5.4 Contract Enforcement and the Judiciary .................................................................................. 154 Perceptions of the Judiciary .............................................................................................................. Court Use.......................................................................................................................................... 154 155 Labor Disputes ................................................................................................................................. 158 How Do Costa Rican FirmsAvoid Disputes? .................................................................................. 159 5.5 Recommendations on Contract Enforcement and the Judiciary.............................................. 162 5.6 Corruption ................................................................................................................................ 163 5.7 Recommendations on Corruption............................................................................................ 166 5.8 Crime and Violence ................................................................................................................. 167 References............................................................................................................................................. 5.9 Recommendations on Crime and Violence ............................................................................. 172 221 ListofTables Table 1: Comparative Survey on the Quality of Infrastructure ............................................................... xviii Table 2.1:Number of FinancialIntermediaries inCosta Rica. 1998 & 2006 ............................................. 17 Table 3.1: Reasons for Changes inGrowth. 1990sversus 1980s ............................................................... 36 Table 3.2: Comparative Survey on the Quality of Infrastructure Table 3.3: Costa Rican Container Traffic through PanamaPorts in2005 (Number o f Containers)...........39 ................................................................ 45 Table 3-4:PercentageDeviations from Expected Values Endowment of Telecommunications Relative to Table 3.5: Cost Structure by Export Product (Excluding Raw Materials) .................................................. Expectations ........................................................................................................................................ 55 Table 3.6: InfrastructureContributions to Cost by Sector and Export Product .......................................... 57 57 Table 3.7: Comparative Survey on the Quality of Transport Infrastructure ............................................... 58 Table 3.8: Quality o fthe National RoadNetwork ...................................................................................... 61 Table 3.9: Average Charge Air Shipment of Garment Exports to U.S ....................................................... 64 Table 3.10: Comparative Distribution Losses inElectricity Distribution, 2003 ......................................... 65 Table 3.11: Prices for Residential and Business Telephone (US$) ............................................................. 75 Table 3.12: ICT Penetration (2004) ............................................................................................................ Table 3.13: Status of RoadProjects under Concession, 2004..................................................................... 78 88 Table 3.14: Summary of Transport Recommendations .............................................................................. Table 3.15: Summary of Recommendations for Costa Rica's Electricity Sector ....................................... 96 .................... 98 Table 4.1: Costa Rica: Growth Accounting Exercise, 1985-2001............................................................ Table 3.16: Summary of Recommendations for Costa Rica's Telecommunications Sector 101 107 Table 4.2: New Productversus Non-Innovative Firms: % Firmswith Key Characteristics Table 4.3: Product Upgrade versus Non-Innovative Firms: % Firmswith Key Characteristics...............113 ..................... Table 4.4: ProcessChange versusNon-InnovativeFirms- %Firmswith Key Characteristics ...............114 Table 4.5: Quality Certification versus Non-Innovative Firms - % Firmswith Key Characteristics .......115 116 Table 4.6: RegressionsResults: Determinants of Long-Term Development-Institutions versus Innovation Dependent Variable: Logof GDP per Capita in2000 (PPP adjusted) ........................... 119 Table 4.7: The ChangingNature of Innovation ........................................................................................ 123 Table 4.8: SeventeenDeveloping Countries: Indirect Investment-Climateeffects on Innovation Outputs and true Inverse Partial Correlations between InnovationInputsand Outputs ................................. 128 Table 4.9: Matching Grants by Activity and Year .................................................................................... Table 4.10: Number o f Matching Grant Projects by ResearchUnit......................................................... 131 Table 4.11: Matching Grants by Type of Innovation (US$) ..................................................................... 133 134 Table 4.12: Negative-Binomial Estimation Results: Determinants of Export Discovery Counts 1994-2003 ........................................................................................................................................................... 139 Table 5.1: Percent o f Inspected Firms Which Were Asked to Make an Informal Payment during .................................................................................................................... Table 5.2: Regulationof Labor inCentral America.................................................................................. Inspections, by Country 148 149 Table 5.3: PayingTaxes inCentral America and Chile ............................................................................ Table 5.4: Enforcing Contracts: Time, Cost and Procedures.................................................................... 151 157 Table 5.5: Correlates o f Some of the BusinessRegulatoryVariables: Costa Rica Table 5.6: Correlation of InformalPayments and Distrust in the Government and the Courts ................173 ................................... 174 Table 5.7: Correlates of Some of the Contract Enforcement Variables: Costa Rica ................................ 175 ListofFigures Figure 1: GDP Growth Rate inCosta Ricaand Latin America, 1961-2005 .................................................. Figure2: Evolution of GDP per Capita, 1975-2004 .................................................................................... ..i 11 Figure3: Costa Rica-Investment Climate Survey- Sample Composition ............................................... iii Figure 4: The Perspective of Costa Ricanfirms -Investment Climate Constraint rated as "Major" or "Very Severe", percent of firms ........................................................................................................... iv Figure5: Manufacturing Firm's Main Obstacle to Growth ........................................................................... v Figure 6: FirmProductivity: Elasticitiesand Semi-Elasticities with Respect to Impact of Investment Climate Variables.. ............................................................................................................................... vi Figure7: Probability of Exporting: Coefficients with Respect to IC Variables (Linear Probability) ........vii Figure 8: Composition of Credit Providedto the Private Sector, 1998 & 2006 ...................................... ... Figure 9: Bank Credit to the Private Sector, 1998-2004.............................................................................. viii ix Figure 10: InternationalComparison: Domestic Credit to Private Sector, 2004 ........................................ ...ix Figure 12: Use of Formal and Informal Sources of Financing in Costa Rica.............................................. Figure 11: Access to Finance and Cost of Financerated as "Major" or "Severe" Constraints to Growth x Figure 13: Sources of Financing for Working Capital andNewInvestments ............................................ xi xi1 Figure 14: FirmsDemandingand ObtainingLoansby FirmSize and InternationalComparison ............xiii ..... Figure 15: Infrastructureas Major or Severe Constraint by FirmSize ....................................................... xv Figure 16: The Time Tax: Share of Senior Management Time Devotedto Government regulations, ........................................................................................................ Figure 17: Bribesto Get Things Done.................................................................................................. inspections, taxes, customs, etc. xxv Figure 18: Procurement Bribes:Prevalence and Size by Country........................................................ xxviii xxviii Figure 19: Costa Rica- Trends inNumber o f Criminal Events ................................................................ xxix Figure20: Victimized firms and firms constrained by crime .................................................................. Figure 1.1:GDP Growth Rate inCosta Rica and LatinAmerica, 1961-2005 ..............................................xxix3 Figure 1.2: Evolution of GDP per Capita, 1975-2004 .................................................................................. 4 Figure 1.3: Costa Rica-Growth Accounting Exercise, 1961-2000 ............................................................. Figure 1.4: Costa Rica - Structure of GDP by Sector ................................................................................... 5 5 Figure 1.5: Costa Rica-Exports 1997versus 2004 ..................................................................................... 6 Figure 1.6: Inflowsand Stocks of FDI, percent of GDP.............................................................................. Figure 1.7: Costa Rica-InvestmentClimate Survey- Sample Composition.............................................. ,7 8 Figure 1.8: The Perspective of Costa Ricanfirms -InvestmentClimate Constraint rated as "Major" or "Very Severe", percent of firms ............................................................................................................ 9 Figure 1.9: Firm'sMain Obstacle ................................................................................................................ 10 Figure 1.10: FirmProductivity: Elasticities and Semi-Elasticities with Respectto Impact of Investment Figure 2.1: Composition of Credit Providedto the Private Sector, 1998 & 2006 ..................................... Figure 1.11:Probability ofExporting: Coefficientswith Respectto IC Variables (LinearProbability)...13 Climate Variables ................................................................................................................................ 14 Figure2.2: Share of Public Bank on Lendingby Sector, 1998 & 2006...................................................... 17 Figure2.3: Composition ofBanks' Lendingby Currency, 2005................................................................ 18 18 Figure2.4: Bank Credit to the Private Sector, 1998-2004 .......................................................................... 18 Figure2.5: InternationalComparison: Domestic Credit to Private Sector, 2004 ...................................... Figure 2.6. Bank Credit Growth by Economic Activity (1987 -2005) ...................................................... 18 19 Figure 2.7: Time and Cost to Solve Legal Disputes .................................................................................. 19 Figure2.8: Lendingto SMEs: Market Share of Public and Private Banks andLoan Distribution by Figure 2.9: Composition of BN-Desarrollo's Loan Portfolio .................................................................... Economic Activity .............................................................................................................................. 20 .21 Figure2.10: Access to Finance and Cost of Financerated as "Major" or "Severe" Constraints to Growth ............................................................................................................................................................. 22 Figure 2.11: Formal and Informal Sources of Financing for Working Capital or New Investments..........23 Figure 2.12: Simultaneous Participation inFormal and Informal Markets................................................. 23 Figure 2.13: Use of Formal and Informal Sources of Financing inCosta Rica .......................................... Figure 2.14: Use of Bank Loans by Industry and Type of Bank inCosta Rica.......................................... 24 25 Figure 2.15: Use of Informal Sources of Credit by Firm Size in Costa Rica ............................................. 25 Figure2.16: Sourcesof Financing for Working Capital andNew Investments ......................................... Figure2.17: Access to Lines of Credit and Outstanding Debtfrom Formal Lenders................................. 26 Figure2.18. Access & Degree ofUse of Credit Lines by FirmSize .......................................................... 27 27 Figure2.19. Median LoanMaturity (months) & Loan Collateral (% value ofthe loan) ............................ Figure2.20: Percent of Outstanding FormalLoans Denominated inForeignCurrency ............................ 28 Figure2.21: FirmsDemandingand ObtainingLoans by FirmSize and International Comparison...........29 Figure 2.22: Main Reasonfor BeingCredit Constrained -Costa Rica ...................................................... 30 Figure 2.24: Firmsas Creditors and Payment Delays by Clients- Costa Rica............................................ Figure 2.23: Sources of Financing for Working Capital andNew Investments by Financing Status.........31 31 32 Figure3.2: BusinessThat View Infrastructureas a Serious Problem(% of Firms)................................... Figure 3.1: Infrastructure as Major or Severe Constraint by Firm Size...................................................... 36 Figure3-3: MainRoad Corridors of CR ..................................................................................................... 37 40 Figure 3.4: Use of Transport Modes, by Percentage of Firmsthat Trade ................................................... Figure 3.5: Distribution of Exports by Transportation Mode, Average 2001-2004 .................................... 41 42 Figure3.8: ProjectedPort Throughput by Country and Coast (Volumes inMillions o fMetric Tons) ......44 Figure 3.7: LinerConnectivity Index o f Costa Rica and Comparator Countries........................................ Figure 3.6: Distribution of HandledContainers in Central America .......................................................... 43 44 Figure3.9: Paved and Total Roads Length................................................................................................. 46 Figure3.10: RoadNetwork Distribution ..................................................................................................... 47 Figure3.11:Benchmarkingof Costa Rica's Electricity Supply and Endowment...................................... Figure 3.12: Share inElectricity Sales inCostaRica by Distribution Company in2004........................... 48 49 Figure 3.14: Endowment of Costa Rica's Electricity Generation vs.Expectations .................................... Figure 3.13: Declining Electricity InvestmentinCosta Rica..................................................................... 50 Figure3.15: Main Lines and GDP per Capita............................................................................................. 51 52 Figure3.16: Comparative Degrees of Telecom Reform inLatinAmerica ................................................. Figure3.17: Fixed`Phone Lines per 100Inhabitants (2004) ....................................................................... 53 Figure3.18: Mobile PhoneLines per 100Inhabitants (2005) ................................................................... 53 .................................................................................... 54 Figure 3.20: Demandfor New FixedLines Among Existing Users ........................................................... Figure3.19: Lines inOperation vs.Lines Installed 54 55 Figure3.21:EndowmentofCosta Rica's Telecommunications Networks vs Expectations . ..................... 56 Figure3.22: Costs Causedby Transportation Delays (% ofTotal Sales) ................................................... 59 Figure3.23: Impact of Breakage and Theft inTransit on Costa Rican Firms ............................................ 59 Figure3.24: Charges at Port ofLimon Versus Port of Cartagena .............................................................. 60 Figure 3.25: Total Cost per Container, Including Operatingand Inventory Expenses Causedby Figure3.26: Mode of Transportation Usedfor Trade by Size (% firms) .................................................... Inefficiency ......................................................................................................................................... 60 Figure3.27: General Caiias Roadway LinksSan Jose with Juan SantamariaAirport................................ 62 62 Figure3.28: Export OriginVersus RoadQuality ....................................................................................... 63 Figure3.29: Average Days to Clear Customs ............................................................................................. 63 Figure3.3 0: Transmission andDistribution Losses SelectedCountries, 2003 .......................................... -64 Figure3.3 1:Electricity Tariffs in SelectedLatinAmerican Countries, 2003 ............................................ -66 Figure3.33: Waiting Periods for New Electricity Connection (Days) ....................................................... Figure 3.32: Electricity Commercial Tariffs SelectedLatin American Countries, 2003 ........................... -66 Figure3.34: Waiting Periods by Company Size and Location................................................................... 67 ........................................................................... 67 Figure 3.36: Frequency and Duration of Power Outages in Costa Rica ..................................................... Figure3.35: Power Outages inSelected Countries, 2004 68 68 Figure 3.37: Companies' Losses Due to Power Outages (% of Annual Sales) Figure3.38: LossesDueto Power Outages(% ofAnnual Sales) ............................................................... ........................................... 68 69 Figure 3.39: Companies that Own Generators in Costa Rica (%) ............................................................... 69 Figure3.40: Companies that Own Generatorsby Size (%) ........................................................................ 70 Figure3.41: Waiting Periods by Size of Company and inDifferent Regions, indays ............................... 71 Figure 3.42: Interruption inTelephone Service (Hours Per Year) .............................................................. Figure 3.43: Reliability o f the Supply of Telecommunications Services.................................................... 72 72 Figure 3.44: Quality of FixedLineTelephony Across DifferentRegions .................................................. Figure 3.45: Reliability of the Cellular Telephony and Internet Services Across Regions ........................ 73 73 Figure3.46: Losses Dueto Telephone Service InterruptionsinDifferentCountries ................................. 74 Figure 3.47: Losses Due to Telecom Service Interruptions by Size of Firms ............................................. Figure 3.48: Relative Cost of Telecommunication Services (% of yearly sales) ........................................ 74 76 Figure3-49:Internet Subscribers and GDP per Capita PPP, 2004 76 Figure3.50: ICTs in SMEs, Benchmarking 79 Figure3.5 1: Internet Total Monthly Price ($ per 20 hour ofuse), 2004..................................................... ................................................................................................ ............................................................. Figure 3.52: Overall Financingfor Infrastructure Investment.................................................................... 80 Figure3.53: Compositionof Infrastructure Investment, 1993 2003......................................................... 83 Figure3-54:Composition of Public Investment ......................................................................................... 84 - 83 Figure3.55: PrivateInvestmentinInfrastructure (1995-2003) .................................................................. 84 Figure3.56: Composition of PrivateInvestment, by Sector, 1993-2003 .................................................... 85 Figure3.57: Composition ofPrivateInvestmentbytype ofInvestment, 1993-03..................................... Figure3.58: InvestmentinTransport.......................................................................................................... 85 86 Figure3.59: Highway InvestmentPer Vehicle Figure 3.60: Gross Margin of ICE by Lineof Business.............................................................................. ........................................................................................... 87 ..................................................................... 89 89 Figure 3-62:Industrial Electricity Prices inCentral America..................................................................... Figure3.61: ICE'SReturnonAssets Ratio by BusinessLine 92 ................................................................. Figure 3.64: .Electricity Prices (Dec.2003) Figure3.63: Commercial Electricity Prices inCentral America 92 93 Figure4.1:InnovationFramework ........................................................................................................... ................................................................................................. 105 Figure4.2: Innovation Outputs inCosta Rica ........................................................................................... 108 Figure4.3: Export Discoveries during 1994-2003 andthe Level ofDevelopment: Predicted and Observed Counts ............................................................................................................................................... 109 Figure4.4: InnovationInputsinCosta Rica ............................................................................................. 109 Figure4.5: Distribution ofEducationalAttainment among the Adult Population .................................... 110 Figure 4.6: FirmsReportinga New Product(Percent) .............................................................................. 112 Figure 4.7: Firms Reporting a Product Upgrade (Percent) Figure 4.8: FirmsReporting a Process Change (Percent) ......................................................................... ....................................................................... 114 115 Figure 4.9: Predicted Returns to R&D Using System GMM Estimators.................................................. 122 Figure 4.10: Diversification & Innovation ................................................................................................ 124 Figure4.11: Total Size ofMatchingGrants, 2000-2004 (Current US$) Figure4.13: Dealingwith the Selectivity ProbleminEvaluatingMatching Grants Programs ................132 Figure 4.12: Matching Grant Projects by Type of Contribution ............................................................... .................................................. 132 Figure 5.1: Interpretations of Government Regulations Are Inconsistent and Unpredictable ..................135 142 Figure 5.2: The Time Tax: Shareo f Senior Management Time Devotedto Government Regulations, Inspections, Taxes, Customs............................................................................................................. 142 Figure 5.3: Procurement Bribes: Prevalence and Size by Country ........................................................... 143 Figure5.4: Number of Days to Registera Firm:A Comparison o fDifferentData Figure5.5: First-Time Business Registration: Share ofApplicants and Time to Register ....................... .................................. 143 144 Figure 5.6: License Renewal and Re-registration, Share of FirmsThat Applied for Renewals, Average Days to Get Licenses Renewed and Informal Payments Incidence .................................................. 144 Figure5.7: Share ofFirms Subjectto Inspectionsby DifferentGovernmentAgencies. % of Responding Figure5.8: NumberofInspectors' Visits andTotalAggregate DurationofInspections......................... Firms................................................................................................................................................. 146 147 Figure5.9: Percent of Firmswhich WouldKeepthe Numberof Workers Constantor ChangeItIf PermanentWorkers CouldBeHiredWithoutAdditionalRegulatoryCosts .................................... 150 Figure5.10:HighFiringCosts andMinimumSalary andBenefitsDeter Changesinthe Number of PermanentEmployees....................................................................................................................... ............................................ 150 Figure5.12:Percentof Sales Reportedto the Tax Authorities, by Type ofFirm..................................... Figure5.11: Percentof Sales Reportedto the Tax Authorities, by Country -151 151 Figure5.13: FirmswhichDoNot Believethat the Courts Will UpholdTheir ContractualandProperty Figure5.14: RankingsofJudicialIndependenceandJudicialCorruption................................................ Rightsina CommercialDispute, % ofInterviewedFirms............................................................... 154 Figure5.15: RankingsofProperty RightsandEfficiencyofthe LegalFramework................................. 154 155 Figure5.16: PercentageofFirmsthat PerceivePropertyRightsandCourtEfficiencyas a Major or Very Figure5.17: ShareofFirmsUsingthe Courtsto Resolve at Least SomeofTheir PaymentDisputes.....155 SevereObstacleto DoingBusiness ................................................................................................... 156 Figure5.18:ShareofFirmsUsingthe Courts to Resolve at Least SomeofTheir PaymentDisputes, by Figure5.19: Number of Daysto Resolvea PaymentDisputeinCourt, by Country................................ Country ............................................................................................................................................. 156 Figure5.20: PercentageofFirmsWhichExperiencedDisputeswith Workers over Layoffs..................157 Figure5.21: Percent of Sales PaidBeforeDelivery, at Deliveryand Soldon Credit, by Country...........158 160 Figure5.22: Percentof Firmsthat made Sales PaidBeforeDelivery, at Deliveryand Soldon Credit, by Figure5.23: Percentof Sales PaidBeforeDelivery, at Deliveryand Soldon Credit, by Type ofFirm...160 Country............................................................................................................................................. 160 Figure5.25: Indicatorsof InternationalCorruption(Percentile Rank)..................................................... Figure5.24: PercentofFirmsBelongingto aBusinessAssociation, by Type ofFirm............................ 161 163 Figure 5.27: GovernanceInefficiency(Percentageof Firms)................................................................... Figure5.26: GovernanceRanks in SelectedCountries-WEF Indicators............................................... 164 165 Figure 5.28: Bribes"To Get Things Done" andto WinPublicContracts................................................ 165 Figure 5.29: PercentofFirmsthat Paidor Were OfferedBribesto ObtainGovernment Services(Subset of .......................................................................... Figure 5.30: EstimatedMortalityRatefromHomicide2002, per 100,000 pop....................................... Firmsthat Requestedthe CorrespondingServices) 165 Figure 5.3 1:Violent Crimes in CostaRica* ............................................................................................. 168 169 Figure5-33:VictimizedFirmsandFirmsConstrainedby Crime, by size andregion.............................. Figure5.32: VictimizedFirmsandFirmsConstrainedby Crime............................................................. 170 Figure5-34:Crime Lossesand Security Costs, by firm size .................................................................... 170 171 Figure5.35: Crime Losses and Security Costs-InternationalComparison .............................................................. ............................................. 171 Figure5.36: Crime Reportingby VictimizedFirms,by country 172 ListofBoxes Box 1: What is an InvestmentClimateAssessment .................................................................................... iii ............................................................................... 2 Box 2.1: Mechanics ofFactoring................................................................................................................ Box 1.1:What's are InvestmentClimateAssessments? .................................................................................................. 33 Box4.1:An EmpiricalLiteratureon Long-RunDevelopment................................................................. Box 3.1:Resultsof RegressionAnalysis 100 Box4.2: Econometric IdentificationofMarketFailuresAffectingthe IntroductionofNewExports.....118 Box4.3: Uncoveringthe Role of R&D andLicensinginNon-PatentableFirmInnovations ...................124 127 ListofAnnexes ANNEX 1 BackgroundInformationon the Investment Climate Survey................................................. 176 ANNEX 2: BackgroundInformation onthe Logistic Survey................................................................... 181 ANNEX 3: The Effects of InvestmentClimate IndicatorsonProductivity. Exports. ForeignDirect Investment. Wages. and Employment inCosta Rica........................................................................ 188 ACKNOWLEDGEMENTS This report was preparedby ateam ledby Susana Sanchez and comprisingDanielLederman (Innovation), Camila Rodriguez (Innovation, Finance, and Governance), Emanuel Salinas (Finance, Energy, Telecommunications), Jordan Schwartz (Infrastructure), Stefka Slavova (Governance), Tito Yepes (Infrastructure), and other people that contributedto the infrastructure chapter. Leonid Koriukin provided valuable assistance with the descriptive analysis of the data. The productivity analysis i s based on a background paper prepared by Alvaro Escribano and Jose Luis Guasch. For the report, two consultant reports were commissioned: i)Ricardo Monge and Francisco Monge-Ariiio "Innovation and Technology Adoption inCosta Rica: The pathto the Knowledge-based Economy."; and ii)FBlix Delgado "La Regulaci6nde las Actividades Empresariales en Costa Rica." Daniel Chodos provided excellent research assistance for the overall report. Paola Granata provided assistancewith some chapters. The IDBco-financedthe investmentclimate surveycarriedout for this report. The Central Bank o f CostaRica and the Ministryof Finance collaborated inthe survey work. Additional thanks to the various organizations that supported the survey work: Uni6n Costarricense de Chmara y Asociaciones de la Empresa Privada(UCCAEP), Camara de Industrias de Costa Rica (CICR), Costa RicanInvestment Board(CINDE), and Promotorade Comercio Exterior (PROCOMER). Additional valuable inputs were received from Ana LuciaArmijos, Jordan Schwartz, Marianne Fay, Manuel Sevilla, Susan Goldmark, and Pablo Fajnzylber. Special thanks are also due to Aires Conceicao for his editorial support. Peer reviewers are Marcia Bonilla-Roth (IDB) and George Clarke (AFTPS). FOREWORD The objective o fthe CostaRica Investment Climate Assessment (ICA) i s to evaluate constraints on growth of the private sector inCosta Rica usinga survey of 343 manufacturingfirms known as the Investment Climate Survey (ICs) and a Logistic Survey in75 firms inthree export sectors (processed foods, cut flowers and plants, and medical equipment). This assessment focuses on the microeconomic and structural dimensions of the nation's business environment, viewed from an internationalperspective. Inthe simplestterms, the investmentclimate ina country establishesthe rules ofthe game andthe environment within which all firms must operate. Although this definition can bebroad enough to encompass exogenous factors like geographical position or natural resourcesendowments, we take here a narrower definition focusing on policies and institutionsthat influencethe return and the risk associated with investment.Itthus includes regulatorypolicies, administrative procedures, infrastructure conditions, as well as incentives embodied in institutional arrangements, such as security o f property rightsand the ruleof law. The Costa Rica ICA was carried out incoordination with the Costa Rica Country Economic Memorandum (CEM) due to overlap in some topics covered inboth reports. As a result, for infrastructure and innovation both reports commissioned identical chapters.Volume Ipresents a summary o f the main results of the analysis, including policy recommendations. To the extent possible, Costa Rican firms' views, constraints, and performance are compared to those observed in fast growing economies and selectedmiddle income countries. The ICA data base allows for internationalcomparisons, as a core group of questions of the questionnaire i s applied inevery country. InvestmentClimateIndicatorsin CentralAmerica Country Costa Rica El Salvador Guatemala Honduras Nicaragua Governance& lnsecun'ty Crime Losses (% of Sales) 0.7% 1.O% 1.4% 0.9% 0.9% Judiciary Distrust (% of Firms) 17.4% 25.4% 48.4% 36.9% 42.3% UndeclaredRev. (% of Sales) 31.6% 22.6% 23.0% 32.1% 35.1% Bribes (% of Sales) 1.8% 1.7% 2.8% i.a% 1.5% Inspections(No. plyear) 5.3 11.5 9.7 11.4 21.3 lnfrastructure Water Interruptions(No. plyear) 3.9 42.2 19.6 13.2 55.3 Power Out. Losses (% of Sales) 3.0% 1.2% 2.2% 3.9% 4.8% Internet Use (% of Firms) 32.1% 29.5% 27.8% 18.4% 14.8% Email Use (% of Firms) 61.5% 62.6% 64.7% 45.0% 33.9% Access to Finance Access to Lines of Credit (% of Firms) 43.2% 45.5% 51.6% 41.4% 27.0% Banks Work. Cap. (% of Firms) 36.7% 30.4% 24.8% 26.9% 16.3% Banks Invest.(% of Firms) -- 18.7% 45.5% 34.1% 37.7% 27.9% SupplierCredit (% of Firms) 34.7% 14.4% 19.6% 9.0% 5.4% Technology Computer Use (% of workers) 19.5% 11.1% 11.9% 7.4% 7.7% Worker Training (% of Firms) 46.4% 45.1% 54.2% 46.4% 36.4% IS0 Certification(% of Firms) 9.3% 6.1% 3.5% 5.7% 5.0% R&DActivities (% of Firms) 30.9% 16.6% 35.7% 12.7% 13.0% Comput. Contr. Mach. (% of Firms) 30.3% 23.6% 24.1% 18.7% 10.2% Source:World Bank InvestmentClimate Surveys CostaRica-InvestmentClimateAssessment SUMMARYREPORT BACKGROUND Costa Rica hasenjoyed a successfulrecordof longterm growthwith respectto other Latin American and Caribbeancountries.GDP growth over the last four decades (1961-2000) averaged4.9 percent, exceeding that of most o f its neighbors and the LAC average (3.6 percent) over the same period. Interms of GDP per capita, Costa Ricaalso grew faster than the rest ofLatinAmerica (1.8 percent versus 1.5 percent). Although duringthe 1960sand 1970s Costa Rica grew at par with the LatinAmerican average per capita growth rate, and even lost some ground duringthe 1 9 8 0the ~ ~ 1990swas a decade of enviable performance as the country surpassedalmost all other Latin American economies. A strong recovery inTotal Factor Productivity (TFP) accounted for almost 1.36percentagepoints of the observed 5.25 percent growth rate duringthe 1990s.As a result, Costa Rica is now an upper middle income country, with a per capita GDP o f US$4,280 (Atlas method).' Figure 1: GDP Growth Rate in CostaRica and Latin America, 1961-2005 Avo. Growth Rate of GDP per capita Avo. Growth Rate of GDP 4 , 7 4 6 ..................... ......................... .................. 5 E 4 1 3 2 1 0 1961.1970 1871.180 (881.180 lsBl.2OW 2WI-XKU IS61.I870 18714 980 1881.1980 2CQ1-2005 mCosta Rica mLatinAmenca & Canbbean Costa Rica LatinAmenca a Canbbean Source: World Development lndicatan Followingthe economicslowdown of the early 1980s, Costa Ricahad a remarkableturnaround by followinga heterodox mix of policiesthat ledto good resultsin subsequentyears. While other Latin American countries fully adopted what is now known as the Washington Consensus policies (stabilize, privatize and liberalize) after facing stark cycles o f high inflation and low growth duringthe 1980s and 1 9 9 0 Costa Rica followed a more unconventionalmix oftrade liberalization and export-led growth ~ ~ coupled with repressedfinancial markets and state ownership of key commercial enterprises.2The first steps towards increasedtrade openness dated back to 1963, when Costa Ricajoined the Central American Common Market (CACM, made up of Guatemala, El Salvador, Nicaragua, and Honduras). The strategy of "open regionalism" fostered by CACM enabled Costa Rica to broaden its manufactured exports to the region, and diversify its export base away from traditional products. Thereafter, the adoption o f an export promotion model advanced the country's trade liberalization efforts. Since the mid-1980s, trade barriers have been lowered, with trade tariffs declining from 53 percent in 1985 to about 5.2 percent in2004.3 Likewise, tariff dispersions have minimized and non-trade barriers have beenremoved. Costa Rica also initiated a proactive policy to attract FDIand promote a free trade zone regime, resulting ininvestment flows of about 3 percent of GDP and attractinghigh-tech investors such as INTEL, Abbott Laboratories, and Procter & Gamble. This positive record inthe economic sphere is also dependent on the country's ' Upper-middle incomecountries are definedto haveper capitaincomesbetweenUS$3,036 -US$9,385. * See World Bank (2004a). CostaRicadid not open its telecommunicationsand insurancesectorsto privatecompetitioninthe 199Os, as most other countries in Latin America did, keepingbothunderthe controlof strong state-ownedmonopolies. World Bank(2004a). i long standing democratic tradition, underpinned by generally effective institutions, a burgeoningmiddle class, a strong educational system, and relatively low income ineq~ality.~ Despitethis notable performance,CostaRicafaces importantchallengesinincreasingeconomic growth.When compared to other middleincome"star" performers, such as Taiwan, South Korea, Singapore and more recently Ireland and China, CostaRica has considerably lagged behind. Thus, one o f the challengesfor the country's progress is not only sustaining its relatively good growth levels by Latin America standardsbut also raising its performance to catch up to some o f the world's booming economie~.~ Still, this will be no easy task, and will requireaiming for a 20 to 30 percent increase inthe growth rate TFP (as opposedto the current TFP growth rate of 2 percent per year) as shown ina recent study by Saume and Sanchez(2003). Not surprisingly, increasing attention has beengivento the needto deepenmicroeconomicreforms to promote a more efficient allocation ofresources and increaseTFP growth. Figure2: Evolutionof GDP per Capita, 1975-2004 1975 1979 1983 1987 1991 1995 1999 2003 Source:World DevelopmentIndicators World Bank (2004a). World Bank(2006a). ii busrness~ n ~ i ~ ~ nIssues nIn~addrtion to the ICs, this ICA rspoFt uses a LogisticSurvey ~n~~~~~ for the r n e i ~ ~ r ~chaptsr~knrthree high~value~addedgoods (e g processed foods, plants& flowers and medicalsuppliers) s ~ ~ r ~ ~ Figure 3: Costa 1tic;t - Investment Climate Surrey - Snrnple Conipwition he most importantinvrstm this rcpari uses boih suEj iii the secondtype of information. However, firms' perceptions providevaluable information onthe priorities that entrepreneurs would adopt iffaced with the task of designing policies to improve the investment climate. A five-point scale i s used, rangingfrom extremely severe to not important for a set of twenty potential investmentclimate obstaclesto growth. The figure below reports the percentageof manufacturingfirms that evaluated the corresponding constraints as "major" or "very severe". Surveyed Costa Rican firms perceive macroeconomicinstability, anti-competitiveand informal practices, and cost and access to financingas the four major obstaclesto growth in Costa Rica. About 55 percent of surveyed firms identifiedmacroeconomic instability as major or very severe obstacle, partly attributed to increasevolatility of inflation and movements inthe exchange rate. As further explained inthe 2006 CostaRicaEconomic Memorandum, althoughCostaRicahas enjoyed notable macroeconomic and financial stability inthe pasttwo decades, it recentyears, inaddition to the potential risks associatedwith highpublic debt and fiscal imbalances, a key vulnerability that has emerged since the endof the 1990sis the risk of increasing financial dollarization. Furthermore, the ICs was conducted in 2005, when there was greater political uncertainty than inprevious years due to the proximity of presidential elections and economic uncertainty due to the proposed fiscal reform, the free trade agreement with the USA, and the acceleration of inflation. Thus, it is possible that perceptions were more downbeat than inprevious years. Also, the manufacturing sector usually is more pessimistic than other sectors interms of economic conditions as reported by the quarterly survey of the Costa Rican Chamber of PrivateBusiness Associations (UCCAEP). The proportion of firms rating macroeconomic stability as a constraint is very similar inEcuador, Nicaragua, and Honduras, but much higher than in Chile, China, El Salvador, or Lithuania. Anti-competitive and informal practices rank second, affecting almost 50 percent of surveyed firms. Despite progress infinancial deepening, the cost and access to financing were selected among the top obstaclesto growth (48 percent and 45 percent, respectively), especially among the micro and small firms. ' Figure4: The Perspective of Costa Ricanfirms-InvestmentClimateConstraintrated as "Major" or "Very Severe",percentof firms 1155 Anti-competitive, informal practices I Cost of financing Access to financing Transport Corruption Tax rate f Regulatory uncertainty Environmental regulations 11 CopyrightsI contract enforcement :10 Trade regulations 7 ; 0 10 20 30 40 50 60 Percentof firms Source: World Bank Investment Climate Surveys iv Transportand corruptionissuesare also amongthe top "major" or "severe" constraint for Costa Ricanfirms.About 16percent and 42 percent of firms ratedtransport and roadquality, respectively, as major or very severe obstacle to growth. Costa Ricanfirms were more likely than their neighboring counterparts inEl Salvador, Honduras, and Nicaragua, and firms incountries with similar levels of income such as Polandor Lithuaniato rate transport issues as major or very severe constraints. Corruption also appears a major or very severe constraints for about 40 percent of Costa Rican firms, higher than inEl Salvador (35 percent) or Chile (13 percent), but lower than inGuatemala (81 percent) and Brazil (67 percent). When asked to select the main obstacleto growth, surveyedmanufacturingfirms cited financial constraints as their predominantproblem,followed by anti-competitive/informalpractices, macroeconomicstability and red tape/regulation.These set ofvariables also topped the list of problems for firm's managers 3 years ago, although the magnitude of their problem has varied across time. Access/cost of financing obtained the highest score, with 26.2 percent of firms indicatingthat financial issues stood as their worst impedimentto growth. However, when comparingthe magnitude of the problem across time (e.g. three years ago), it seems to have improved at leastmarginally.The opposite case is true for anticompetitive informal practices: it appears that nowadays this i s more of a pressing problem for firms than it was three years ago. Other problems that are apparently worsening for firms are taxation, transport, and water and electricity issues. Although they cited by lessthan 10 percent of sampled firms as the premierobstacle to growth, their relative importance seems to have increasedvis- a-vis previous years. Figure5: ManufacturingFirm'sMain Obst -owth - Accesdcast of financing Anti-comp finformalprscdcss Macroeconomic instablily RedtapeRegulatlon Slulls quality and technology today M 3 y~Ago . 0 5 10 15 20 25 30 ;ource: Wolld Bank Investment Climate Surveys A numberof investmentclimateindicatorsdrawn from the ICs were econometricallyrelatedto measuresin productivity.The econometric analysis shows that investment climate variables affect firm productivity in the expected direction. Usingthe econometric methodology developed by Escribano and Guasch (2005), we tested different specifications o fthe production function to get robust empirical elasticities (or semi-elasticities) that could help guide policy discussions. For this exercise, investment climate (IC) variables were grouped into four categories: infrastructure, governance, including redtape and crime, finance and quality, innovationand skills. The estimation was performedholding constant basic firm characteristics, including location, industryaffiliation, firm size, firm age, and other factors. The detailed results as well as the details ofthe methodologyare presented inAnnex 1to Chapter 1 in Volume 11. V Overall results ofthe ICs show that variables in all four categories of investmentclimateaffect CostaRicanfirms interms of their productivity.The results, summarized inthe figure below, indicate that IC variables related to three categories are highly statistically related to productivity. Figure 6: Firm Productivity: Elasticitiesand Semi-Elasticitieswith Respect to Impact of Investment Climate Variables % I n f r ; u u u C N l t RcdTape, Conupuon and FinanceandCorporate Quality,Innovationand LaborSkills Other ConmlVanabler Crime Govcmancc 0.60 0.40 0.20 0.00 4.20 4.40 IID.yWrlr.r~u.Wmi faoxpoN. 1.2 A v m w dunlion ofpweroui.g~. I1W.*, W W I I4 W." fordSCmC1YppIy. 2 IS.lr. &i..d 10 -9, 2 I N u m b ~ o f m s p l m n i 2 IPaymenu iD o h m a 00nY.ilulUie iovemmonl 2 4 S h n s ~ lmud r 2 IAbionwmm 1 ITldr Y,OI,."Dn 12C.dllm. I3DcbYriUlindim 3.4 Prndl IJOmsrofLeIhnb When the IC variable is not expressed in log form, the estimated coefficient is generally described as a productivity-ICsemi- elasticity. While the constant productivity-ICelasticity measuresthe percentage change in productivityinduced by a percentage change in the IC variable, the semi-elasticitycoefficient multiplied by 100, measuresthe percentagechange in productivity induced by a unitary change in the IC variable. Red tape, corruption and crime- related variables have in general a significantly negative impact upon productivity, with the exception o f payments to obtain a contract with the government. An increase o f 1 percent inthe number o f inspections results ina decrease o f 0.3 percent inproductivity. However, firms that make payments to obtain a government contract have productivity 28 percent higher. Among the infrastructure variables relevant for productivity, power and water outages appear with a strong negative effect. An increase o f 1percent inthe number o f water outages per year will decrease productivity by 0.2 percent while a similar increase in the number o f days to get public electric supply will decrease productivity by 0.107 percent. Furthermore, an increase inthe average duration o f power outages (measure inhours) o f 1percent will reduce productivity by 0.027 percent. Inthe case o f the number o f there i s evidence that labor training and innovation -as measured by having I S 0 certification and days to clear customs for exports, one percent increase will reduce productivity by 0.071 percent. Also, getting new technological license -increase productivity. For example, when a firm has I S 0 certification or new technological license its productivity will be 26.7 percent and 19.4 percent higher, respectively, on average. Finally, with respect to finance, we find that having a line o f credit and debt with suppliers boost impact on firms' productivity by 5 percent and 25 percent, respectively, on average. In additionto the analysis on firm productivity,the econometricanalysis looked at the effect of investmentclimate variables on the probabilityof exporting. Some o fthe key findings are: number o f days to clear customs for imports and having experienced a criminal attempt at the firm have a negative effect on the probability o f exporting, Furthermore, training events o fthe workforce and the education o f the manager have a positive effect on a firm exporting. vi Figure7: Probability of Exporting: Coefficientswith Respectto IC Variables (LinearProbability) Rcd Tbpc, Corruptionand Crime I 0.279 4W1 . O M -0002 0 IS0 1.1 2.1 2,2 2.3 3.1 3.1 3.3 3.4 3.5 3.6 4.1 4.1 4.3 4.4 1.1 S.2 1.3 1.4 1.5 6.1 6.1 6.3 5.1 Joint Y S O N ~ ~ Wforeign fima I ~ 5 2 LACOhiET ccrtificafion 5.3 h n g n and m%msenng. 5 4 Tminingu)skilled warkcta 5 S Eduoatianofths manager. 6 IInwporakd company. 6 2 lndultri~lzmc. 6 3 Finnbcnsfitsd from ICC. 6 4 Agc, yean ~n~psntian. The conclusions ofthe econometric analysis are that investment climate variables significantly affect total factor productivity and that increased emphasis on governance and business regulation, infrastructure, and innovation is appropriate. The results show are consistent with firms' perceptions that put infrastructure and regulatory issues as severe obstacles to growth. The remainder of this report is organized around four areas ofthe investment climate: finance, infrastructure, innovation, and governance and business regulation. Each one of these areas i s analyzed next inmore depth. FINANCE The development of financial marketsis widely acknowledged to be one of the crucial issuesfacing emergingmarkets, and one that has a noticeable impact on economic growth.Financialmarkets channel resources from those who have the funds but lack the investment ideas, to those who have the ideas but lack the funds. The empirical researchon financial market development shows that there is a strong correlation, and possibly causality, with economic growth. For instance, Levine and Zervos (1996), show that stock market development is positively associatedwith economic growth and Demirguq-Kunt and Levine (1996) also demonstratethat the level of financial market development is a good predictor of economic growth. Levine (1997) and Beck and Levine (2001) find a positive causal impact of financial development on productivity and economic growth. A recent study by Beck, Demirguq-Kunt and Maksimovic (2002) showed, usingdata on firms from 54 countries that financial vii constraints interms o f access and cost of funds exert an influence on firm growth andthat smaller firms are most affected by those constraints. BankingintermediationdominatesCostaRica's financialsector, although in recentyears the system has becomemorediversified.Over the past decades, Costa Rica's financial sector has consolidated with the number of financial intermediaries declining from 86 in 1998 to 59 in2006. The onshore banking sector accountsfor 84 percent of the system's lendingto the private sector. Non-bank financial companies and savings and loans cooperatives represent only 2.4 percent and 6.8 percent respectively of the total system's credit to the private sector. Eventhough offshore banks are also important sources o f financing to the private sector, this report focuses only on the onshore financial sector due to data availability. Figure 8: Composition of Credit Providedto the Private Sector, 1998 & 2006 50 7 46 IBDec-98 EJan-OB I 40 E 30 2 8 20 14 10 0 Public banka Private banks Non-bank finSavings 6 loans Omer comp. associadons intermediaries Source: Authors'calculationsbased on data from SUGEF Despitefinancialliberalization,public banksaccount for an increasingshare of onshore bank lendingto the privatesector, but privatebanks have gained market share inthe housingand consumer lending markets.Financial liberalizationhas focused on a dismantling of public banks' `privileges' as a way to foster competition. However, public banks still enjoy access to lower cost of funds due to: i)state guarantee on all their liabilities; ii)tax exemptionoftheir dollar deposits; iii)full and explicit deposit insurance (which is not yet available for private banks), and iv) private banks' requirementto put 17percent of deposits raised inpartially remuneratedaccountsat public banks. Public banks have increasedtheir market share in lendingto the private sector, from 36 percent in 1998 to 46 percent inJanuary 2006. Moreover, they have dominated private sector lending-especially services, trade and manufacturing- whereas private banks have gained access to the housing and consumer credit markets. Financialdepth inthe onshore system has improvedsince mid-1995, but remainslowerthan comparatorcountries. Domestic creditto GDP increasedfrom 17.6 percent of GDP in 1998to 27 percent in 2004, however, this level of financing is still low even for Central American standards and compares unfavorably to that observed in economies that have developed more dynamic financial systems. The expansion o fcredit has beenuneven, favoring specific segments ofthe economy such as consumer credit and corporate lendingto trade and services industries, to the detriment of credit to other segments such as agriculture, and, to a lesser extent, manufacturing. viii -- Figure 9: Bank Credit to the Private Sector, 1998- 2004 -= -Bankcredit to private seaorlGDP (?,) --CDomestic creditto private sector (96 of GDP) PeN 17.4 35 - Ecuador 20.1 30 - Honduras -- 37.4 CostaRica -iNNNN42.5 0 25- Argentina -- 45.4 0 0 16 20- El Salvador 49.2 1 Chile - 70.2 15 Brazil - 80.9 0 10 - 0 5L Israel 82.8 Nicaragua 88.4 Panama 90.4 1998 1999 2000 2001 2002 2003 2004 Malaysia - 134.3 China 166.9 Source: WDI database Source: WDI database The bankingsystem is becomingfurther dollarized,which may becomea potentialsource of vulnerability.In2002, 50 percent of onshorebank credit representeddollar denominated lending, and in 2005 this proportion increasedto 54 percent. For private banks, the situation is a bit more severe as dollar loans account for almost 80 percent oftotal loans (up from 75 percent in 2001). Inthis backdrop, there is a potential vulnerability inthe system, since dollar loans are being made available to borrowers that only have access to revenues in local currency. This i s reinforced by the fact that as shown by the ICs, micro firms and non-exporting firms are increasingly tapping dollar lendingto fund their operations, which creates a clear mismatchbetween their local currency revenue stream and the dollar payments neededto service a loan.6 Costa Rica's financialsector infrastructurehasa mixed performance. On one hand, corporate insolvency proceedings are hampered by a lowjudiciary, excessive protectionof debtors and lack effective out-of-court workouts. As reported inWorld Bank (2004a), corporate insolvency and reorganization procedures are entirely managedby courts, leadingto inefficiencies, delays (the verification of claims alone can take several months) and limitedparticipation from borrowers as out-of- court settlements are not easily achieved under the current legal framework. According to the World Bank's DoingBusinessreport, thejudiciary processto recover a non-performing debt requires an average o f 34 different procedures, requiring 550 days, and generating costs estimated to be as much as 41 percent of the amount of the non-performing debt. Inall these accounts Costa Rica compares very negatively to regional and global peers, On the other hand, availability of information on prospective borrowers in Costa Rica appears relatively good. According to the DoingBusiness report in2005, Costa Rica achieved an index level of 6, indicating the relatively highquality of borrowers' information, well above the Latin American average of 4.5. Furthermore, 38 percent of adults are covered by the credit registry. However, only 4.5 percent of adults are covered inthe private credit bureau, substantially below the LatinAmerican average of 31.2 percent. In case micro firms and non-exportingfirms markettheir services in foreigncurrency, for which there is anecdotic evidence, they may not face an idiosyncraticriskto servicethe foreign denominatedloans. However, they may be exposedto a systemic risk in case of devaluation. ix Although lending to SMEs is activelypromotedby public banks,it appears to be stagnating.Bank lending to SMEs has beendrivenmainly by public banks, with clear leadership from BancoNacional de Costa Rica and Banco Popular, and modest participation from private operators such as Financiera Miravalle and Banca Improsa. In2005, estimated bank lendingto SMEs inagribusiness, manufacturing trade, services and tourism stood at around US$333 million, which i s equivalent to only 16 percent ofthe total bank lendingto those sectors.' This relatively low share of lendinghas not changed substantially over the past 5 years (in 2001 it represented 15 percent of total bank lending), suggesting that, while the aforementioned banks have established specific SME lendingprograms, the overall lendingto these companies has not kept apace o fthe rest of bank credit growth. Although the government has attempted to increasethe level o f financing to SMEsthrough various entities and programs, these programs have very limitedcoverage. The ICs datashows that cost of financingand accessto finance are ratedamongthe top five perceived constraints to growthby surveyed firms.With 45 percent o ffirms indicating access to finance as severe or major constraints, Costa Rica, with the exception of Brazil, Nicaragua, and Honduras, ranks worse than other countries inthe region such as Peru, Ecuador, Guatemala, and El Salvador. In terms of cost of financing as a major or severe constraint to growth, Costa Rican firms rank better than many countries inthe region such as Brazil, Nicaragua, and Honduras. However, Costa Rican firms are 7 and 2.75 more likely to perceive the cost of financing as a constraint than their counterparts inLithuania and Chile, respectively. Inthe case of Costa Rica, accessto finance affects more micro and small firms than medium and large ones, however there are wide differences by size when rating the cost of financing as a major or severe constraint. Figure 11: Access to Finance and Cost of Finance rated as "Major" or "Severe" Constraints to Growth Access to financing Cost of financins Brazil Brazil Nicaragua Nicaragua Honduras Honduras CoStaRica PEN Peru Poland Ecuador CostaRica Poland Ecuador Guatemal Guatemal ElSalvador Indonesia China ElSalvador Chile Philippines Indonesia China Thailand Chile Lithuania Thailand Philippines 4 Lithuania 0 10 20 30 40 50 M) 70 0 I O 20 3U 40 YI SO 70 I O W Percentofnrm. Percentofnrm8 Source: Wodd Bank InvestmentClimateSurveys About 71 percent of CostaRicanfirms used financing from formalor informalsourcesinthe past 12 months previous to the survey.' Inoverall access to finance, Costa Rica ranks better than Chile, Honduras, Poland or the Philippines, but worse than other Latin American countries such as Peru, Guatemala, El Salvador, Ecuador, or Nicaragua. Costa Rican formal access to finance slightlyprevails over informal financing: 54 percent and 47 percent of firms access formal and informal credit, respectively. Simultaneousparticipationin formal and informalcredit marketsis muchmorecommonfor medium and large firms than for micro-firms.About 43 percent of firms that use credit got it from both formal and informal sources, suggestinga much lower degree of market segmentation than in other '*Formalproviders Hall, Monge-NaranjoandArce (2002). of finance include banks, such as state-owned andprivatebanks, as well as non-bankproviders, namely loans from governmentprograms,finance companies, credit cards providers, and factoringand leasing companies. Inturn, informal providersof finance include supplier credit, loansfrom family andfriends, andmoneylenders. X countries. Inthis area, Costa Rica performs better than Chile with only 26 percent o f firms getting finance from both formal and informal sources or thanNicaragua(34 percent), Honduras (33 percent), or Poland (23 percent), suggesting a lower degree o f market segmentation between formal and informal credit markets. Suppliercreditand loans from state-owned banksare the most predominantsources of finance used by surveyed manufacturingfirms in CostaRica. Overall, 38 percent o f firms received financing from some type o f bank. Not surprisingly, more manufacturingfirms got loans from state-owned banks (26 percent) than from domestic private banks (15 percent), foreign banks (5 percent), or off-shore banks (1 per~ent).~Although only 27 percent o f surveyed firms got financing from non-banks, most did so from credit cards (13 percent) and factoring (9 percent). Supplier credit is the most prevalent source o f financing with 35 percent o f firms usingit. Furthermore, loans from friends and families reach out 20 percent o f firms, which is the highest rate among comparator countries. Figure 12: Use of Formal and Informal Sources of Financingin Costa Rica Banks (38 percent) Nonbanks (27 percent) 40 7 Informal Sourcesand Suppliers(47 percent) 35 I 13 State- Domestic Foreign Offshore Finance Credit Leasing Factoring Family8 Money Suppliers owned Private banks banks companies cards Friends Lenders banks banks Source: Wotld Bank InvestmentClimateSurveys Eventhough a large proportionof firms have accessto externalsourcesof financing, CostaRican firms financed 56 percentofworkingcapitalneedsand 62 percentof the value of new investments with retainedearnings or internalfunds. Interms o f external financing, banks are the most important source o f financing for either working capital or new investments for all firm size. They financed 17 percent o fworking capital and 21percent o fthe value o f new investments. Supplier credit i s the second most important source to finance firms' working capital needs (12 percent). Furthermore, supplier credit i s mainly used to financing inputs requirements as 57 percent o f inputrequirements are purchased on credit from suppliers, with medium and large firms financing more their inputswith supplier credit than micro firms (75 percent versus 33 percent). The relatively low percentage of foreign bank loans could emerge from several factors. First, private banks (including off-shore banks) face competition from public banks, who can offer lower cost loans basedon their regulatory advantages. Second, interviewed enterprises might have been unable to differentiate between on-shore and off-shore lendingor might have been unwillingfully declare their offshore loans. xi t-term lirrcs of credit is visibly lowcr for Costa Recanfirms than for other s. Acccrrdiiigto the ICs. only 1 3 percent of cornpattics suneyed rep From a r ~ g ~ o ~ ~ a lhe, other Central A If h sin ElSatvadora ter access to short- it than ~ o ~ ~firms ina Costa~Rica. Co r ~ r ~ ~ Iattd citcd that nicmthan three in fi3ur firm report havingacccss to crc Costa Ricsn firms have formal loans with the largest m ~ t u r~i ~ mglobal peers. According to the ~ n ~ ICs, Costa Ricati firms r c p ~ kadtiicdia~~ a ~of BO months.A~I ~ ~ ~ osimilar to E1Salvador, Costa ~ r i ~ u g I ~ iina or ~ ~ or eve1d ~ parators, ~ ~ ~ e a1 loan does not var] by 11rhougir, ms, this may riot suggest that rt"rinsdo not Surveyed firms report that loans rcceived from formal lenders are generally colIarc~ali~edwith r e d estate properties. Most forinaf loans are secured cvitticoflateral: 86 percent. ~ ~ l ~ h sevcrafhdiffcre~~ o u ~ rqpes ofasscfs cati be plcdgcdto secure formal loans, Costa Rican firms offered real estate collateral in 67 percerir oftheir oLitsta~idiIi~formal toatx Many firms offer assets of owners and ~ n a n ~ ~toe msu r er ai toans), tl.tl,icttf l xturcs were used as coflatc used as collaterat for I 5 S l i ~ ~more~than half o f o ~ t ~ ~ formal loans~in Costa Rica arc issued in local currency, yet t l ~ n d ~ n foreigti-if enon1inat xii aving an unn1etde icnthan in e o ~ ~ a ~countries."' fn ~ t o r c tvhich is tisn times higher flirtti in Chilc, ever demand far loans becausethe loan cotifracts offered by and also becausetheir loana ~ ~ ~ ~ j ~ a t i ~ ppt) fix formal lonits becauseo fcum (38 percent), foreign- firms that don't use external auditors (28 ~sercent),and firms inthe food and textile industrim(33 percent). About 3 8 percent of credit~ o n ~ ~ r firms~r~~ e o ~having its toan a ~ p ~ i c arejected.~Even a ~ p d e d ~ i o ~ ~ h o ~Costa Rica Iriis one of'tht" lowest coll~~eral g h ~ ~ a l u ~ - ~ osize~ratios,i about 30 percent of credit - l ~ a i ~ o n s t ~ ~ firmsi ereported high cc,ttateral require~~ie~~~s ~ j I ~ as a deterrent to apply for formal toans. ~1~~~~~~ and large firtiis are more likelq to c o ~ ~ pabout~c~i ~~l l a ~r~erqau~i r ~ ~ ~ ~ e ~ ~ s . l a rt having an unmet demand far credit, w hree tines as highfor m ~ c r o e ~ t ~ r p ~ j tires to access credit f II and 8 pcrccnt r ,mediumaiid lar insteadof proceduralproblems or t rates (4 percent in both cases). To e ~ ~ t~ io~~~t ~een~~ ~~ ndepth~and access to finance, it is necessary lo review the current role ~ cgj l of public tsmks IS providcrs of credit to the private sector. E thnugtr thc oterall bank credit fa 1 private sector has increased, there are segments o fthe economy that appear neglected by both private and public banks, while some activities seem to be favored by all types o f lenders. Inthis context, it i s necessary to consider what should be the role o f the public banks going forward, that is, whether that role is one o f open competition with private players, or one o f complementariness, targeting economic activities and market segments that are not properly serviced by private creditors. Inthe first case, public banks should be enabled to compete more freely by avoiding subjecting their strategic credit decisions to government mandates, while phasing out the current privileges that they enjoy over private players. Inthe second case, a clear strategy should be defined in order to identify the economic activities or segments o f the private sector that are not adequately serviced by private banks due to higher risks inherent to their ventures and the current weak contract enforcement environment. Enhancementsin contract enforcement are requiredto promotesecured lending.The poor contract enforceability in Costa Rica evidenced through costly and time-consumingjudiciary processes generate higher risks for lenders. Inturn, such inefficienciestranslate into tangible constraints for prospective borrowers to access credit due to stringent collateralrequirements, burdensome credit processes and higher cost o f credit. While some enhancements to the legal framework have been implemented, the limited role o fthe creditor inthe legal process, the lengthy proceedings and cumbersome proceedings (notably the verification o f claims) and the difficulties to reach out-of-court settlements are still considerable obstacles. The developmentof a dynamic factoringsector could provide a significantsource of financingto the private sector while reducingliquidity and credit risks. Most firms inCosta Ricaprovide financing to their clients on a consistent basis. Receivable accounts take up a sizable part o f companies' resources, reducing their liquidity. At the same time, companies are subject to considerable risks from defaulting suppliers given the deficiencies inthe contract enforcement environment. In other countries the development o f a country-wide factoring platform linking suppliers, factors and buyers" has enhanced significantly this role o f this sector as a source o f financing to private firms by reducing risksand transaction costs while increasing competition. INFRASTRUCTURE A wide range of empiricalstudies supports the conclusion that infrastructureis, in its own right, a major contributor to economicgrowth, particularly for developing countries. The approach to understanding the linkage has varied, with different analyses considering the impact o f infrastructure on aggregate TFP (Krugman, 2004), the impact o f individual sectors on growth (Roller and Waverman for telecommunications or Fernald for roads), the LatinAmerican region-specific impact o f infrastructure stocks across sectors (Calder6n and Serven, 2003a), and the separate impact o f service quality on growth (Esfahani and Ramirez, 2002 and Calder6n and Serven, 2004a). The cumulative result o fthis growing literature is a robust demonstration o f infrastructure's role as a driver of growth.12 Underlying the "direct linkage literature" (infrastructure and growth), is the recognitionthat infrastructure i s an important determinant o f firm productivity. That is, the supply, quality and price o f infrastructure are defining elements o f firm competitiveness. With trade liberalization spreading, logistics and transport costs alone tend to be higher than duties imposed on imports as well as the cost o f quotas and other non-tariff barriers. See Klapper (2005) for a detailedstudy of successfulfactoring mechanismsbasedon similar legalframeworks. l2 Synthesized from Fay and Morrison (2005), and Calder6n and Servdn (2004b) with input fi-om Bricefio- Garmendia, Estache, Shafik (2004) xiv This micro or firm-level perspective on the importanceof infrastructure for competitivenesscan be capturedtwo ways: through perception-based surveys of firms and investors; or through firm-level analyses that evaluatethe costs of doing business. Many surveys-such as the World Economic Forum (2005)'s Business Competitiveness Index-query firm managersand investors about their perceptions of infrastructure services. Other surveys, such as the ICs usedinthis study, compile financial and trade data from individual firms to illustrate the relative importance of each element of production, including transport services, customs, electricity and telecommunications. When aggregated, the surveys helpto quantify and prioritize infrastructure-related challenges such as bottlenecks to the shipment o f goods; the impact of delays and lost, damagedor stolen cargo on shipment values; and the cost impact of energy and telecommunications service problems. Just as strong trade policies and efficientinfrastructurecan contributeto growth, trade barriers and poor infrastructurecan stymie growth. InCostaRica, direct barriers to trade such as duties and quotas appear to be less constraining than physical bottlenecks inthe productionand movement of goods. Indeed, as shown inthe figure below 52 percent of firms surveyed for the ICs found infrastructure to be a major or severe constraint to their investment climate while only 7 percent of firms found trade regulations to be a major or very severe constraint. When asked inmore detail about the infrastructure constraints, 42 percent found road quality and/or transportation to be a major constraint, disaggregatedto 40 percent for road quality and 16 percent for transport. Likewise, 28 percent identifiedelectricity and/or telecommunications services as major constraints-disaggregated as 13 percent (telecomm) and 16 percent (electricity). Figure 15: Infrastructure as Major or Severe Constraintby Firm Size 80 70 68 60 e 50 u- 2 40 30 a 20 10 Infrastructure Telecommunications Electricity Transport Road Quality Water rn Micro Small BMedium& Larae OTotal Source: World Bank Investment Climate Surveys Perhapsmoreimportantly,the analysis also found that the poor conditions of infrastructure in Costa Rica affect firms' integrationinto global markets. Poor infrastructure affects the capacity of firms to export, as well as the ability of countries to attract foreign investments. It thus reduces opportunities for greater internationalintegration, higher competitiveness and enhancedtechnology and innovation. Becauseof the importance of infrastructure inthe physicalmovement of goods, bottlenecks contribute to high logistics costs which, inturn, lead to high inventory levels. Unreliable infrastructure will result inhigher losses intransit, the needto holdhigher inventory rather than orderjust-in-time, and generally higher cost of transport. xv The Logistics Survey conductedfor this study focusedon threehighvalue-added goods and found the range of logisticscosts as a percent ofvalue to be 13 to 24 per~ent.'~ Because the goods analyzed- -processedfoods, cut flowers and medical equipment--are of extremely highvalue inrelationto their weight, the logistics costs for those products are low in comparison to the nation's total mix o f products. (Transport costs alone often representover 50 percent o f the deliveredcost of low-value-to-weight goods such as cement, coal, grains and other products shipped in bulk.) This suggests that Costa Rica's national average logistics cost for goods may be even higher. How does that compare with industrialized countries which should serve as the benchmark for Costa Rican competitiveness? The average share of all logistics costs to productvalue in OECD countriesis around 10 percent.14 This average includes the full range ofproducts--fromhighvalue air shipments down to low value bulk cargoes--suggestingthat Costa Ricanfirms are faced with a significant cost disadvantagewhen competing against firms in industrialized countries. Much ofthis extra logistics cost burdenthat has beenplaced on Costa Rican products can be attributed to differences ininfrastructure quality and reliability-particularly intransport. Poor quality and reliability result indamagedgoods, demurrage charges, lost sales and higher inventory levels. For CostaRica,this lessonis of criticalimportance: In orderto unlockthe benefitsof trade, infrastructuremust be available,reliableand cost effectiveand a wide range of firms must have access to that infrastructure. By focusing on the bottlenecks to trade that are revealedthrough this process, policy makers can address the country's competitiveness and potential to achieve higher growth rates. Infrastructure-Related Constraintsand the Competitivenessof CostaRica's Firms The results of the sectoral diagnoses and the surveys conducted for this study tell a remarkably consistent story acrossinfrastructuresectors about the unique paradoxthat CostaRicanow faces: The country possesses a tremendous endowment of infrastructure forged from a legacy of public commitment. That is, access to infrastructure in a broad sense i s excellent in comparison with neighboring countries. 0 Service and infrastructure quality are suffering from underinvestment, lack of innovation and weak regulation and that i s impacting firm competitiveness. Over decadesof steady investment,CostaRicabuiltan extensive networkof infrastructurein nearly all productiveservice areas. The financing ofthis infrastructure has mostly relied on public funds andthe management and operations ofthe serviceshas relied onpublic institutions. These transport, electricity and telecommunications networks were allowed to develop inthe context o f a profound sense of "social compact" felt by taxpayers toward public service providers. The resulting infrastructure endowment has contributed to Costa Rica's high and stable growth levels indecades past. A high-level review of CostaRica's transport,electricityand telecommunications endowment revealsa countrythat is a regionalleaderin productiveinfrastructureinterms of connectivity. Across all of Costa Rica's primary, productive infrastructure backbone-roads, electricity and telecommunications-the country has made remarkable achievements inproviding access to a large portion of its citizens and businesses. Intransportation, Costa Rica leads its peer group inroad density, l3Calculationexcludes raw material inputs to avoid redundantcalculationas raw materials generally contain even higher transport costs as percentage o f total value. 14See Guasch (2002), xvi measured as the lengthof total or paved roads per worker. Indeed, it has 30 percent more paved roads per worker than the next most densely paved country inLatin America. Inelectricity, the reach of the network and connection rates are among the highest inthe regionwhile the country ranks third in electricity capacity per capita. Costa Rica has made impressiveprogress inthe availability of information and communicationtechnology (ICT), ranking first among its peers inmainline teledensity as well as personal computer density and second inInternet usage. Despitepast successesin buildingout infrastructurenetworks, public expenditure levelshave declined and some ofthe publicservice providershave beenunableto keep upwith sectoral innovation.The private sector has not been allowedto play a compensatory role becauseofthe long- established positionof public authorities and agencies as integrated owners, operators, investors and managerso f infrastructure services. Regulators who mighthave attacked the issue of declining service quality have not been granted sufficient tools, resourcesor independenceto raise the specter of institutional shortcomings on the part of public service providers. The result has been a decline in the quality of services across sectors-ven as connectivity remains high. That quality slippage is beginning to affect firm competitiveness, particularly for small and medium-sized manufacturers. As a result of this falteringcommitment to infrastructurein recentyears, growthinthe endowment of most of CostaRica's productive infrastructurehas begunto wane. Intransport, Costa Rica's paved road density has declined eachyear since a highin 1998as growth inpaved roads was offset by more rapid growth inthe labor force. The maintenance o f such an extensive network has proven to be a core challenge for the Government -a point which is discussed in more detail inthe section of Chapter 3 of Volume T I which is dedicated to Costa Rica's infrastructure quality. Similarly, efforts to increasethe capacity o fthe ports through a concessioning program inCaldera and a rationalization o f operations at Limon and Moin have not progressed, leavingCosta Ricawith notably uncompetitive ports, and forcing about 60,000 containers per year to move through Panama's ports. Likewise, an upgradingof the internationalairport has beenon hold while the awarded concession has battledthrough the court systems. In electricity,generationexpansion hasstopped over the last few years and shortagesloomin the futurewithout a rejuvenationof the investment program. Mobile telephony has also has notkept up with neighbors, competitors or the potential of Costa Ricansto utilize the newtechnology. As for the quality of services, the ICs reveals that Costa Ricanbusinesses suffer from surprisinglyfrequent outages and long waiting periods for connections inboth electricity and fixed line telephony. In additionto the immediateimpacton accessto marketsand firm competitiveness, CostaRica's reputationas an attractiveinvestment location mayalso be impacted by the falteringquality of infrastructureservices. A recent survey o fmajor industrialists gave Costa Rica low marks inthe quality of its transport infrastructure (Table 1). Costa Rica rankedpoorly in most categories of transport infrastructure inthe survey of business executives contained inthe World Economic Forum's Global Competitiveness Report 2004-2005. Inregards to ports, Costa Rica was tied with Guatemala for the lowest ranking in its peer group. Air transport was the only category inwhich Costa Rica's score exceededthe peer group average. xvii Table 1:ComparativeSurvey on the Quality ofInfrastructure Overall Port Air transport infrastructure infrastructure infrastructure quality quality quality Argentina 3.6 3.6 4.1 Brazil 3.5 3.1 5.1 Chile 4.9 4.8 5.7 Colombia 2.9 3.0 4.4 Costa Rica 3.0 2.5 El Salvador 4.4 3.3 5.6 Guatemala 2.7 2.5 3.5 Honduras 3.0 3.8 3.3 MBxico 3.4 3.3 5.0 Panamti 4.0 5.7 5.2 Indonesia 4.2 4.4 4.4 Philippines 2.5 2.6 3.9 Thailand 4.6 4.2 5.3 Average 3.6 3.6 4.6 Source: World EconomicForum, Global CompetitivenessReport2004-05 Notes: Survey basedsubjectiveevaluation on scale from 1-"poorly developed and inefficient" to 7-"among the best inthe world." What are the specific impacts of the decline in expenditure and the inability to leverage private sector involvementin infrastructure? 0 The quality ofthe primary road network is poor and worsening, resulting inlossesfrom delays of shipmentsas well as breakageand theft of between 8 and 12percent of sale value for exported goods; 0 The primary ports remainunreformedand inefficient resultinginover 15 percent of container cargo now moving through Panamaand absorbing estimated US$70 to US$lOO million in additional road haulage costs per year; Electricity quality measurementsfrom time for connection to severity and duration o f outages is surprisingly poor and worse than competitor countries; 0 Electricity generation capacity i s low given Costa Rica's level of income and has not keptup with the rise indemand inrecent years; 0 Mobile penetration levels are low by regional or competitor standards. This quality slippage is beginningto affect Costa' Rica's competitiveness, particularly for its small and medium-sized firms. To reversethe decay, public sector resourceswill have to be re-dedicatedto the task of selective rehabilitation and expansion while some sectoral reformsthat challenge the traditional "in-house" public solutions may be necessary. KeyPolicy OptionsforEnhancingInfrastructurefor Growthand Competitiveness Policy options for improvingthe performanceof Costa Rica's infrastructure includetwo key elements: (1) arecognition ofthe real source of the fiscal constraint related to infrastructure; and (2) a series of sector-specific initiatives that requirethe involvement of senior fiscal authorities as well as the technical agenciesthat implement each service. xviii 1)InvestmentDecisions How should the infrastructure investment needs be financedgiven currentfiscal constraints and how will this differ from the country's traditional investment patterns? Historically,CostaRica'sinvestmentlevelsininfrastructurehave mappedclosely to its growth levels-to the benefitof the country's economy. That is, at between 3 and 4 percent of GDP, investments in infrastructure have traditionally beenthe second highest inLatin America-after Chile (4 to 6 percent)-as have Costa Rica's growth levels. Perhaps becausethe rate of infrastructure investment as percent of GDP continues to remain higher than most LatinAmerican countries or perhapsbecause Costa Rica's levels of access to basic services (electricity, roads, fixed line telephones and water and sanitation) are among the highest inthe region, infrastructure investment trends have not attracted much attention. Ithas only beenrecent reports of quality problems arising from Costa Rican investors, shippers and businesses that have focused a clearer light on the state of infrastructure investment inthe country. Indeed, signs of quality problems inCosta Rica's infrastructure service provision are at odds with the traditional view of Costa Rica as a regional leader inthe provision of infrastructure service^.'^ To understand the cause of the quality problems that have arisen acrossthe productive infrastructureservices requires a deeper analysisthan the overallinvestmenttrends. The nextlevel of detail-investments levels by sector (telecom, electricity, transport, water)-reveals a pattern of expenditure which i s different from other middleand upper income countries throughout the world. Nearly all comparator and competitor countries use public funds for those infrastructure investments that contain an important social or merit good characteristic-such as roads, water and sanitation. Those same countries rely on the private sector to finance infrastructure services which are more readily paid for by user charges-such as telecommunications, electricity and other types of energy supply. By contrast, the lion's share of Costa Rica's public expenditures in infrastructure i s increasinglygoing toward telephony and electricity generation while public investments in other areas of infrastructure are falling. In terms of Governmentaccounts, ICE's growing investmentsin telecommunications and energy hides the massivedeclinein Costa Rica'spublic investment. Infact, public investment intransport dropped from about 2.0 percent of GDP between 1976 and 1984 to about 0.3 percent of GDP between 1996 and 2004. As a result of the public nature of all the financing sources for infrastructure, a chain reaction of fiscal constraints has emerged: The government's budget has reachedits current state basedupon atradition of investment in infrastructure that appearedhigh(because of the independent revenue sources of ICE from telecommunications and electricity tariffs), but which is, infact, woefully low; The underinvestment intransport stock hasresultedina poor quality roadnetwork, dilapidated bridges and poor port access. This deferment of investment and routine maintenance has driven upthe per unit cost of maintenance andrehabilitation exponentially; ICE's autonomy and the logic of auto-sufficiency inICE's two sectors does not allow for transfer of investment funds between sub-sectors (e.g., from telecommunications to roads); Evenifthe transferringof funds were possible through a systemof cross-subsidiesor bond financing on the back of ICE, it would not be desirable. ICE will have enough difficulty inthe years aheadto finance the backlog of investment needs inenergy supply; and address the growing IsSee the WorldEconomicForum'sGlobal CompetitivenessReport and inthe InvestmentClimate and Logistics Surveys conductedfor this Report xix quality concerns inelectricity distribution and fixed line telephony. This will have to be done in the face of greater competition (and, possibly, lower revenues) inmobile telephony. In short, additionalsourcesof funds will be required to rehabilitatethe transport networkof Costa Rica. Having recognizedthis, the Government is movingforward with concessioncontracts for the few highways with sufficient traffic to self-finance through tolls; and the concessioning of the ports. The Government is also looking at ways to increase the fuel tax to cover roadmaintenance andrehabilitation for lower densityroads. These initiativesare vitally important and are encouraged in the infrastructurechapter of this report. However, unless the Government is able to construct a large, separate account for roadfinancing out of fuel taxes, these measures are unlikelyto finance the investment, rehabilitation and deferred maintenance gap that the sector currently faces. As discussedbelow, the Government may have to consider even more creative approachesto accessingcapital and leveragingthe private sector inthe provision of low and medium-densityroads. 2) Sector-Specific Initiatives While the commitmentof highlevelfiscal authoritiesis a necessary prerequisitefor derivingnew sources of financing for infrastructureinvestmentand maintenance,a series of sector-specific policies are requiredto shore up the performanceof the sectors and protect the value of existing and future assets: Intransport, rehabilitationand maintenanceofthe keytrade corridors, beginningwith the road from San Jose to Puerto Limon and the operations of the Atlantic portswould help facilitate trade and businessexpansion. The new Government's announced intentions to rededicate itselfto infrastructure investment is welcome news to Costa Rica's manufacturers, service firms and potential investors alike. Inleveraging private financing and enhancing Costa Rica's reputationfor contracting integrity, the financial closure of at least one major road concession over the next six months or so will send positive signals to the infrastructure investment market. Given the singular importance of Puerto Lim6n-Moin for the competitiveness of the country's trade, and the current levels o f inefficiency suffered by Costa Rica's shippers, a new governance structure and investment strategy for the Atlantic ports becomes a priority. Port reform at Lim6n-Moin should no longer await the results ofthe concessioning of Caldera. Where highway rehabilitationand expansion are necessary but tolling is unlikelyto cover the entire cost, the lumpy fiscal burdensmight be "levelized" or spread out over manyyears throughthe use of enhancements. Credit enhancementssuch as minimumtraffic or revenue guaranteesbackstopping partialtolling commitmentswould shift the initial financing costs to a consortium of construction, maintenance and operating firms. While the contingent liabilities associatedwith suchguaranteeswould need to be valued openly and fairly inthe public accounts, they would, at least, helpto spreadout lumpy investments andto shift maintenance and operating responsibility to the private sector. For roads and bridgeswhere traffic volumes are too low to cover large rehabilitation or expansion projects, toll-financed contracting might still be considered to cover the costs o f routine maintenance. A detailed analysis o f per unit costs associatedwith current maintenance contracting should be undertaken to determine whether longer term and performance-based rehabilitationand conservation contracts would yield greater returns for the scarce resourcesbeingspent onthe roadnetwork. Finally, the bundlingof road and port investmentobligations with land development opportunities (e.g., property leasing, tourism site or industrial park development) could be considered to entice consortia into providing infrastructure as part of more complex investments. xx In the electricitysector, incentivesfor expandinggeneration assets and improving regulatoryoversightwould enhancethe sector's governance and contractualframework and contributeto greatersupply and reducedenergy prices. Inthe short-term, the Instituto Costarricense de Electricidad(ICE), Autoridad Reguladora de Servicios Publicos (ARESEP), and Ministerio del Ambiente y Energia(MINAE) should focus on relievingthe impending generation shortages by empoweringthe agency to concession hydro-power; definingtariff adjustments that provide ICE with the resourcesto fund immediate generation investments; and definingcontractual arrangements for renewingprivate generation agreementsas well as the trading of existingcontracts. Inthe medium-term, a sector strategy that reevaluates market structure including the role of greater regulatory independencewill become necessary. Without a sector plan that considers the Central America trading mechanism, it will be difficult for Costa Ricato take full advantage of the integrated market. In telecommunications, sector reforms now under discussionare likelyto bringproductivity gains and technology transfer. The Government of Costa Rica has begunthe process of designing a more modern legal and regulatory framework that recognizes the competitive potential of the industry. While this is being done in anticipation of CAFTA's requirements, the Government should press aheadwith the sector reforms now under discussion. This will require the restructuring of the sector to create a separatetelecommunications regulator; liberalization of service provision; the creation of a telecommunications policy function; increased and rationalizedaccess to radio spectrum; and the improvement of information generation. Inorder to carry out these reforms ina coherent manner, the Government should consider drafting o f a comprehensive "e-Costa Rica" strategy or digital agendathat would define telecommunications sector reform and connectivity agenda; an integrated e-Government strategy, and a strategy to promote the development of the IT industry and attract investmentthrough IT-enabledservices. INNOVATION Numerousstudies recognizethe link between productivitygrowth and investmentsininnovation, and some point out that muchof the widening gap between richand poor countriesis due, not to differences incapitalinvestment, butintechnologicalprogress. The mainfocus ofthe analysis summarized inthis section i s onthe role playedby the private and public sectors and how these efforts interact inthe context of public policies that help or hinder private innovation. Itprovides a description o f the status of innovation in Costa Rica by analyzingaggregate and firm-level data and comparingthis country's performance in recent years with those o f countries at similar levels of development. The work also discusses new macroeconomic evidence linking innovation and economic growth on the one hand, and the role of market failures inhamperingoverall innovation performance on the other hand. Finally, it describes innovation policies and programs currently inplace inCosta Rica, assessestheir recent performance through a qualitative analysis and presents conclusions and main policy recommendations. WhyGovernmentPolicyMatters Policy makersare interestedin understanding the factors that promote or impedeinnovationand in undertakinginitiativesand policy actionsthat benefitthe general society by targeting innovation-relatedmarketfailures.The analysis o fthe causes and consequencesof innovation and its relationshipto economic growth and firm performance can be captured succinctly in a simple framework where firm-level innovation is a result of firm level investments ininnovation inputs (Figure 6).Butthe firm-level decisions regardingexpenditures or other business decisions that determine a firm's ability to learn, adapt, and change, are themselves shaped by the businessenvironment. Without a proper xxi xxii Figure7: Median TFP G ~ QRates~by~RegionsC w ~ to Costa Ric8%Average a ~ ~ ~ ~ ~ 2 50 2 oa I50 7 00 0 $0 a oa LCR ECA EAP MENA SSA OECD Costa Rica I (mean) Source World Bank Staff ~ a l c f f ~ ~assuming$ a~ capital share of GDP of 40% for ali countries and years, ~ i ~ n an@basadon data provided by Loa e results, it is cicnr that Costs Rica canto increase its total h pursue the higher and sustained rates of growth that are necessaryto catch up to more stelXar ~ c r f o r ~In~this~cantext, ~ e . nand ~ ~r ~ h ~~~o iptakcicenter stage. a o~~ l ~~~ ~~ ~ ~ ~ ~ ~ A s t r ~ education base is a ~ ~ r e r ~ ¶for innu~~ationand t ~ e ~ ~ o lchange~andaCosta Rics's n ~ ~ ~ s ~ t c o ~ ~ l c ~ u ~ a t i aot~t a i~n ~ eis~antorigthe h ~ g hin Latin America, but there is still room for t ~ ~ t population has some prim hort art almost 1QC) pcree tc growth c) cIC.Average 1cars of cdtr !%\xihatlowcr than other Latin American c ~ ~zt irti similar~iricornc ~per capita, and far from ~ r ~ ~ e ~ ~c ~ ~ i ~ ~suchr aselsracl arid ~ ~ i s~ ~ Ireland. Insum, from an ~ n t e r n a t ~cumpar~t~vep e ~ ~ ~ ~ Costa~Ricn shows some ~ ~ r e nandt ~ s o ~ ~ ~ 1 c t j e , ~ atiun outputs and input 1intertiationnf patenring, sxiii development than governance or the quality o f public institutions; Second, the social rates o f returnto R&Dseem to be quitehighsuggesting that ifCosta Ricacan providethe correct incentives and institutional framework, the payoffs from innovation policies can be substantial; and third, market failures seem to hamper the most common type of innovationindevelopingcountries, namelythe introduction of export products that already exist around the globe. Key conclusions are: Policiesto promote innovationwould help to improveCostaRica's development prospects. Innovation outcomes, measured by the accumulated number of patents over a longtime period, appear to raise the level of development across countries. Inthis context, innovation isjust as, or perhaps even more important for long-term economic development as governance or the quality of public institutions. But,national innovation systems-public sector policies, researchcenters and universities, and the private sector-should be well integrated inorder for innovationpolicies to have a highrate of social return. Hence to aid the targeting o f innovation policies inCosta Rica, this report provides a comprehensive empirical assessment o f firm characteristics and innovation inputs that are associatedwith various indicators of innovation outputs, namely the introduction of new products, product upgrading, changes inproductionprocesses, and meeting international product-quality standards. CostaRicacan provideincentivesand the appropriateinstitutionalframework so that it receivesthe potentiallyhighpayoffsfrom the social returnsto R&D and innovationpolicies. The social rates ofreturnto R&D, one o fthe key innovationinputs, seem to be quite highfor countries with similar levels of development as Costa Rica. Givenits levelof development, CostaRicaseems to be an under-performerinR&D, scientific publication,and export discoveriesand would benefitfrom greaterinvestmentsin innovationor improvingthe qualityof public policiesand institutionsthat affect private- sector investmentsin innovation.Market failures seem to hamper the most commontype of innovation in developing countries, namely the introduction of export products that already exist around the globe. Consequently, the benchmarking exercises that portrayedCosta Rica as an under-performer in R&D, scientific publication, and export discoveries become worrisome when the empirical evidence suggeststhat the potentialgains from improving either the level of investments in innovation inputs or improvingthe quality of public policies and institutions affect the efficiency with which the country uses its scarce innovationinputs. Although CostaRica's matching grants programthat subsidizes private-sector innovation projectsis consistentwith global best practices,various aspectscan be reformedinorderto enhance its performance. Some ofthe features that could be reviewed are: (i) the limits on the participation of large firms; (ii)the narrow scope ofthe grants, which are currently targeted on joint ventures between firms and researchcenters that are not chosen by the firms themselves; and (iii)the fixed-time grant competitions, which limitthe grant applications to those submitted by certain dates, could be changedto an openwindow allowing firms to submit proposals at any time. However, it is difficult to derive strong recommendations from the available data, andthus itis arguablethat the mainreforminthe near future should focus onthe future monitoringand evaluation ofthe program. The matchinggrants programcould be monitored to improveperformance,in accordance with state-of-the-art evaluation techniques, butthis might requirecollectingadditional informationfrom private-sector participantsinthe program.Furthermore, the activities of PROCOMER and of the Ministryof Scienceand Technology, which are key pieces of Costa Rica's national innovation system, could also be evaluated inthe future, butthese remaintopics for future discussions and analysis. xxiv Education,innovation, and infrastructure,seem to beworth prioritizinginthe country's publicpolicy agenda. The evidence put forth inthis report suggests that CostaRica's public expenditures relatedto secondary schooling, its matching grants program, and perhapsthe budget of the Ministryof Science and Technology, as well as those related to improvingthe quality of its infrastructure, should beprotected as much as possible inthe context of fiscal consolidation. If budget cuts inthese areas are requiredto maintainthe country's cherished macroeconomic stability, then the recommendations regardingthe efficiency o f public expenditures outlined above and inthe previous chapter become even more important. GOVERNANCE ,BusinessRegulations CostaRica rankswell inmostindicators of businessregulations.On the time tax (time spent dealing with different government regulations), firm's managers spendalmost 12 percent oftheir time dealing with redtape and regulations, which is a substantial time tax when compareto the same measurefor El Salvador, Brazil and Chile, but much lower than inChina or Guatemala. The time tax is important since - apart from quantifying one aspect of the regulatory burden- it also correlates with other measuresof regulation and property rights.The higher the time spent on regulations, the higher the probability that a firm will make informal payments "to get things done", andthe higher the size ofthe informal payments made to obtain government contracts Figure 16: The Time Tax: Share of Senior ManagementTime Devotedto Government regulations, inspections,taxes, customs, etc. China Guatemala Nicaragua India Honduras Costa Rica El Salvador Brazil Chile Percent of Senior Management Time Source: World Bank Investment Climate Surveys In the area of tax issues CostaRicanfirms are less likely to be inspected by tax authoritiesthan other CentralAmerican countries and they reportroughlysimilar share of sales. Tax inspections affect by far the largest share o f interviewed companies across the 4 comparator countries -more than halfof firms inNicaragua, Honduras and El Salvador (66, 56 and 52 percent respectively) and 45 percent o f Guatemalan firms, but are nowhere near as frequent inCosta Rica-with 25 percent of firms reporting an inspection. Furthermore, the average number of inspections per year experienced by Costa Rican firms i s lower (4 visitddays) than in El Salvador and Guatemala where f i r m s spent 3 times longer with tax inspectors (9 days each per year). SurveyedCosta Rican firms report to the tax authorities 69 percent o f their sales income, which is comparable to the share ofreported sales inHonduras, Nicaraguaand Brazil (66 to 68 percent), but lower than that of Chile (97 percent), El Salvador and Guatemala (77 percent both). xxv Labor regulationshinder firms to increase their workforce and contributeto underreportingof workers to social security and tax administration.The ICs data findsthat when other factors are held at a constant, about 30 percent o f Costa Rican firms are under-employed or could ideally operate at a higher level of employment evenassuming the same firm output level. Labor regulations are likely to be blamed16as the firms would increasethe number of permanent workers ifregulations 40 percent reported that they would not do so due to highhiringcosts (minimumsalary and other benefits) and 31percent due to highfiring costs." The desiredincreases inthe number of workers are nottrivial - iflabor regulations were to be eased, the 30 percent of Costa Rican firms who would increaseworkers, would do so by over 100 percent, i.e. would double, on average, their present level o f employment. Another likely consequence of labor regulations is that firms would not report a share of their workers for social security and taxes. Surveyed manufacturingfirms indicatedthat about 31percent of workers are not officially declared, and very likely lose out on adequate social security and other benefits. While data on percent of reported labor are not available for other Central American countries, the comparison to Chile (96 percent o f workers reported) and the Dominican Republic (60 percent of workers reported) does point to Costa Rica's labor regulations being more restrictivethan those inChile, and only marginally better than those inthe Dominican Republic. This conclusion is borne out bythe DoingBusiness rankings ofthese countries on the regulationo f labor.18 ContractEnforcement Overall, the perceptionof the judiciary is good.About 40 percent of surveyed Costa Ricanfirms are confident that the courts will defendtheir property and contractual rights incommercial disputes, which is the highest among comparator countries, and double the share of respondents from El Salvador, Nicaraguaand Honduras who express confidence intheir countries' courts. Furthermore, Costa Rican courts are also perceived as the most independent and least corrupt as well as having an efficient legal system according to the rankings ofthe World Economic Forum (Global Competitiveness Report2004- 2005 -Index of Public Institutions). Similarly, the legalframework for economic activity is seen as the most efficient in Costa Rica among the five Central American countries. When dealingwith paymentdisputes, court decisionstake a longtime and in many cases the verdict is not regularlyenforced.When using courts to resolve payment disputes, Costa Rican firms face substantial delays, unpredictable court proceedings, and poorly enforce court sanctions. About 23 percent of surveyed firms having payment disputes with clients report usingthe courts to resolve at least some of their payment disputes inthe 2 years before the survey. Court use is often low due to lengthy,costly, and unpredictable court proceedings as the average time to resolve a court case -from filing untiljudgment -- was 62 weeks (or 431 days), which is only lower than Brazil (579 days). One third of court users (33 percent) indicate that it took them more than one year (over 52 weeks) to obtain a courtjudgment over their dispute. Less than half(46 percent) ofthe courtjudgments onpayment cases hadtheirjudicial decisions enforced. One likelycause for this lack o f completion ofjudgment execution inCosta Rica is the automatic suspensiono fexecution uponfiling o f an appeal onthe first-instance courtjudgment. Many debtors will file appeals simply to delay thejudgment execution and the payment o f the debt. Inefficienciesof the courts in dealingwith paymentdisputes may partially explainwhy surveyed Costa Rican firms have a lower share that sells on credit.Incountries where the courts are slow and judgments hardto execute, firms will avoid runninginto disputesby interactingonly with known suppliers and clients, and by structuringtransactions with a view to avoidthe emergenceof disputes, such l6 The DoingBusiness datasetfinds that CostaRica's hiring costs are 24 percentofthe average salary, which makesthem the highestin CentralAmerica andabove the LAC average, eventhough byno meansamongthe highestinternationally. '*"Chileranks Accordingto DoingBusiness, CostaRicastandsout interms of rigidity of workinghours andhighhiring costs. 37`h, CostaRica-72"d,andthe DominicanRepublic- loothon the overallHiring and Firingindex. xxvi as requiringpre-payment or payment at the moment of sale. Indeed, many authors have argued that the share of pre-paid sales is higher incountries with worse contract enforcement regimes, and among firms which do not have easy access to the courts or to alternative mechanism to resolve disputes ( e.g. Hendley and Murrell,2003). Not surprisingly,surveyed Costa Rican firms report that 52 percent of annual sales were made on credit, which is substantially lower than inBrazil(79 percent), Chile (73 percent), or Ecuador (68 percent). Corruption Costa Rica hastraditionally enjoyeda reputationfor transparencyand fares well relativeto other regionalpeers in internationalcorruption rankings. Kaufmann et al.'s (2004) indicator ofthe control of corruption places Costa Rica inan enviable positionagainst some o f its Central American neighbors. The country stands inthe 77th percentile of a sample of 204 countries, whereas other countries inthe region rank below the 50th percentile. A similar finding emerges from the Corruption Perception Index (CPI) by Transparency International, which shows Costa Rica performing significantly betterthan most comparator countries inthe region. When trying to get governmentcontracts, Costa Ricanfirms are less likely to pay bribesthan other comparatorcountries.Bribeswhich are paid out to secure the awardof government contracts during public procurement bids are an indicator of corruption and a measure o fthe regulatory cost to firms. For example, a little over a quarter of Costa Rican firms (26 percent) report that making informal payments to secure government contracts i s common intheir industry.Incontrast, the share of Honduran and Salvadoran firms which report the same is more than twice that of Costa Rica (54 and 57 percent of interviewedfirms respectively). The same-albeitto a lesser degree -applies to the size of procurement bribes-these constitute 10percent of contract value inCosta Ricaversus 14-15 percent inCentral America, and 16 percent inBrazil.) Yet, compared to Chile, the Costa Rican incidence of procurement bribes is high-only 4 percent of surveyedChilean firms report that procurement bribes are common against 26 percent in Costa Rica. Therefore, although faring well among its Central American neighbors interms ofprocurement bribes, Costa Ricadoes muchworse compared to Chile. The ICs suggests that corruptionis lower in Costa Rica than in neighboringcountries,yet bribes "to get things done" seem to be the modus operandi for firms and representa sizeable portionof firm sales. With respectto corruption stemmingfrom the inconsistency and unpredictability of regulation, Costa Rica does a lot better than its peers: only 29 percent of firms reported having problems with this issue. This compares favorably to the occurrence of suchregulatory hurdles incountries such as Guatemala, where 7lpercent o f surveyed firms acknowledge havingto deal with inconsistent and unpredictable regulation. On the other hand, the frequency with which companies have to pay bribes"to get things done" is still relatively high-almost 47 percent of Costa Rican firms reported engaging inthis type of corruption on a regular basis. Although this fraction is relatively lower than what is often found in other countries inthe region, such bribes representa considerable portion of companies' sales. On average, Costa Rican firms report paying close to 6 percent of their annual sales in informal payments or bribes "to get things done" - an amount which is not trivial, eventhough it is substantially lower than in other countries of the region. xxvii Figure17: Bribes to Get ThingsDone Figure18: ProcurementBribes: Prevalenceand 1 Size by Country 60 60 70 50 60 40 -50 8 40 I O & 30 20 20 10 10 0 0 Guatemala Chlle Costa Rica Guatemda Nicaragua Chtle CostaRica ElSalvador Nicaragua Honduras Honduras El Sawador Brull Crime & Violence I t is widely recognizedthat crimeand violence representan importantobstacleto economic development in Latin America and the Caribbean, and affect negativelythe investmentclimateof a country. Many studies, for example Ayres (1998) and Lederman, Fajnzylber, and Loayza(1998), among others, have stressed that crime and violence inLatin America and the Caribbean have a significant negative impact on economic growth, and thus increasepoverty, which itselfbreeds crime. Inthis sense, LatinAmerica i s caught ina vicious circle: on the one hand, economic growth is hindered by highcrime rates, but on the other hand, insufficient economic opportunities stimulate and incite crime. This fact has become important not only in societies that experienced political and civil conflicts, such as Guatemala, El Salvador, andNicaragua, where levels of crime andviolence are particularlyhigh,but also incountries with a long-standing democratic tradition, such as Costa Rica. In the area of homicide rates, Costa Rica fares well comparedto other countries in the region, but nevertheless, crime has beengrowing steadily over the past severalyears. CostaRica displays a rate of 6.2 homicides per 100,000 inhabitants in 2002, similar to countries such as Uruguay (5.2) and Argentina (7.0). These are among the only LatinAmerican countries with homicide rates close to those inadvanced industrializedcountries. Onthe other hand, countries likeGuatemala, Brazil, ElSalvador and Colombia registeredwell over 20 homicides per 100,000 inhabitants over the same period of time. Since the early 1990s,various types of crime, such as assaults, car theft, intentional homicides, and sexual aggression crimes have increased steadily. At the firm level, the ICs data suggest that CostaRicais no longer an exceptional case in Central Americawith respectto crime and violence, since it presentssimilar ratesofcriminalactivity as its neighboringcountries. Once notably better than its neighbors interms of crime and violence, nowadays Costa Rica suffers from many of the same problems of violence that plague the rest of Central America. Costa Rica's firmvictimization rate, measuredas the percentage of firms that have experienced any losses due to criminal actions such as theft, robbery or vandalism, is comparable to that of other countries, such as El Salvador, Guatemala, Honduras and Nicaragua, all of which have long-lastinghistory of criminal and civil conflicts.'' The percentageof firms reportingthat they had been subjected to a criminal act in It is possiblethat the type of crimes experiencedby CostaRicanfirms is differentthan inother CentralAmerican countries. Unfortunately,the ICs does not presentdatadisaggregatedby type ofcrime. xxviii Costa Rica (33 percent) is lower than inGuatemala (52 percent) and El Salvador (41 percent), but higher than Nicaragua(26 percent) and Honduras (3 1percent). Figure19: CostaRica-Trends inNumber of Figure20: Victimizedfirms and firms constrained CriminalEvents by crime yo ............................................................., 4...... *i 78 100i 4 ..................................................................... 58 I MlCW Small Medium L Large mVicUmlzsd (%] . Constrained by crime(%) s Somesec Costs (%) 1 Source World Bank lnvsatmsnt Climate SuweyD Crime losses and security costs are significantly lowerin CostaRicathan in comparatorCentral American countries. Since the variable "constrained by crime" is a perceptionvariable at the firm level, the fact that crime losses and security costs remain lower inCosta Rica mightexplainwhy Costa Rican firms report they are less constrained by crime. According to ICs data, Costa Rican firms spend significantly less than their counterparts elsewhere in Central America. Security costs (as percentage of total costs) in Costa Rica represent approximately one-fourth of the same expenditures in El Salvador and Guatemala. The propensity to report a crime is lower inCosta Rica than inother Central American countries: only 58 percent of interviewed firms in Costa Ricareported criminal activities against their business, against 78 percent inEl Salvador and Guatemala.2o POLICYRECOMMENDATIONS Business-GovernrnentRelations Despitethese positivedevelopments inthe area of businessregulations,thereis a perception that some of the earlier reform momentum has beenlost over the past 4 years. Ininterviewswith various government and private sector officials Delgado (2005) found that the Government has not definedhow to continue advancing the process of improvementof business regulationthrough rationalizing the legal framework, which is often cited as the main reason for excessive procedures and corruption. In the area of businessregistrationthe Government should undertakereformsaimed at reducing the time of the processto start a company through removalof requirements for annualrenewalof operatinglicenses,and throughintroducingstandardized forms to enter the businessinthe CommercialRegister. Some ofthe mainbottlenecks lie inthe steps mandated by law, but other lengthy procedures are observed inthe Commercial Register and the municipalities for obtaining an operational license. Two types ofreforms could be pursued: introduction of standardized forms to apply for entry o f the businessinto the Commercial Register, which has worked inother countries to reduce times and 2o CostaRicanfirms maynot find it is worthwhile to reportcrimesperhapsdue to the nature ofcrimes andthe ability o fthe police to punishcriminal. Furthermore,the costs associatedwith reportingmaynot compensatedthe expectedbenefitsof capturingthe perpetrators of crime. xxix rejectionrates.2'Municipallicense issues shouldalso be streamlinedby makingthem also standardized andprovidingforms and informationonline, andthe needfor their annualrenewalshouldbe eliminated. The Government should also take measuresin reducingthe times for obtainingconstruction permitsand environmentalassessments, whichat present are time-consuming. A possibleway to overcome longdelays inconstructionpermitissuanceis to give buildersstep-by-steps procedurechart so that they do nothaveto visit the municipalityseveraltimes onlyto hear that new requirements must be incorporatedintothe buildingplan. Another possiblereformis to consolidate all buildingproject clearances within the municipalityso to avoidvisitsto different government agenciesthat must approve buildingspecifications.Some steps inthis directionhavealready beetaken. For example, inthe period 1998-2001the principleof"silence is consent" was adoptedinthe area of constructionpermitissuancein Costa Rica. For smaller buildings(less than 300 sq. m,) on 1to 2 floors a permithadto be issuedwithin 5 business days, with the applicationof the "silence i s consent" rule after the 5 days. Similar ruleswere adoptedfor larger building(1 monthplus "silence is consent"). Labor regulationsand lawscan also be reformedto allow CostaScan firms to hiremore easily. While firing and its costs are consideredless ofa problem accordingto the DoingBusinessdata, Costa Ricanlabor regulations are morerigidwith respectto workinghoursandto hiringnewworkers. Existing restrictionson nightwork, on weekly holidaywork, andonthe maximumnumber ofworkinghoursper day couldbe removed. Second, at presentterm contracts can only beusedifthe work is seasonalor requires specialskills.This couldalso be amended. Finally,few CostaRicanfirms availthemselvesof availableonline applications and procedures. The Governmentcould promoteavailableelectronic procedures(such as intax-related matters) and also make moreinformationavailableon the Internet. The experience of Chileand other countries aroundthe worldwhichhave successfullyadoptede-Governmentfor registration,different permits andtax paymentscan be utilizedto implement suchareform. This is especially true for tax payments, where CostaRicais foundto be laggingbehindcomparator countries onthe ease ofpaying taxes as demonstratedearlier bythe relevant DoingBusiness data. ContractEnforcementand theJudiciary While CostaRica rankswell internationallyon measuresofjudicial corruptionand firms express greaterconfidence inthe courts than elsewherein CentralAmerica, the Government could undertakereformsto improvethe time it takes to resolvea commercialcaseincourt. Oneway to do so is throughreforms ofthe Civil and CriminalProcedureCodesmightberequired. It is worth mentioningthat disputedclaims are normallydecidedinCostaRicancourts ina criminallawsuit. However, it is normalpracticefor creditors to also file a civil claimagainst the debtor (the so-called accidn civil resarcitoria)22. The highnumber of proceduralsteps which are involved ina simple payment dispute (34) indicatesthat the process is burdensomewith the relevant procedural codesmandatingmany of these steps. The mosttime-consumingpartofthe court processaccordingto DoingBusiness2006 data is fromthe moment of filing defenseto the moment ajudgment i s issued(300 days). Filingand notificationsonlytake 10days. Enforcementofthe issuedjudgmenttakes 240 days. It mightbe advisable to use the DoingBusinessteam's expertise inanalyzingpossible stepswhich couldbe eliminatedfromthe process. The Government should also considerstreamliningcourt execution procedureswhich at present they are lengthy as well-200 days for executionofthe judgment. Furthermore, less than halfof ''Ssee chapter on "Starting a Business" in World Bank (2006b). 22Information based on Doing Businessdatabase. judgments are reportedto havebeenenforcedby ICs respondents. Oneway is to facilitatejudgment execution is to removethe automatic suspensionofthe first-instancecourtjudgmentwhich at present kicks in once appealis filed. Another way to cut the time for executionofthejudgmentis to openthe processto privatecompetition-with privatefirm actingas enforcementagents-somethingwhichhas recentlyworkedwell in Colombia for example. Certain changes that could be considered practicalto the courts, include, improvingjudges' incentives by administeringcourt case managementreform and allowing for specialized procedures and judges inthe regulartrack courts, who could review only smaller claims or commercialcases. As reportedinDoing Business in 2006: CreatingJobs, four types of reformreducetimes to dispositionof court cases. Amongthem are usingbetter case managementpractices(with onejudge followingthe case from start to finish); introducingsummary proceedingswhereby the creditor only needsto present evidenceofthe transactionandnon-paymentto obtainajudgmentagainst the debtor; simplifying proceduresfor gettingandhearingevidence incourt; andusinglower courts to hear simple claims.The Government of CostaRicais already implementingajustice systemmodernizationprojectwith support fromthe IADB. The Governmentcould also consider alternative dispute resolution(ADR) mechanisms, such as mediation. Inthat respect, businessassociationscouldhave an importantrole to playas 46 percentof businessassociationmembersinterviewedreportthat they use the associationto whichthey belongin resolvingdisputeswith the Government, workers, or other firms.Mandatorymediationfor smallpayment cases and other civil cases can reduce case backlogs ifadministeredwell. It has had success ina World Bankjudicial pilot projectinArgentina- see WorldBank (2004b) andWorldBank(2001). Corruption 4 Oneway to dealwith corrupt practices in different governmentagencies such as the Health - Ministry and the Social Security Fund, where this seems to affect relatively more users -i s to adopt a system of transparency and good governance,which havebeenadopted in other countries (e.g. Mexico). For example, throughannouncingtime limits for issuing licenses andpermitsandguidelines for applicationsonthe web or inthe nationalmedia, itwould bepossibleto enhancetransparency. Furthermore, user surveys and scorecards canbe introducedto monitorhowdifferent government agencies complywith the rules onthe issuanceof permitsand licenses. The resultsofthese couldbe made availablepublicly on a regular basis. With respect to grand corruption,which appears to havetarnished the reputationof successive former governmentofficials,it would be usefulto implementthe recommendations of the CPAR to strengthenpublicprocurement. Other countries' experiences suggest that electronicgovernment and publishingprocurement guidelines and procedures, announcementsoftendersandtheir results onthe Internetcan go far towardreducingthe scope for corruptpractices. The fact that certainindustrialsectors (e.g.wood, paper andpublishing,andmetalproducts) are more likelyto reportprocurementbribes indicatesthat the problemmightbe moreacute in some government agenciesthan others. Inany case, strengtheningpublicprocurement systems and audits ofthe processcouldbe aremedy for the currently observed levelof procurement bribes. Crimeand Violence Costa Rica should work toward reversingthe worseningtrends of crime recordedin recentyears by adoptinga nationalstrategy to dealwith crime and makingit operational. TheNational Police, thejudiciary, the business communityandthe public at large shouldbe consulted and includedin implementingsuch a strategy. Countrieswith highcrimerates, suchas Colombiaor some ofthe Caribbean islands (e.g. Jamaica) have adopted similar approaches, which have achieved a reasonable success. Collectingcrime statistics and improvinginformationsystemswithin the Police and the Judiciary are crucialto identifywhich types of crime affect privatefirms the most, inwhich areas, etc. While the gathering of informationon crime against persons is well established, the recordingofcrime against firms is not so. To remedy that, business surveys runby the statistical authorities could be usedto ask firms about crime acts that they have been subjectedto. A usefuland testedway to reduce crime directed at privatefirms is to get firms' efforts in community policing,educationaland preventionactivities, dealingwith youth-at-risk, etc. Costa Rica's business associations could have a potentialrole to play in supporting such efforts. Regionalcrime-preventionefforts could also helpwith respectto cross-border criminalactivity such as drugtrafficking, illegalarms dealing, amongothers. While these are not identified as problems, the Government could seek ways to cooperatewith the other Central American governments to enhanceregional security. REFERENCES Ayres, RobertL. 1998. Crime and Violence as Development Issues inLatinAmerica and the Caribbean. World Bank, Washington, D.C. Beck, Thorsten, Asli Demirgiip-Kunt and Vojislav Maksimovic. 2002. "Financial and Legal Constraints to FirmGrowth: Does Size Matter?" World Bank Policy ResearchWorking PaperNo. 2784, World Bank, Washington, D.C. Beck, Thorsten and Ross Levine. 2001. "Stock markets, banks, and growth : correlation or causality?," World Bank Policy ResearchWorking PaperNo. 2670, World Bank, Washington, D.C. BriceAo-Garmendia, Cecilia, Antonio Estache, andNemat Shafik. 2004. Znfiastructure Services in Developing Countries :Access, Qualiw, Costs, and Policy Reform. InfrastructureNetwork, Office of the Vice President, World Bank, Washington, D.C. Calderh, Cesar and Luis Serven. 2004a. The Effects of Infrastructure Development on Growth and Income Distribution. Latin America and the Caribbean Regional Office, World Bank, Office o fthe Chief Economist, Washington D.C. Calderbn, Cesar, and Luis ServCn. 2004b."Trends inInfrastructure inLatin America, 1980-2001." Office of the ChiefEconomist, LatinAmerica andthe Caribbean RegionalOffice. Finance, Private Sector, and Infrastructure Department, World Bank, Washington DC. Calderon, Cesar, and Luis. Serven. 2003a. "The Output Cost of Latin America's InfrastructureGap." World Bank, Washington, D.C. Delgado, FClix.2005. "La Regulaci6n de las Actividades Empresariales en Costa Rica." World Bank, Washington, D.C. xxxii DemirgiipKunt,Asli and RossLevine. 1996.StockMarkets, CorporateFinance andEconomic Growth : Overview.World Bank, Washington, D.C. Departamento de Planificacibn de Estadistica, Area Policial. Accessed from http://www.poder- judicial.go.cr/planificacion/estadistic~policiales/cuadros%2Ogenerales/index.htm Escribano, Alvaro and J. Luis Guasch. 2005. "Assessing the Impact o fthe Investment Climate on Productivity UsingFirm-Level Data: Methodology and the Cases o f Guatemala, Honduras, and Nicaragua." WorldBank Policy Research WorkingPaper No. 3621,WashingtonDC. Esfahani, H.and M.T.Ramirez. 2003. "Institutions, Infrastructure, and Economic Growth." Journal of Development Economics. Fay, Marianne, and Mary Morrison. 2005. "Infrastructure inLatin America andthe Caribbean; Recent Developments and Key Challenges." World Bank, Washington, D.C. Guasch, J. L.2002. "Logistics Costs and Their Impact and Determinants inLatin America and The Caribbean." World Bank, Washington D.C. Processed. Hall, Luis J., Alexander Monge-Naranjo, and Gilbert0EArce. 2002. Bailouts in CostaRicaAs a Result of GovernmentCentralization andDiscretionary Transfers. Inter-American DevelopmentBank, Washington, D.C. Hendley,K.and P. Murrell, 2003. "Which Mechanisms Support the Fulfillmentof Sales.Agreements? Asking Decision-Makers inFirms." Economics Letters 78: 49-54. Kaufmann, D.,A. Kraay, and M.Mastruzzi 2005. Governance Matters IV: Governance Indicators for 1996-2004. World Bank, Washington, D.C. Klapper, Leora. 2005. "The role of factoring for financing small and mediumenterprises." Policy ResearchWorking Paper WPS 3593. World Bank, Washington, D.C. Krugman, Paul. 2004. The Great Unravelling: Losing Our Way inthe New Century. W.W. Norton& Company, New York. Lederman, Daniel, Pablo Fajnzylber, and Norman Loayza. 1998. "Determinants of Crime Rates inLatin America and the World: An Empirical Assessment." Viewpoints 1,World Bank, Washington, D.C. Levine, Ross and Thorsten Beck,. 2001. "Stock Markets, Banks. and Growth: Correlation or Causality?" Policy Research WorkinnPaper Series 2670, World Bank, Washington, D.C. Levine, Ross, and S. Zervos. 1996.StockMarket Developmentand Long-Run Growth. World Bank Economic Review, Washington, D.C. Levine, Ross. 1997. "Financial Development and Economic Growth: Views and Agenda," Journal of EconomicLiterature, American Economic Association 35 (2): 688-726. Loayza, Norman, P. Fajnzylber and C. Calderbn. 2005. "Economic Growth in Latin America and the Caribbean: StylizedFacts, Explanations, andForecasts.DevelopmentEconomics ResearchDepartment. World Bank, Washington, D.C. xxxiii Roller, L.H.and L.Waverman. 2001. "Telecommunications Infrastructureand Economic Development: A Simultaneous Approach." The American Economic Review91(4). Sauma, P. and M.Shnchez. 2003. Exportaciones, Crecimiento Econ6mico, Desigualdady Pobreza. Editorial Isis, San JosC. World Bank. 2001. Argentina - Legal andjudicial sector assessment. World Bank, Washington, D.C. World Bank. 2003. Annual Report. World Bank, Washington, D.C. World Bank. 2004a. "Country Partnership Strategy for Costa Rica." ReportNo. 28570, Central America Country Management Unit,Latin America and the Caribbean Region, World Bank, Washington, D.C. World Bank .2004b. DoingBusiness in2004: Understanding Regulation. World Bank, Washington, D.C. World Bank. 2006a. "Costa Rica-Country Economic Memorandum," ReportNo. 36180-CR, Central America Country Management Unit, LatinAmerica andthe Caribbean Region, The World Bank, Washington, D.C. World Bank. 2006b. Doing Business in2006: CreatingJobs. World Bank, Washington, D.C. World Economic Forum. 2005, Global Competitiveness Report 2004-2005, World Economic Forum, Geneva. xxxiv CostaRica InvestmentClimateAssessment - DETAILED FINDINGS AND RECOMMENDATIONS Chapter 1. Introduction 1. Since 1984 CostaRicafollowed an export promotionstrategy that resulted inabove average growth rates,which havesince thenshown a decliningtrend. During 1961-2004, CostaRica's GDP growth averaged 4.8 percent, exceedingthat of LatinAmerican region (3.6 percent) or all four CentralAmerican countries. Interms of GDP per capita, Costa Rica also grew faster than the rest of Latin America (1.8 percent versus 1.5 percent). To some extent, Costa Rica's growth success resulted from the combinationof policies, including outward-oriented export-led growth, openness to foreign investment and gradual trade liberalizationpairedwith a strong educational system, poverty reduction, and relatively low inequality levels.23The country has successfully attracted foreign direct investment, fuelingeconomic growth, which averaged 5 percent inthe 1990s-well above the LatinAmerican average. As a result, Costa Rica is now an upper middle income country, with a per capita GDP of US$4,280 (Atlas method).24 Furthermore, the economy witnessed a substantial transformation in its economic structure, with increasing shares of manufacturingand service sectors. Despite its success story, Costa Rica's economic growth shows a declining trend. During2001-2004, the country's GDP per capita growth rate declined to 2 percent from 3 percent inthe first halfof the 1990s. Costa Rica has considerably lagged behind other middle income "star" performers, such as, Ireland, Singapore, and Korea. Insum, Costa Rica is faced with the challenge of not only sustaining the growth rates that made it one of Latin America's best performers duringthe 1990s, but also of catching up to the other most recent global "star" performers. 2. The objective of this InvestmentClimateAssessment (ICA) is to develop a better understandingof the constraintsto productivitygrowth,employmentgeneration, and exports in Costa Rica that emerge from its investment climate. Deficiencies inCosta Rica's investmentclimate may hinder its prospects for sustain economic growth. Future growth prospects are to a great extent associatedwith achieving higher rates of investmentand productivity growth, which i s inturn depends on the risksand expected returns faced by potential investors. Since a country's investment climate influences risks and expected returns, improving the investment climate i s becoming widely recognized as a key pillar to promote economic growth and poverty alleviation. Inparticular, this report seeks to (i) measurethe investment climate conditions inCosta Rica, (ii) provide comparisons of investment climate conditions with those prevailing inother countries inthe same and other regions, and (iii) identifythe features of the investment climate that matter most for competitiveness. This report looks indetail at factors constraining business operations, in particular weaknesses pertainingto the legal and institutional framework, access to finance and quality of infrastructure and the human capital available to drive technology and innovation. See Box 1.1for a more detailed description o f ICAs. 3. This chapter is structuredas follows. First, it presents an overview of Costa Rica's growth performance and recent economic trends. Second, it describes the data sources used inthis ICA report. Then, it shows the main investment climate constraints faced by firms usingsubjective and objective measures.This chapter ends with some general findings from an econometric analysis performed on the basis of the firm-level survey that was administered for this report. 23See World Bank (2004a) and World Bank (2006b). 24Upper-middleincome countries are definedto have per capita incomesbetweenUS$3,036-US$9,385. 1 Box 1.1: What's are Investment Climate Assessments? InvestmentClimate Assessments (ICAs) systematicallyanalyzethe conditions for private investmentandenterprise growth in a country, drawingonthe experienceof localf m s to pinpointthe areas where reformis mostneededto improve the private sector's productivityandcompetitiveness.By providinga practicalfoundation for policy recommendationsand involvinglocalpartnersthroughoutthe process, the assessmentsare designedto give greater impetusto policyreforms that can speedthe privatesector's growth. Producedby the WorldBank Group inclose partnership with a public or privateinstitutionineachcountry, the ICAsare basedon a survey of privateenterprises designedto capture f m s ' experiencein a range ofareas -financing, governance,regulation, tax policy, labor relations, conflictresolution, infrastructure services,technology,andtraining, amongothers.All these are areas where difficultiescan add substantiallyto the costs of doingbusiness.The survey attemptsto quantify f m s ' costs relatedto the investmentclimate bottlenecks.Usinga standardmethodology,the assessmentthen comparesthe survey findings with those insimilar countriesto evaluatehow the country's private sector is competing. The findings ofthe survey, combinedwith relevantinformationfrom other sources, provide a practicalbasis for identifyingthe most important areas for reformaimedat improvingthe investmentclimate. The findings andpolicy recommendationsemergingfromthe assessmentsare discussed extensively with the private sector andother stakeholders inthe country. This broaddisseminationofthe findings is aimedat engagingnotonly policymakersbut alsobusiness leaders, investors,nongovernmentalorganizations, andthe donor community inshapingthe national private sector developmentstrategy, forging consensusonthe prioritiesfor reformofthe investmentclimate, and layingthe groundwork for concreteresponsesto the problemsidentified. The ICAs shouldbe seen as complementaryto anothereffort ofthe WB to evaluatethe business climate, whichis the DoingBusinessreport. There are different ways to assess the businessclimate andhow it affects fmbehavior. One possibilityis to analyzeexisting laws andregulationsandtheir effecton a single hypotheticalfm.This is the methodologyadoptedby the DoingBusinessreport. A secondalternative is to ask the enterprisesabouttheir experiences,derivingquantitative informationon a large sample of f m s . This is the methodologyusedinthe ICAs. The quantity andquality of investmentflowinginto a country or into any of itsregionsdependon the returns that investors expectandthe uncertainties aroundthose returns. These expectationsdependinturn onthree mainfeatures o f a country'spolicy andinstitutionalenvironment: Macro- or country-level issues:stabilityand openness. This group includesmainlynationalpublicpolicies that affect the country affectthe country's degree ofpolitical andeconomic stabilityandthe extent to which the country is integratedinthe globaleconomy.These generally refer to macroeconomic,fiscal, monetary,trade, andexchange ratepolicies andpoliticalstability. Efficacy of the regulatoryframework. For firms, this relatesto entry and exit, laborrelations and flexibility in laboruse, ownershiptransformation,efficiencyandtransparencyof financing andtaxation, and efficiencyof regulationsrelatingto health, safety, the environment, andother legitimatepublic interests.When it comes to regulation, the questionis not whether to regulateor not, butwhether regulationsare designedinincentive-compatibleways, avoid adverseselectionandmoralhazard, serve the publicinterest, are implementedexpeditiously without harassment andcorruption, andfacilitate efficient outcomes.While regulatory efficacy is difficult to measure, surveysclearly suggest that it varies widely across countries. Quality and quantity of physical,financial and technologicalinfrastructure. This includespower, transport, telecommunications, bankingandfinance, and- giventhe imperfect mobility ofskilledworkers andthe clusteringoftechnology-the endowmentof skills andtechnology.Entrepreneurssurveyedabout their problems andbottlenecksoften cite, as key determinantsoftheir competitivenessandprofitability, such issuesas reliability ofpower,time andcost oftransport,access to andefficiency offinance, the supply of skilledworkers, and access to advancedtechnologies. 2 1.1 Costa Rica's GeneralEconomicTrends 4. Costa Rica has enjoyed a relativelysuccessfulrecord of longterm growthwith respect to other LAC countries.GDP growthover the last four decades (1961-2000) has averaged4.9 percent, exceedingthat of most of its neighborsandthe LatinAmericanaverage(3.6 percent) over the same period.Althoughduringthe 1960sand 1970sCostaRica grew at parwith the LatinAmericanaverageper capitagrowthrate, andevenlost some ground duringthe 1980s, the 1990swas a decadeof enviable performanceas the country surpassedalmost all other LatinAmericaneconomies (Figure 1.1). Figure 1.1: GDP Growth Rate in Costa Rica and LatinAmerica, 1961-2005 Avg. Growth Rate of GDP per capita Avg. Growth Rate of GDP 6 .................. 5 .................. !` r3 2 1 0 1961.1970 1971.1980 mCosta Rica PI Latin America 8 Caribbean mCosta Rica .Latin America & Caribbean Source: World DevelopmentIndimtori 5. Followingthe economic slowdown of the early 1980s, Costa Rica had a remarkable turnaround by following a heterodoxmix of policiesthat ledto stellar results in subsequent years. While other LatinAmerican countries fully adoptedwhat is nowknownas the Washington Consensus policies(stabilize,privatizeand liberalize)after facingstark cycles ofhighinflationand low growth duringthe 1980sand 1990s, Costa Ricafolloweda more unconventional mix oftrade liberalizationand export-ledgrowthcoupledwith repressedfinancial marketsand state ownership of key commercial enterprise^.^^ The first steps towards increasedtrade opennessdatedbackto 1963, when Costa Rica joinedthe CentralAmerican CommonMarket(CACM, madeup of Guatemala, ElSalvador, Nicaragua, andHonduras).The strategy of "open regionalism" fostered by CACMenabledCostaRicato broadenits manufacturedexportsto the region, and diversify its export baseaway from traditionalproducts.26 Thereafter, the adoptionofan export promotionmodeladvancedthe country's trade liberalizationefforts. Since the mid-l980s,trade barriers havebeenlowered, with tradetariffs decliningfrom 53 percent in 1985to about 5.2 percentin 2004.27Likewise, tariff dispersionshaveminimizedandnon-trade barriers have beenremoved.CostaRicaalso initiateda proactivepolicyto attract FDIandpromote a free trade zone regime, resultingin investmentflows of about 3 percentofGDP andattractinghigh-techinvestors such as INTEL,Abbott Laboratories, and Procter & Gamble.This positiverecordinthe economic sphere is also dependentonthe country's longstandingdemocratic tradition, underpinnedby generallyeffective institutions, a burgeoningmiddleclass, a strongeducationalsystem, andrelativelylow income inequality.28 6. Notwithstanding,when comparedto other middleincome "star" performers, Costa Rica has considerably lagged behind.Duringthe 1960sthe countrygrew at similar ratesthan other South 25See World Bank (2004a). CostaRica did not open its telecommunicationsand insurance sectors to private competition inthe 199Os, as most other countries in Latin America did, keeping bothunder the control of strong state-owned monopolies. 26"Open regionalism" has been a subject of controversy. The literature suggests that as far as regional trade agreements do not create trade diversion nor hamper efforts to broaden inter-regional trade negotiations, they may be useful mechanisms to open new trade opportunities and develop local capacity inthe negotiating arena. See Jaramillo and Lederman(2005) for more details. 27World Bank (2004a). 28World Bank (2004a). 3 EastAsian countries, butthereafter growthhas not kept abreastwith the performanceofmany of its most successful middleincomecompetitors (Figure 1.2). Indeed,while countries suchas Taiwan, SouthKorea, Singaporeand morerecently Irelandand China, grew at 7 to 8 percentper annum inrecent years, Costa Rica's economic growthhas averaged4.8 percentperyear between 1983 and2003.29Hence, the challenge for the country goingforwardis not only to sustainitsrelativelygood growthlevelsby Latin Americastandardsbutalso raise its performance andcatch upto some ofthe world's booming econornie~.~' Figure 1.2: Evolutionof GDP per Capita, 1975-2004 .... 35,000 ........................................................................................................... 30,000 ................................................................................................... wrvMF Costa Rica 1975 1979 1983 1987 lQ9l 1995 1999 2003 Source: World DevelopmentIndicators 7. To a large extent, CostaRica's boominggrowthduringthe 1990swas a resultof accelerationinthe contributionof Total FactorProductivity(TFP), as evidenced by astandard growthaccountingdecompositionof GDP growth.As showninFigure 1.3, the sourcesthat have contributedto the country's growthperformancehave largelyfluctuatedovertime. CostaRicawitnessed sustainedincreases in its laborsupply that contributedto explaina large share ofGDP growth.The 1980s saw a sharp decline in all contributorsto growth, mostnotablyphysicalcapitalandTFP, whichdropped to 1.02percentandnegative 1.52respectively.However, by the 1990sa strongrecovery inTFP growth accountingfor almost 1.36 percentofthe observed5.25 percentgrowthrate, thus placedCostaRica inan enviablepositionvis-a-visother LatinAmericancountries.Althoughthis trend- a sharp decline inTFP duringthe 1980s, followedby a modestrecovery duringthe 1990s-was generallyobserved inLatin Americaas countries overcame some ofthe problemsposedby the region's so called "lost decade", CostaRica's TFP improvementwas amongthe highest inthe region. As reportedby Loayza, Fajnzylber, andCalder6n(2005), TFP increasedto about 2.1 percent for the averageLatinAmericancountry during the 1990s,with CostaRicabeingone ofthe top performersalongwith Argentina,Bolivia, Chile andthe DominicanRepublic.All ofthese countries reportedproductivitygrowthrates above 1percentperyear in average duringthe 1990s.Although growthaccountingis a descriptivemethodologyandby definition, does not provide specific insightsintothe factorsthat underliethe TFP growthcomponents, economists have increasinglyviewed this growth"residual" as a measure ofa country's technologicalchange and innovation.Viewedinthis light, the set of policiesfollowedby CostaRicato achieve this economic *'Monge-Gonzales and Monge-Arino (2005). 30World Bank (2006a). 4 transformationare importantto analyze, since it hasbeenarguedthat duringperiods ofreform, productivitygains tendto be higher. Figure1.3: CostaRica-Growth AccountingExercise,1961-2000 7 6 5 4 3 2 1 0 -1 U U -2 1 3 I .3 1961-1970 1971-1980 1981-1990 1991-2000 rnGDP growth Contribution Labor OContribution Capital OContributionTFP Source: Loayza, Fajnzylber, and Calderon (2005) Note: Growth accounting includes adjustments for human capital. 8. First and foremost, CostaRica's trade liberalizationhas significantlystimulatedexport diversificationand has beenassociatedwith the deep changesinthe structureof prod~ction.~' Agriculturenow accounts for less than9 percentof economic activity in2001-04, down from 22 percent in 1981-85(Figure 1.4). The share of the manufacturingsector marginallyincreasedto 22 percentduring the same period.As agriculturehas faltered, the service sector, most notablytourism, has gained momentum. Figure 1.4: Costa Rica Structure of GDP by Sector - rn 1981-85 XB! 2001-04 0 5 10 Percent 15 20 25 Construction Electricity,water Manufacturing Transport & Communication Commerce & Tourism Housing Banking PublicAdministration& others 24 Source: Central Bank of Costa Rica as reported in World Bank (2006a, Table 1.3). 3 1World Bank (2004a). 5 ~ i I.5: Costa ~Hicu ~Exports 1997 versus 2004 ~ - e 1991 2004 Source Central Bank of Costa Rrm and the en~ironment.~~ A recent study by Monge-Gonzalez and Monge-Ariiio (2005) found that the great majority o f local suppliers to multinationalcorporations that have invested inthe country reported significant improvement intheir sales performance and quality o ftheir products since they beganworking with these enterprises. Likewise,the study points out that some knowledge spillovers have steamedfrom FDI: for instance, 27.6 percent of local suppliers reported that one of their owners had previously worked for a multinational corporation, while 27.6 percent of local suppliers receivedtraining from them. Figure 1.6: Inflows and Stocks of FDI,percent of GDP Brazil Chile Costa Rica Dominican Republic El Salvador Guatemala Honduras Nicaragua Panama Ireland Singapore 0 25 50 75 100 125 150 175 percent IIFDIStock2003 Net inflows 2000-2003 Source: World Development Indicators& UNCTAD 11. Goingforward, the approvalof the CentralAmerican Free Trade Agreement (CAFTA) offers new trade and investmentopportunities and serves as catalyst for further structuralreforms. For Costa Rica, signing the free trade agreementwith the U.S.offers the possibility to make further progress in fostering trade-led growth. Yet, these benefits will only materialize ifpolices are implemented to address key constraints and bottlenecks that undermine the potential o f this initiative. According to a recent study by Jaramillo and Lederman (2005) on the challenges and opportunities for CAFTA member signatories, Costa Rica will be requiredto make significant legislative changes to adapt policies and regulations to its commitmentsunder CAFTA, allowing access to significant portions of its telecommunications and insurance markets. Under the agreement, the country has finally committed to introduce competition to state agencies, which will only serve to further bolster the modernization, efficiency and competitiveness of these areas ofthe economy. Other areas noted as priority items for Costa Rica under CAFTA are improving road quality, port and customs efficiency, boostingfinancial depth, and enhancing the quality and coverage of secondaryeducation.36 1.2 Data Sources 12. This ICA reportis basedon an Investment Climate Survey (ICs) of 343 manufacturing establishmentsthat was implemented betweenMarchand November2005.The sample covered establishments in 7 manufacturing sectors and three geographical regions (Figure 1.7). The sample was selectedfrom a list of establishments ofthe CCSS provided by the Ministry of Finance, and it is representative at the level of economic sectors, with sample sizes chosen to ensurethat variables can be estimated with a 90 percent confidence and sampling error of almost 7 percent. All establishment sizes 35ILO (2003). 36See Jaramillo and Ledeman (2005) for more details. 7 were included, including micro (1-5 workers), small (6-30 workers), and medium and large (more than 31 workers). Survey datawas collected by means of face-to-face interviewsof company management, administered by trained enumerators from UnimerReasearchInternational under the supervision of the World Bank. Figure 1.7 shows the sample composition by sector, geographical region, and firm size. About 20 percent of surveyed establishments come from the wood, paper and publishingsector, 17 percent from textile and leather manufacturing, 14 percent from chemicals & plastics, 14 percent from food & beverages, 15 percent from metal production and equipment, 10 percent from non-metallic minerals, with the rest of firms corresponding to other manufacturingsectors. Furthermore, 45 percent of the sampled firms were from SanJose (the capital city), 27 percent from the province ofAlajuela, and the remainingfirms were from other regions of the country. Interms of size, 29 percent represented microenterprise, 41 percent were small, and 31percent were medium and large establishments. See Annex 1for more detailed information about the ICs' sample design and survey implementation. Figure 1.7: Costa Rica InvestmentClimate Survey SampleComposition - - 102% Sector Province Size 7% OFoodLBev .Taxtllsr 8 Leather 30 BWood, papersnd publishing Sen Jose .Micro mCham~cala8 piast~os MAlajuela .Small ENon-metallicminerals OOtheirgn. UM8L 0 0 Metml prod B equipment UGihsrmsnul 40 5% Sourcs: World Bank InvestmentClimate Surveys 13. In additionto the ICs, this ICA reports uses a Logistic Survey conductedfor the infrastructurechapter.The Logistic survey was carried out duringMay-June ,2005, and surveyed about 75 firms inthree specific sub-sectors, eachvital to the diversification of Costa Rica's exports: processedfoods, cut flowers and plants, and medical equipment. These sectors were selectedgiven considerations of relative strategic importance for the country based indiscussions with PROCOMER (Promotora de Comercio Exterior). The main objectives were: (i) identify logistics problems which raise the price of nationalproduction diminishingcompetitiveness; (ii) the relative importance of the assess logistics costs intotal costs; (iii) the logistics chain cost structure (transportation, inventories, revise warehousing) and different modes composition (maritime, air, and surface); (v) assess quality perceptions and access to logistics services. The was selectedfrom companies registeredinfour databases: the PROCOMER directory of exporters, and lists of membersof Chamber of Food Industry(CACIA - Camara de la IndustriaAlimentaria), the Association o f Producers of Plants and Ferns, and the Coalition of DevelopmentInitiatives (CINDE - Coalici6nCostarricense de Iniciativas de Desarrollo). See Annex 2 for more detailed information about the Logistic Survey's sample design and survey implementation. 1.3 MainInvestmentClimateConstraints 14. This section presentsevidence on the impactof the investment climatein CostaRica, using both qualitativeand quantitativeinformation.We start with a discussion of entrepreneurs' perceptions about investment climate constraints to firms' operations, followed by the presentation of the econometric analysis of the determinants of total factor productivity (TFP), as well as other performance variables. Annex 3 describes the main features ofthe empirical methodologyusedfor the econometric analysis. 15. In evaluating the most important investmentclimate constraints affectingCostaRican establishments,this report usesbothsubjective and objective indicators.The emphasis, however, is placed on the secondtype of information. Subjective indicators are basedon the perceptions of the 8 surveyedestablishments regardingthe key factors that constrain their development. This approach provides valuable information on the priorities that entrepreneurswould adopt iffaced with the task o f designingpolicies to improve the investment climate. However, we argue that for policy-makingpurposes the emphasis should beplaced on the analysis of objective and quantitative indicators regardingthe costs associatedwith various investment climate problems. Indeed, the perceptions of the entrepreneurs may be biased by recent events reported inthe media, and they may also reflect their specific cultural and socioeconomic background. For instance, managerso f firms that concentrate on local as opposed to national or internationalmarkets may lack the necessary benchmarks tojudge the severity of the problems existingintheir cities or provinces, and compare them to national or internationalbest practices. ThePerspective ofFirms 16. To construct subjective indicatorsof the main investmentclimateconstraintsexistingin Costa Rica, interviewedbusinessmenwere asked to evaluatethe severity of twenty potential investmentclimate obstaclesto growth. A five-point scale is used, ranging from extremely severe to not important. Figure 1.8 report the percentageof manufacturingfirms that evaluated the corresponding constraints as "major" or "very severe". Whenever possible we compare the results for Costa Rica with the correspondent figures for the selectedcomparator countries. Figure 1.8: The Perspective of Costa Rican firms InvestmentClimate Constraint rated as "Major" or - Very Severe", percentof firms Macroeconomicinstability 1155 Anti-competitive, informal practices Cost of financing r Access to financing Transport Corruption Tax rate Regulatoryuncertainty Crime & violence 28 Labor regulations 28 Legal system I conflict resolution 24 j I ~ 22 Tax administration 19 Electricity 17 Business licensing, operating permits 14 Skills, education of available workers I ~ ~ ~ 13 Custom regulations I Access to land 13 Environmental regulations I ~ 12 ~ Copyrights I contract enforcement r ,;1011 Trade regulations 7~ 0 10 20 30 40 50 60 Percent of firms Source: World Bank Investment Climate Surveys 17. Costa Rican firms perceive macroeconomicinstability,anti-competitiveand informal practices,and cost and access to financingas the four major obstacles to growth in Costa Rica. As shown inFigure 1.8, about 55 percent of surveyed firms identifiedmacroeconomic instability as major or very severe obstacle, partly attributed to increasevolatility of inflation and movements inthe exchange rate. As further explained inthe Costa Rica Economic Memorandum, although Costa Rica has enjoyed notable macroeconomic and financial stability inthe past two decades, it recent years, inaddition to the potential risksassociatedwith highpublic debt and fiscal imbalances, a key vulnerability that has emerged since the end ofthe 1990sis the risk of increasing financial dollarization. Furthermore, the ICs was conducted in2005, when there was greater political uncertainty than inprevious years due to the 9 proximity of presidential elections and economic uncertainty due to the proposed fiscal reform, the free trade agreementwith the USA, and the acceleration of inflation. Thus, it i s possible that perceptions were more downbeat than inprevious years. Also, the manufacturing sector usually is more pessimistic than other sectors interms of economic conditions as reported by the quarterly survey o f the Costa Rican Chamber of Private Business Associations (UCCAEP). The proportiono f firms rating this area as a constraint i s very similar inEcuador, Nicaragua, and Honduras, but much higher than inChile, China, El Salvador, or Lithuania. Anti-competitive and informal practices rank second, affecting almost 50 percent of surveyed firms. Despiteprogress infinancial deepening, the cost and access to financing were selected among the top obstacles to growth (48 percent and 45 percent, respectively), especially among the micro and small firms. 18. Transport and corruptionissuesare also amongthe top "major" or "severe" constraint for Costa Ricanfirms.About 16 percent and 42 percent of firms ratedtransport and road quality, respectively, as major or very severe obstacle to growth. Costa Ricanfirms were more likely than their neighboring counterparts inEl Salvador, Honduras, and Nicaragua, and firms incountries with similar levels of income such as Polandor Lithuaniato rate transport issues as major or very severe constraints. Corruption also appears a major or very severe constraints for about 40 percent of Costa Rican firms, higher than inElSalvador (35 percent) or Chile (13 percent), but lower than inGuatemala (81percent) and Brazil (67 percent). 19. The natureof maininvestmentclimate constraintsvaries by firm characteristics(Figure 1.9). For example, foreign-owned firms were less likely to select macroeconomic instability as investment climate constrained than their domestic counterparts (37 percent versus 56 percent). Inthe case of access to finance, the percentage of entrepreneursthat report major or very severe constraints is 1.7 times larger among micro than among large firms, about 40 percent larger in SanJose compared to Alajuela, and 33 percent higher for domestic than foreign owned firms. Transport issues tendto affect more foreign owned firms, mediumand large firms, and exporters. These differences may reflect either different actual constraints and/or distinct firms' perspectives on their gravity. Figure 1.9: Firm's Main Obstacle Accesslcost of financing Anti-cornp nnformalpradicea 15.0 Macroeconomicinstability RedIapeRegulation D .today M 3 ym. Ago 0 5 t o 15 20 25 30 Source: World Bank Investment ClimateSurveys 20. When asked to select the main obstacleto growth, firms cited financialconstraints as their predominantproblem,followed by anti-competitive/informal practices, macroeconomicstability and red tape/regulation.These set o fvariables also topped the list of problems for firm's managers3 years ago, although the magnitude of their problem has varied across time. Accesdcost of financing obtained the highest score, with 26.2 percent of firms indicating that financial issues stood as their worst impediment to growth. However, when comparingthe magnitude ofthe problem acrosstime (e.g. three 10 years ago), it seems to have improved at least marginally. The opposite case is true for anticompetitive informal practices: it appears that nowadays this is more of a pressingproblem for firms than it was three years ago. Other problems that are apparently worsening for firms are taxation, transport, and water and electricity issues. Although they cited by less than 10 percent of sampled firms as the premier obstacle to growth, their relative importance seems to have increasedvis-his previousyears. Impact of theInvestmentClimatein Growthand Competitiveness:EconometricEstimates 21. To estimate the correlationbetweeninvestment climatevariables and total factor productivity(TFP) at the firm level,we usedthe robust econometric methodologypresented Escribano and Guasch(2005). Annex 3 summarizesthe methodology and the empirical results discussedby Escribano, Guasch, Penaand Orte (2006). Total Factor Productivity refers to the effects of any variable different from the inputs --labor (L),intermediate materials (AI) and capital services (IC)--, affectingthe production (sales) process. Ingeneral, we expect TFP to be correlated with the inputs L,A4 and K,and therefore the inputs must be treated as endogenous regressorswhen estimating production functions. Inparticular, TFP is assumedto include the effects of I C variables such as infrastructure, governance, quality of labor, innovation, researchand development (R&D),technological and regulatory changes, competition and any other firm-specific characteristics or control variables (0. 22. Total factor productivity(productivity), together with the inputs of the production function, is the key element explainingthe evolution of labor productivity.Therefore, improvingthe investment climate is a key policy instrumentto promote economic growth and to mitigate the institutional, legal, economic and social factors that are constraining the fast convergence of per capita income and labor productivity of Costa Rica relative to more developed countries. For that, we need to identifythe main investment climate variables that affect economic performance (productivity, exports, foreign direct investment, employment and wages) and this is the main goal of the econometric evaluation. 23. Since there is no universallyacceptedmeasureof productivityor total factor productivity (TFP), the analysis used about 10 differentalternative measures. The alternative productivity measures considered in the analysis come from considering: 0 differentfunctional forms ofthe production functions (Cobb-Douglas and Translog); 0 differentset o f assumptions (technology and market conditions) to get consistent estimators basedon Solow's residuals, or OLS and Random Effects,. and, 0 different levels of aggregation inmeasuring input-output elasticities (at the industry level or at the aggregate country level). 24. The analysisseeks to measurethe impactof differentinvestmentclimate(IC)variableson (log) productivity,controllingfor other characteristics, as well as on other variables of interest, such as probabilityof exporting. Inevitably, any empirical evaluationofthe impact o fthe I Cvariables will be contingent uponthe productivity measureused.Thus, the methodology shouldaim at obtaining robust and consistent conclusions from all productivity measures, providing a consistent range of productivity gains and losses due to IC variables. To reduce the simultaneous equation bias and the risk o f getting reverse causality problems for those IC variables that are endogenous, we use their region- industry average ( E).Theproductivity coefficients of investment climate (E)variables and other plant-specific control (C) variables are maintained constant but we allow the production function elasticities, and therefore the productivity measures, to change for each functional form (Cobb-Douglas and Translog), and for each aggregation levels (industryand regions). Restricted estimation (equal input- output elasticities among industries) and unrestricted estimation (different input-output elasticities for each industry),are the two levels of aggregation considered inthe input-output elasticities of the production functions. 11 25. The main findings of the econometric analysis suggest that the differentestimates of TFP are highlycorrelatedand the sign of all I C variables are equal and the rate ofvalues of the elasticities is reasonable. The correlations for each o fthe (log) productivity measures obtained from the restricted production functions range from 0.98 to 0.90. The unrestricted by industryproduction functions differ and therefore the correlations are much lower between those productivity measures. 26. A number of investment climateindicatorsdrawn from the ICswere econometrically relatedto measuresin productivity(see Figure 1-10). The econometric analysis shows that investment climate variables affect firm productivity inthe expected direction. Usingthe econometric methodology developed by Escribano and Guasch (2005), we tested different specifications o fthe productionfunction to get robust empirical elasticities (or semi-elasticities) that could help guide policy discussions. For the econometric analysis, investment climate (IC) variables were grouped into four categories: infrastructure, governance, including redtape and crime, finance and quality, innovation and skills. The estimation was performed holding constant basic firm characteristics, including location, industryaffiliation, firm size, firm age, and other factors. The detailed results as well as the details ofthe methodology are presentedin Annex 3. 27. Red tape, corruptionand crime- relatedvariables have ingeneral a significantly negative impact uponproductivity,with the exception o fpayments to obtain a contract withthe government. An increase o f 1 percent inthe number of inspections results in a decrease o f 0.3 percent inproductivity. However, firms that make payments to obtain a government contract their productivity is 28 percent higher. Firmsthat declare a higher percentage o f sales for tax purposes have higher productivity; ifthe percentage o f sales declared to taxes rises by 1percent, productivity could increase by 0.01 percent. 28. Furthermore,infrastructurevariables also have a negativeeffect on firm productivity. An increase o f 1 percent inthe number of water outages per year will decrease productivity by 0.2 percent while a similar increase inthe number o f days to get public electric supply will decrease productivity by 0.1 1percent. Furthermore, an increase inthe average duration o f power outages (measure inhours) o f 1 percent will reduce productivity by 0.027 percent. Inthe case o f the number of days to clear customs for exports, one percent increase will reduce productivity by 0.071 percent. 29. Financeand corporate governancevariablesalso influencefirms' productivitylevels.For example, firms that are members o f trade associations present productivity levels that are 45 percent higher on average. Firmsthat have a line o f credit are on average 5 percent more productive than other firms (semi-elasticity). Furthermore, firms' productivity could be increased by 24 percent, iffirms are able to purchase on credit from suppliers. Not surprising, firms' profit are associated with higher productivity: iffirms' profit measured as percentage o ftotal sales increases by 1percent, productivity will grow by 0.14 percent. 30. There is evidencethat innovationand labortraining increase firm productivity(Figure 1.10). For example, when a firm has I S 0 certificationor new technologicallicense its productivity will be 26.7 percent and 19.4 percent higher, respectively, on average. Another result is that firms using computer controlled machinery are on average 0.2 percent more productive than other firms (semi- elasticity). Moreover, ifthe number o f firm's employees designatedto deal with tasks related to design and engineering grows by 1 percent, productivity could increase by 0.2 percent. Ifthe percentage o f unskilled workers that received formal training during last year increases by 1percent, productivity could increase by 0.005 percent. Finally, ifthe percentage o f workers usingcomputer atjob increases by 1 percent, productivity could increase by 0.002 percent. 12 Figure 1.10: FirmProductivity:Elasticitiesand Semi-Elasticitieswith Respect to Impactof Investment Climate Variables InfrasUUClUre RcdTap, Conupuon and Financeand Coporate Quahry, lnnovauonand Labor Shlb OtherControlVanablCS % C"llE GOVSll!allCS 0 60 0 10 0 20 0.00 4 20 nA" 3 5 4.1 4.1 4 3 4.4 4.5 4.6 4.1 5.1 5.2 5 3 5.4 5.5 When the IC variable is not expressed in log form, the estimated coefficient is generally described as a productivity-ICsemi- elasticity. While the constant productivity-ICelasticity measuresthe percentagechange in productivity induced by a percentage change in the IC variable, the semi-elasticity coefficient multiplied by 100,measures the percentage change in productivity induced by a unitary change in the IC variable. 3 1. The econometric analysis found that firm productivityaffects exports, foreign direct investment,and realwages. Inadditionto the effect of investmentclimatevariables on firm productivity,the econometric analysis lookedat the effect ofproductivityand investmentclimate variables on other variables of interest. Forexample, moreproductivityfirms aremore likely to export moreand attract foreigndirect investment(FDI). Ifproductivityincreases by one percent, the probability of exportingandreceivingFDIwill increase, on average, by 0.22 and 0.24percent, respectively. Moreover, the econometric results show that the elasticity of firm productivityandrealwages is 0.56; thus, iffirm productivitywere to increaseby 1percent, realwages will increase by 0.56percent. 32. Investmentclimatevariablesinfluencethe probability of exportingnot only indirectly through firm productivity, but also directly (see Figure 1.11).Among infiustructure variables, the econometric results showsthat an increase inthe number of days to clear customs for importsor the number of days to obtaina cellular phoneconnectionwere to increaseby one percent,the probabilityof exportingwill decrease by 0.22 and 0.03 percent, respectively. Firmsusinga web pageto communicate with their clientsand suppliers have a 10percentgreater probabilityof exportingregularly. Firmsthat suffered any criminalattempt duringlastyear the probabilityof exportingdecreasesby 15 percent(semi- elasticity).The probabilityof becomingexporter is 7 percentlargerfor firms enjoyingthe benefits of havinga loan line, relativeto firms without a loan line(semi-elasticity). Another findingis that both innovationandtrainingvariables havepositiveeffects onthe probabilityof exporting, 13 Figure 1.1 Probability of Exporting: Coefficients with Respect to IC Variables (Linear 'robability) II. Piadty lnfrsslruclun Rsd Taps, Corruptionand Financeand Corpoml~ C"lllC oovernancs I 0.179 0 20 0 10 OW tl IO !I10 0 30 I 1 2 1 2 1 1 3 3 1 3 1 33 3 4 3 6 3 6 4 1 4 1 4 3 4 4 6.1 5.1 5.3 5.4 5.5 6.1 6.2 6.3 5 IJo~nlv~nrunwilh forrignfirma. 5.2 l A C O h 5 T cinification 5 3 Dsstanand mgin~~nng 5.4 Tnining u)rkillsd wrkcn. 5 5 Education of the mmqer 6 IIncorporakd compmy. 6 2 Indunnil zone 6 3 Firm bsnsfilsd from ICC 6 4 Age y c m inopralmn. 3 3 . The conclusionsof the econometric analysis are that investmentclimatevariables significantly affect total factor productivityas well as other firm performancevariables. As such, increasedemphasison governance and businessregulation,infrastructure,and innovationis appropriatefrom the policy pointofview. Interms ofthe absolute contributionof groups of investment climate variables, the econometric analysis shows that redtape, corruption, and crime variables have the largest effect on firm productivity, followed by finance and infrastructure variables (See Figure 8 of Annex 3. Inthe case of the probability of exporting, infrastructure ranks first, followed by redtape, corruption, and crime as well as finance. For the probability o fattracting FDI, innovationand training variables will have the largest effect. These results are somehow consistent with firms' perceptions that put infrastructure and regulatory issues as severe obstacles to growth. 14 Chapter 2. Finance3' 2.1 Introduction 1. The development of financial markets is widely acknowledged to be one of the crucialissues facingemergingmarkets,and one that has a noticeable impacton economic growth. Financial markets channel resources from those who have the funds but lack the investment ideas, to those who have the ideas but lack the funds. The empirical researchon financial market development shows that there is a strong correlation, and possibly causality, with economic growth. For instance, Levine and Zervos (1996), show that stock market development is positively associatedwith economic growth and Demirguq-Kunt and Levine (1996) also demonstratethat the level of financial market development is a good predictor of economic growth. Levine (1997) and Beck and Levine (2001) find a positive causal impact of financial development on productivity and economic growth. A recent study by Beck, Demirguq-Kunt and Maksimovic (2002) showed, usingdata on firms from 54 countries that financial constraints in terms of access and cost o f funds exert an influence on firm growth and that smaller firms are most affected by those constraints. 2. This chapter summarizes the basic characteristicsof the Costa Rican financialsystem and uses firm-level data collected through the ICsto provideevidence about the levelof access to finance, the products most commonly used and the nature of credit constraints.It finds that: 0 Financial depth in the onshore system has improved since mid-1995, but remains lower than comparator countries. Onshore banking credit has expanded significantly, and it remains as the largest source of external financing for firms inCosta Rica. However, the expansion o f credit has beenuneven, favoring specific segments ofthe economy such as consumer credit and corporate lendingto trade and services industries, indetrimentof credit to other segments such as agriculture and, to a lesser extent, manufacturing. The level of financing inCosta Rica i s low, even for Central American standards and compares unfavorably to that observed ineconomies that have developed more dynamic financial systems. The liberalizationof the banking sector has enabled the participation of private players, which appearto complement rather than compete with public banks.Nevertheless, competition between private and public banks is still hindered by a legal framework that still protects public entities. 0 The banking system is becomingfurther dollarized, which may become apotential source of vulnerability. This is reinforcedby the fact that SMEs and non-exporting firms are increasingly tapping dollar lendingto fundtheir operations, which creates a clear mismatch between their local currency revenue stream and the dollar payments neededto service a loan. There is a marked tendency for private banksto serve larger exporting firms, while state banks focus on smaller firms that operate in domestic markets. SMEs lending i s actively promotedby public banks, but lendingto this segment appears to have stagnated. Inturn, SMEs use informal sourcesto finance their operations and investments, such as family loans or retainedearnings. Although supplier credit is common in Costa Rica as a source o f financing (but still lower than in other countries), SMEs have less access to it than larger firms. 0 Access and cost offinancing are the third andfourth factor that impedes growth of manufacturingJirms surveyed. Moreover, there appears to be differentiated access, directly linked to firm size. While micro and SMEs play an important role inthe economy, there are limited channels for them to access formal financing. Similarly, `traditional' industries such as food and chemicals appearto be more frequent recipients o f financing than other industries. 37This chapter was written by EmanuelSalinasandCamilaRodriguezwith contributionsfrom Daniel Chodos. 15 The incidence of credit constraints (havingan unmet demandfor formal loans) is moreprevalent in CostaRica than in comparator countries. InCosta Rica, about 31percent o f firms are credit constrained, which is two times higher than in Chile, even after scalingby the fraction of firms demanding formal loans. Only 15 percent of large firms inCosta Ricareport beingcredit constrained or having an unmet demand for formal loans, while this proportion is twice as high for small firms (35 percent), and almost three times as highfor micro firms (40 percent). Credit- constrained firms have an unmet demand for loans because the loan contracts offered by formal lenders do not matchtheir needs, and also becausetheir loan applications are rejected. Supplier credit is a major source of funding to companies but it can also represent liquidity and credit risks. Purchasesof supplies on credit are a major source o f funding for companies, and a well developed practice among all segmentsofthe economy. Onthe other hand, companies also provide credit to their clients and this can be a source of risksbothfrom a liquidity perspective (accounts receivable are usually unproductive assets), and from a credit perspective (companies are subject to defaults from their clients). The existence of a well developed factoring market could reduce both of these risks. 3. This chapter is organized as follows. Section 2.2 presents an overview of Costa Rica's financial system, by means of analyzingthe structure ofthe banking sector and providing some stylized facts related to overall access to finance. Section 2.3 presents the main findings drawn from the ICs, and examines them in four subsections. The first subsection provides a glimpse of the use of credit services (formal and informal) by surveyed firms. The second subsection reviewsthe characteristics of formal credit -both short-term credit lines and formal loans- and the cost of financing. The third subsection examines the main credit constraints faced by Costa Rican firms, and the fourth subsection provides a review of firms as creditors. Finally, section 2.4 presents this chapter's main conclusions and some policy recommendations. 2.2 CostaRica's FinancialSystem 4. Bankingintermediationdominates Costa Rica's financialsector, although in recentyears the system hasbecome morediversified. Financialgroups are important, and include onshore banking units, a stock broker, an investment fund, afinancial corporation, an insurance marketingfirm, apension fund and a mortgage company. Offshore banks are also important sources of financing to the private sector, but because they are licensed in foreignjurisdictions, data on their performance and lendingi s scarce, the discussion on this section will solely focus on the onshore financial system. Consolidation o f the systemover the past decadehas decreasedthe number offinancial intermediaries, from 86 in 1998to 59 in 2006 (see Table 2.1). This process of consolidation has strengthenedthe primacy o f the onshore banking sector, which now accounts for 84 percentofthe system's lendingto the private sector (see Figure 2.1). Non-bank financial companies and savings and loans cooperatives contribute to the deepening ofthe system, albeit belatedl~.~' They representonly 2.4 percent and 6.8 percent respectively of the total system's credit to the private sector. At the same time, as a consequence o f reforms inthe regulatory framework, investment funds-both mutual and pension funds- have grown rapidly, and are becoming significant institutional investors, although their financing to the Costa Ricanprivate sector i s mainly done through bank intermediation. 38The bulk of savings and loans cooperatives' portfolio is allocated to consumer and housingcredit. 16 Table 2.1: Number of Financial Intermediaries in Figure 2.1: Composition of Credit Provided to the Costa Rica, 1998 & 2006 Private Sector, 1998 & 2006 Type of credit intermediary 1998 2006 Public banks 4 6 50 1 Private banks 22 12 40 Non bank financial companies 16 9 Savings and loans 35 28 Other la E 9 4 c 30 Total System 20 86 59 14 Source: Authors' calculations based on data from SUGEF. 10 la Includes Mortgage Finance Companies & "Caja de Ahorro y Prestamos de la ANDE". 0 Public banks Private bank8 Non-bank Rn Savings 6 loans Other cornp. associations intermediaries Source: Authors' calculations basadon datafrom SUGEF. 5. Despitefinancialliberalization,public banksaccountfor an increasingshare of onshore bank lendingto the privatesector, but private banks have gained marketshare inthe housingand consumerlendingmarkets.The banking systemremainedunder full government ownership untilthe early 1990s, when the liberalization of the sector started allowing credit operationsby private banks. However, liberalization has not been accompaniedby a clear exit strategy for public banks, and has rather focused on dismantlingtheir `privileges' as a way to foster competition.Infact, public bankshave increasedtheir market share in lendingto the private sector, from 36 percent in 1998to 46 percent in January 2006. As shown inFigure 2.2 public banks have dominatedprivate sector lending- especially services, trade and manufacturing-whereas private bankshave gainedaccess to the housingand consumer credit markets.The advantage of public banks originates from lower cost of funds due to: i) state guarantee on all their liabilities; ii)tax exemption of their dollar deposits; iii)full and explicit deposit insurance (which is not yet available for private banks), and iv) private banks' requirementto put 17 percent of deposits raisedin partially remuneratedaccounts at public banks. 6. The bankingsystem is becomingfurther dollarized,which may becomea potentialsource of vulnerability.Initially, dollar loans were grantedmainly to largercustomers, due to the high processing costs implied. However, decreasingcosts of dollar loans inducedexpansionacross the boardeven to consumer credit and mortgages, both from private and public banks. In2002, 50 percentof onshore bank credit representeddollar denominatedlending, and in2005 this proportion increasedto 54 percent. This situation is more severe within the credit portfolios ofprivate banks (see Figure 2.3), where dollar- denominatedloans accountfor almost 80 percentoftotal loans (up from 75 percent in2001). Inthis backdrop, there is a potentialvulnerability inthe system, since dollar loans are beingmade availableto even borrowersthat do not have revenues inforeign currency, Nevertheless, anecdotic evidence suggests that non-exportingfirms also have dollar revenues. Thus, although a devaluationofthe dollar could result ina systemic risk for the financial system, they might not be generatingidiosyncraticrisk for these firms inparticular at the moment. 17 Figure 2.2: Share of Public Bank on Lending by Figure 2.3: Composition of Banks' Lendingby Sector, 1998 & 2006 Currency, 2005 W Osc-98 EJJan-06 100, 78 Source:Authors'calculations basedon datafrom SUGEF. Source:AuRan'calculationsbasedon data horn SUGEF. 7. Domestic bankcredit to the private sector39hasincreasedsubstantially over the past decade, but still Costa Rica lags behindcomparator countries. Liberalizationofthe bankingsector in the early 1990sreignitedcredit, which grew from a low of 17.6 percent ofGDP in 1998to 27 percent in 2004 (Figure2.4). Inspite ofthe observed increase, this levelof financingis still low even for Central Americanstandards andcomparesunfavorablyto that observedin economiesthat have developedmore dynamic financialsystems as shown inFigure2.5. Similarly,the countryranksvery low (80 out of 117 countries surveyed) interms ofthe ease ofaccessto credit accordingto the World Economic Forum's Competitiveness Report, andremainswell below other neighboringcountries suchas El Salvador (49), Panama(39, andother globalcompetitors suchas Chile (32), Ireland(6) and Singapore(16).40 - Figure 2.4: Bank Credit to the Private Sector, Figure 2.5: International Comparison: Domestic -- 1998-2004 Credit to Private Sector, 2004 -Bankcreditto pnvate rectorIGDP(%) Guatemala fi 15 1 -8-Dornesbc credit to pnvste sector (% of GDP) Pam -= 17 4 35 - Ecuador 20 1 Honduras -- 37 4 CostaRica -%\\\\\\\\\ 42 5 Argentina -- 45 4 3 5 8 250- gb 2 30: 17 6 21 0 El SalvadorChile - J 5 e 49 2 70 2 1 5 - Brazil -1 80 9 0 10 - Israel - 02 0 5 - Nicaragua - 00 4 Panama 90 4 0 7 - 1998 1999 2000 2001 2002 2003 2004 Malaysia 1343 166 9 8. Furthermore,growth in credit appearsunevenacross differentsectors of the economy. While overallbankingcredit has grown substantially, this growthis drivenby lendingto specific segmentsofthe market(Figure2.6). The area of highest growthwithin banks' portfoliosis retaillending (includingconsumer andhousingcredit), which has gone frombeinga relativelysmallshareoftheir 39For the purpose of this chapter, private sector does not include non-bank financial institutions. 40World Economic Forum (2005). 18 portfolios to accounting for more than 50 percent o f the bank credit granted to the private sector. Onthe other hand, the evolution o f corporate lending has been mixed. Indeed, while lending to trade, construction and services has increased substantially since the beginning o f the 1990s, credit to manufacturing and agrib~sinesses~lactually decreased. According to Monge-Naranjo and Hall (2002), lendingto specific segments o f the market is closely linked to differing target industries o f banks, with public banks serving the more traditional industries like agribusinesses and private banks focusing on the faster-growing segments o fmanufacturing and services. Figure 2.6. Bank Credit Growth by Economic Activity (1987 -2005) 1,200. Credit to Manufacturing and Consumer Real Growth in BankingCredit 1687.2004 1911% (Billions of Coloner of 2000) 1,000. 800. , 0 600 . c - * 400. 0 644% 4% 394% 200. 4% O T Agribu8inaer Manufaduring Commerce Construction Sewices Consumer Source:Authofs calculationsbased on data from SUGEF FinancialSectorInfrastructure 9. Corporate insolvency proceedings are hampered by a low judiciary, excessiveprotection of debtors and lack effective out-of-court workouts. As reported inWorld Bank (2004a), corporate insolvency and reorganization procedures are entirely managed by courts, leadingto inefficiencies, delays (the verification o f claims alone can take several months) and limited participation from creditors, since out-of-court settlements are not easily achieved under the current legal framework (Figure 2.7). According to the World Bank's Doing Businessreport, thejudiciary process to recover non-performing debts requires up to 34 different procedures, takes 550 days on average, and generates costs estimated to be as much as 41 percent o f the amount o fthe non-performing debt. Inall these accounts Costa Rica compares very negatively to regional and global peers. Figure 2.7: Time and Cost to Solve Legal Disputes Time to Resolve Legal Dlsputes (Days) Cost of Legal Dispute (% of debt) Nicaragua Chile Ireland El Salvador China Argentina El Salvador Ecuador Malaysia Brazil Chile Nicaragua Panama Malaysia Peru Ireland Ecuador Israel Latin Amer & Caribbean Latin Amer B Caribbean Argentina China Honduras Honduras Brazil Peru Costa Rica Panama Israel Costa Rica 0 100 200 300 400 500 600 700 0 10 20 30 40 5( Days Percent Source: 2005 Doing Business Indicators 4' For the purpose o f this chapter, agribusiness refers to business activities directly related to agriculture and livestock. 19 10. On the other hand, availabilityof informationon prospectiveborrowersin CostaRica appears relativelygood. The DoingBusinessreport in2005 presents a Credit InformationIndex, which measuresthe rules affectingthe scope, accessibility and quality of credit information available through either public or private bureaus. The index ranges from 0 to 6, with higher values indicating that more credit information is available from either a public registryor a private bureauto facilitate lending decisions. Costa Rica achieved an index level of 6, indicating the relatively highquality o f borrowers' information, well above the Latin American average of 4.5. While 34 percent of adults are covered by the public credit registry, only 4.5 percent of adults are covered bythe private credit bureau, substantially below the Latin American average of 31.2 percent. Moreover, according to Monge-Gonzalez (2006), the current legal framework does not allow banks to share information on defaulters with the credit bureau (Central de Deudores) managedby the bank regulator (SUGEF), which severely limits its scope and effectiveness. LendingtoSMEs 11. Although lendingto SMEs is actively promoted by publicbanks, it appears stagnated.Bank lendingto SMES~~beendriven mainly by public creditors, with clear leadership from BancoNacional has de Costa Rica and Banco Popular, and modest participation from private operators such as Financiera Miravalle and Banca Improsa(Figure 2.8). In2005, estimated bank lending to SMEs inagribusiness, manufacturingtrade, services and tourism stood at around US$333 million, which i s equivalent to only 16 percent of the total bank lendingto those sectors.43This relatively low share of lending has not changed substantially over the past 5 years (in2001 it represented15 percent of total bank lending), suggesting that, while the aforementioned banks have established specific SME lending programs, the overall lendingto these companies has not kept apace o fthe rest ofbank credit growth. Although the government has attempted to increase the level of financing to SMEs through various entities and programs, SMEs still have very limited access to formal credit lines. Figure 2.8: Lendingto SMEs: Market Share of Public and Private Banks and Loan Distribution by Economic Activity Source Monge-Gonzalez (2006) 12. The governmentof CostaRicapromotesthe provisionof financialservices to SMEs and other under-served market segmentsthroughthree types of programs. The first one is through public banks, which have the mandate of strengthentheir provision of financial services to SMES.~~ BN- Desarrollo, a unit of Banco Nacional de Costa Rica (BNCR), aims at enhancing the provision of financial services to SMEs and other under-servedclients (e.g., micro-firms, municipalities, and agribusiness) by developing self-sustainable set of financial instrumentstailored to the specific needs of those market 42Since the bank regulator (Superintendencia General de Entidades Financieras, SUGEF) does not report breakdown of banks' loan portfolio by size of borrowers, SME lendingfigures are estimations basedon the size of loans. 43Monge-Gonzalez (2006). 44For example, the Directiva-015 of January 19th, 1999 mandates that public banks strengthen their provision o f financial services to SMEs. 20 segments (Figure 2.9). In its operations, BN-Desarrollo has benefitedfrom mergingtwo existing government programs (Programa de Financiamientoa las PYMES and Departamento de Credit0 Rural) as well as from the vast branch network and credit processes of BNCR. At the end o f 2005, BN- Desarrollo's loan portfolio was still modest at US$284 million (up from US$ 70 million in2000). Nevertheless, the program representedthe largest source of fundingfor micro and SMEs inCosta R i ~ a , ~ ~ either as a direct creditor or through secondtier financing through commercial financial institutions. In addition to credit services, BN-Desarollo helps SMEsto acquire basic financial literacy and bankingtrack record, so that they would eventually `graduate' as clients of mainstream commercialbanks46.However, it i s importantto note that the composition of the loan portfolio of BN-Desarrollo, interms of the industries served, does appear significantly different from that o f other commercial banks, as it has a strong concentration on activities such as commerce and services, indetriment of agribusiness and manufacturing. Inother words, according to this breakdown o f its lendingactivities, BN-Desarrollo does not appear to have a particular focus on under-servedeconomic sectors. c Figure 2.9: Composition of BN-Desarrollo's Loan Portfolio 100% 80% EOther 60% 0Services aCornrnerce 40% 0Manufacturing 20% .Agribusiness 0% 2000 2005 Source:Author's calculations based on Monge-Gonzalez (2006) 13. Credit guaranteesis the second instrumentused by the CostaRicangovernmentto para el Desarrollo de las Micros, Pequeiiasy Medianas Empresas- FONDEMIPYME)47with the view of programcreditto SMEs.In2002, the government createda guarantee fund for SMEs (Fondo Especial enhancing the commercial viability o f lendingto borrowers operating in high-riskmarket segments. FONDEMIPYME focuses on two mayor areas: i)provision of relatively low-cost guaranteesfor micro firms and SMEs to access bank credit, and ii)direct financing of technical assistance and innovation projects. The fund started with a seed capital o f roughly US$ 18 million. However 18 months after its inception, it had provided only 75 guarantees, all of them to clients of Bank Popular. According to Monge-Gonzalez (2006), the fact that the fund is administered by a public bank (Banco Popular) deters other public banks from applying for the guarantee, as it requires sharing information on their clients with their competitor. Furthermore, privatebanks do not haveaccess to this credit guarantee, which further limits the scope and impact ofthe program. 14. Another government fund that promotesSME lendingis the Programade Fortalecimiento para la Innovaciony DesarrolloTecnologico de lasPYME (PROPYME). PROPYMEwas created in 2000 with the objective of fostering R&Dactivities through joint ventures between researchcenters and SMEs, andthe co-financing of projects through matchinggrant schemes. While the objective ofthe program is highly relevant inthe context of Costa Rica's focus on innovation and technology, the impact of the program is still very limited. Between2000 and 2004 less than US$2.6 million of matching grant 45 Basedon estimates from Lizano, Monge andMonge(2004). 46 See Hayden (2002). 41 The legal structure of FONDEPYME was created by the Law 8262 Fortalecimiento de las Pequenas y Medianas Empresas enactedinMay 2002. 21 financing was granted, and only 50 projects have benefited from those finds. According to Monge- Gonzalez and Monge-Ariiio (2005), this accounts for a mere 1.3 percent of R&Dspending inCosta Rica during the same period, and suggests an important under-execution of the yearly budget ofthe program.48 2.3 Results of the Investment Climate Survey (ICs) 15. As mentionedin Chapter 1,the evidence inCostaRica pointsout that cost of financing and access to finance are ratedamongthe five mostimportantconstraintsto growthas perceived by surveyed companies.As shown inFigure2.10, with 45 percent of firms indicating access to finance as severe or major constraints, Costa Rica, with the exception o f Brazil, Nicaragua, and Honduras, ranks worse than other countries inthe region such as Peru, Ecuador, Guatemala, and El Salvador. Interms of cost of financing as a major or severe constraint to growth, Costa Rican firms rank better than many countries in the region such as Brazil, Nicaragua, and Honduras. However, Costa Rican firms are 7 and 2.75 more likely to perceive the cost of financing as a constraint than their counterparts inLithuania and Chile, respectively. Inthe case of Costa Rica, access to finance affects more micro and small firms than mediumand large ones, however there are wide differences by size when rating the cost of financing as a major or severe constraint. Figure 2.10: Access to Finance and Cost of Finance rated as "Major" or "Severe" Constraints to Growth Access to financing Cost of flnancing Brazil Brazil 82 Nicaragua Nicaragua 61 Honduras Honduras I CostaRica PEN. 5759 Peru Poland 49 Ecuador CostaRica . 48 Poland Ecuador. 44 Guatemal ElSalvador China Chile Indonesia Thailand Lithuania 15 Philippines 0 1 0 2 0 3 0 4 0 5 0 6 0 7 0 8 0 9 0 0 10 20 30 40 50 60 70 60 Percentof firms Percentof firms Coata Rica 50 e 40 5 30 g n 20 10 Access to financing Cost of financing rn Micro `:.Small aMediumbi Large OAll firms Source: World Bank investment Climate Surveys Use of CreditServicestoFinance WorkingCapitalandNewInvestments 16. To assess the sourcesof finance used by firms for working capitaland new investments needs,we construct two types of indicators usingthe ICs data.The first set of indicators refers to the percent of firms using external sources of finance for working capital or investment needs whether from formal or informal sources. Formal providers of finance include banks, such as state-owned and private banks, as well as non-bank providers, namely loans from government programs, finance companies, 48See Chapter 4 for a thoroughassessment of this government program. 22 i7. About 71 percent of Costa Rican the pest 12 months p fa finance, Costa Rica ranks better than c a u n ~ rsuchsas C ~ ~ ,Potandorthe~ ~ i ~ ~ ~ phowever,,it is i n e s i ~ ~ i ~toonote~rliat this is largely due to ~ n f osources of~~ I ~ ~ nratherthan to, the forma^ ~ n t r ~ ~ c i ~ ~ Figure 2.1 1: Fornial arid lnfarniat Sources UT Finan rkine Carsitalor New Inv is much more c ~ ~ i ge firms than fur ni~cro- s that used credit got it from both formal and i ~ ~ ~ sources,m a ~ ~ ~ r sLig~es~in~ a rntich lower degree of market s e g ~ ~ e n t ~than~inn t j ~ other c o ~ ~ ~ t rAses11owr.r in Figure 2.12, Costa Rica performs betterthan Chile vdth only 26 percentof ~ s , n 19. Supplier credit and loans from stati;-o rl banks: are the most ~ r ~ ~Sawces of o ~ i ~ ~ ~ ~ finance used by sunreyed ~ ~ ~ a i ~ ufirms in Costs Rica. ~OvcralI, 38 pcrcentof firms got ~ ~ c t u ~ ~ n ~ ~ ~from; any~t ) p~of batiks. A s~shown in~Figure 2.13, 26 percentof firms gat loans from state- c i ~ 23 ownedbanks, followedby domestic privatebanks(15 percent) andforeignbanks(5 per~ent).~'Although only 27 percentof surveyed firms got financingfromnon-banks,mostdid so from creditcards (13 percent) and factoring(9 percent). Supplier creditis the mostprevalent source of financingwith 35 percentof firms usingit. Furthermore, loans from friends andfamiliesreach out 20 percentoffirms. Figure 2.13: Use of Formal and Informal Sourcesof Financingin Costa Rica Banks (38 percent) Nonbanks (27 percent) InformalSources and Suppliers (47 percent) 40 I I 35 State- Domestic Foreign Offshore Finance Credit Leasing Factoring Family 8 Money Suppliers owned Private banks banks companies cards Friends Lenders banks banks Source: World Bank InvestmentClimate Surveys 20. The use of bankloans differsby firm characteristics, such as size and economicsectors.For example, 54 percentof mediumand largefirms usedbank loans versus 37 percentand21 percent reportedby smallandmicrofirms, respectively(Figure2.14). A larger proportionofmicrofirms get loans from state-ownedbanks (17 percent) than from domestic privatebanks (4 percent). Exportingfirms and foreignownership also appearto be importantcharacteristicsfor firms that have access to credit from privatebankswith only 8 percent of non-exportingfirms receivingprivatebank lendingover the pastyear versus 43 percentofexportingfirms.At the same time, banks' creditactivity differssignificantlyacross industries. Some sectors ofthe economy appear neglectedby bothprivateand state-ownedbanks, while some activitiesseemto be favored by all types of lenders.Take for instance the foodandbeverages sector; inthis sector a large proportionof surveyedfirms appearedwell servicedby state-ownedbanks (40 percent)privatedomestic banks (23 percent) andforeignbanks(19 percent).At the other endofthe spectrum, only a small proportionof manufacturingfirms inmetalproductsreportedlygot bank loans either publicor privatedomestic banks(15 percent), andhadvery little access to financingfrom foreign banks. Privatedomestic banks seem to favor specific industries such as chemical& plasticand food& beveragesmanufacturing, but appearedless attractedto industries such as textiles, paper andnon-metallic manufacturing. 49The relatively low percentageof foreign bank loanscouldemerge from severalfactors. First, privatebanks (including off-shore banks) face competitionfrom public banks, who can offer lower cost loans basedon their regulatoryadvantages. Second, interviewedenterprisesmight have been unableto differentiatebetweenon-shore and off-shore lendingor might havebeen unwilling fully declaretheir offshore loans. 24 Figure2.14: Use of BankLoansby Industryand Type of BankinCosta Rica 50 40 40 E 30 0 L fial20 a 10 0 Food 8 beverages TeX1iIes8 leather Paper 8 publishing Chemicals 8 plastics Other non-metallic Metal products Other Source: World Bank Investment Climate Survey 21. Firm characteristicsalso influencethe use ofsupplier credit,which is the second most common source of externalfinancing used by surveyed firms. Supplier finance (also knownas trade credit) refers to short-term creditor graceperiodprovidedby commercialfirmsto their clients inthe context of a sale of products or services.Eventhoughmorethan 35 percentof firms surveyedreported usingtrade credit, access to this type of financingappearsto be linkedto the size of firms, with almost one intwo medium-sizedand large firms usingit, versus only one infive microfirms (Figure2.15). 22. Other informal sources of financing such as relativesand moneylenders are still relatively common. One infive of the firms surveyedobtainfinancingfor their investments or operations from friends andrelatives.While this figuremay not seemhighfor microfirms, it is worthnoticingthat 25 percentof smallfirms, and 14percentof mediumand large ones also relyonthis type of financing. Moneylendersare more seldomused, but counterintuitively,their financingappearsthree times more commonamong smallfirms thanamongmicroenterprises. Figure2.15: Use of InformalSources of Credit by FirmSize inCostaRica 50 44 40 E 30 L 25 * fi 20 2 10 0 Friends & Relatives Moneylender Supplier Credit Im Micro ..:Small 4 Medium & Larcre OAll firms I Source:World Bank InvestmentClimate Survey 23. Even though a largeproportionof firms have access to external sources of financing, Costa Rican firms financed 56 percentofworking capital needs and 62 percentof the value of new investmentswith retainedearnings or internal funds. Interms of external financing,banks are the most importantsource of financingfor either working capitalor new investments for all firm size. As shown inFigure2.16, banks are the mostprevalent sourceof external funding, financing 17percentof workingcapital and 21percentofthe value ofnew investments. Supplier credit is the secondmost importantsourceto finance firms' workingcapitalneeds(12 percent). Furthermore, supplier credit is 25 positionof tnrge flrnis re credit risk c ~ ~ n s ~ d ~ r a~t i o~~~s " ~smallerrfirmsbappear as more risky clients. i c ~ ~ `rnf, reliance in the fi 25. To analyze the ~ h g ~ a ~ t e rof furmglssector credit, we d i f f e r ~ ~ rbetween two types of ~ s t ~ ~ ~ a t ~ ~ r ~ The firstu ~ r~o ~ ~ru csrst to~s l ~ ~ } ~ ~creditr ~fines, ; t ~ ~ ~arec o ~ ~ r dfacilities, u s ~ i a ~ ~ y ~ - t e t ~ i h ~ a f ~ reneuable e w r j 30,60 or 90 days, p a ~ i c ~ ~suitable for working capitat needs. The secund credit l a r ~ ~ product refers to loans from ~ ~ n a i i cii a~~ ~ ~ ~~ i ~~or~ i ~i~o ~~ ~~ i -obukitfi~~a s s~~ i athat~~~a r~ i ~~e ~s ~ n ~ ~ b arid ustrallj iit1kedto specific i floR h. is visibXy lower for C Kicanfirms than fur other b ~ ~ ~~ b o ~ ~ ~ ~r r~ ~e ~ S, acccss~to a,s h ~ ~ ~credit ~ - ~ efine ~is quite limited r in Costa Rica, \;tit11orify 43 percent # ~ ~ o ~ surveyed having eones(Figure 2.17). ~ ~ u r c oonly~29, ~ ~ ~ n ~ ~ r perretit of firitis actually made use of it at the time of tfie survey, 'This disparity between the level of access tirid the use oftlie credit lines may be due to the highcost and ~ I ~ ~~ o~l a~ ~r~ofe~thcse~ facilities, iIt y ~ uhicli titakc tfrem ~ ~ i i s ~ ~fort a~~~l e~ n ~ c~ nr a- i~i ceineeds. From a r e ~ i o r ~perspective, other Central nr ~~ ~ a l A t ~ ~ e ~firmsaiii~El S a l ~ rand ~ c i ~ ~~~ ~~ r~ ~report~greater access tol ~a ~ ~ o ~credit than ~firms in ~ e m ~ ~ - t e r Costa Rica, and access to these ~acilitiesfor firms in Chile and Brazil is almost twice as high. 26 Figure2.17: Access to Lines of Credit and OutstandingDebt from FormalLenders Access to Llnesof Credit OuitandlngDebtwlth Formal Lenders Indonesia Indonella China Philippines Nicaragua Brazil Philippines Poland PWU Honduras Guatemala Costa Rica Nicaragua El Salvador(2003) Costa Rica Peru Thailand Guatemala Honduras Ecuador Lithuania Brazil China Chile Thailand El Salvador (2003) Chile Ecuador 0 30 60 0 30 60 90 Percent of firmsvnth accelilito lines 01 oredit Percentof firms wim outstanding formal loans Source World Bank InvestmentClimate Survey 27. In Costa Rica, factors such as company size, economicsector and locationappear to influencethe availability of credit lines. As expected, the availabilityof short-termcredit facilities is linkedto firms' characteristics(Figure2.18). For instance, only 30 and 39 percentofmicroand small firms respectively, reportedhavingaccess to a creditline, while 61percent ofmediumand largefirms stated havingaccess to one. Froman economic sector perspective almost halfof surveyedcompaniesin the chemical sector have a credit line, while only around one inthree companies inother manufacturing sectors have access to these facilities.Among firms that have a creditline, the reliance on it alsovaries across industries, from 53 percent ofthe line withdrawnamongpaper & publishingfirms, versus only 33 percentamongfirms manufacturingnon-metallicproducts. Suchdifferences across industriesmaybe linkedto the natureofthe businessesandthe terms oftheir expected cashflows, andaccordingly, may not be a sourceof concernper se. Finally, it is noteworthy that a larger proportionoffirms inAlajuelathan in SanJose reportedaccess to creditline facilities. Figure2.18. Access & Degree of Use of Credit Linesby FirmSize 70 61 60 50 20 l o 20 10 0 Percent of Firms with Access to Percent of Firms Using a Credit Percent of Credit Line in Use Credit Line Line Medium & Laroe OAll firms 1 Source:World Bank InvestmentClimate Survey LoansJFom Formal Lenders 28. The ICs survey finds that a smaller proportionof CostaRican firms have outstandingdebt with formal institutionsthan in other Central American countries.As shown inFigure2.17, almost 50 percent of surveyedfirms have outstandingloansfrom formal lenders at the time ofthe survey. Althoughthis comparesfavorablyto firms inthe Philippinesor China, it is belowthe figures observedin 27 other Central American countries such as Guatemala (58 percent), El Salvador (57 percent) and Honduras (52 percent). 29. CostaRican firms have formal loanswith the largestmaturity among global peers. According to the ICs, Costa Ricanfirms reported having loans with a medianmaturity o f 60 months (Figure 2.19). Although similar to figures reported by firms inEl Salvador, loanmaturities inCosta Rica are very different from those in countries like China or Indonesia or even regional comparators, such as Chile, Ecuador, and Peru. When examined by firm characteristics, the formal loan maturity distribution is fairly uniform, suggesting that there is no differentiatedtreatment by formal lenders according to the size or the ownership of firms, and that longmaturities are widely available for those firms with formal loans. For example, 67 percent of micro firms with formal loans and 73 percent of firms owned by domestic capital had a maturity of 60 or more months. Eventhough, maturities of loans in Costa Rica appear comparatively longer than in other countries, this does not imply that firms do not face problems in accessing long-term financing (see paragraph 34) Figure2.19. Median Loan Maturitv(months) & Loan Collateral (YOvalue of the loan) * \ Median Maturlty of Formal Loans (Months) Average CollateralValue to Loan Amount Costa RICB NlCa,.p"@ El Salvador Ecuador Chile Poland Honduras Hondurii Guatemala Brnlll Poland El Satador LRhuanis Guatemala 0,BZll Lithuania Nisafagua Indonesia Philippines Chlle Indonesia costa RlC. China China PBN P*N Ecuador Philippines 0 30 60 so 0 30 BO 80 120 150 180 210 Monms Percent Source World Bank Investment Climate Survey 30. Formal lenders in Costa Rica requirecollateralfor their credit operations, and favor real estate over other types of assets. Most formal loans (86 percent) are securedwith ~ollateral.~~Although several different types o f assets can be usedas guarantee for formal loans, Costa Ricanfirms pledgedreal estate collateral in 67 percent of their outstanding loans. More than 30 percent of Costa Rican firms do not own any real estate, accordingly many firms offer assets of owners and managersto secure formal loans. Overall, 20 percent of formal loans were securedwith personal assets of owners and managers. This is especially the case among micro firms (36 percent). Plant fixtureswere usedas collateralfor 21 percent of formal loans. Movable assets, such as machinery, equipment, inventories, and accounts receivable were used as collateral for only 15 percent o f formal loans. The small proportion of loans secured with movable assets may be due to the lengthy foreclosure process, which diminishes the value of these assets as collateral. 3 1. Another findingwhere Costa Rica stands out is that surveyed firms reporteda ratio of collateralvalue to loan amount that is among the lowest. Whereas inmost countries surveyed firms have declared that lenders require collateralvalue various times higher than loan amounts, the 50The results of our regressionanalysis show that firms that own real estatepropertyare more likely to get formal loans. 28 Mlcm Small ~ e d ~&~ r n Never Exported Some All formal Large exported directly ~ ~ ~ o ~loans n g ~ experience Source Wortd Bank ~ ~ v Climate ~Survey e ~ ~ e ~ ~ 33 The large spread between interest rates in local and dollar bans may entice firms to borrow in cfollsrsin order to redace the cast of finsn~~ng. reported by surveyed firms, the cost of ~naricing As in local currcncy is mort` than I O ~ ~ r c e i pointsa higher titan the cost of f i ~ ~ a in dollarsi ~(average ~ ~ ~ e ~ ~ i i annttnl interest rates it? colones stmd at 22 percent while interest rates in dolfars average almost f O percent in the sarnplc of survcjcd firms that have format loans). As ~ ~ ~ t j inoWorlddBank ~ n ~ ~ ~ ~ ~ the ~ c l a t i ~high~fiscsl deficit, zi.hich is beiiig f i ~ ~ a to a largedextent by the b a i i ~ iscctor e l ~ ~ ~ e ~ t ~ ~ ~ s p cptibiicj banks),l increases ttic interest rate gap ~ e ~forcign d e~ n ~ ~ n~ i ~loans dand loans in ~ ~ ~ ~ ~ ~ c a t e colones. `The spread, in turn, attracts firms of all tjpes to o b ~ a~i ~~~ ~ ain dol~ars. j 1 ~ ~ ~ ~ c 33. To assess the extent ~ f ~ rconstra~n~~ degree of an unmet d ~ m a fordformal e ~ ~ t or the ~ loans, we classify surveyed firms in three categories. The first category includes those firms that do ticat dernarid formal loans. The second catego9 is the so-called c r e d ~ t - c o ~ s t r agroup,~which iiicludcs both ~ ~ e tliosc wfio Itad d ~ ~but did not apply and those who a p ~ ~and~got rejected. This group will i~icludr: ~ ~ i i ~ i d 29 ~ l ~procedures, high ij ~ ~ ~ o ~ n will be denied, The I 35. Theprop on ~ s firms that d e ~ loans~eis rather iarge and similar fo o ~ ~ ~ ~~ d ~ ~ ~ o ~ ~A5~stiowri~ ineFigure. 2.2 1 almost 80 percentof Costa Ricatr firms have a d ~ m a kn r~fortztat ~ s ~ loans. Ihir, some firtm have a lower de~~iandfor formaf loans, such as micro ~ r n i(73 percent) and s foreign-a\\tied (63 percent). When comparedto other c o ~ ~ t r iOIIIY in Chile arid ~ u ~ ~ r ~are n a l a ~ s ,firms ~ less like& to demand fori~~al loans (73 percent)than CostaRican ones, 36, The i o ~ of credit constraintsc(or ~~ ~ rdema~dfar a~mal ~ ~ ~ ~ n ~ t loans) is more prevalent in Costa Rita than in ~ ~ ~ ~countries. Irti CostatRica, about 3 1 percent offirms are credit ~ a ~ ~ r ctstistrained, this fevef is the hi~hestan^^^^ c ~ n i ~ a ~Centralr An~crican~ a ~ o Q ~ ~and~ is~tuo times s r i ~ ~ h i g h tlinn that of Chile, eken after scaling by the ~ r a c tofi ~firms~d e ~ a ~ toms.nOnly 15 percentof~ d ~ ~ large firms in Costa Kica report beingcredit cons~rained,whilc this p ~ ~ pis twice as high~for~small ~ r t ~ firms (35 percent), and alrnost three times as high for micro firm (40 ~ e r ~ e n t ~ . Ill0 ~ ?ti , : i 5 511 2 25 I . .... .............".......... ......................"..... ....... 30 39, hlniust t ~ r ~ e - ~ of fxrrxis ~actr as creditors by grantinga grace period for paymentsof # ~ ~ ~ ~ s rtm sold $2 percent ofthcir snntral safes oti credit, scitli 100 TS c CT 8t so 0. 25 0 t Said on Percentof Firms with Clients Percent x Micro Small M~~~~~& Large DAfl firms in8 Sinancingto their eli to the risk of clients' d 32 I Factoring i Box 2.1: Mechanicsof Factoring s a type o f supplier financing in which firms sell accounts receivable to a factor (lender) at a discount (composed by interests and service fees), receiving immediate cash inreturn and the remaining balance at a later time, once the factor receives the full payment from the buyer. Reverse factoring is a usefulalternative to ordinary factoring given that the latter has not been profitable inemergingmarkets, due to the lack o f goodhistorical credit information and fraud problems inthe industry. Inordinary factoringthe factor generally purchases many accounts receivable from a limited number o f sellers. Incontrast, inreverse factoring the factor purchases accounts from a larger number o f sellers but these accounts are payable by a few creditworthy customers only. Thus, reverse factoring limitsthe needto collect and analyze credit risk information on buyers. Additionally, it facilitates access to finance for SMEs that sell their goods and services to high-quality customers as they can borrow on the credit risk o f their clients. A well known example o f reverse factoring is found inMexico, where Nacional Financiera (Nafin), a government development bank, has implemented a successful program (Cadenas Productivas - Productive Chains) o f reverse factoring. The program uses an electronic platform to provide on-line factoring services to smaller and riskier suppliers who have accounts receivable from larger and credit worthy buyers, enabling the former to transfer their credit risk to their customers to access financing at a lower cost. Source:Based on Klapper (2005) and Cheikhrouhouet al (forthcoming). 2.4 PolicyRecommendations 42. I t is necessary to review the current role of publicbanks to determineiftheir net contribution is positive. Inthe context o f increasedmarket share o fpublic banks inprivate-sector lending, it is particularly important to evaluate ifthe interest rates and products they are offering to the private sector are adjusted to the sector's needs and contribute to the growth o f the country. Even though the overall bank credit to the private sector has increased, there are segments o fthe economy that appear neglected by both private and public banks, while some activities seem to be favored by all types o f lenders. Inthis context, it is necessary to consider what should be the role o f the public banks going forward, that is, whether that role i s one o f open competition with private players, or one o f complementariness, targeting economic activities and market segments that are not properly serviced by private creditors. Inthe first case, public banks should be enabled and encouraged to compete more freely by avoiding subjecting their strategic credit decisions to government mandates, while phasing out the current privilegesthat they enjoy over private players. Inthe second case, a clear strategy should be defined in order to identify the economic activities or segments o fthe private sector that are not adequately serviced by private banks due to higher risks inherent to their ventures and the current weak contract enforcement environment. 43. I t is necessaryto review the structureand scope of governmentprograms aimed at bolsteringprivate sector financing.While official programs such as the guarantee fund can help companies to overcome the obstacles o f collateral requirements to access credit, the current set up o f these programs appears to affect their potential by limiting incentives for competition among public banks, and excluding private lenders altogether. Inthe specific case o f the guarantee fund, some activities (i.e. agriculture and livestock) excluded are also the most credit-constrained. Other official efforts such as BN-Desarrollo have gained an important role as sources o f SME credit, but still lack sizable volume to cover the overall financing gap for these companies. 44. Enhancementsin contract enforcement are requiredto support secured lending.The poor contract enforceability in Costa Rica evidenced through costly and time-consumingjudiciary processes 33 generate higher risks for lenders. Inturn, such inefficiencies translate into tangible constraints for prospective borrowers to access credit due to stringent collateral requirements, burdensome credit processes and higher cost o f credit. While some enhancements to the legal framework have been implemented, the limited role o fthe creditor inthe legal process, the lengthy proceedings and cumbersome proceedings (notably the verification o f claims) and the difficulties to reach out-of-court settlements are still considerable obstacles. 45. The development of a dynamic factoring sector could provide a significant source of financingto the privatesector while reducingliquidity and credit risks.Most firms inCosta Rica provide financing to their clients on a consistent basis. Receivable accounts take up a sizable part of companies' resources, reducingtheir liquidity. At the same time, companies are subject to considerable risksfrom defaulting suppliers given the deficiencies inthe contract enforcement environment. Inother countries the development o f a country-wide factoring platform linkingsuppliers, factors and buyers53has enhanced significantly this role o f this sector as a source of financing to private firms by reducingrisks and transaction costs while increasing competition. 53See Klapper (2005) for a detailedstudy of successfulfactoringmechanismsbasedon similar legalframeworks 34 Chapter 3. Infrastr~cture~~ 3.1 Introduction 1. The objectiveof this chapter is to present an overviewof Costa Rica's infrastructure endowment and service quality while presentingthe findingsof the ICs and the Logistic Survey. It provides a summary of the arguments that link infrastructure as a dimension o fthe investment climate to trade and growth. Furthermore, the findings of the chapter will help prioritize the areas of intervention that will be needed in order for infrastructure to remain akey contributor rather than a bottleneck to growth. 2. A wide range of empiricalstudies supportthe conclusion that infrastructure is a major contributor to economic growth, particularly for developing countries. The approach to understandingthe linkage has varied, with different analyses considering the impact of infrastructure on aggregate Total Factor Productivity (Krugman, 2004), the impact of individual sectors on growth (Roller and Waverman for telecommunications or Fernald for roads), the Latin American region-specific impact of infrastructure stocks across sectors (Calder6n and ServBn, 2003)' and the separateimpact o f service quality on growth (Esfahani and Ramirez, 2002 and Calder6n and Serven, 2004b). The cumulative result of this growing literature is a robust demonstration of infrastructure's role as a driver of growth? Underlyingthe "direct linkage literature" (infrastructure and growth), is the recognitionthat infrastructure i s an important determinant o f firm productivity. That is, the supply, quality and price of infrastructure are defining elements of firm competitiveness. With trade liberalization spreading, logistics and transport costs alone tend to be higher than duties imposed on imports as well as the cost of quotas and other non- tariff barriers. 3. Underlyingthe "direct linkage literature" (infrastructureand growth), is the recognition that infrastructureis an important determinant of firm productivity. That is the supply, quality, and price of infrastructure are defining elements of firm cost structure and competitiveness. For example, an analysis of the factors that were important for Central America's growth from the 1980sto the 1990s suggests that infrastructure has had about as much impact on growth as increasing trade openness (Table 3. l)? 54 This chapter was written by Jordan Schwartz(World Bank) baseduponimportant contributionsfrom Juan Navas-Sabater,Tito Yepes, Ada KarinaIzaguirre,EmanuelSalinas, andJuan GalarzaTohen, (World Bank)as well as AlejandroVivas andJustin Pierce, and DanielChodos (consultants). 55 Synthesizedfrom Fay and Morrison (2005), andCalder6nand Servtn (2004a) with input from BriceAo-Garmendia,Estache, Shafik (2004). 56 Trade and infrastructurealso complement each other intheirjoint impact on growth. Efficient infrastructurehelpstrade to boost growthwhile increasingtrade leadsto greater demand for infrastructureallowing for greater investment, lower per unit costs andhigherfirm productivity. 35 Table 3.1: Reasons for Changes in Growth, 1990sversus 1980s El CostaFbca Salwdor h b d a Hondusas Nicaragua Stmcnrml dstRiminants Education 0.15 0.42 0.46 -0.10 0.48 Financialdepth -0.10 0.13 -0.06 -0.16 0.41 0.41 0.37 0.2 1 -0.07 0.30 Govenlmeatbwda 0.25 0.65 0.43 0.44 1.00 Infr,srmcture 0.35 0.63 0.4 1 0.60 0.37 otfier 0.0s -0.11 -1.45 0.10 -0.72 Changeingr.orvth 1990svs 19SOs Frehcted 1.13 2.09 2.44 0.82 1.84 Actual 3.80 4.14 3.05 0.84 4.40 Source: Jaramillo and Lederman (2005) as adapted from Loayza, Fajnzylber and Calderdn (2005). 4. This micro or firm-level perspective on the importanceof infrastructurefor competitiveness can be captured two ways: through perception-based surveys of firms and investors; or through firm-level analyses that evaluatethe costs of doingbusiness. Many surveys--such as the World EconomicForum'sBusiness Competitiveness Index--queryobservations of firm managersand investors about infrastructureservices. Other surveys, such as the WorldBank's InvestmentClimate Surveys, extract and compilefinancialandtrade datafrom individualfirms to illustratethe relativeimportanceof each element of production, includingtransport services, customs, electricityandtelecommunications. When aggregated,the surveysreveal infrastructure-relatedimpactssuch as bottlenecksto the shipment of goods; the impact of delays and lost, damagedor stolen cargo on shipmentvalues; andthe cost impactof energy andtelecommunications service problems. 5. The evidence in Costa Rica points out that infrastructure is perceivedas the main obstacles to growth by a manufacturingfirm. The ICs found that about 52 percent of surveyed manufacturing firms reported infrastructureas major or severe constraintto growth, with roadquality selectedby the largest fractionof firms. As shown inFigure3.1, mediumand largefirms are more likely to perceive infrastructureas anobstacle to growththan smallandmicrofirms. Figure 3.1: Infrastructure as Major or Severe Constraint by Firm Size 80 70 68 60 :50 50 2 40 30 n 20 10 Infrastructure Telecommunications Electricity Transport Road Quality Water I Micro Small Medium & Larae OTotal I Source: World Bank Investment Climate Surveys 36 6. Across LatinAmerica, the importanceof infrastructureon firm competitivenesshasbeen confirmedinsurvey after survey (Figure 3.2). Over halfo f all firms inthe region questioned as part o f the Investment Climate Surveys, considered infrastructure to be a major obstacle to the operation and growth o f their business. That level, shared by the Middle East and NorthAfrica, is the highest inthe world. Figure 3.2: BusinessThat View Infrastructureas a Serious Problem (YOof Firms) 1 LAC Middle East & NorthAfrica Sub-SaharanAfrica SouthAsia Europe& CentralAsia East Asia & Pacific I 7 0 10 20 30 40 50 60 Percent of firms Note: Figure shows the share of firms that report electricity, telecommunications, andlor transportation as "major" or "severe" obstacles to the operation and growth of their business. Source:World Bank (2005a) based on InvestmentClimate Survey data. 7. Beyond perceptionsof managers,the detailed cost resultsof the ICs suggest that competitivenessis affected by poor infrastructure. Indeed, an in-depth cross country analysis o fthe ICSs confirms that infrastructure is a major determinant o f Total Factor Productivity (TFP) 57: The cumulated effect o f infrastructure-related variables on TFP adds up to about 55 percent for the countries studied.58 Infrastructure variables with the highest impact on average productivity include poor electricity and transport services. 8. Perhapsmore importantly,the analysis also found that the poor conditionsof infrastructureinLatinAmerica affect firms' integrationintoglobal markets. Poor infrastructure affects the capacity o f firms to export, as well as the ability o f countries to attract foreign investments. It thus reduces opportunities for greater international integration, higher competitiveness and enhanced technology and innovation. Because o f the importance o f infrastructure inthe physical movement o f goods, bottlenecks contribute to high logistics costs which, in turn, lead to high inventory levels in Latin America and the Caribbean. Average logistics costs through the region range from a low o f 15 percent of product value in countries such as Chile to a higho f 34 percent, in Peru. Unreliable infrastructure will result in higher losses in transit, the need to hold higher inventory rather than orderjust-in-time, and generally higher cost o f transport. 9. The LogisticsSurvey conducted for this study focused on three highvalue-added goods and found the rangeof logisticscosts as a percent ofvalue to be 13 to 15 percent. This suggests that the 57Escribano and Guasch (2005). 58Based on ICs data for El Salvador, Honduras and Nicaragua. 37 national average, which would include the movement o f low value goods (such as cement-the primary import into Puerto Caldera), i s considerably higher.59 H o w does that compare with industrialized countries which should serve as the benchmark for Costa Rican competitiveness? 10. The average share of all logistics costs to productvalue in OECD countriesis around 10 percent6' This average includes the fullrange o f highvalue and low value shipments suggestingthat Costa Rican firms are faced with a significant cost disadvantage when competing against firms in industrialized countries. Much o f this extra logistics cost burden that has been placed on Costa Rican products can be attributed to differences in infrastructure quality and reliability-particularly intransport. Poor quality and reliability result indamaged goods, demurrage charges, lost sales and higher inventory levels. While US.businesses typically hold inventories o f around 15 percent of GDP, inventories in Latin America and other developingregions are often twice that (Guasch 2004). Such levels are expensive to maintain, principally because they tie up capital which has a highcost inmost o f LAC. This significantly increases unit costs, diminishingcompetitiveness and productivity. Guasch estimates that, assuming an interest rate for financing holdings o f 15-20 percent, the cost to an economy of additional inventory holdings i s more than 2 percent o f GDP. 11. For Costa Rica, this lesson is of critical importance: In order to unlockthe benefits of trade, infrastructuremust be available, reliable and cost effectiveand awide range of firms must have access to that infrastructure. The aim o fthis chapter is to evaluate the performance o fthe physical infrastructure and logistics services as integral parts of the production chains o f Costa Rican firms. By focusing on the bottlenecks to trade that are revealed through this process, policy makers can address the country's competitiveness and potential to achieve higher growth rates. 12. The resultsof the sectoral diagnosesand the surveys tell a remarkably consistentstory across infrastructure sectors about the uniqueparadoxthat Costa Rica now faces: 0 On one hand The country possesses a tremendous endowment o f infrastructure forged from a legacy o f responsive public agencies. That is, access to infrastructure ina broad sense is excellent incomparison with neighboring countries. 0 On the other hand Service and infrastructure quality are suffering from underinvestment, lack of innovation and weak regulation and that is impactingfirm competitiveness. 13. Over decades of steady investment,Costa Rica built an extensive network of infrastructure in nearly all productiveservice areas. The financing o fthis infrastructure has mostly relied on public funds and the management and operations o fthe services has relied on public institutions. These transport, electricity and telecommunications networks were allowed to develop inthe context o f a profound sense o f "social compact" felt by taxpayers toward public service providers. That public trust has largely been reciprocated through the decades by the public institutions which provide basic services. The resulting infrastructure endowment has contributed to Costa Rica's highand stable growth levels 14. Despitepast successes in buildingout infrastructurenetworks, publicexpenditurelevels have recentlybecome unevenby sector and some of the publicservice providershave beenunable to keep upwith sectoral innovation. The private sector has not been allowed to play a compensatory role because o fthe long-established position o f public authorities and agencies as integrated owners, operators, investors and managers o f infrastructure services. The result has been a decline inthe quality 59Transport costs alone oftenrepresentmorethan 50 percentofthe deliveredcost o f low-value goods suchas cement, coal, coke, grains and other productsshipped inbulk. 6oGuasch(2002). 38 of services across sectors--even as connectivity remains high. That quality slippage is beginningto affect firm competitiveness, particularly for smalland medium-sized manufacturers. 15. In additionthe immediate impacton firm competitiveness, CostaRica's reputationas an attractiveinvestment locationmay also be impactedby the falteringquality of infrastructure services. A recent survey of major industrialists gave Costa Rica low marks inthe quality of its transport infrastructure (Table 3.2). Costa Rica rankedpoorly inmost categories of transport infrastructure inthe survey of business executives contained inthe World Economic Forum's Global Competitiveness Report 2004-2005. Inregardsto ports, Costa Rica was tied with Guatemala for the lowest rankingin its peer group. Air transport was the only category inwhich Costa Rica's score exceededthe peer group average. Table 3.2: ComDarative Survey on the Quality of Infrastructure Overall Port Air transport infrastructure infrastructure infrastructure quality quality quality Argentina 3.6 3.6 4.1 Brazil 3.5 3.1 5.1 Chile 4.9 4.8 5.7 ~ Colombia 2.9 3 4.4 Costa Rica 3 2.5 4.8 El Salvador 4.4 3.3 5.6 Guatemala 2.7 2.5 3.5 Honduras 3 3.8 3.3 Mexico 3.4 3.3 5 Panama 4 5.7 5.2 Indonesia 4.2 4.4 4.4 Philippines 2.5 2.6 3.9 Thailand 4.6 4.2 5.3 Average 3.6 3.6 4.6 Note: Survey based subjective evaluation on scale from 1-"poorly developed and inefficient"to 7-"amongthe best in the world". Source:World Economic Forum (2005). 16. The rest of this chapter examinesthe state of CostaRica's productiveinfrastructureusing internationalcomparisonsto highlightareas of strength and weakness.61Resultsof the Investment Climate and Logistics Surveys are usedto incorporate the perspective o f firms and to identifythe impact on competitiveness and trade causedby infrastructure bottlenecks. The chapter begins with an analysis of the endowment of productive infrastructure inCosta Rica. That section is followed by a comparison of the quality of services available intransport, electricity and telecommunications. The fourth section provides an analysis of the flow of investment ininfrastructure as well as a diagnostic of financing challenges related to infrastructure services. The final section of the chapter provides sectoral recommendations for policies to address the supply, quality and financing challenges raised inthe earlier section. 3.2 The Endowment of CostaRica'sInfrastructure 17. A high-level review of CostaRica's transport, electricityand telecommunications endowment reveals a country that is a regionalleaderin productive infrastructure. Across all o f Costa Rica's primary, productive infrastructure backbone-roads, electricity and telecommunications- ''For purposes ofthis chapter, productive infrastructure is defined as paved roads, port and airport quality, electricity generation capacity, teledensity, availability of personal computers and Internet access. 39 the country has made remarkable achievements inprovidingaccess to a large portion o fits citizens and businesses. Intransportation, Costa Rica leads its peer group inroad density, measured as the lengthof total or paved roads per worker. Indeed, it has 30 percent more paved roads per worker than the next most densely paved country inLatin America. Inelectricity, the reach of the network and connection rates are among the highest inthe region while the country ranks third inelectricity capacity per capita. Costa Rica has made impressive progress inthe availability of information and communication technology (ICT), ranking first among its peers inmainline teledensity as well as personal computer density and second inInternet usage. 18. Growthin the endowmentof mostof Costa Rica's productiveinfrastructurehasbegunto wane in recentyears. Intransport, Costa Rica's pavedroaddensity has declined eachyear since a high in 1998 as growth inpavedroadswas offset by more rapid growth inthe labor force. While this trend reversalis not alarming in itself, it is a reflectionof declining investment inthe sector. Indeed, the maintenance of such an extensive network has provento be a core challenge for the Government o f Costa Rica-a point which is discussedinmore detail inthe following section on infrastructure quality. Similarly, efforts to increasethe capacity of the ports through a concessioning program inCalderas and a rationalization of operations at Limon and Moin have not progressed, forcing about 60,000 containers per year to move through Panama's ports. Likewise, an upgradingof the internationalairport has beenon hold while the awarded concession has battledthrough the court systems. 19. In electricity,generationexpansion hasstopped over the last few years and shortages loom in the futurewithout a rejuvenationof the investmentprogram. Mobile telephony has also has not kept up with neighbors, competitors or the potential of Costa Ricans to utilize the new technology. As for the quality of services, the ICS reveals that Costa Ricanbusinessessuffer from surprisinglyfrequent outages and long waiting periods for connections inboth electricity and fixed line telephony. TransportInfrastructureEndowment Figure 3.3: MainRoad Corridors of CR Nicaragua Pacific Ocean Panama noas I Source: Ministv of Transport. 20. This section focuses on the CostaRica's maintransport assets: the primary intercity road network,the portsof Lim6n Moinand Caldera,and the internationalairport (Figure 3.3). Unlike many other countries, Costa Rica retains a single large supply and demand center-the Central Valley around San Jose-making its primary logistics network easier to define. The inter-oceanic corridorsthat pass through Greater San Jose, and, to a lesser degree, the two parallel corridorsthat connect Costa Rica 40 to its neighbors serve as the mainaxes oftransport infrastructureandunderpinthe competitivenessof CostaRica's trade. The inter-oceanic corridor is madeup oftwo segmentsconnecting each coastwith the Central Valley where the maincities are located. The logisticscorridorof San Jose-Lim6nandthe access to Limb fromthe northrepresenttwo ofthe primarytradingroutes inCentralAmerica. 21. Ifviewed as independentgatewaysto trade, each mode--roads, portsand airports-serves as a critical component of Costa Rica's logistics network for reasons that are best illustratedby different types of usagedata. There are three ways to view the use of a giventransport modeintrade: By numbers of firms, which gives equalweightto smallfirms movingsmallquantities as to large firms movinglarge quantities ofproduct; By volume, which indicatesthe traffic throughput that each mode oftransport must handle; and By value, whichreflectsthe importanceof a givenmode inthe nationaltrade accounts. 22. The diagrams below show use of transport mode by number of firms-thus givingequal weight to all firms regardlessof how much they ship or the value of their shipments (Figure3.4). Firmsinterviewedinthe ICs reportedusingmaritimetransportationas their primarymodefor imports- with two-thirdsofthose shipments comingthroughthe Atlantic ports(Figure3.4 a), Forexports, the data are more equitable (Figure3.4 b). Surfacetransportation was reportedas the most frequentlyusedmode at leastto the customspointsof the country. This reflectsthe disproportionaterole of smallfirms in regionaltrade as well as the growinguseof Panama's ports as an exportjuncture. Figure 3.4: Use of Transport Modes, by Percentageof Firms that Trade a. CustomsPointfor Imports b. Customs Pointfor Exports I Other Other herto Caldera Land only 51% 62% I Source:World Bank InvestmentClimate Survey (2005). 23. Use of transport mode for export by volume and value offers a different perspective on the relativeimportanceof each mode of transport (Figure3.5). Maritimecorridorsrepresent 80 percent of exports on a volume basis and about halfof exports byvalue. This differenceis the resultofthe value of time andthe resultinguseof air shipment for highvalue, lowweight productssuch as medicalequipment, cut flowers or computer chips. Infact, air shipmentsrepresentonly 1percentofthe volume of exports but 37 percentof the value of exports. Another importantcharacteristic inthe differentusagedata is the smallpercentageofexports-by volume or value-that use surface transport (roads) as opposedto the largenumber of firms that report a dependenceon roadsfor expoert. The fact that 50 percentof firms are exportingby landwhile only 19percent of exports by volume or 15 percentby value leave CostaRicaby landsuggeststhat smaller firms are moredependentonregionalmarkets, andthus the roadnetwork,for their exports. 41 Figure3.5: Distribution of Exportsby TransportationMode, Average 2001-2004 a. Volume (Tons) b. Value Surface 1 Source: Based on data from SIECA and MOPT. 24. The data in combinationsuggest that all three modesare important. Consideredthrough the lens of these three sets of data, the road network surfaces as the central concern for smaller firms which are trying to export; the ports are vital because they handle the vast majority of Costa Rican cargo movements; and the international airport remains a key asset for its disproportionate role inthe shipment of high value goods. A logistics or transport strategy intendedto increasethe competitiveness of Costa Rica's exports will thus have to pay due respectto all three modes as well as their interconnectivity. 25. The pull of Limon-Moin is a definingcharacteristicof Costa Rica's trade. Giventhat Costa Rica is the wealthiest country o f Central America and its primary trading partners requiremaritime transit to the East, the Ports of Limon-Moin represent an important channel for the sub-region's commerce (Figure 3.6). As can be seen from the map below, Moin-Lim6n handles nearly one-third of all containerized cargo from Central American countries, making it CentralAmerica's busiest port area (excluding Panama).62 ~ ~~~ Panama'sports handle about as muchcontainer cargo as the restof CentralAmericacombined. These volumes include significant amounts of Europe-US-Asiatransshipmentcargo passingthrough the Canal, butthey also includemost of Central America's Asia-destinationandorigincontainer traffic,particularlythat of CostaRica. 42 26. Because Costa Ricrt's trade outside of Central A4mericarepresentsover 80 percent of its total tradc, port access and ~ f ~ ~isi2% major concern for the country's firms. Limon is thc ~ n c ~ primary port of the country in terms of both irnportsand cxports, h a n d ~ncarfy 76 percent ofthe i ~ ~ countrq*s frcight. Exportsat Li~iionare ~ o ~ ~(82cperccrtt)~ in~primaryas ~~c ~ o~r ~~r ~products itr ~ r ~ a t e d tthich fogistics play a centtaf role in their c ~ m p c ~ ~ ~ i A~sed~~e t~asinthe~later section ~. ~ d 01-1 ~ j ~ ~ r (.the capacity and per ~ ~ ~ t ~ ~ ~ c ~ o~ f ~' L~ ~ ~~combine~IO make ~ o ~ ~ ~ ~ ~ ~ - mints and the ~ ~ ~ f i ~ j ~ nltter in this chapter, ~ rif set by its level ofinco aliner ~ ~ n n ~ ~ t ~ v 43 ' W e The k e r Shim n3 Cowec! ty 'wex i. IS 3 cornp3sPe ndex toat iCcudes 'leet ass g-men1 rer seru ces a*a esse 3-c s zes 3Ddrse 4,:hors ca cula:ixs based 07 fwecas's of UNCTAD (2C35j 5- 2003 20.63 211111 2020 ........................................................................................... .................... 201..................................................2020 0 " " ... ........"I .................................................... " " " " . 30. Where will Costa Rica's cargo go ifnot throughits own ports? There are two partsto the answer to that question. The most obvious responseis that Costa Rica's cargo will move increasingly through Panama's ports (Table 3.3). Indeed, data taken from all four of Panama's primary ports show that, in 2005, over 60,000 containers coming from or going to Costa Rica moved through Panama's ports. Table 3.3: Costa RicanContainer Traffic throughPanama Portsin2005 (Number of Containers) I 1 PanamanianPort CostaRican Carno Ocean Imports Exports Total Trade Imbalance Puerto de Colon 15,209 498 15,707 -14,711 Atlantic Puerto de Manzanillo 20,998 22,601 43,599 1,603 Puerto Cristobal 69 118 187 49 Pacific Puerto Balboa 2,583 1,335 3,918 -1,248 Total 38,859 24,552 63,411 -14,307 Source: Autoridad Maritimade Panama (2006). 3 1. This representsabout 100,000 TEUs or over 15 percent of Costa Rica's containertraffic. Becauseof the trade imbalance, nearly one-fourth of all trucks are empty (non-revenue) between Costa Rica and Panamadoubling the impact on the shipper from cost of operating those trucks. Fromthese figures it is possible to calculate about 80,000 truck movements a year (220 per day) that are moving mostly betweenPanama's Atlantic ports to and from the Central Valley of Costa Rica-along 800 or so kilometers of road as opposedto the 162 kilometers of road between San Jose and Puerto Lim6n. When converted into costs, CostaRican firms are absorbing about $1500 of extra roadhaulage fees per container to move their cargo through Panama. This totals approximately US$lOO million per year in additional road haulage costs to avoid Limon-Moin. 32. The other part ofthe answer to the questionaboutwhat will happento Costa Rica's cargo in the absence of increasedefficiency and capacityat its Atlantic ports is harder to quantify but equally important to consider. The comparative disadvantagesoffered by an inefficient and capacity- constrained logisticsnetwork will mean fewer firms that will be able to afford to acquire neededinputs from overseasor to compete for export markets. That is, there will be less CostaRican cargo overall. TheRoadEndowment 33. Through the 1970sand 1980sCosta Rica invested heavilyin road infrastructure creating the highest pavedroad density among all Latin American countries, surpassing the runner-up by 30 percentin per worker terms (Figure 3.9). These investments have substantially contributedto Costa Rica's economic development, makingthe country an oft-cited benchmark for the entire region (Serven and Calderon, (2004a); Fay and Morrison (2005)). However, as can be seen below, the growth inthe network has stagnated. 45 Figure 3.9: Paved and Total Roads Length , Paved and Total Roads Length -CostaRica 7 , 40 35 30 25 Pa 20 5 `. CD 15 f z 10 5 5 8 0 I , , , / , , , , , , , / , , , , , , , , , , , / , , , , I , , , / / / J I I I I I / 0 1960 1965 1970 1975 1980 1985 1990 1995 2000 1-t RoadsTpawd (thousand km) -Total Road length,(thousand km) 1 lource: World DevelopmentIndicators. ,Paved Roads and Growth in Paved Roads T 0. 0 6 # . S t o c k 2 0 0 2 + A v g G r o w I h R u l e 1 9 6 0 . 0 2 1 -0u1c8:Authors' calculationsbasedon datafrom:World DevelopmentIndicators, LANAMME;Ministriesof Transport; and Easterlyand Seven(2003). 34. Costa Rica's total road networkhad nearly 35,884 kilometersin2002, only 22 percentof which is paved(Figure 3.10). There is adirect relationshipbetweenthat quality gap andthe administrativelevel assigned responsibility for a roadcorridor. There are two administrativelevels for the network: "national" reflectingthe maincorridorsand"cantonal" or municipally ownedroads representingnearly 80 percent ofthe total. Differences among the two administrative levels are substantial interms of demandlevels. The primary network totals about 2000 kilometers and has an average traffic per day of 13 thousandvehicles, while those managedat the sub-nationallevel have less than 500 vehiclesper day. Thoughthismakesit easier to definepriorities interms of economic impact, it also shows the burdenfaced by sub-nationalauthorities inmaintaining a large network of roads with relatively low use. 46 Figure3.10: RoadNetworkDistribution Nacionai Fav. 7 4 . 4 9 9 h Nacionai No FaV 2.930 kmr u Canlonal Fav Source: Author's calculations based on MOPT. 35. Eventhough mostof Costa Rica's exports and importsmove by ocean-borne shipping, roads and highwaysremainan importantelement to trade. This is due to the following characteristics of Costa Rica's commerce: smaller firms tend to concentrate on Central American markets and thus depend on land transport for most of their trade activities most Asia-origin and destination shipmentstravel through Panama(and hence require long-haul over land); an increasing share of Caribbean-bound traffic (mostly to East and Gulf Coast US.) is traveling via Panamain order to utilize better ports and shippingservices; and 0 the primary demandand production center o fthe country-the Central Valley-is physically removed from Lim6n-Moin or the Port of Caldera. 36. Becauseof the importance of the road networkto trade, the effects of the decreasing investmentin roads and the resulting declinein the quality of the roads is ofcentralconcernto CostaRicanfirms and policy makersalike. These issues are discussedinmore detail insections 3.4 and 3.5. Airport Endowment 37. Passenger traffic through CostaRica's primary airport,el AeropuertoInternacionalde Juan Santamariahas grownrapidly-about 10 percent peryear-over the last decade. Inparallel, the increasing role of very highvalue and time-sensitive exports as a total share of exports has placed considerable demand on the Airport's cargo facilities. Inorder to expand the Airport's passengerand cargo capacity, a concession was signed in 1997. About half of all construction was completed with the cargo area significantly improved untilthe time at which the concession was halted due to a dispute with the concessionaire. Although the airport remains the highestranked mode of transport infrastructure in Costa Rica according to business survey respondents, current capacity o f the airport duringtourism season is insufficientto meet demand. 47 Electricity Sector Endowment 38. In terms of over-all endowment,Costa Rica performswell in the provisionof electricity services compared with its LatinAmerican peers and fast growing economies inEastAsia. Its electrification rate is the secondhighest inthe region and comparableto the best performersinEast Asia (Figure 3.11). Figure 3.11: Benchmarkingof Costa Rica's Electricity Supply and Endowment a. Access to Electricity (2004) Korea Chlle China Costa Rica Malaysia MEXICO Argentina Colombia Panama Thailand El Salvador 0 20 40 60 80 100 % of population Source:Authors' calculations based on data from ECLAC, OLADE, and World Bank (2004). b. Electricity Generation Capacity (2003) 2- 1.8-- N. 651.6-- 1.4-- 1.2- 85 1.- 0.6 -- 0.6 - O r Source:Organizacion Latinoamericanade Energia,andthe US.Energy InformationAgency 39. In terms of generationassets, Costa Rica is characterized by a relianceon renewable energy-based generation. Of the 1,958 MW installedin2004, hydro power plants accountedfor 67 percent, plantsbasedon other renewablesources such as geothermalandwind represented13 percent, 48 of Camgo mid IIercdia, rcspectivcly. !:our ~ o ~ ~ eserve~rural isolated systems. ICE d ~ s ~ r ~ ~ ~ ~ e ~ r ~ i ~ ~ ~ s cleetricit) in all other regions (Figure 3.12). ICE also stipplies electricity to the other seven e ~ e c ~ r ~ ~ j ~ y ~ j i ~ ~ r ICE andi CNFL~jointit ~CCCWI~for m r c than 8Ipercent of finat electricity sales. i ~ t ~ ~ ~ ~ , Note * It does not includeelectricitysales to other ~ i s ~ r rcompanies~ ~ ~ u ~ i Souice ARESEP (2005) ~ ~ dto ~ r~ ~i ~etectrici ~ j ices,~ICE tias the ~ ~ n dt ~ t e # ~ ~i n pmentof Costa Ries's Nation ric System (SEX). ARESEP ZR.. ap in N """11 ... ...., " G i w n Costa !Aka% income level5it is grossly ~ n ~ ~ r p e r f ~ ostn Rica does not meet expectations in 50 In 0 Source: Authors' own calculations based on date from the World Bank Development Indicators Telecommunications Endowment 47. The accelerationof productivitygrowth in developed countries has beenwidely attributed to the rapid increasein investmentin informationand communicationtechnology. This growth acceleration is to a large extent due to improved productivity growth inthe ICT-producing sector, as well as an increasingly productive use o f ICT goods and services elsewhere inthe economy65.ICT adoption in Costa Rica is essential inorder to implement strategies to obtain higher sustainable rates of growth and competitiveness inthe future. 48. The state-owned electricityinstitute(ICE) currently providesboth telecommunications and electricityserviceswithin Costa Rica on an almost exclusive basis, as only niche segments of the market are open to private participationand competition. Thejoint provision oftelecommunications and electricity services challenges the future liberalization of the telecommunications sector, and therefore innovative solutions are neededto builda competitive framework. The public monopolistic nature of this market structure is uniquewithin the region (see diagram below). 49. On a global scale, the telecommunications sector in Costa Rica still faces great development challengeswhen comparedto regionalcounterpartsas well as to OECD countries.According to the World Economic Forum (WEF), on the Network ReadinessIndex66which measuresthe relative level of ICT development in 104 nations across the World, Costa Rica was ranked 61 in2004, significantly down from 49 in 2003. Brazil, for example was ranked 46 (vs. .39 in2003); and Chile 35 (vs. 32 in2003). Singapore and the US are ranked among the first five. 50. When assessing Costa Rica's success in deployingfixed telephone service, as measured by number of main lines per 100 inhabitants,the performanceof the country is above its regional counterparts. Costa Rica outperform countries such as Mexico, El Salvador, and Chile inthis area and 65Van Ark et. al. (2002). 66Network Readiness Index:The first pillar capturesaspects ofthe environment o f agivennationfor ICT development, suchas the regulatoryregimeandthe legalframework for ICT, the available infrastructure, and other factors capturingelements o f the market for technologicaldevelopment. The secondpillar looks at actual levels of networkedreadinessofthe three mainstakeholdersinthe economy: individuals, businesses, andgovernments. Finally, the actual levels ofusage of ICT by these three groups are also broughtinas athirdpillar. 51 is even comparablein performanceto countries such as Ireland,the U S andthe UK, when adjustingfor their higher per capita income, as shown inFigure3.15 (measuredbythe trendline). Figure 3.15: Main Lines and GDP per Capita y =0.001x'~0'~6 Rz=0.8021 SA IRE rrt 10000 100000 I z -1 0 LNGDPperCapita PPP ~~ Source: ITU,World Bank Indicatorsfrom DevelopmentData Platformdatabase. 5 1. However,CostaRica's overalldevelopmentof its telecommunications infrastructurehas not beenas successfulas some of its regional counterparts and OECDcountries (Figure 3.16). While ICE hasfocusedon the developmentof mainlines, havingreachedan official teledensity of 31.6 mainlines per 100 inhabitants, other countries have focusedmostlyon cellular development, achieving highertotalteledensities. The figures belowillustratethis difference: Out of 20 comparator countries, CostaRicaranks 5' infixed line penetrationbut 17* inmobilepenetration(Figures 3.17 and3.18). 52 Figure 3.16: ComparativeDegreesof Telecom Reform in Latin America s -0 HGH 2e. E -.3 z%.s 3 Rhlicmxqxdyindl COSTARCA Figure 3.17: FixedPhone Linesper 100Inhabitants(2004) sIEhTi m m a w cb9aFacd !Atuzia olra BZ3l 4mra ale mMa, a Eshcrlr m paare [;bririonF$1 M a m FEnl N=w 10 23 30 40 ED m Source ITUfrom Development Data Platform Database& WClS Database. 53 Source: ITUl from DevelopmentData Platform Database & WClS Database. 52. The quality of the statisticalinformationon the sector is however notvery high,with a large number of inconsistencies. Almost every source consulted on basic telecommunications indicators for Costa Rica has shown different numbers, eventhough ICE has beenthe primary source for that information. For instance, various reports produced by ICE for different purposes quote the number o f fixed telephone lines for the year 2004 as either 941,254 or 1,343,193. This gap may be explained ifone considers that the lower figure quoted reflects the number of lines actually in operation, whereas the more generous figure reflects the capacity of lines available inthe switches. As can be seen from Figure3.19 below, the ratio of lines inoperation to installedcapacity has been dropping dramatically, mostly due to the fact that expansion ofthe line capacity of switches is done withvendor financing, which is a financial vehicle not available for investments in outside plant. Figure3.19: LinesinOperationvs. LinesInstalled 1,400 - 1,198 95% 90% 85% 80% 600 -- 75% 400 -- 70% 65% 60% 1992 1993 1994 1995 1996 1997 1B98 1999 2000 2001 2002 2003 I -Number of main lines (Thousand) +Lines operating I lines installed source: lnforme del Estado de la Nacion (2004). 53. Clearly, Costa Rica's performancein the cellular industryhas been poor comparedto countries with similar characteristics. By September 2005, inCosta Rica, there were only 26 cellular lines per 100 inhabitants, as compared to countries like Chile (70), Ireland (100), South Korea (78), and even Panama(49) or Dominican Republic (33). While this relative underperformance can be attributed in part to the highnumber of main lines inthe country, its main cause is more likely to bethe lack of 54 efficiency inallocatinginvestmentsby ICE, due inpartto cumbersomeproceduresrelatedto its statusas a government entity. 54. Accordingto the InvestmentClimate Survey demand for additionalconnectionsto fixed line telephony is strong, even among existing users. Almost one inthree of the companies participatinginthe ICs requestedconnectionto fixedtelephony services over the last two years. A breakdownofthese data showsthat the demandis higherinthe segment ofmediumand large companies, where one intwo companies requestedadditionalconnections (Figure3.20). Froman industrial perspective,the highestdemandappearsto be incompanies operatingwithin the chemicals, andpaper and publishingindustries. Figure3.20: Demand for New FixedLinesAmong ExistingUsers a. Demandby Company Size b. Demand by industry 60% 50% 50% 40% 30% 20% 10% 0% Micro Small Larger e L P #% 0 W Note: Demand for fixed lines represents the proportion of respondents that requested a new telephone connection over the last two years Source:World Bank InvestmentClimateSurvey (2005). 55. A simple regressionmodelwas also usedto compare Costa Rica's telecommunications infrastructureoutcomesto a sample includingall developingcountries, while accountingfor income differencesacross countries.68This modeltells uswhat levels of infrastructuredevelopment are "expected" for a country with CostaRica's per-capitaGDPa6' Table 3.4: PercentageDeviationsfrom ExpectedValues EndowmentofTelecommunicationsRelativeto Fixed Mobile Total Teledensity Teledensity Teledensity Percentage Deviation from 19.30% -60.80% -1I.80% Source:Author's own calculations. 67The ICs capturesinformationfrom companiesusingICT servicesas away to assess their relative importancefor the growth o f the privatesector. Full results ofthis regressionanalysis are providedinAppendix 1. 69This simple modeltakes into account only the effect ofper-capitaGDP on infkastructureoutcomes and shouldnot be viewedas inclusive of all variables affectinginfkastructuredevelopment. 55 56. Table 3.4 above reports percentage deviationbetweenobserved and predictedtelecom networkendowments. Thus, a positive value indicates that Costa Ricahas achieved coverage levels superior to those predicted by the model, while a negative value indicates the opposite. The results, graphed inFigure3.21 below, show the extent of CostaRica's fixed telecommunications network as well as its underperformance inmobile telephony giventhe income levels of the country. Note: A data point above the fitted line indicates an endowment above that expected by the model. A data point below the fitted line indicates an endowment below that expected by the model. Source:World DevelopmentIndicators. 57. In the expansion of access to informationtechnology, Costa Rica has experienced considerable success, particularly with fixed liner telephony, personalcomputer densityand internet usage. Costa Ricaboaststhe highestpersonal computer density-measured by the number of personal computers per 1,000 people-in its peer group. Similarly, Costa Rica ranks behindonly Chile in Internet usage, having overtaken Argentina in 2002. While these figures reflects Costa Rica's role as a technological leader inCentral America, they point to the needfor a different set of targets for the use of information technology. 3.3 The Quality and Efficiencyof Costa Rica's Infrastructure Services 58. When one drills down below the levelof infrastructureconnectivityor the supply of Costa Rica's infrastructure,concernsabout Costa Rica's future competitiveness and trade potentialarise. Indeed, the quality of Costa Rica's infrastructure in some areas is below regional standards-including less wealthy neighbors-while even its stronger performing sub-sectorsare beginningto see marks of decline. This deterioration has not gone unnoticedby investors and businesses. A recent survey o f major industrialists ranked Costa Rica below the regional average inport efficiency and overall transport infrastructure quality. The ICs reveals a higher level of concern among firms in Costa Ricawith regard to the quality of roads, electricity and telecommunications than other countries inLatin America. 59. Why do firms care so much about infrastructurequality and efficiency?The product cost analysis conducted with data from the Logistics Survey of three core export groups-processed foods; flowers and plants; and medical equipment-show the importance ofinfrastructure inthe cost structure of Costa Rica's export products (Table 3S). Whentranspodlogistics, energy and telecommunications are combined, they represent between 17 and 36 percent of the total cost of production and delivery (excluding raw material inputswhich contain, in and of themselves, even higher component contributions of infrastructure inputs). For the higher value-added products-processed foods and medical supplies- this represents the primary cost components. For plantsand flowers, only labor is a more significant cost contributor to the final cost of the goods. 56 Sector Processed Plants & Medical Foods Flowers Supplies Total Infrastructure 36% 35% Labor 27% 63% 35% Capital 15% 8% 12% Financial 10% 7% 9% Others 12% 5% 9% 60. Within infrastructure,the relativeimportanceof transportversus energy versus telecommunications will depend uponthe natureof the productionprocessand the value-added elements of the product beingconsidered. For low value goods shippedinbulk-such as, cement, iron ore, edible oils or grain products-transport costs are always a large portion of deliveredcosts. For processedbulk products such as fertilizers, energy may also be a large component. For information technology (as well, of course, for service firms), telecommunications costs may be a more significant part of the cost structure. And although it is not analyzed here, water is a primary cost component for such industries as breweries, distilleries and chemical producers. 61. Table 3.6 shows the cost breakdownby sector of infrastructure for the three sectors analyzedin the Logistics Survey. This breakdown illustrates the importance ofthe three sectors, particularly transport and logistics, inthe cost structure of firms and the competitiveness of their outputs. Table3.6: InfrastructureContributionsto Cost by Sector and Export Product Sector Processed Plants & Medical Foods Flowers Supplies Transport & Logistics 24% 13% 22% Electricity,gas, and other energy sources I 9% 3% 7% Telecommunications 1% 6% I Note: This breakdownillustratesthe importanceof the three sectors,I particularly transport and logistics,in the cost structure of firms and the competitivenessof their outputs. Reducing infrastructure-related costs by ten percent would provide. Source: Author's calculation based on ICA survey. Quality of the TransportNetwork 62. Despitepossessing a larger endowment of roads perworker than its peers as well as the busiest port in Central America (excludingPanami), Costa Rica ranked poorly in most categories of transport infrastructurein the survey of businessexecutivescontainedinthe World Economic Forum's GlobalCompetitivenessReport 2004-2005. Inports, Costa Ricawas tied with Guatemala for the lowest rankingin its peer group (Table 3.7). Air transport was the only category inwhich Costa Rica's score exceededthe peer group average. 57 Table 3.7: ComparativeSurvey on the Qualitv of Transport Infrastruc ire Overall Pori Comparator infrastructure infrastructure Air transport quality quality infrastructure quality Argentina 3.6 3.6 4.1 Brazil 3.5 3.1 5.1 Chile 4.9 4.8 5.7 Colombia 2.9 3 4.4 Costa Rica 3 2.5 4.8 El Salvador 4.4 3.3 5.6 Guatemala 2.7 2.5 3.5 Honduras 3 3.8 3.3 Mbxico 3.4 3.3 5 Panama 4 5.7 5.2 Indonesia 4.2 4.4 4.4 Philippines 2.5 2.6 3.9 Thailand 4.6 4.2 5.3 Average 3.6 3.6 4.6 INotes: Survey based subjective evaluation on scale from 1 "poorly developed and inefficient"to 7 "amongthe best in the world." Source:World Economic Forum (2005). 63. The impact of poor transport quality and securityon firm competitivenessis multi-tiered; it impactsthe cost of productionand shipment as we haveseen above. Inaddition to these direct costs, delays, breakage and theft total cost Costa Rica's exporting firms an average of 12 percent oftheir sale value. This explains the disproportionately highshare of logistics costs associatedwith deliveredprice of Costa Rica's exports. 64. According to the Logistics Survey, logistics services (transportation,warehousingand procedures to comply with regulations)representas muchas 35 percentof the total delivered costs of the three export productsanalyzed. When raw materials are included as a single cost input, transportation and logistics alone represent 15 percent of the product. This figure is significantly higher than in Costa Rica's industrializedcompetitors where the average percentageof logistics costs for all goods rarely surpasses 10 percent. Moreover, the costs for logistics services inCosta Rica appear to be rising, having increasedby 1.2 percentjust between 2002 and 2004. The primary cause o fthat increase is shippingtransportation costs (2 percent) while other stages ofthe supply chain and production process have seen a decrease, particularly financial costs which have decreasedby 0.7 percent). 65. The Logistics Survey revealedthat, on average,transportation system delays representan 8 percent loss in total sales for the three products analyzed. These costs compound from: demurrage fees paid to carriers who must wait for the cargo to arrive; additional storage and warehousing fees; and 0 lost sales from inability to meet a customer's schedule. 66. The diagram below (Figure 3.22) shows these losses for each productfor bothinputsand finished products. 58 Figure3.22: CostsCausedby TransportationDelays (YOofTotalSales) I ~ 5.6% 5% 4.6% 4% 3% 2% 1% 0% Processed Food Flowers & Plants Medical Equip't All Products Source: CEM/ICA LogisticsSurvey. 67. In additionto the calculablecosts of delay described above, firms must plan for higher inventoriesand incur the capitalcosts associatedwith that lost productivity. Still, the poor quality of transport infrastructure affects firms' competitiveness beyondthe direct and indirect cost of delays. Goods are often damaged and congestion leadsto greater opportunities for theft. These problems are commonplace in Costa Rica. 68. The ICs found that damage and theft in transit alone cost Costa Rican exportersover 4 percentof their total sales. For those exporters that reported breakageor theft-22 percent and 12 percent of firms, respectively-losses rose to over 8 percent of sale value (Figure 3.23). The impact was felt greatest for exporting firms, suggesting that port-related activities are a primary area of concern for transport quality as well as the concerns about the quality ofthe road network that impact all shippers. Figure3.23: Impact of Breakageand Theft inTransit on CostaRicanFirms 6 5 - 4 i 3 a 2 1 0 Percent of cargo value Percentof cargo value lostto breakage or lost to breakage or Percentof f i r m that Percentof f i r m that theft (average for all theft (average for ship domesticallyand export and report exportingfirm) exportingfirms that report breakage or breakageor theft of experienced breakage theft of cargo cargo or theft) Source: World Bank InvestmentClimate Survey (2005). Quality of Port Services 69. Port inefficiencyand lack of capacityis one of the main competitivedisadvantages for Costa Rican exporters. For instance, the Port of Caldera was designedto move a maximum o f 600,000 metric tons annually. That amount was surpassedin 1988 and, for 2003, the saturation level (throughput of 59 cargo/maximumtolerated cargo rate) was close to 300 percent. Additionally, important bottlenecks are causedby redtape and logistics inthe operation of businesses depending on imported materials. Bontempo, Chavez and Rivera estimated in 1996that in the case of a company which imported grain through Puerto Caldera it could see an increaseinthe CIF price, of at least 6 percentjust because of warehousing expenses. Although there are no updated studies, it is more than likelythat the situation has not changed significantly. 70. At first glance, the Port of Limonappears to enjoy a cost advantage over other ports inthe region. According to a 2004 study by Kentand Fox, chargesper vessel and per container are lower at Port of Limon than at Colombia's Port of Cartagena(Figure3.24). This comparison seems impressive given that Cartagenahas been operated under a concession contract since 1993, operates ina highly competitive environment and is widely considered to be an efficient port. Figure 3.24: Charges at Port of Limon Versus Port of Cartagena a, Total Charges- b. Average Costs-per Container or TEU $60000 $50 000 > Caiagena $150 1 nCartagent 540 000 la Limon $30 000 $100 ;I Limon $20 000 $10 000 $50 so Total Cost Charges to Charges to Cargo SO Vessel i Ag Cost perContainer Ag.Cost perTEU Source: Kent and Fox (2004). 71. However,any cost savings from lowerport chargesis morethan offset by higheroperating and inventoryexpenses due to inefficiencyat Limon. Crane productivity is significantly lower at Limon (38 moves per ship-hour) than at Cartagena(52 moves per ship-hour). Moreover, waiting times to dock are 12 hours longer at Limon than at Cartagenaand waiting times at the berthare 1.5 hours longer. These waiting times result in additional expenses associatedwith idling ships, as well as higher inventory expenses. After taking these expenses into account, Kent and Fox estimate that the total cost per container for a call at Port of Limon exceedsthe cost at Port o f Cartagenaby $171-89(Figure 3.25). Figure 3.25: Total $393.89 Limon Cartagena I Source:Kent8. Fox (2004). 60 Road Quality 72. While CostaRica ranks first in its peer group in paved road density per worker, independent studies of the quality of its roadways have found that large percentages of the system are inpoor condition. A 2004 study conducted by the NationalLaboratory of Materials and Structural Models at the Universityof Costa Rica (LANAMME-UCR) found that only 32 percent of Costa Rica's paved roadswere of "good" quality. A 2002 study by the National RoadAdvisory (CONAVI) rated 24 percent of Costa Rica's paved roads as being in"good" condition. Moreover, while most countries report only the lengthof highways intheir paved road statistics, Costa Rica also reports urban roads, which leads to an overstatement of its paved road density relative to other countries. 73. Although the impact of the large endowment of transport infrastructure has historically supported CostaRica's trade and growth, deterioration inthe road network's quality and the ports' efficiencyare beginningto hinder firm competitiveness. Incomparison to InvestmentClimate Surveys conducted throughout the region, a disproportionately large share of Costa Rica's firms view transport as a constraint to doing business. The Logistics Survey of three key export sectors confirmed that roads quality appears in 80 percent of responsesas one of the three biggest impediments affecting businesses. Moreover, 40 percent of firms surveyed for the ICs inCosta Rica found that Road Quality was a major or very severe constraint to their businessenvironment. By comparison, only 7 percent found trade regulations to be a constraint. 74. Despiteusers' consensus about the low quality of roadsinfrastructure inCosta Rica, there i s some disagreementamong entities in chargeof the sector about exactly how poor the roadsare. The proportionofthe network found ingood conditionrange from 24 percent to 52 percent depending on the source. In2002, an assessmentofthe state o fthe nationalpaved network was performed, for the first time, by the National Laboratory of Structural Materials and Models (LANAMME Laboratorio - Nacional de Materiales y Modelos Estructurales) of the Universityof Costa Rica: 24 percent were in good condition, 38 percent were inaverage condition and 38 percent were inpoor condition (Table 3.8). These results contrast with the official assessment from the Ministryof Transportation, which concluded that 52 percent was in good condition. This significant difference has led to broad discussions among the institutions and the Comptroller's Office. Table 3.8: Quality of the National Road Network Condition CONAVI-MOPT (2002) LANAMME-UCR (2004) 1 52% 32% I Good Fair 27% 34% Poor 21% 34% Source: CONAVI-MOPT (2002) and LANAMME-UCR(2004). 75. However the institutions rate the over-all quality of the network, drivers on the highways of Costa Ricawidely recognizethat the country's main corridors offer insufficient capacity for the level of demand and are poorly maintained. This explains the World Economic Forum's relative ranking. The poor quality of roads disproportionately impacts smaller companies that dependonthem for a larger share of exports, as seen inthe section above on infrastructure endowment (Figure 3.26). 61 .................................................................. ....................... ........................................... .., ______--___- Figure 3.27: Generaf Ca6as ~ ~ Links~ San Josedwith Juan ~ ~ a~ ~~ Airport t ~ ~ ~ ~ i a I966 2005 is found in the ce ion, which producesclose to si. 62 7%. After ~ ~ ~ n s p o ~costs, customs is the second largest barrier to trade ~ d e n in the ~ e ~ a t ~ o n ~ ~ ICs, Costa Iiica ~~erfarmsworse than the rest of Ceritral America inexportscustoms clearanceand aboirt awrage far Latin A m ~ r i sunreyedfirms in import customs ~ F ~3.29). ~ a ~ ~ ~ Stitl,ethe 6 day r delaj for import c ~ s ~ ~ ~ ~ c~is very~~high~hrsnthe. types of firms that Costa Rica wishes to attract in ~~ ~ u i n ~ e ~ ~Costa~Kica's~ s t ~ e n ~ ~ ~ ~ ~ ~ s ~ ~ c ~ ~ ~ o ~ ~ . 79. To the degree that cost is a reflection of efficiency, the low cast of air freight far ~ a r ~ e ~ t exports to the Cnited States supportsCosta Eiica's a ~ a ~ ~ e - a ranking~ineair transport. Air ~ ~ r a frciglit chargcs torsti 4.7 perccnt of the free on boardIFOE3) value of ~ a r mcxports thip^^^ by air to the ~ ~ ~ United Status from Costa Rica (Table 3,t3), This ctiarge is lower for Costa Rica than any of its pccr countries, with the e ~ ~ ~of~~ t o~ lo on ~ ~ ~ ~ . Table 3.9: Average charge (% FOB) Colombia 4.3 Costa Rica 4.7 Mexico 5.6 El Salvador 5.9 Honduras a QualityofElectricityServices 80. There are manyways of consideringservicequalityfor electricity. Someindicatorsof quality reflectefficiency-such as distributionlosses or lines per employee. These do not affect users directly although they may serve as indications of commercial success among providers. Other indicators-frequency of outages, duration o f outages, waiting periods for connections-are directly felt by consumers. Inthe primary commercial indicators of quality--distribution losses--Costa Rica performs well. It is the indicators ofquality that affect consumers-particularly small firms-that show weaknesses. 81. CostaRicandistributionutilitiessuffer linelosses significantly below those in neighboring countries. Line losses inCosta Rica stood at 9.7 percent of output in2003 (Table 3-10), the lowest in Central America and similar to competitor countries inother regions (Figure 3.30). Figure 3.30: Transmission and Distribution Losses Selected Countries, 2003 15 - 10 - 5 - I 0 - Thailand China Costa Pica Indonesia milippines Latin Amrica Source:World Bank (2005a) and ECLAC. 64 ution, 2003 Countv Distribution losses, 2003 (% of total output) El Salvador Guatemala Honduras 21.9 Nicaragua 32.5 Panama 19.4 Average (9 countries) 20.8 Costa Rica 9.7 Source:ECLAC in Energy Sector Report. 82. However, the ICs data suggest that while CostaRica's losses are relatively low, other indicators of service quality-waiting periods for new connections, frequency and duration of outages, and business losses due to outages-are below those of its regional peers. This is particularlytroublesome becauseof CostaRica's interest indevelopinghigh-techindustries for which highlyreliableelectricityis essential. 83. The data also suggest that the impact of service quality varieswidely within the country. Small companiesand companies in San Jose are those most affectedby longwaitingperiodsfor new connections. Companiesin SanJose andregions otherthan Alajuelaare the most affectedby outages. Micro enterprisesand companies in chemicals, metalproducts, andpaper andpublishingindustries have the highestfinancial losses dueto outages. 84. Intariffs, CostaRican consumers enjoy one of thelowest ratesinthe LatinAmerican region, while industrial and commercial users paytariffs similar to the average (Figure 3.31). 65 Figure 3.31: Electricity Tariffs in Selected Latin American Countries, 2003 a. Electricity ResidentialTariffs b. Electricity Industrial Tariffs Argentina Bolivia Brazil Chile Colombia Costa R i a DominicanRep. Ecuador ElSalvador Guatemala Honduras Source:OIADE. 85. The current tariff structureis the resultof a gradual reductionof cross-subsidiesfrom industrialand commercialusersto residentialones.The residentialtariffs increased, inrealterms, 18 percent between 1998 and 2004; while the industrial and commercial ones declined by 14 percent and 10 percent, respe~tively.~~ The weightedaverage realtariff remained unchanged at US$ 7.4 per kWh between 1998 and 2004. Despite these adjustments, the tariff structure still appears to contain important cross-subsidies. The ratios of industrial and commercial to residential tariffs inCosta Rica were 96 percent and 139percent respectively in2004. Those ratios are among the highest ones inthe selected sample o f Latin American countries (Figure3.32), which tend to rely significantly inthis type o f cross- subsidies. Inhighincome countries, where those cross-subsidies tendto be lower, the ratio of industrialto residentialtariffs varied from 30 percent inDenmark, France, and Germany to 70 percent in Czech - Republic, Italy, and Taiwan. Figure 3.32: Electric y CommercialTariffs Selected Latin American Countries, 2003 Argentina Bolivia Brazil Chlie Colombia Costa Rica - DominicanRep. Ecuador L ElSalvador Guatemala Honduras Mexico Nicaragua Panama Trinidadand Tobago m UNguay 0 3 6 8 12 15 18 'OAuthor's estimates based onthe averagetariff pertype of userreportedby ARESEP. 66 86. Accordingto the recentInvestmentClimate Survey (ICs), companies in Costa Rica reportedan average waiting period of 60 days for a new electricityconnection,which is one of the highest in Central America (Figure3.33). This problem appearsto bemore acute for small companies and for companies in SanJose (Figure3.34). Incontrast, Alajuelaprovinceseemsto bethe better served areawith shorter waitingperiods. This maybethe subtle influenceof "yardstick competition"-the ability of consumers, advocates andprovidersto comparethe performanceoftwo distributioncompanies. Unlikeother areas ofthe countrywhich are servedby one provider,this provinceis servedbytwo, ICE and Coopelesca. Figure3.33: Waiting Periods for New ElectricityConnection(Days) I I 85 60 33 16 17 18 I Source:World Bank InvestmentClimate Survey (2005). Figure3.34: Waiting Periods by Company Size and Location I I Micro Small Large San Jose Alajuela Other 87. Poweroutages in Costa Rica also appear to be more frequent than in other LatinAmerican countries (Figure 3.35). The ICs reportedthat as muchas 84 percent of surveyedcompanies experienced at least one outage in 2004, which is slightlyhigherthanthe Central Americanaverage (8 1percent). Surveyedcompanies also reportedexperiencing, on average, 20 power outages in2004, the thirdhighest number amongthe LatinAmericancountries with ICs. The incidenceofpower outages varies within the country with Alajuela beingthe less affectedprovince(Figure3.36). 67 50 29 xi 40 + "30 " 1 0 0 5 Q u m World Bank InvestmentCltrnataSunray 12005) I Figure 3.38: Losses Due to Power Outages (% of Annual Sales) a. Company Size b. Sector 3.0 4.5 4.0 2.5 2.6 3.1 3.4 1.7 '" 2.2 Micro srrd Large beverages products nnnufact products FIlbleh Source:World Bank Investment Climate Survey (2005). 90. The quality of public electricitysupply is particularly importantfor CostaRica's competitiveness becausemostcompaniesrelyon public supply to meet their demands. According to ICs, only 11percent o f Costa Rican companies surveyed own generation facilities, a ratio that is among the lowest in Latin America (Figure 3.39). The reliance on public supply i s higher in San Jose than in Heredia and Cartago, suggestingthan the quality o f electricity services may be lower inthese cities. Figure 3.39: Companies that Own Generatorsin Costa Rica (YO) a. Country b. Region Source:World Bank Investment Climate Survey (2005). 91. Medium and largefirms, however,appear to use alternative sourcesof supply: more than 28 percent of surveyed companieshavetheir own generators. Even more, 20 percent of large companies surveyed indicated that their generators were their primary source o f electricity, and notjust a backup. Given the high electrification rate in Costa Rica, the reliance on own generations appears to be a reflection of an inadequate service quality rather than an access problems as with most o f the Latin America region's businesses. 92. A minor share of small and microfirms own generators.This appears to reflect the higher costs of generation equipment for those firms rather than better service quality (Figure 3.40). Surveyed small companies reported that generation equipment represented 8.3 percent of their annual sales while it only represented 2.3 percent for medium and large firms. 69 Figure3.40: Companiesthat OwnGeneratorsby Size (YO) 30 28.7 25 - 20 - 15 - 10 - -m E v) I Source:World Bank Investment Climate Survey (2005). 93. Companiesintechnology-relatedindustries(chemicals and electronic equipment) appear to be the ones relyingless on publicsupply. Inthese industries, more than 20 percent o f surveyed companies own electricity generators, a percentage that is twice the average inother industries. The high share o f self-generation inthese industries, however, is common as chemical production offers co- generation opportunities and electronics require high levels o f service cooperation. 94. The ICs's data are basedon companies' experienceand are difficultto comparewith officialstatistics. Inaddition, there is little official data on service quality and the few available statistics show mixedresults. Some quality indicators improve significantly. The frequency o f interruptions (FPI) and average duration o f interruptions (DRIP) declined by more than 50 percent and 20 percent, respectively between 2001 and 2004.'' Other indicators, however, deteriorated substantially. For instance, average duration o f outages to clients increasedmore than 60 percent inthat period. 95. ICE appears to acknowledgethe quality problemsand is focusing on improvingit albeit on a selectivebasis. ICE offers agreements to businesses inwhich the quantity and quality o f electricity supply are clearly indicated. Ifthose agreements stipulate new investments such as additional transport capacity, the benefited company finances those investments and ICE repays them through lower tariffs duringan agreed period. The first agreement o fthis type was signed with U S Intel in 1998.These agreements are now becoming more popular, reflectingthe growing concerns onthe reliability o f electricity supply. ICE signed 45 new agreements inDecember 2005.72However, these agreements have a limited capacity to address the supply problems o f business clients. At best they could work for large companies connecting to very highvoltage networks, or companies which can have multiple connection points for their site such as airports and large industrial parks, or companies whose problems are inthe direct connection assets. Those agreements may not be solution for sites with single connections to the electricity network. Quality of Telecommunications Services 96. The quality of telecommunications servicesinCostaRicaappearsto be below expectations for a sectorwhich has so successfully builtout its mainlineservices. According to ITUdata, there are 7'ICE'SRelevantdata Electricity Sector December2004. 72Oviedo (2005). 70 closeto 65 faults per 100 lines per annum, 79 percentfaults clearedwithin 24 hours (vs. 98 percentin Korea), a 4 monthwaiting time for the installation of a fixed line and awidening gap betweenthe number of lines installed inthe switches andthose actually inoperation. 97. Surveyed companies inthe InvestmentClimate Survey reportedwaitingperiods of 168 days (over 5 months) on average for a newtelephoneconnection.Moreover,thisproblemappearsto be more acute for micro-enterprises,which reportedlyhave to wait almost oneyear for a new telephone line. Figure 3-41is 2.5 times higherthan that reportedby larger companies, suggestinga differentiated treatment of customers.On a regionalbasis, the provision ofthis service also differs, with companies in the area of San Jose waiting 6.5 monthson average, while customers inAlajuela experiencea waiting period of less than five monthson average. Figure 3.41: Waiting Periods by Size of Company and in Different Regions, in days 347 Micro Small Larger San Jose Otherrgn. Alajuela 98. The reliabilityof the telephonyservice in CostaRicacompares unfavorablyto that of regionalpeers. CostaRicancompanies surveyedreportedly experiencedmorethan four interruptionsin the service duringthe previousyear, each one ofthem lasting morethan 16hourson average.This translatesinto an aggregatedperiod oftelephone shortage of 71hours per year73.Incomparison, telephone companies inother CentralAmerican countries suchas Honduras, Guatemalaand El Salvador appear to provide a muchmorereliable serviceto customers (Figure 3.42). 73Telephony shortagesamounting71 hoursper year implythat the service is available99.19percento fthe time. The importance of this figure stems from the fact that, in Service Level Agreements, international high tech companies commonly request availability o f service on 99.999percentofthetime (Le. telephonecuts for duringless than 1hourper year). 71 Figure3.42: InterruptioninTelephone Service (Hours Per Year)'4 El Salvador Guatemala Brazil Honduras 56.0 Nicaragua 79.5 Ecuador I 203.0 99. Consideringthe frequencyand duration of interruptions, the Internet appears to be the most reliableservice in Costa Rica (Figure 3.43). Costa Rican cell phone users reportedly experienced more than 12 interruptions in service last year, slightly above the number o f interruptions inInternet service in the same period. Figures 3.46 show a significant difference inthe reliability o f these services as compared to that o f fixed-line phones (with four interruptions inthe service on average). However, the duration o f the service breakdowns in fixed-line telephony was the highest, at more than 16 hours per event (three times higher than interruptions inInternet service, and almost 30 percent higher than interruptions inmobile phone service). Considering both the frequency and duration of the interruptions, cellular telephony appeared to be the less reliable service, with almost 150hours o f disruption inthe service in 200475,while internet was unavailable during53 hours duringthe same period. Figure3.43: Reliability ofthe Supply of TelecommunicationsServices I 14 Interruptions in 12 52 7 %NlW 10 (Hours per year) 8 6 4 2 0 Cell phone Internet Fixed line 149 1 cp3Frequency (Intemptions per year) +Duration (hours) Source.World Bank InvestmentClimateSurvey (2005) 100. The quality of fixed-linetelephony service is variable across different regionsof the country. Interms o f reliability o fthis service, companies based inAlajuela reportedly experience twice as many interruptions as those operating inother regions. However, the duration o f each interruption in Alajuela is significantly shorter than that in San Jose and other regions (Figure 3.44). The difference in frequency o f service interruptions may point out different degrees o f deterioration o f existing infrastructure across regions, while the uneven duration o f interruptions appear to suggest different levels o f efficiency inrestoration processes among local teams. 74Aggregate interruptiontime per year is calculated by multiplying the average number of interruptionsreportedly suffered by surveyedcompanies times the average durationof interruptions. 75Calculatedas the average number of interruptionsin service per year multipliedtimes the average durationof each event. 72 San Jose Afajjueki Other rs acro$s regions, while the aics suffer losses 831'10 to 2*6percent of total f ix s in e is La t l co OSSCS d 73 -- reported by companies based in other CentralAmerican countries such as Guatemala and El Salvador. This estimation of losses is fairly consistent with the figures reported interms o fthe frequency and duration o f interruptions in the service ineach one o fthese countries. ountries El Salwdor 1 0 . 3 Guatemala 2.0 Costa Rica P///////A 2.6 Brazil 3.0 Honduras 3.0 Nicaragua 7.0 Ecuador 11.0 104. CostaRicancompaniesreportedcombinedlossesabove 5 percent of totalyearly sales due to faults intelecommunicationsservices.According to the ICs, the combined losses stemmingfrom interruptions in the provision o f telecommunications services (including Internet, fixed line and cellular telephony) represented 5.2 percent o ftheir total yearly sales on average. Moreover, service interruptions appeared to have different degrees o f impact on companies, based on their underlying characteristics such as size and industry(Figure 3.47). Indeed, the negative impact of interruptions infixed line telephony appears to decrease with the size o fthe companies, with losses for micro firms averaging 4.6 percent o f yearly sales, almost three times the level o f relative losses suffered by larger firms (1.6 percent of sales on average). As opposed to this, interruptions in internet service appear to affect most significantly the segment o f larger firms, which reportedly experienced losses o f 2.1 percent o fyearly sales on average. Figure 3.47: Losses Due to Telecom Service Interruptions by Size of ?irms Losses caused by intemptions in different serices 5.8 (% of yearly sales) 5.8 Micro Small Larger Total Losses Fixed line oCell phone ta Internet Source:World Bank Investment Climate Survey (2005). Telecommunication Prices 105. Prices are one criticalindicatorof successfultelecommunications and ICT policies.As shown in Table 3.11, when comparing Costa Rica with the rest o f CentralAmerica in local and long distance prices, Costa Rica shows the lowest rates except for international long distance. A local basket price for Costa Rica represents around US$12 for commercial and around US$8 for residential users. These prices are much lower than the rest of Central America where Guatemala has a price basket o f 74 US$28 and US$16 for commercial and residential users respectively, and El Salvador US$35 and US$22 for the same categories. Table 3.11: Pricesfor Residentialand BusinessTelephone (US%) Local Long Distance Residential Commercial International National (600) min. (1000) min. (per min.) (per min.) 2003 2003 to the US) 2005 Guatemala 16.71 28.03 0.25 0.04 El Salvador 22.58 35.28 0.22 0.03 Honduras 10.51 23.72 0.84 0.09 Mexico n/a n/a 0.28 0.047 Nicaragua 16.84 41.83 0.35* 0.08 Costa Rica 8.22 12.50 0.27 0.01 Note:Total Basket = (installation cost/l20) (monthlyrate) * (charge plmin call) estimated Source: RegulatoryAgencies 106. The relatively low prices in localand nationallong-distancecalls for CostaRicacan be associatedwith a cross-subsidy scheme.One o fthe key challenges for ICE as it strives to compete in a liberalized sector inthe future will be to eliminate cross subsidies intheir pricing scheme. Inthe medium to long term, users should not feel a negative impact as a result o f the gradual elimination o f cross- subsidies. There i s likely to be an increase inthe use of international service on the part of firms which will lead to an overall decrease inprices. Inaddition, a universalservice mechanism directed towards users o f lower income can help to achieve the same goals as the cross-subsidy scheme with greater allocative efficiency. 107. Becauseofthe liberalizedsector in Guatemalaand ElSalvador, internationallong distance rates are lowerthan in CostaRica. Guatemala's international long distance rate representedby a one minute call to the US is US$0.25, and inEl Salvador it can be as low as US$0.22, which i s lower than Costa Rica's US$0.27 rate. Honduras and Nicaragua are inthe process of liberalizing their long distance telecommunications sector. Nicaragua in2005 showed a long distance rate o f around US$0.35 for a one- minute call to the US, much lower than the US$O.80 prevalent in 2003 prior to the liberalization o f the market. 108. Overallprices of telecommunicationservicesin CostaRicaare competitive in the context of LatinAmerica.The ICs survey provides an additionalperspective onthis issue, by collecting information on how significant i s the cost o f these services for different segments o f companies. As expected, the relative impact o f these decreases with the size o f companies (Figure 3.48). However it is noteworthy that the impact o fthese costs is several times higher for small andmicro companies (more than 2 percent o fyearly sales) than it i s for the segment o f larger firms (less than 0.5 percent). A similar discrepancy is observed on an industrybasis, with companies operating inNon-metallic Minerals, Equipment Manufacturing and Paper and Publishing spending more than 3 percent o f yearly sales on telecommunication services, while firms in other industries spend less than one third o f that proportion. It i s also noteworthy that most o f the industries that reported the highest average costs, also suffered the highest losses due to service failures. 77 Calculatedas the cost of telecommunications as apercentage of yearly sales. 75 Figure 3.48: Relative Cost of TelecommunicationServices (YOof yearly sales) 1 Cost of telecommunications (% of yearly sales) Cost of telecommunications Food 0.3 (%of yearly sales) Chemicals Textiles Other manu(. 1.1 Minerals Micro Equipmenl Paper 8 Publish 3 6 'ource:World Bank InvestmentClimate Survey (2005). Broader ICT Sector ICT indicators - 109. Eventhough the levelsofInternet and PC penetrationin Costa Ricaare relativelyhigh comparedto similar countries in the region, CostaRicahasvery low levelsof broadband penetration.These low levels o f broadband penetrationrepresenta major challenge for the country's competitiveness. Costa Rica has shown a satisfactory performance in Internet penetration (23 percent) compared to its regional counterparts with penetration that i s almost as high Chile (27 percent), and significantly higher than countries such as Mexico (13 percent) or Brazil (12 percent). But still countries such as S. Korea or Estonia have increased their number o f Internet users to well over 50 per 100 inhabitants (Figure 3-49). Figure 3.49: Internet Subscribersand GDP per Capita PPP,2004 1000 y = 0.0001x' 255' R2= 0.7495 .-Q 1 100 c .- 0 2 l o k3 n * 62 1 - * * 1 0 10,000 100,00( 0 E 1 H f 0.1 0.01 LNGDP per capita PPP (constant 2000,$) Source: ITU database, DDP World Bank Indicators. 76 110. The Government hasbeen keen on implementingpolicies to promotethe use of PCs. These policies have been effective and show how Costa Rica i s evidencinga significant lead inthe number of PCs per 100 inhabitants as compared to its regional counterparts. However countries like S. Korea or Ireland have a stronger penetration among their citizens with more than 50 PCsper 100 inhabitants. 111. Despitethe positive resultsinInternet and PC penetration,CostaRicafaces a major challengein developingits broadbandinfrastructure.In2003, there were only 9 broadband subscribers for every 100,000 Costa Ricans (Table 3-12), This i s an extremely low level of broadband penetration, compared to countries such as Chile (22 per 1000 inhabitants); Lithuania (13.7 per 1000 inhabitants); or South Korea, with an impressive rate of 233 subscribers per 1000inhabitants. Latin American countries like Argentina, Brazil, and Mexico, or even Nicaragua, have substantially higher levels of broadband penetration. This is a clear example of the risk Costa Rica faces of staying behind due to the fast pace oftechnological innovation, which a public sector institution is incapable of keeping upwith. The main cause ofthe delay indeploying a modembroadband infrastructure, which ICE planned as early as the year 2000, has beenthe long and cumbersome procurement processes imposed on it.Ithastaken ICE more than 2 years to select the vendor to supply the first batchofthe necessaryADSL cards to be installed inthe switches for the provision of broadband services. 77 Table 3.12: ICT Penetration(2004) Broadband Internet usersper subscribersper PCs per 700 700 inhabitants 7000inhabitants, inhabitants (2003) 4rgentina 13 3 a Brazil 12 4.1 11 Chile 27 22.1 14 China 7 8.2 4 Costa Rica 24 0.1 24 Dominican Rep. 5 0.7 5 El Salvador 9 4 Guatemala NA 2 3 NA 2 27 7.6 Israel 97.2 73 Lithuania 13.7 15 4.4 20 Mexico 13 1.7 11 Nicaragua 2 0.4 4 Panama 9 NA Peru 12 3 10 S. Korea 66 233.3 55 ioum:Basedon datafromWDI and ITU(2004). 112. CostaRicanSMEs confrontan importantchallengeinthe face of globalizationand the growth of knowledge-based economies.The adoption ofPCsandInternetapplicationsby these enterprisesis relativelylow, andthere is a digital divide among SMEs within the country, as well as betweenCostaRicanbusinessesandthose incountrieswith whichthe CostaRicanbusinessesare competing inthe internationalmarket, suchas those inCanadaandChile(Monge-Gonzalez andMonge- Arifio 2005). 113. Although the levelsof Internet penetrationinCostaRicaare relativelyhighcomparedto its regionalcounterparts, only 40 percent ofthe small and mediumenterprises (SMEs) in CostaRica have Internetaccess andjust 9 percent own aweb page(Figure3.50). 78 Figure3.50: ICTsin SMEs, Benchmarking 90% 80% 70% 60% 50% 40% 30% 30% 20% 10% 0Yo Canada Uunited Chile Costa Rica El Salvador Ouaternala Honduras Nicaragua States Source: Monge-GonzAlez et al. (2005b) 114. According to Monge-Gonzalez and Monge-Ariiio (2005), there are three main reasons mentioned by CostaRicanSMEs for not makinguseofICTs: (i) beliefthat these tools are not the necessary for their productive activities; (ii) the belief that their installation and maintenance are very expensive; and (iii) lack o f knowledge about how to use these technologies. 115. Consequently, the use of Internet contents(for B2B,B2C, B2G and electronic banking)in Costa Rica can be summarized as follows: Internet-based transactions with financial intermediaries (e-banking) is still incipient inCosta Rica - the percentage o f SMEs that report usinge-banking is still very low (about 25 percent). E-commerce between enterprises (B2B) i s still uncommon inCosta Rica- the percentage o f SMEs that order from their providers through the Internet is only 13 percent. Inaddition, the percentage o f SMEs that make payments to their providers through the Internet is only 5 percent. E-commerce with individual clients (B2C) is approximately as common as B2B inCosta Rica- 13 percent o f Costa Rican SMEs receive orders from their clients through the Internet. Moreover, only 8 percent o f Costa Rican SMEs receive payments from clients through the Internet. With regard to Internet-based interactions between enterprises and governments (B2G),the lack o f participationo f Costa Rican SMEs in biddingprocesses, as well as the lack o f use o f other Internet services provided by public institutions, may be due to the low access that enterprises have to the Internet (40 percent), as well as to low penetration o f electronic government (e-government) activities inthis country as will be describedbelow. ICT Prices 116. A fair indicator of ICT performance ina country can be shown by the levelsof Internet prices. Prices for the use o f Internet in Costa Rica are low compared to countries like Guatemalaand El Salvador (Figure 3.51) but are high compared to Argentina, Mexico, Chile, Estonia or S. Korea. High prices for the use o f Internetrepresent less Internet access to lower income households and SMEs. 79 Figure3.51: Internet TotalMonthlyPrice($ per 20 hour of use), 2004 60.0 51.0 50.0 48.1 40.6 40.0 34.1 36.0 30.0 20.0 10.0 0.0 .-m 4- $C Source:World Bank Indicators, DDP (2005). ICT Environment andReadiness 117. During the last decades, the Government has beenpromotingpoliciesto attractForeign Direct Investment(FDI). Nearly 100Multinational Companies (MNCs) are currently operating in Costa Rica under the free-zone scheme as a result of these efforts. One-third of these MNCs are high- technology companies, including Intel. These businesses, inparticular those inthe high-technology sector, have established programs to promote productive linkages with local businesses. Inaddition, to overcome an important technological gap between MNCs and Costa Rican businesses, the Government along with the academic and private sectors, in 2000 designed and implementeda programcalled Programa CostaRica Provee to strengthen linkages between MNCs and Costa Ricanbusinesses(Monge- Gonzalez and Monge-Ariiio 2005). 118. Despitethese initiatives,CostaRicadoes not have a regulatoryframework conduciveto encouragingthe use of ICTs inthe country. Out of 102countries ranked inthe WEF Political and Regulatory Environment index, Costa Rica is ranked71 when comparingthe laws relating to ICT, (E- commerce, digital signatures, consumer protection) and is ranked 75 when comparingthe Government prioritization of ICT. 119. In addition,the Government's agenda for e-Government does not seem to be sufficiently developed.According to the WEF Government usage and readinesscomponents, Costa Rica was ranked 61on Government online presence and 86 on Government online services out of the same 102 countries ranked. Main ChallengesFacing the ICT Sector 120. CostaRica's ICT sector has importantchallengesto addressinorder to be a competitive playerin a global environment.Many ofthese challenges have emergedrightto the top ofthe country's development priorities as a result of the CAFTA Treaty, which commits Costa Ricato a gradual and selective opening of the market to competing operators other than ICE. However, the GoCR is convinced that opening the telecommunications market to competition is an imperative for Costa Rica, 80 independently of CAFTA, which will contribute to economic development and competitiveness inthe country. 121. In particular,Costa Rica's telecommunications commitments, as describedinAnnex 13 to the Treaty, involve openingto non-discriminatoryservice provisionthe Internet and private networksegmentsby January 1,2006 and the wireless mobile servicessegment by January 1,2007. Regardingthe latter, it must be noted that it i s defined in a footnote inthe Annex as covering all types of services (voice, data, broadband) providedby wireless means, including fixed terminals 122. Imminently,the GoCR is expectedto submit to Parliamenta modernizationlaw for ICE and a moderntelecommunicationslaw inlinewith the mainregulatoryprinciplesincludedinthe Treaty. These principles, emerging from best internationalpractice, cover issues such as universal service, regulatory independence, transparency, scarce resource management, interconnection, network access, information services, competitive safeguards, access to submarine cables and technological flexibility. 123. The following summarizesthe main challengesahead for the GoCR to be able to develop a modernand dynamic telecommunicationssector. The GoCR recognizesthat Costa Rica's legaland regulatoryframeworkfor the telecommunications sector is underdevelopedand needsto be modernized to promotecompetition, growthand the influxof privateinvestment. Inparticular, the ICE Modernization Law together with the new general telecommunications law need to be promulgated. The GoCR is convinced that ICEwill needto be strengthened and modernized to act as an efficient competitor in a liberalized market and separatedfrom policy decision-making, Fromthe perspective of the Government, the transition ofthe telecommunications market will be from a monopoly to a mixed model market where the public and private sectors will be able to compete. This poses a complex challenge to the general telecommunications law, as it will have to allow for selective competition, while ensuringtransparency andnon-discrimination. Inaddition, the full regulatory framework further developing the provisions of the law will needto be drafted inrecordtime to be ready shortly after the law comes into force. 124. The GoCR further recognizesthat CostaRica's institutionalframework for regulatingthe telecommunications sector is currently notwell adapted to the opening of the marketto competition. It is generally perceived that currently, the regulatory entity (ARESEP) is basically limited to regulating ICE'Stariffs annually. While its degree of successful performance, notably inthe area of quality of service regulation, may be questionable, the regulatory authority will needto fully reinvent itselfto operate in a completely new environment and guarantee fair and transparent regulation of a liberalized sector. Two main alternatives emerge at thisjuncture, whether to attempt a complete overhaul of ARESEP, or whether to create a new regulatory authority from scratch dedicated to the telecommunications sector. Ineither case, the GoCR believes that the regulatory authority needs to be independent and impartial focused on guaranteeing a level playing field for the telecommunications sector. Inparticular, the telecommunications regulatory agency will needto have a fully functioning independent board o f directors with staggeredterms as far as possible removed from political pressures, be capable of attracting new well-qualified staffto address new areas of regulation, including interconnection and spectrum, and of reorganizingits business processes to facilitate market entry, guaranteefair competition, resolve conflicts, enforce regulationand protect the interests of consumers, among others. 125. Managementofthe radiospectrum currently lacksefficiency, as it hasbeentraditionally monopolized for the most part by one single operator. While this may have been an acceptable situation inan environment of a state-owned telecommunications monopoly, efficient allocation and management of scarce resources and ready access to it by new operators is key to the success of the 81 reforms in Costa Rica. This may involve the definition of new regulations, the transfer of the spectrum management function to the sector regulator, and the implementationof a migration planto reclaim unusedradio frequencies primarily inmobile telephony bands, so that new entry may be feasible. Also, the licensingofradio frequency for Internetand broadband services inan open and simple registration process is necessaryto promote the participation of multiplenew operators under equal rules and opportunities. This creates another important challenge for the general telecommunications law and regulatory framework to allow for simplermodes of accessto spectrum than are currently available. 126. The transitionto a competitive regimealso posesimportantchallengesto the implementationof an effective and efficient universalservice financingscheme.Although Costa Rica does not requirean aggressiveuniversal access strategy for basic telephony, given the highlevel of geographic coverage achieved, inthe transitionto a competitive environment, it is possible that some of ICE'Stariffs may need to be rebalanced, which will require a careful analysis of its impact on the most vulnerable users. A transitory support scheme may be necessaryto maintainbasic voice telephony service for low income households. Inaddition, an innovative universalaccess strategy would needto be defined interms of Internet access (particularly with regardsto broadband services), which may require the creation of a universal service fund. This fund can be financed by contributions from operators and can work as a financing instrumentfor the deployment of rural telecommunications infrastructure, for both telephony and Internet services inunservedareas. The deployment of telecommunications infrastructure may be focused inthe use of new technologies such as broadband, Wimax and Wifi. 127. Costa Rica hasyet to develop a comprehensivedigitalagenda that takes fully into account the changestaking placein the telecommunicationssector and positionsthe countryto buildan InformationSociety.As described above, the broadband penetration inCosta Rica is among the lowest inthe region, which means a major competitivedisadvantagecompared to regional counterparts. The GoCR is aware that the country needs to develop and implementa comprehensive e-strategy to move Costa Ricatowards a fully developed technological and innovative environment which may attract investmentsand contribute to economic development, ifthe country is to emulate the successes of countries such as Estonia or S. Korea. An aggressivebroadband roll-out program could be one of the pillars of this strategy. 128. Finally,the GoCR is aware that thereis no specific regulatoryframework orientedto the use of ICTs. Consequently, there are not enough incentives to attract investments ininformation technology-enabled services and innovation. Without regulations promoting E-commerce, digital signatures, or consumer protection inthe digital world, there is no guarantee for investment attraction related to ICTs becauseof a lack o f confidence and security by private investors. Inaddition, the service export or outsourcing potential of the country, given its relatively highavailability of qualified professionals, remains largely unrealized due this lack of confidence inthe investmentclimate for ICTs. 3.4 InfrastructureFinancing 129. While CostaRicatraditionally investeda larger percentageof its GDP ininfrastructure than most LatinAmerican countries, investmentlevelshave begunto slip inrecentyears. With the exception of the early 1990s, investment in infrastructure has accounted for 3 to 4 percent of GDP. Investment levels are also comparable to several East Asian countries. Costa Rica's infrastructure investment has been roughly equivalent to that of Thailand and Indonesia over the past 10years. Financing levels prior to 2000 also tended to be muchmore stable inCosta Rica than in its East Asian peers. Only the Philippines maintained levels of investment that were generally higher than Costa Rica. 130. Infrastructureinvestmentjumpedto over 4 percentof GDP in2000 with the concession contract for investmentinJuan SantamariaInternationalAirport, but hasfallen sharply inthe 82 pastyears. Investmentininfrastructureaccountedfor less than 2.9 percent of GDP in2003 (Figure 3.52). Figure 3.52: Overall Financingfor Infrastructure Investment (a) Against Latin American Peer Group b. Against East Asian Peer Group .7% , ....... I ... .. ..- .- ..._l_...l._.l.._ 0. 1 U 6% - ae A. P E 5% pE , */ L./ / 4% > 5E E 3% 2% .t 2 1% +Argentina i Brazil A Chile -Colombia +Costa Rica --cEl Salvador+Mexico Source: MIDEPLAN;Easterly and Serven(2003); ElSalvador Source:MIDEPLAN,World Bank (2004d). Ministryof PublicFinance. Figure 3.53: Composition of Infrastructure Investment, 1993 2002 - - 100% ;;% -2$ 8 70% 60% 50% 5 30% 40% 20% 2 0% 10% - C Source: MIDEPLAN;Easterly and Serven (2003); World Bank (2004~). 131. CostaRica's strong levelsof total investmenthave beendrivenprimarily by public investment. Public investment accounted for more than 75 percent oftotal investment inCosta Rica from 1993 to 2003, and Costa Rica has a higher rate of public infrastructure investment than any o f its Latin American peers (Figure 3.53). In contrast, only 40 percent o f infrastructure investment came from public sources in other upper middle-income countries such as Mexico, Chile and Argentina. Relatively stable levels o f total public investment mask significant fluctuations inthe sector composition o f public investment from year to year (Figure 3.54). 83 Figure3.54: Composition ofPublicInvestment - 70% c 60% -$250% 3n -m- Transport 0 40% 8 30% 28 Telecorn 20% nE 10% ~- A -#-Water & -6 -A- -- x x "c_-?(----x ~ Sanitation 0% 1995 1996 1997 1998 1999 2000 2001 2002 2003 132. In contrastto public investment,private financing of infrastructure in Costa Rica accounts for a low percentage of GDP relative to its peersin LatinAmerica and EastAsia. The share of privateinfrastructureinvestment inCostaRica's GDP was lowerthan in any of its LatinAmericanand EastAsian peersfrom 1995to 2003 (Figure3.55). Infact, there were severalyears duringthis periodin whichthere was noprivateinvestment ininfrastructurewhatsoever. Figure3.55: PrivateInvestmentinInfrastructure(1995-2003) I -E 4.0%I/ c 35% 30% s n 2 5% p! 8 2 0% if 5-f$ 15% 0 10% 05% 00% Source: PPI Database 133. In addition,the composition of private investmentin Costa Rica differs markedly from its peers. Mostnotably, Costa Ricawas the only country within its peer group to have no privateinvestment inthe telecommunicationssector. This lack ofprivateinvolvementintelecommunications is especially noteworthywhen comparedto countries suchas Guatemala, Indonesia, BrazilandEl Salvador, whichhad telecom investmentsharesof around 50 percent (Figure 3.56). CostaRica's modestlevelsofprivate investmenthavebeendirectedto the Energy (66.1percent) andTransportation (33.9 percent) sectors. 84 Figure 3.56: Composition of Private Investment,by Sector, 1993-2003 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 1 BTelecom Energy Transport Water and sewerage Source:PPI Database 134. CostaRicaalso stands out amongits LatinAmerican peers interms of the channelsused for privateinvestmentin infrastructure. There has been no asset divestiture inCosta Rica inthe past ten years and private participation has taken place solely through greenfield projects and concessions. Whereas some Latin American countries, such as El Salvador, Guatemala, Brazil and Panama received over half o f their private capital flows inthe form o f revenues from asset sales, Costa Rica had no asset divestiture from 1993 to 2003 Figure 3.57). Rather, private capital flows went exclusively toward greenfield projects (65.2 percent, primarily IPPs for electricity generation) and concession contracts (34.8 percent, namely the international airport and the grain terminal in Caldera). Inthis sense, Costa Rica's private capital flows tended to be most similar to countries such as Mexico, Honduras and the Philippines, which also had little or no asset divestiture from 1993 to 2003. Inthat there has been effectively no private provision o f retail services (electricity distribution or supply; water supply; or telecommunications services) Costa Rica stands out as by far the most publicly financed and provisioned country interms o f infrastructure services o f its peer group. Figure 3.57: Composition of Private Investmentby type of Investment, 1993-03 = 100% 90% I70%80% .- U 60% 50% 3 40% " i? 30% i Q) 20% 10% 0% I Divestiture Greenfield project Concession Mgt. 8 Lease I Source: PPI Database. 85 estmerrt in Transport 8. A s a'%,of 137. Incontrast to infrastructure investment, CostaRicanvehicle stock has progressively increased over the past decade while road investments made per vehicle have not grown at the same pace (Figure3.59). Figure 3.59: Highway InvestmentPer Vehicle =Investment per Vehicle +Vehicle stock 30,000 800,000 700,000 -cs v) 25,000 v) 0 600,0002 20,000 0 I- 500,000 f CI 3 c > 15,000 400,000 v) c 0 10,000 0 300,000 p 5 200,000 z'E 5,000 100,000 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Source:Authors' Calculations,based on MOPTdata. 138. Total required investment calculations, in static conditions, have been estimated by the ACCCR at US$3.720 billion, equal to 20 percent of one year's GDP. The financingofthis program will haveto be prioritizedcarefullyto ensuremaximum impact on competitiveness andeconomic growth with minimalimpactonthe fiscal accounts. Fora summary of approved andplannedprojects, see Annex 2. Private Financing 139. Although there are several major projects waiting to be executed through concession arrangements, to date, no road concessions have been initiated. Table 3.13 summarizes the projects which are underway. The SanJos6-Calderaprojectis probablythe one which hasadvancedthe most. 87 Table 3.13: Status of RoadProiectsunder Concession,2004 Condition Length in h. costs Anillo Total: US$203.5 million Perife'rico Feasibility study concluded 24 Expropriations:US98.4 (Beltway) million Construction:US$104.1million Radial Heredia Project review which includes :ircunvalacid updatingthe demand study 15 US$llOmillion n Norte San Jose- The previousperiodof Caldera conditions is currently 78 US$140million suspended On October 1,2004, the concessioncontractwas signed. 3an Jose- San Itwas countersignedby the Rambn GeneralComptrollershipof the 65.8 US$170million Republic. Then, the order to commencewas issued. The CONALVIAS S.A. San Jose- company, in alliance with three It dependsonwhich alternative Limbn other partners, filed its bid 156 beforethe National Concessions is chosen Council Surveying studies are being SanJose- conducted in order to establish US$74.Smillion Cartago the requiredright ofway and 20.5 US$20 million in expropriations other relatedaspects :ource:The NationalConcessionsCouncil (ConsejoNacionalde Concesiones). 3.4.2 Electricity Finance 140. The electricitysector's greatest financialchallengesare reflectedthroughICE's constraints to access financial resourcesand to increase its debt, the difficultiesfor tariffs to absorb higher servicecosts, lackof public resourcesto finance additionalinvestments,and unnecessarydelays in projectimplementationdue to inadequateprojectmanagement.Onthe last issue, some important generation projects are suffering from inadequateplanning, contracting and public discourse. The 120 MW Garabito thermal plant was plannedto start commercial operations in2006, but is not expected to begin before 2008 becauseof disputes over its tender process and a pendingsuit. The 128 MW Pirris hydro power plant, which secured finance in 1996 and was expected to start commercial operations in 2009, may not be developed at all due to populationconcerns of its negative environmental impact. 141. Two financial ratiosindicate that ICE's ability to generate resourcesto finance its investmentshas declined significantly in recentyears. First, the gross margin o f ICE inelectricity has declined substantially since the 1990s, leaving fewer resourcesto pay labor, administrative and financial costs and to fund investments (Figure 3.60). Second, the return on assets has also fallen significantly in recent years. ICE's return on assets fluctuated between 0.5 percent and 3 percent in2002-04, while it was 5.2 percent in 1997 (Figure3.61). ICE estimatesthat a returnon assets between 6 percent and 8 percent is necessaryto finance the investments requiredfor meetingthe expected annual demand growth of 5.3 percent inthe next decade. The deterioration of ICE'Sfinancial ratios could be explained inpart by 88 insufficient tariff adjustments. ICE estimated that its 2005 average tariffwere 15 percent lower than its real tariff in 1995, year inwhich the company was comfortably able to finance its investment needs. Figure3.60: GrossMargin of ICE by Line of Figure3.61: ICE'sReturnonAssets Ratio by Business BusinessLine 70%GrossmarpinIOperatinp revenue 1EBTlkpreoiatedassets 60% , -cICEEectricidad 50% 10%. 40% 8% - 30% 20% - 10% - 0% O K 1997 1998 1999 2000 2001 2002 2003 2004 1997 1998 1999 2000 2001 2002 2003 2W4 Source: ICE's consolidated financial statements. 142. The limited ability ofICE to financesector expansionhas not beencompensated by private investmentbecause this is seriously constrainedby the legaland institutionalframework. Private Participation in theElectricity Sector 143. Private participationin the sector is limited to generationand is regulated by the Law of Auto or Parallel Electricity Generation." The law allows ICEto buy electricity from other agents through two types of contracts. One contract type is for power plants of 20 M W or smaller. Power purchase agreements (PPAs) are directly negotiated between ICE and the plant's owners, althoughthey have to be approved by the sector regulator, ARESEP. The secondtype o f contract is for BOTpower plants up to 50MW. The BOT contractsjointly with their PPAs have to be awarded through competitive processes.For bothtype of contracts, power plants have to use renewable energy sources such as hydro, geothermal or wind. PPAs can not exceed20 years. Inaddition, capacity under all PPA contracts can not exceed 15 percent of the installed capacity inthe national electric system (SEN). 144. Under the first type of contract, 20MW plants or smaller, ICE signed around 30 PPAs in the 1990s. The power plants under those PPA account for 10 percent ofthe country's installedcapacity and represent the primary form of private participation inthe sector. Under the BOT scheme, there are only two contracts: Miravalles 111, a 29 MW geothermal plant that started its commercial operations in 2000; and La Joya, a 50 M W biomass power plant that is expected to begin commercial operations in 2006. Most of ICE'S PPAs are 15-year contracts. 145. None of these contracts includes explicitgovernmentpaymentguarantees, beyond the purchase agreements from ICE. The tender processeso fthese contracts explicitly statedthat the winningbidder should renounce the rightto request such forms of guarantee. Given the apparent financial soundness of ICE, there is little inthe way of contingent liabilities that these contracts represent for the Government. ''Law 7200 (Generaci6n ElkctricaAut6noma o Paralela)was enactedinApril 1990and itsmodification,law 7508, was enacted inApril 1995. 89 Legal and RegulatoryFramewarp' 146. CostaRicalacks a coherent and clear legalframeworkthat governsthe electricitysector. The Constitution and at least twelve laws enacted over the last six decades plustheir modifications regulate the sector. Inaddition, the Central American regional electricity market treaty with its regulations also imposes rules upon the sector. As a result the legal framework is fragmented, outdated and dispersed, making difficult its interpretation. Current legal proposals aim at maintainingthe status- quo because they focus on consolidatingthe position o f specific agents such as the proposalto financially and institutionally strengthen ICE. 147. In addition,the current legalframework hinderssector investmentsby makingthe entry and contributionof agentswith current or potentialparticipationin the sector difficult. The main obstacles for a greater participation o f new investors or sub-national entities include: 0 Lack o f clarity on legal rights for independent generators; 0 Gaps and preferential treatments inthe legal system related to the allocation o f rightsfor the use o f hydro resources; 0 The uncertain future o f PPA contracts after their expiration are TheLack of Clarity on LegalRights toBe a Generator 148. The legalpermitsto enter in the generationbusinessare set indifferent regimesand vary substantially accordingto: (i) type o f entity (public, cooperative, municipal or private), (ii) o f the source generation (conventional, no conventional, or hydraulic), and (iii) size o f generation facility with special regimens for plants o f 20WM or smaller and for plants o f 60 MW or larger. This legal framework creates in an intricate and dispersed regimen o fgeneration permits, which are granted by different authorities. Although it is not unusual to have different rightsand obligations o f generation permits depending energy source and generator size, the Costa Rican regime has resulted in a very limited and atomized participation o f most agents, which revolves around the dominant state-owned enterprise. GapsandPreferential Treatmentsin theLegal System toAllocate Rightsfor the Use ofHydro Resources 149. Except for the special regime for cooperatives and municipaloperators, there are not clear and explicitregulationswhich norm concessions ofwater's hydraulicpower despitethose concessions are mandated by the Constitution.Such gaps affect both private and public agents, which lack o f a clear regimen for the usage rights over hydro resources for electricity generation. 150. The legalframework also establishespreferentialand discriminatorytreatmentswhich further limit the participationof new agents.The legal framework allows ICEto buildhydro power plants without the need to obtain concessions or being subject to regulations governing those concessions. Inaddition, a special law grants to ICE a preferential accessto the country's electricity reserve zone in Arenal and Cote Lakes and Arenal River. There is also a special regime that grants water concessions for up to 60 MW to cooperatives and municipal utilities. Private sector hydro power plants are limited to 20 MW. This section and the following one rely on ARESEP (2005). 90 UncertainFuture ofPPA after TheirExpiration 151. Most of ICE'SPPAsexpire inthe next five years. Hence, there is a needto definethe future of the power plants after the expirationoftheir contracts with ICE. Although the current legalframework allows independentpower producers to selltheir electricity only to ICE, there are several options for the future of these power plants. Those include extending current contracts, renegotiating those contracts, negotiatingnew ones, selling the power plants to the ICE or to other qualified agent such as municipal utilities and cooperatives. Contract extensions, however, would be difficult becauseof disagreementsover amortization and investment repayment period and the controversies inwhich those contracts have been involved. The agreed rates inPPA contracts have been considered too highand publicly questioned. The agreed rates in those contracts vary between US$0.06 y US$0.07 kWhwhile the average ICE costs is around US$0.03 kWh. 152. The conclusionof the PPA contractscreates an opportunityto openthe generation business in a controlled manner.For instance, new and future independentpower producers could be allowed to commercialize its electricity output through energy traders. Ifsuch measure i s taken as part of a well- designed sectoral development strategy, it could create incentives for private investmentand, thus, contribute to attain an adequate electricity supply. Integration to CentralAmerica Electricity Market and CAFTA 153. CostaRicasignedthe CentralAmericanelectricitymarkettreaty (TratadoMarco del MercadoElectric0de America Central, TMMEAC) in 1996 and ratifiedit in 1998. CostaRicahas ' also acquired foreign debt to finance its participation inregional interconnection network (SIEPAC), which is expectedto enter inoperations in2008. 154. Despitethis progress, CostaRicahasyet to define how itwill participateinthe regional electricitymarketwhich has beenoperatingsince2002 undertransitionalregulationsand whose final regulationsare in the processof beingapproved. So far Costa Rica has limitedto delegateall country's rights and responsibilities under the treaty to ICE. The current legislation, Law 7848, designatesICE as the single agent in the Costa Rican electricity market able to participate inthe regional electricity market. The law also delegates all of the government's functions inthe regional market to ICE. 155. Basedon the commitments acquired under this treaty, however,such legislationonly representsan initial situation that hasgraduallyevolved to anothermore competitive one. Costa Rica and Honduras are the only two signing States memberswhich have not yet reformed their electricity sectors. Because of this, the treaty established the regime o f "limited initial situation", which should gradually evolve into a situation of greater openness and competition. Therefore, Costa Rica's model of market integrationwill requires the definition ofthe characteristics o f its "limited initial situation" typified by the presence of a "single agent". It also requires defining common conditions ofreciprocity and symmetry to which Costa Rica committed to "evolve gradually." Among the common conditions of reciprocity and symmetry are competition ingeneration, vertical disintegrationat least at an accounting level, open access to third parties to transmission networks innon-discriminatory basis, and the free flow of electricity interritories of states members. Finally, Costa Rica's integration model requires identifying the existing legal and regulatory barriers to comply with boththe "limited initialsituation" andthe common conditions o f reciprocity and symmetry. 156. The market integrationmodelwill also be shaped by the rulingof Court IV (Sala IV) regardingan injunctionclaimingthe unconstitutionalityof article2 of Law 7848.This article is the one granting to ICE all of government functions underthe treaty. According to the injunction, this article 91 i s unconstitutionalbecause it modifies the treaty. The Legislative Assembly can only approve or reject internationaltreaties, not modify them. A rulingby Court IV infavor of this injunction would give a clear mandateto the government to define a model to open the electricity market. 157. Unlike the TMMEAC, CAFTA will not have a directimpactonthe sector becauseit does not includecommitments regardingthe electricitysector. On the contrary, the electricity sector is included inAnnex Iwhich lists the sectors exempted from the commitments on eliminating restrictions to foreign investment and market access. 158. A successfulintegrationto the CentralAmerican electricitymarketcould create important investmentopportunitiesto export electricityfor CostaRica. The country hasthe most competitive electricity prices (Figure 3.62 and 3.63) and, after Guatemala, the largest hydropower potential inthe region. Currently Costa Rica uses 1,300 MW of its estimated 6,220 MW hydropower potential. Figure 3.62: Industrial Electricity Pricesin Figure 3.63: Commercial Electricity Pricesin Central America Central America UVsikW VSSmv 0 16 0161 0 1 4 ] 012. 1 006 - ::I: 0Oo4 02 0 00 - 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 20M -- 1993 1994 1995 1996 1997 1998 1999 20002001 2002 2003 2004 tBSaivador-*-Costa rca -Handuras -- bkaragua -Panam -+-0 Sahlador -t-Casta rra-Mnduras Nraragua Panam Source:ECLAC. 159. Electricitypricesin CostaRicaare near the LatinAmericanaverage. The price of residentialelectricity inCosta Rica i s US$0.062 per kWh, 23 percent below the regional average of US$0.082 per kWh (Figure 3.64). Prices for industrialusers (US$0.06 per kWh) and commercial users (US$0.086 per kWh) are near the regional average. 92 Figure3.64: ElectricityPrices(Dec. 2003) 0 5 10 15 mConmercial Rice of electricity, Dec. 2003 (US$ Cents per khh) 0 Residential Source: OLADE. 3.5 Recommendationsfor PolicyAction Relatedto InfrastructureTrade and Growth 160. While Costa Ricaretainsone of the region's mostextensive networks of infrastructure services, it is startingto lose its competitiveedge. The past achievements attained through considerable investment are injeopardy from eroding quality. Over the past several years, public expenditure levels have become uneven by sector-particularly intransport and electricity generation-while some o fthe public service providers-most notably inmobile telephony, and ports-have been unable to keep up with sectoral innovation. The private sector has not beenallowed to play a compensatory role. The result has been a noticeable decay inthe quality o f services across sectors--even as connectivity remains high. That quality slippage i s beginning to affect Costa Rica's competitiveness, particularly for its small and medium-sized firms. 161. Policy options for improvingthe performance of CostaRica's infrastructureinclude two key elements:(1) a recognition o fthe real source o fthe fiscal constraints related to infrastructure; and (2) a series o f sector-specific initiatives that require the involvement o f senior fiscal authorities as well as the technical agencies that implement each service. InvestmentDecisions 162. It is importantto consider the options for meetingits infrastructure investment requirements in the context o f the country's growing fiscal constraints. How shouldthe infrastructureinvestment needsof Costa Ricabe financed and howwill this differ from the country's traditionalinvestment patterns? 163. Historically,CostaRica'sinvestmentlevelsininfrastructurehave mappedcloselyto its growthlevels-to the benefitof the country's economy. That is, at between 3 and 4 percent o f GDP, investments in infrastructure have traditionally been the second highest inLatin America--after Chile (4 to 6 percent)--as have Costa Rica's growth levels. Perhaps because the rate o f infrastructure investment as percent o f GDP continues to remain higher than most LatinAmerican countries or perhaps because Costa Rica's levels o f access to basic services (electricity, roads, fixed line telephones and water and sanitation) are among the highest inthe region, infrastructure investment trends have not attracted much attention. 164. It has only been recent reportsof quality problemsarisingfrom CostaRicaninvestors, shippers and businesses that have focused a clearerlighton the state of infrastructureinvestment in the country. Indeed, signs o f quality problems inCosta Rica's infrastructure service provision are at odds with the traditional view o f Costa Rica as a regional leader inthe provision o f infrastructure 93 services.81 An understanding o f the cause o fthe quality problems that have arisen across the productive infrastructure services i s revealed by the sector-level analyses presented in Section 3.4. 165. Investmentlevels by sector (telecommunications, electricity and transport)-reveals a pattern of expenditurewhich is different from other middle and upper income countries throughoutthe world. Nearly all comparator and competitor countries use public funds for those infrastructure investments that contain a large social or merit good characteristic-such as urban and rural roads. Those same countries rely on the private sector to finance infrastructure services which are more readily paid for by user charges-such as telecommunications, electricity and other types o f energy supply. By contrast, the lion's share o fCostaRica's public expenditures ininfrastructure is increasingly going toward telephony and electricity generation while public investments inother areas o f infrastructure are falling. 166. I n terms of Governmentaccounts,ICE'Sgrowinginvestments in telecommunications and energy obscure the massive decline in Costa Rica's publicinvestmentin transport which declined from about 2.0 percent of GDP between 1976 and 1984 to about 0.3 percentof GDP between 1996 and 2004. As a result o f the public nature o f all the service providers, a chainreactiono f fiscal constraints has emerged: The federal budget has reached its current state based upon a tradition o f investment in infrastructure that appeared high(because o f the independent revenue sources o f ICE from telecommunications and electricity tariffs), but which is, infact, woefully low; The underinvestment intransport stock has resulted in a poor quality road network, dilapidated bridges and poor port access. This deferment o f investment routine maintenance has driven up the per unit cost o f maintenance and rehabilitationexponentially; ICE's autonomy and the logic of auto-sufficiency inICE's two sectors does not allow for transfer o f investment among sub-sectors (e.g., from telecommunications to roads); Even iftransferring o f funds were possible through a system o f cross-subsidies or bond financing on the back of ICE, it would not be desirable. ICE will have enough difficulty in the years ahead to finance the backlog o f investment needs in energy supply; and address the growing quality concerns inelectricity distribution and fixed linetelephony. This will have to be done inthe face o fgreater competition (and, possibly, lower revenues) in mobile telephony. 167. I n short, additionalsources of funds will be requiredto rehabilitatethe transport network of Costa Rica. Currently, the Government is movingforward with: concession contracts for the few highways with sufficient traffic to self-finance through tolls; and concessioning o fthe ports. The Government i s also looking at ways to increase the fuel tax to cover road maintenance and rehabilitation for lower density roads. 168. These initiativesare vitally important. However, unless the Government is able to construct a large, separate account for road financingout of fuel taxes, these measuresare unlikely to finance the investment,rehabilitationand deferredmaintenancegap that the sector currently faces. As discussed below, the Government may have to consider even more creative approaches to accessing capital and leveraging the private sector inthe provision o f roads. Inaddition, some sectoral reforms that challenge the traditional "in-house" public solutions may be necessary. These initiatives are described below, broken out by sector: See the World Economic Forum's GlobalCompetitivenessReport and inthe InvestmentClimate andLogistics Surveys conductedfor this Report. 94 3.5I TransportationRecommendations 169. CostaRica's commitmentto transport infrastructurehasdeclined precipitously in recent years. Likewise, the lack ofmaintenance of Costa Rica's accelerateddeterioration o f its assets. Moreover, significant delay inthe implementationo fthe private participation contracts has further paralyzed the modernization of key transport infrastructures throughout the country. 170. A depnition of a trunk network associated to the current location of economic activitiesmust be adopted. Although there are regions with great development potential, Costa Ricamust ensurethat the sectors which are already inserted into the global economy continue to be successful. 171. Focuspublic esforts on expanding,rehabilitating and maintaining key trade corridors: Public investment will have to focus on strengtheningthe most important logistics corridors and improvingthe commitment to road maintenance-particularly inthe central region. Fiscal constraints implythat public investmentshould respondto clear prioritization basedontraffic demand and trade corridors. The adoption of logistics corridors is necessary. 0 The San JosB-Lim6n axis generates 32 percent o f Central American trade. Road improvements must go alongwith a betterorganizing ofthe entranceto the greater metropolitan area, and the development of areas of logistics provision and modal integrationwith the Atlantic train inthe port access. Inthis system, the operational modernizationprocess ofthe port i s necessary. The concessionfor the The SanJosB -Caldera corridor should be completed The northern component of the Trans-AmericanCorridor should be completed so that it can facilitate exports to the rest of Central America and open up access to the northern areas for greater tourism development 172. Enact at least one signijicant road concession in the short-term toprove the seriousness of intent of the Government: Concessions as an approach to leveraging private sector finance, operational and management skills suffer infamously lengthy delays inCosta Rica. Strategically, the most advanced concessions--for instance the San JosB-Calderatoll road--must be implemented inthe short-term, so as to break the procedural impasseand demonstrate to investors that Costa Rica is serious about private participation in its infrastructure services. 173. Where highway rehabilitationand expansionare necessarybut tollingis unlikelyto cover the entire cost, the lumpyfiscal burdens might be "levelized" or spread out over many years throughthe use of creditenhancements. Credit enhancementssuch as minimumtraffic or revenue guarantees backstopping partialtolling commitments would shift the initial financing costs to a consortium of construction, maintenance and operating firms. While the contingent liabilities associated with such guaranteeswould needto bevalued openly andfairly inthe public accounts, they would, at least, helpto spread out lumpy investments and to shift maintenance and operating responsibility to the private sector. For roads and bridgeswhere traffic volumes are too low to cover large rehabilitation or expansion projects, toll-financed contracting might still be considered to cover the costs o f routine maintenance. A detailed analysis of per unit costs associatedwith current maintenance contracting should be undertakento determine whether longer term and performance-based rehabilitation contracts would yield greater returnsfor the scarce resourcesbeingspent on the roadnetwork. Finally, the bundlingo f roadand port investment obligations with land development opportunities (e.g., property leasing, tourism site or industrial park development) could be considered to entice consortia into providing infrastructure as part of more complex investments. 174. Reform and modernizethe main containerports,preferably throughpublic-private partnershipssuch as concessions: Costa Ricancontainer ports, especially on the Atlantic, must be 95 modernized. As maritime transportation is the mode most widely used for exports, and the ports have been identifiedby firms as a key bottleneck to trade, port reform shouldbe addressedas a matter of urgency as should improvements in road access to the ports. 175. Further the customs reform initiativesalready underway: Despite the efforts undertaken by Costa Rica inthe past few years to modernize its customs offices, firms still find that bureaucratic procedures are taxing and service hours must be extended(Table 3.14). This will requiregreater coordination among trade regulation entities, such as the Ministryo f Agriculture and Livestock (MAG) and the Ministryof the Environment and Energy (MINAE) Table 3.14: Summary of Transport Recommendations Recommendations Priority Term Responsible Difficulty/Co Party st Expand. rehabilitate and maintain kev trade Hiah - Short-term MOPT. CNC. Medium to coiridors, beginning with road from San Jose ARECEP, High to Puerto Limon Contraloria Implement at least one major road concession High Shod-term MOPT, CNC, Medium program over course of 2006-2007 to show ARECEP, government`s commitment to financing Hacienda, infrastructure through public-private Contraloria partnernships Redefine the port model in general, and Limon High Medium MOPT, High in particular to make the ports more efficient. JAPDEVA, This will involve investment in Atlantic HACIENDA, container ports, logistics plan, rationalization of Ministry of operations at Limon and Moin and serious Trade institutional reform Expand customs reform and modernization Medium Medium MAG, MINAE Medium initiatives by increasing interaction between and ARECEP resulatorv agencies 3.5.2 Electricity Sector Recommendations: 176. Two related challenges stand out in the evolution of Costa Rica's electricity sector: How to increaseand maintain sector investments to levels that ensure electricity supply that supports and facilitates Costa Rica's growth; and How to successfully integrate Costa Rica to the Central American electricity market so that the country can seize the opportunities offered by this market 177. The Costa R c a n electricity sector has been developed around ICE, a dominant and vertically integrated state-owned company. Although this sector structure has allowed the Costa Rican sector to become one ofthe best performers inthe region, its ability to meet the demand growth has substantially declined inthe last few years. ICE'S insufficient investments have taken place in a context of a fragmented, outdated and disperse legal framework that severely restricts the participation of other agents inthe sector. Consequently, other current or potentialagents have not been able to compensate for ICE'Sinsufficient investments, which have putthe country at a risk of electricity rationing inthe coming years. On the other hand, the new Central American electricity market creates opportunities to enhance Costa Rica's electricity system reliability and increaseits electricity exports. 178. This context creates a window of opportunity to rethink Costa Rica's electricity sector policy. A new long-term sector strategy that aims at guaranteeing an adequate supply and addressingthe 96 quality issues that Costa Ricanbusinesses are confronting would have to be definedwith the active participation of main stakeholders inthe sector (Table 3.15). That sector strategy should include the long- term vision of sector structure, institutional arrangements including regulatory independnece, market rules both internally and for trading internationally, and phases of the transition toward the new sector structure. Shorter term investment decisions, such as those relatedto the size or type of generation projects to be pursuedby the Government, will be impacted by the long-term vision of the energy sector. Large projects-particularly inhydro-electric generation-will fortify the integrated nature of ICE. Conversely, the pressuresfor fair or "level field" purchasing arrangementsthat come from IPP's may facilitate ICE'Smove toward a more competitive or unbundled structure. 179. Once the sector long-termstrategy hasbeenagreed upon, CostaRicashould develop an action planto move towards the new sector developmentstrategy. These recommendations as well as other short-term ones are listed inthe Table 3.15 below. 97 Table 3.15: Summaryof Recommendations for CostaRica'sElectricitySector Recommendations Priority Term Party Difficulty/Cost Ensure that tariff adjustments provide ICE with the financial resources needed to Fund investments required to adequately High Short-term ARESEP Medium meet electricity demand in the next three years Define future of PPAs after expiration and mechanism for trading existing contracts in a High Short-term ICE High more competitive market Define public agency responsible for granting concession on Legislative hydraulic power at least High Short-term Assembly High temporarily Define Costa Rica's model for participating in the Central American MINAE and electricity market High Short-term Presidency Medium Improve ICE project management processes primarily on environmental Medium Short-term ICE Low management and tender processes Define new long-term sector development Medium Medium term MINAE and Medium strategy Presidency Establish accounting vertical disaggregation ICE and of incumbent Medium Medium term ARESEP Medium Establish third party MINAE, access rights and use Legislative of network charges Medium Medium term Assembly and High ARESEP 3.5.3 TelecommunicationsSector Recommendations 180. Althoughthe basic indicatorsfor the telecommunications sector revealhigh penetration, other important issues such as the low quality of service (both landlineand mobile), the low penetrationof highspeed internet,the lack or delay in technological innovation, the slow pace of investmentin the sector, and the uncertaintyin the efficient allocationof scarce resources, notably spectrum, revealthe needfor a shift in the current regulatoryenvironment towards a more 98 competitiveone. Withthe signingofthe CAFTA CostaRicahastaken an importantstep inthe right directionand is now activelyexecutingthe necessarysubsequentmeasuresto ensure timely implementationofthe commitments, whichwill bethe first step inthe implementationofthe new country's digitalagendaand a strongcontributorto the creationofa more competitiveandfaster growing economyattractiveto investmentandemployment. 181. Based on the analysis of the situation and the challengesidentifiedabove, the GoCR is consciousof the needto undertakea numberof actions, underthe overallumbrellaofwhat can emergeas the country's comprehensive "e-Costa Rica" strategy or digitalagenda, structuredalong threemain themes: (i)telecommunicationssector reform and connectivity agenda, (ii)an integrated e-Government strategy, and (iii)a strategy to promotethe development of the IT industryand attractinvestmentthrough IT-enabledservices.Giventhe moreurgentcharacterofthe first one, it is dealt with in moredetail inthe followingparagraphs: 182. Finalize thelegalframework: The ICEmodernizationlaw, whichwas recentlysubmittedto Parliament, has receivedsome criticismas beingsomewhat contrary to the principlesofthe CAFTA. Prior to its approval by Parliament, the GoCR is revisingthe draft. Inaddition, the currentlywell advanceddraft ofthe GeneralTelecommunicationsLaw is currentlybeingfinalized, after discussion within government andwith key stakeholders.Itis expectedthat bothlaws will be discussedin Parliament shortly after the new administrationtakes office. 183. Draft and enact subsidiary legislation:Inorder to swiftly implementthe provisionsof the GeneralTelecommunicationsLaw, keypieces ofthe regulatoryframeworkare also currentlybeing drafted.Notably, licensingand interconnectionregulations inorder to allow for new entrants to participateinthe market segments as they are beingopenedupto competition. 184. Restructurethe regulatory agency or create a separate telecommunicationsregulator to allow it to regulate the whole industryandensurefair competition.Inparticular,accordingto the draft General TelecommunicationsLawthe regulatoryauthoritywill be able to enforce itsregulationson all players equally, includingICE, in order to mitigatethe riskperceptionofpotentialprivateinvestors.This may involverequiringstrictaccount separationbetweenservicesprovidedby ICE incompetitiveandnon- competitivesegments ofthe market. Inaddition,the draft lawforeseesthatthe regulatoryauthoritywill have a higherdegree of independenceand an enlargedscope ofregulation,to includeissues suchas interconnectionand spectrum, amongothers. 185. Createthe telecommunicationspolicyfunction within government, most likely assignedinthe forthcomingTelecommunications Lawto the renamedMinistry ofEnvironment,Energyand Telecommunications.It is expectedthat there will be strict separationbetweenICEandthe new policy- maker, to ensurethat ICEbecomesa pure operator anddoes not interfere with governance ofthe sector. 186. Improve information generation:Every source consultedon basictelecommunications indicators for Costa Ricahas showndifferentnumbers, eventhoughICEhas beenthe primarysource for that information.The Ministry andthe regulatoryagency are aware ofthis issue andthe reforms undertakenwill allow them to becapableof collectingverifiableinformationfrom all the operators and conduct audits on all players inthe industry,includingthe incumbent. 187. Implement a market openingplan: Inorder to quicklytake advantageofthe benefits ofreform to the overalleconomy and competitivenessofthe country, andinline with its CAFTA commitments, the GoCRhas undertakenthe preparationof an effectivesector liberalizationplan, through accelerated licensingof new operators.Inparticular,tenders for the licensingof new mobileoperatorsare expectedto be preparedandconductedshortly after the approvalofthe law.Inaddition, as away to promote 99 competition inInternet services, rules for the use o fthe spectrum bands internationally allocated to unregulated use will be drafted. 188. Simplifv access to spectrum:Most new entrants will probably choose the provision o f services via wireless technologies. Therefore, the GoCR is aware that the current process that requires individual concessions ratified by the Parliament could constitute a tremendous entry barrier and needs to be simplified, taking into account the precedent o f paging services. The General Telecommunications Law contains provisions for delegating inthe appropriate government agency the concessioning o f radio frequencies inorder to allow for competition inwireless services. 189. Improve efficiency of spectrum use: this involves a spectrum reallocationplan, currently under execution, to reclaim unused bands and provide an incentiveto operators to improve the efficiency inthe use o f the bands already allocated. 190. Increase the capacity to manage and monitor the radio spectrum:the office currently incharge o f spectrum management, under the Ministryo f Interior, is expected to be moved to the regulatory authority. In addition, the agency will be strengthened with proper capacity, both human and technical, in order to manage this scarce national resource. 191. Define a detailed universalservice/accessstrategy: As a measure to ensure that the benefits o f competition reach beyondthe main urban areas, the GoCR wishes to identify a suitable universal service/access strategy and funding approach. The draft law foresees the creation o f a universal service fund, and detailed studies will be conductedsubsequently to identify the needs and adequate targets for eventual subsidies. Based on the outcome o f these studies, the appropriate institutional arrangements and regulatory mechanisms will be put in place. 192. Conducttendersfor subsidiesfrom the universalservicefund Inorder to ensure fair treatment o f all operators, it i s expected that universal service/access projects will be tendered. Box 3.1: Resultsof RegressionAnalysis ProductiveInfrastructure SimpleModel Electricity Total Generation Telephone Telephone Mobile Paved Capacity Lines Mainlines Subscribers Roads GDP 0.00 0.07 0.04 0.03 0.00 (5.60)*** (12.08)*** (11.16)*** (9.50)*** (6.62)*** Constant 0.19 45.33 32.90 11.46 -0.03 (3.73)*** (2.99)*** (3.41)*** (1.46) (0.45) Observations 118 116 118 116 108 R-squared 0.21 0.56 0.52 0.44 0.29 Source: Based on author's own calculations. 100 Table 3.16: Summary of Recommendationsfor Costa Rica's Telecommunications Sector Recommendations Priority Term Responsible Party Difficulty/Cost Develop a comprehensive"e-Costa Rica" strategy or digital agenda to define: i) telecommunications sector reform and connectivity agenda, (ii) an integrated e- High Short Presidency Low Government strategy, and (iii) a strategy to promote the development of the IT industry and attract investment through IT-enabledservices. Finalizethe legalframework and draft and enact subsidiary legislation. Presidency and Restructurethe regulatoryagency or create a Ministry of Science separate telecommunications regulator; create High Short and Technology or High the telecommunications policy function; and successor improve informationgeneration. Presidency and Implement an effective sector liberalization pian Ministry of Science through accelerated licensing of new operators. High Short and Technology or High successor Radio spectrum optimization: Simplify access to spectrum; improve efficiency of spectrum use; Ministry of Science and increasethe capacity to manage and High Short and Technology or Medium monitor the radio spectrum. successor Universal service and universal access: Define a detailed universalservicelaccess strategy and Ministry of Science conduct tenders for subsidies from the universal Medium Short and Technology or Medium service fund. successor Implement an integratede-Government strategy that would improveefficiency, quality and transparency of government services, and would be structured around horizontal actions Presidency/ Vice- (infrastructure, standards, legislation, capacity Medium Medium Presidency Low building) as well as vertical (financial management, customs and taxation, registries, social security, education, health, etc.). Implement a strategy to promote the development of the IT industry and attract investmentthrough IT-enabledservices aimed Ministry of at capitalizing on Costa Rica's achievements in Medium Long Economy, lndust,ry the high-tech industries, and promote the and Trade development of a domestic IT-enabledservices industry. 101 102 ChaDter 4. The Role of Innovation in Costa Rica's DeveloDment82 4.1 Introduction 1. Fosteringinnovationis a key ingredientin pursuinganew growthagenda for Costa Rica. As mentionedinChapter 1, Costa Ricahas enjoyed a successful record of long-term growth with respect to other Latin American and Caribbean countries, but when compared to middle income "star" performers outside the region Costa Rica still lags behind, especially interms of total factor productivity (TFP). In this backdrop, the challenge going forward is not only to returnto the country's relatively good growth levels by Latin America standardsduringthe 1990s, but also to catch up to some of the world's booming economies. Still, this will be no easy task. A recent study by Sauma and Sanchez(2003) attempted to quantify this effort and estimated that for Costa Rica to attain similar growth as that experienced by East Asian countries, Irelandand China, the country neededto aim for a 20 to 30 percent increase inTFP (as opposedto the current TFP growth rate of 2 percent peryear). Although TFP estimates are notoriously imperfect as indicators of innovation or technical progress, partly becausethey are subject to a variety of technical pitfalls, the real question remains how to accelerate economic growth for the longterm. 2. What is less obvious for countries and policymakers are the factors that promote or impede innovation.Despite a long literature on the importance o f researchand development (R&D) and science and technology policy to innovation, a distinction between adoption and invention indeveloping countries should lead us to explore numerous other areas that may pose barriers to the creation of more innovative firms. These non-R&D sources of innovation (and TFP growth) have generally received less attention inthe innovation agenda, butmerit closer scrutiny especially inthe context of developing countries such as Costa Rica Maloney (2005). Moreover, the relation between R&Dand other innovation inputs on the one hand, and innovation output onthe other remains murky. 3. The objective of this chapter is to providea bird's eye view of the potentialrole that innovationcan play inacceleratingCostaRica's development. To this end, this chapter combines macroeconomic and microeconomic analyses concerning the relationshipbetween innovation outputs and inputs, as well as their potential effects for economic growth and firm performance. Moreover, the chapter provides a qualitative assessment of relevant government policies. 4. Innovationmightseem to be of secondaryimportanceinthe current CostaRican context characterizedby challengesinthe fiscal and governance areas; the evidencediscussedinthis chapter strongly suggests otherwise. The chapter has three mainfindings. First, the characteristics of the Costa Rican economy interms of its level ofdevelopment, educational level, and even institutional quality, imply that smart policies to promote private-sector innovation can have tremendous payoffs. In fact, some evidence suggests that the payoffs can be even larger than improvingthe quality of governance. Second, both R&D and licensing payments to secure the legal use of foreign technologies are significant correlates of common types o f innovation in a large sample of firms operating in developing countries, including Costa Rica. Thus these innovation inputs, which are commonly believedto be important only for very sophisticated innovation indeveloped countries, seem to be part and parcel o fthe process of innovation and economic diversification inpoor countries. Costa Rica is ready to reap the ~~~~ 82This chapter is summary of a backgroundpaper writtenby DanielLederman (WorldBank), CamilaRodriguezandDaniel Chodos (consultants)for boththe CostaRicaInvestmentClimateAssessment and the CostaRicaCountry Economic Memorandum. 103 benefits from policies that solve key market failures that inhibitinnovation indeveloping countries. Third,Costa Rica's current subsidy program aimed at promoting innovationthrough a matching grants system, as well asits efforts to promote exports through the activities of PROCOMER are welljustified by the empirical evidence presentedherein. The country also faces challenges regarding its policies towards Export PromotionZones (EPZs, Zonas Francas in Spanish), which provide tax incentives for companies that assembleproducts for export. A detailed analysis of the costs and benefits of alternative reforms to these programs is well beyondthe scope ofthis report, it i s worth highlightingthat EPZs tax exemptions linkedto export performance will needto be reformed inthe comingyears due to World Trade Organization norms, whichnonethelessallow the use of such incentives to promote private R&D. Moreover, the matching grants program, however close it is to global best practices, can be improved while at the same time it can be rigorously evaluated to enhanceits future performance. 5. The rest of the chapter is organized as follows. Section 4.2 focuses onthe role playedby the private sector, the public sector, and how these efforts interact inthe context of public policies that help or hinder private innovation.Inthis context the businessenvironment plays a crucial role. Itthenexplains the role of government policy inresponseto market failures that hinderinnovationbythe private sector. Section 4.3 provides descriptive statistics,on the status of innovation inCosta Rica by analyzing aggregate and firm-level data and comparing this country's performance inrecent years with those of countries at similar levels of development. Section 4.4 discusses new macroeconomic evidence linking innovation and economic growth on the one hand, and the role of market failures inhampering innovation on the other hand. Section 4.5 describesthe roadmap followed to empirically pinpoint the main correlates of firm-level innovation inCosta Rica and elsewhere inthe developing world and presentsthe corresponding econometric results. The final section 4.6 describes innovationpolicies and programs currently in place inCosta Rica and assessestheir recent performance through a qualitative analysis. It also discusseschallenges that must be met to evaluate and monitor the performance o f such public subsidy programs. Lastly, Section 4.7 summarizes our conclusions and mainpolicy recommendations. 4.2 InnovationFramework 6. Figure 4.1 illustratesthe innovationframework linking firm-level innovation"inputs" with firm-level innovation"outputs." This na`ive view relies on simple logic: the level of innovationby a firm will be a resultof its own innovative efforts. Inturn, the sumof all firms' innovation outputs yields the economy-wide level of innovation. Inthis simple framework firm-level innovation is aresult of firm investments in innovation inputs, but firm decisions regardingexpenditures or other business decisions that determine a firm's ability to learn, adapt, and change, are themselves shapedby the business environment. Without a proper participation of the public sector inpromoting firm investments in innovation, it is likely that the private sector alone will make sub-optimal levels of investments in innovation. 7. Firms' propensityto invest in innovationinputs, namely,R&D,licensing, importedinputs and worker training, and to learn from other firms is directly and indirectlydetermined by the investmentclimate and public policies. Firmcharacteristics such as size, exporter status, business sector, and foreign ownership also affect firms' levels of innovation outputs, either becausesuch characteristics "cause" innovation or becausethe most innovative firms tend to have those characteristics. Other factors inthe investment climate, including the costs of financing risky investments ininnovation, corruption, or the coverage and quality o f domestic infrastructure may affect the private sector's propensity to innovate. These direct effects of the business environment are illustrated by block arrows in Figure 4.2 below indicatingthe direction o f influence. However, these variables may also affect innovation indirectly(not shown inFigure 4.2) by affecting the characteristics of firms that inturn affect private-sector innovation, such as limitingthe size o f firms and thus preventingthe private sector from achieving economies of scale necessaryto finance risky innovative activities. Inaddition, innovation 104 inputs and firm characteristicsmay actuallybedeterminedby the innovationoutcomesper se, leadingto a process of technologicalupgradingthat takes placeendogenously at the firm-level.This process is labeled"reverse causality" inour framework to highlightthe fact that observedcorrelations betweenfirm innovationinputs and outputs canbedueto innovation(e.g., producinga new product) creatinga needto increasethe inputs (e.g., trainingthe workforceto producethe new product). 8. The incentives to invest in innovationinputs are affectedby the example and ideas developed by other firms, which produces market failuresthat justify governmentinterventionsto promote privatesector investment.The bolddashedarrowfeeding back to firm-levelinnovationinputs depicts this effecthere. When firms can imitatethe commercialideas oftheir competitors, be it inthe form ofthe commercializationof scientificideasor inthe form ofproducingproductsthat already exist elsewhereor evenjust improvingthe quality of existingproducts, the incentivesto makesuch investments are low.This "appropriability problem" is the principalmarket failure thatjustifiesthe use of government subsidies or other instrumentsto stimulateprivateinvestments ininnovationinputs, butthere are others discussedinthe remainingsections ofthis chapter. Subsequenteconometric exercisesattempt to providequantitativeestimates of the relationships highlightedinFigure4.1, butwe were unableto uncover underlyingcausalrelationships betweenfirm-levelinnovationinputs andoutputs, for example, althoughwe do uncover potentialcausaleffects concerningthe existence of marketfailures by using macroeconomicdata in Section4. We now turn our attentionto the marketfailures that presumably justify government interventionsto promote innovation. Figure4.1: InnovationFramework ............................ I Patents ~NewProducts ~ , Licensing ~ExporterStafus ~ imported inputs ' ............._.__..._____._ Training !.Fore!~~ownershr-! ~Business Sector ~ ~ ~ Cornpetifion I ~ Labor regulation Training policies ~ Education policies ~ Financial markets Source: Based on author's own calculations. MarketFailuresin the CreationandDiffusionofInnovation 9. The market failures that shape private-sectorinvestments in innovationhave beenwidely discussed in the specialized literature (Kortum 1997;De Ferrantiet al. 2003; Maloney2005; Jonesand Williams 1999;HausmannandRodrik2003, amongothers). Innovationoftenrequireslumpyand complementary investments (sunk costs), andonce an innovatorundertakesthis activity, others maybe inclinedto follow suit and imitateor appropriate the incumbent's new idea.Suchmarketfailures or implicit "taxes" on innovationundercutthe creation ofnew ideasand depress privateinvestmentin innovationinputs.Overcomingthese shortcomings requiresan understandingofthe forces that create these marketfailuresand a pro-activestrategic policy stance to guide a country's innovationagenda. 105 10. One of the mostcommonly discussed"taxes" on innovationis relatedto the appropriability of rents and the low cost and barriersto imitation.The process of innovationrequires entrepreneursto investment inexperimentingand discoveringnew products or processes. However, once this entrepreneur discovers an innovation that pays off, others will be inclined to imitate and drive down the entrepreneur's profit. This can occur through a reduction ofthe new product's sales price ifit is a non-tradable good. It can also occur through increasesinthe costs of non-tradable factors of production, such as labor and land. The result is that firms will under-invest inR&D and other innovationinputs, becauseof the riskthat other firms will appropriate such benefits. Inthis case, a market failure arises becauseprivate returns to innovation will inherentlybe lower than the social returns, thusjustifying a role for public intervention. 11. Ifinnovationcan beperfectlyprotectedthroughintellectualpropertyrights(IPRs),then additionalincentivesmightnot be requiredto promote private-sector innovation,but this would come at the expenseof higher costs for usersof those innovations.Furthermore, it is possible that many innovations in developing countries cannot be protected by IPRs. The advantage of rigorously enforcing IPRs regulations is that it brings the additional benefit of knowledge diffusion through the informational content provided inthe patent applications. Hence inmost contexts the optimal policy mix for advancing innovation will entail a mix of IPRs, their enforcement, and public support to private-sector investments in innovation inputs. 12. Another "tax" on innovation-and one extremelyrelevantfor developingcountries-is associatedwith the sunk costs that comewith the activityof innovatingand the economiesof scale that are ultimatelynecessaryto spread these costs and make a profit.Technological changes and expenditures on R&Dare for the most part sunk costs, and indeveloping countries most firms do not have the scale for these investments to make economic sense. Not only does the innovator face the threat of being undercut by imitators once he makes a discovery, but he also needs to consider how he will recover his initial investment.When firm size and market scope are limited, there is an inherentbarrier that discourages innovation from taking place. This situation is exacerbatedbythe lack of all other downstream investment (i.e. transport, logistics, marketing, distribution, etc) associatedwith the launchof a new product or service. Inthis context, government interventionmakes sense either by providing sweeteners to initial investors so that sunk costs can be recovered, or by promoting sector associations or industrialists' groups that can coordinate these upstream and downstream activities and spread the costs among a number of firms. 13. Lastly,another issue to be considered inthe innovationagenda and one that further stunts the growthof the marketplacefor new ideasis credit marketimperfections.Access to credit and financing in developing countries usually takes the form of bank lending.The underdevelopment o f capital markets inthese places means that most firms tap into bank loans as a main source of financing. This not only exacerbatesthe cost of accessingcapital but also limits the availability o f funds for riskier projects, since bank lendingis necessarily low risk as it involves intermediatingdeposits. Inthe absence of riskier forms of financing, the creation and diffusion of innovation is limited, and inturn, the possibility that it will act as a growth catalyst diminishes.The empirical analyses presentedsection 4 in this chapter evaluatethe potentialmagnitudes of some ofthese market failures, but we first describe Costa Rica's macro- and micro-economic position interms of innovation outcomes and inputs. 4.3 How MuchDoes Costa Rica"Innovate"? 14. Growthin per capita income and improvementinthe standard of livingof CostaRica's populationdriven by productivitygrowthand private-sector investment are the fundamental measuresof innovationsuccess.A standardgrowth accounting exercise for Costa Ricasheds light on the contributionto growth that can beattributed to the accumulation of physicalcapital, the increasein the labor force andthe increase intotal factor productivity (TFP). As evidenced by Table 4.1, the 106 1085 5.9 2.5 t Ilwx_ I.8 I,6 5.8 1.8 3.3 2.7 1")s - 2001 4,4 1.b t . 1 1.6 1985 -200 I 5.37 2 1.4 1.97 Source Rooles-Corder0 and Rodrigdez-Care (2002) WIC could saj rtrat Co a does not seem to sys I07 - - - - - 0 0 - ' 19bO 1 9'70 19'80 19bO 2obo I Scientific Publications ----- Patents I Source:World Bank (2003). 18. In terms of the introductionof new export products, a form of non-patentable innovation, Costa Ricadoes seem to be underperforming.Another indicator of innovation outcomes is the appearanceof new products in a country's export basket. Recent evidence suggests that there is a linkage between the appearanceof new export products and economic growth. For instance, Khan (2004) finds that the introduction of new products does indeed affect economic growth by stimulating productive investment, and econometric evidence provided by Klinger and Lederman(2004; 2006) suggeststhat market failures may reduce the frequency with which new export products are introduced by developing countries. Figure 4.3 shows the predicted and the observed number of export discoveries during 1994- 2003, as a function o f the level of development (GDP per capita) ina sample of 73 c~untries.'~The graph shows two different predictions. One is derived from a Negative Binomialestimation that controls only for GDP per capita and its squared terms, while the other also controls for sector-specific effects, where Learner's (1984) commodity groups encompassthe corresponding sectors. This latter adjustment could have beenimportant ifthe introductionof new export products indeveloping countries is the result of structural transformation, whereby growing economies change their patterns of production. Since both curves seem very similar, the data suggestthat structural transformation i s not an important part of the story. Either way, Costa Rica is an underachiever inthis realm.86 ''Adiscoveryi s definedas agood if it was not exportedduring 1994-1996,but exportedfor morethan US$10,000 in 2002 and 2003, basedon disaggregatedexport data at the 6-digit level of the HarmonizedSystem.See Klinger andLederman(2006). 86This new evidence contradictsthe evidencereportedby World Bank (2005c), which showeda similar graphwhere CostaRica appeared to be an overachiever. This previousfinding was due to recordingerrors inthe export dataaffectingnumerouscountries including CostaRica.For a methodologicaldiscussionconcerning recordingerrors andthe measurement of export discoveries, see Klinger and Lederman (2006). 108 Figure4.3: ExportDiscoveriesduring 1994-2003 and the Levelof Development: Predictedand Observed Counts *""I I GDPperCapita (PPP4djut.d;2000US. Dollan) obser& DiscoMrieS-Predicted Diaamiea- Redictionv4h Inhtrier Source: Klingerand Lederman (2006). 19. Recent evidence also suggeststhat Costa Rica is underperforming in terms of its investment inR&D.Similar benchmarking can be done with innovation inputs at the aggregate level, namely expenditures inR&D and payments for licensing o f foreign technologies. The results o fthese exercises are depicted in Figure 4.4. The data suggest that Costa Rica's R&D effort has been weak compared to countries o f similar size (0-line). Onthe other hand, the share o f GDP Costa Rica devotes to licensing does not show deficits in investment. These low rates o f investment inR&D are not due to low returns, as will be discussed further below insection 4.2. Figure 4.4: InnovationInputsin Costa Rica Decade R&D/GDP Lieensln /GDP 0 23% 0 14% 0 26% 0 09% 0 23% 0 07% -54, , , 1990 I995 2000 -R&D/GDP-----Licenring/GDPI Source:World Bank (2003). 20. A strong education base is a prerequisite for innovationand technological change.Bosch, Lederman, and Maloney (2005)' for example, find that educational attainment o f the labor force is an important determinant of the efficiency o f R&Dinvestments. Costa Rica's educational attainment is 109 among the highest in Latin America, butthere i s still room for improvement, especially when one comparesthis performance to other countries with similar income level (Figure 4.5). The country has made remarkable efforts inreachingthe goal of universal primary education o f its population. Today, more than 60 percent ofthe adult populationhas some primary schooling, and enrollment rates for those inthe appropriate age cohort are almost 100percent (World Bank 2003b). Despitethis, CostaRica's overall educational performance i s still not ready to propel the country into a virtuous growth cycle. Average years of educational attainment are still somewhat lower than other LatinAmerican countries with similar income per capita, and far from innovating countries such as Israeland Ireland. Figure4.5: DistributionofEducationalAttainmentamong the Adult Population Argentina Brazil Chile costa Rica 61 Dominican Republic El Salvador Guatemala Honduras Nicarague Panama Singapore Malaysia Korea 0 10 20 30 40 50 BO 70 Percent of Adun Population %ISome Teltiary .Some Secondary Some Primary .NO School Source:De Ferrantiet al (2003) based on Barro and Lee (2002). 21. To some extent, Costa Rica's educationalattainment is beinghampered by a "secondary education gap". The country has gone through an unbalancededucational transition characterized by excellent coverage for primary education, rising enrollment intertiary, but dwindlingenrollment and high dropout rates at the secondary level. Infact, Costa Rica has one o fthe highest coverage rates at the primary level among its adult population, but also has a greater proportion of the population with university degrees than with secondary schooling (De Ferranti et a12003). The declining proportions of secondary school graduates also evidence this phenomenon and increases inthe number of secondary school drop outs inthe work force (Gindling 2005). The problem is that this deficit in secondary school enrollment impinges on the country's long-term prospects for increasing overall educational attainment of its work force and thus its ability to upgrade its economic structure through technological upgrading. This is evident when one compares Costa Rica's situation with the educational transition followed by most East Asian countries, whichfollowed a pattern of skills upgradingfrom the bottom-up. That is, they started increasing the fraction of adults with secondary education while enrollment intertiary education was almost left unchanged. Incountries likeKorea, Hong Kong and Singapore, the fraction of adults with primary education or less fell by more than 30 percentagepoints between 1960and 2000, while the fraction with secondary schooling increasedby more than 25 percentagepoints over the same period (De Ferranti et a12003). 22. In sum, from an internationalcomparative perspective, Costa Rica shows some strengths and weaknesses in terms of its innovationoutputs and inputs.Regardingoutputs, it is difficult to 110 conclude that Costa Rica is falling behind in internationalpatenting, giventhat it is a relatively small economy, but it does seem to be laggingbehindinterms o f scientific output and with respect to the frequency of emergence of new export products. On the side ofthe inputs, Costa Rica's clearly underperforms interms of R&Deffort, but seems to be outperforming similar countries interms o f licensing payments. Without additional empirical work, it i s difficultto derive strong policy conclusions basedon these benchmarking exercises, because inthe presenceof market failures the average or typical performer for a given level of development might reflect the "mediocre" case, rather than best practices. Moreover, falling behindin one indicator might be less harmful than falling behind inanother since the social rates of returnmight be different across the different types of innovation inputs, which inturn can vary dependingon the institutional context and investmentclimate inwhich firms operate. We now turn our attention to the characteristics of Costa Rican manufacturingfirms interms of their apparent innovative capacity and effort, based on new international survey data. 4.3.2 Firm-level Innovation Outputs and Inputs 23. New data on firm-level innovationcan be used to assess Costa Rica's performancerelative to other developing economies.The new survey datawas collected under the auspices o fthe World Bank's InvestmentClimate Assessment (ICA) program. A sample of over 300 Costa Rican manufacturing firms was surveyed in 2005. To place this country's microeconomic innovation performance in comparative perspective, we also use comparable data from sixteen other developing countries. Since developing country firms tend to innovate more frequently through the introduction o f new products or changing existing production processes, the survey data is relatively strong interms o f measuring accurately these types of innovationoutcomes. 24. The surveys also collect data on various innovationinputs, such as R&Dexpendituresand licensing, as well as on other firm characteristicsthat could be correlatedwith both innovation outputsand inputs.The following paragraphsassess internationalcomparisons ofmanufacturing firms along these dimensions, by relying on all available data from the World Bank's ICA surveys of the countries that are part of the sample usedinthe regression analyses discussedinsection 5 below. Overall we cover seventeencountries, including Costa Rica, althoughthe firm samples used inthe regressions is smaller than the sample of over 10,000 firms (for some of the indicators) that were used to calculate the descriptive statistics used inthe following paragraph^.^' Furthermore, readers should be cautious and not derive strong policy conclusions basedpurely on this descriptive statistics that follow, becausethe average firm-level characteristics by types of firms tells us nothing about the direction o f causality nor about the magnitude of the any measurementerrors afflicting the data.88 25. Newproduct. InCosta Rica, 53 percent of surveyed firms reported introducinga new product during the previous 2 years, which is above the sample mean (47 percent) but in line with results from other countries inthe region, namely Chile (45 percent), Guatemala (53 percent), Honduras (47 percent), and Nicaragua (47 percent). However, other countries inour sample, such as Brazil, South Africa, and "ThesampleoffirmsusedintheregressionspresentedinSection5belowissmallerthanthesampleusedforthedescriptive statistics by country because the regressions require that every firm in the sample have data on all dependent and explanatory variables, whereas the descriptivestatistics only requirethat firms report answerson each questionof pairsof questions. ''Ifmeasurementerrors are "classical" in the sense that the magnitudes of the errors for each variable are not systematically correlated with the other variables under investigation,then group averages can approximate true averages. But causalitycannot be inferredeven from well measureddata basedpurely on a comparisonof averages across groups of firms, suchas comparisons between innovative and non-innovative firms, as done in the following text. Furthermore, even classical measurementerrors in the data can have profound effects in regression analysis that attempts to estimate partial correlations among variables. Our subsequent econometric estimations of section 5 attempt to deal with some types of measurement errors in order to uncovertrue partial correlationsbetween firm-level innovationoutcomes and inputs.Nevertheless, the problem of endogeneity and causality are not resolved in our econometric exercises, which limit the policy conclusions that can be derived even from multivariate regressions. 111 evenEl Salvador, havemorethan 60 percentof surveyedfirms engagedinnew productdevelopment (Figure4.6), andthus these datado not contradictthe macroeconomic evidenceon exportdiscoveries discussedabove. Brazil - 68 Cambodia - 52 Chile I 45 China -3 - 15 CostaRica -I 53 Ecuador 52 _1 Egypt - 15 El Salvador 62 - Guatemala - 53 Honduras - 47 Kosovo - 60 Madagascar -r 39 Nicaragua - 47 Oman - 34 Philippines 47 South Africa A1 68 Zambia - 51 Sample Mean - 42 Source:World Bank InvestmentClimate Survey (2005). 26. There is a close association between firm's investmentsin innovationinputsand outputs in Costa Rica and elsewhere.InCosta Ricathe percentage of firms that introducednew products also reportofferingtrainingto employees, beingexportersandforeign owned, licensingnewtechnology, and investingin R&D to a notablygreater extent thannon-innovativefirms, as showninTable 4.2 below. With the only notableexceptionofworker training, the same pattern is broadlyconfirmedinthe sample fromthe seventeencountries studied inthe regressionanalysesreportedlater inthis chapter.Another pieceofevidence that stands out is the fact that inCostaRicaalmost 71percentoffirms that introduced new products also claimed beingexporters, while only 15 percent offirms reportedexportingbutnot engaginginthis type of innovation. This is the highest frequency amongbenchmarkedcountriesand substantially abovethe sample mean.Other countries, like Chinathat is usuallyassociatedwith high tradingvolumes, actuallyreports that only slightly morethan 11percentoffirms that introducenew productsengage inexports. 112 Table 4.2: New Product versus Non-Innovative Firms: % Firms with Key Characteristics Country OfferedFormal Training Exportedpreviousyear ForeignOwnership Paidfor Licensed Use ImportedInputs MadeR&D Expenditures Technology from Foreign Firms Firms w/ OtherFirms Firms w/ OtherFirms Firms w/ OtherFirms Firms w/ OtherFirms Firms w/ OtherFirms Firms w/ OtherFirms New New New New New New Product Product Product Product Product Product urazii /U SY ti8 19 76 4 76 5 74 7 /ti 93 Cambodia 53 22 63 34 62 31 57 16 63 38 82 3 Chile 53 57 55 25 51 14 56 14 53 15 65 11 China 0 31 11 2715 11 24 0 6 14 7 22 38 Costa Rica 63 37 71 67 6 65 24 65 24 69 7 Ecuador 60 58 35 60 71 50 13 51 24 55 39 60 33 Egypt 33 8 15 26 3 37 7 26 16 35 6 El Salvador 70 29 65 35 68 7 69 11 66 31 78 10 Guatemala 59 36 4858 29 48 11 60 17 58 29 64 27 Honduras 56 34 33 45 16 62 11 49 33 69 7 Kosovo 82 10 63 10 100 0 61 23 64 52 81 10 Madagascar 43 40 43 30 43 36 50 7 42 49 39 17 Nicaragua 61 19 47 22 42 11 56 7 50 34 64 9 Oman 37 18 56 17 42 11 64 6 43 41 33 6 Philippines 67 11 46 3642 57 19 63 11 51 31 61 15 South Africa 70 58 70 65 . 21 75 18 68 20 81 30 Zambia 50 28 52 30 56 25 53 8 54 46 57 15 SamoieMean 47 47 46 26 39 16 55 9 51 18 53 24 Source: World Bank InvestmentClimate Survey (2005). 27. Product upgrade. CostaRicaranks fifth amongbenchmarkedcountries interms of firms reportinga product upgrade(Figure 4.7). Indeed, 83 percent of firms reporthavingdone a product upgrade, whichtranslatesas the mainsourceof innovationfor firms surveyedinthe country.Inthis categorythe samplemeanis 66 percent, and interestinglyenoughBrazil is one ofthe countries that most engages inthis type of innovation,while China, Omanand Egyptlie at the bottomofthe scale among benchmarkedcountries. Still, the fact that over sixtypercent of all firms inthis sample ofcountries report product upgradessuggests that this type of innovationis commonplaceindeveloping countries, andthat there mightbe littlejustificationfor the public sector to providesubsidies or other incentivesto stimulate this type of innovation,becausepublicactionisjustified inthe presenceof marketfailures that presumably limit the privatesector's abilityto innovatewithout some sort ofpublic intervention.Itis unlikelythat this is the case when the vast majorityof firms reportproductupgrades andmany cases over 80 percentof firms reportthis outcome. 113 Brazil 68 Cambodia - I 52 Chile 45 China 15 CostaRica 53 Ecuador I 52 Egypt 15 El Salvador 62 Guatemala 53 Honduras 47 Kosovo ' 60 Madagascar I 39 Nicaragua 47 Oman 34 28. Nonetheless, Table 4.3 shows that inthe case of Costa Rica, firms that do some sort of product upgradingalso report offeringtraining, beingexportersand foreign owned, licensing technology from abroad and investingin R&D.Notethat inmost cases almost 90 percent of firms that innovate also reportthese set of characteristics. Infact, most firms that engage inproduct upgradingalso have these traits. Although the sample averagesare slightly below the Costa Rican average, it i s clear that there is a strong positive correlationbetween this innovationoutcome and the corresponding inputs across the seventeencountries. Since the vast majority of firms report product upgrades, the few othersthat do not innovate inthis manner seem to be, Table 4.3: Product Upgrade versus Non-Innovative Firms: YOFirms with Key Characteristics Technoiogyfmm Fomign Films Finns lhal Other Finns Finns that OlhorFinns Finns that Other F i m Finns the1 OlhorFinns Finns that Other Finns Finns that Other Finns Uwraded Uwmded Upgraded Upgraded Upgraded Uwnded Pmduots Pmducls Pmduols Pmducts Pmducls Pmducts Brazil 86 45 86 14 85 4 85 7 85 8 88 20 Cambodia 90 3352 88 11 88 11 88 11 85 33 100 0 Chile 76 78 21 74 13 85 8 71 18 88 7 China 50 24 44 27 51 20 88 1 55 5 88 24 Costa Rica 80 27 82 12 87 7 88 20 88 24 84 3 Ecuador 85 81 86 77 82 13 84 22 85 38 87 32 Egypt 48 7 45 14 37 3 55 8 40 15 51 5 El Salvador 88 23 88 24 84 7 88 8 85 28 80 10 Guatemala 88 25 84 28 80 I 1 87 14 82 31 86 27 Honduras 78 32 74 32 80 11 78 13 78 26 83 7 KOSOVO 88 7 50 13 100 0 83 , 10 64 53 81 10 Madagascar 71 28 87 24 54 40 63 7 63 44 67 13 Nicarapua 86 7 87 I 8 88 7 82 4 88 28 87 3 Oman 42 20 72 13 33 14 73 5 57 38 50 5 Philippines 78 10 60 37 67 20 78 9 63 33 76 13 South Africa 88 42 89 30 88 15 88 16 85 18 81 28 Zambia 67 32 78 24 76 24 73 8 78 42 83 4 Sample Mean 74 30 71 24 67 15 84 6 74 16 82 16 Source: World Bank InvestmentClimate Survey (2005). 29. Processchange. The incidence of firms innovatingviaprocesschange is rather low inCosta Rica (less than 30 percent of surveyed f i r m s mention doing so) and below neighboring El Salvador, Guatemala, Honduras andNicaragua. Among benchmarked countries, only Chile and Egypt have a lower rate of respondent firms mentioning processchange as a type of innovation(Figure 4.8). Nevertheless, the data suggestthat processchanges are relatively rare comparedto product upgrades(66 percent ofthe sample) and similarly frequent as the introductionof new products (43 percent ofthe sample). 114 Figure4.8: FirmsReportinga ProcessChange (Percent) Brazil' 68 Cambodia 61 Chile 26 China L 41 Costa Rica 29 Ecuador 51 Egypt. 11 El Salvador L 51 Guatemala 43 Honduras ' 46 Kosovo I 47 Madagascar I 37 Nicaragua I 53 Oman 30 Philippines 41 SouthAfrica 61 30. The fraction of firms in Costa Rica that innovate by means of processchangesand also report beingforeign owned or beingan exporter,or investingin licensing or R&Dtend to hover around 40 percent.Although these percentages seem low, they are even lower for the sample of Costa Rican firms that do not innovate through process changes. For example, o fthe non-innovative firms, only 9 percent report investments in R&D and 8 percent report beingforeign owned. For the sample average, licensingtechnology and R&D seem to be notable characteristics of firms that report process changes, as 59 percent and 61 percent of innovators report licensingpayments and R&Drespectively. The corresponding shares o f non-innovative firms are well below those numbers. Inseveral countries (Cambodia, China, Nicaragua, and the Philippines) this type of innovation is associatedwith f m s that license foreign technology to a greater extent that R&D. 3 1. Quality standards (ISO). InCosta Rica, only 9 percent o f surveyed firms report having I S 0 quality certification for their products. This is similar to firm responsesinother countries inthe region (except for Brazil), but considerably lower than China (46 percent) or South Africa (42 percent), as shown inTable 4.4. Table 4.4: ProcessChangeversus Non-InnovativeFirms YOFirmswith Key Characteristics - Countw OfferedFormal Training Exportedpreviousyear ForeignOwnership Paidfor Licensed Use ImportedInputs Made R&DExpenditures Technologyfrom Foreign Firms Firmsw/ OtherFirms Firms w/ OtherFirms Firmsw/ OtherFirms Firms w/ OtherFirms Firms w/ Other Firms Firmsw/ OtherFirms Process Process Process Process Process Process Change Change Change Change Change Change Cambodia 83 10 15 29 74 27 83 8 72 35 84 8 Chile 32 62 33 27 26 15 36 15 34 15 37 14 China 44 25 41 26 42 23 71 3 51 5 60 28 Costa R i a 41 39 40 21 31 8 42 26 36 30 40 9 Ecuador 56 62 58 64 43 14 53 23 58 36 61 32 Egypt 30 8 24 16 32 3 49 6 21 17 27 6 El Salvador 63 27 63 29 53 8 69 8 60 29 60 14 Guatemala 47 3936 58 24 52 9 52 17 49 30 49 32 Honduras 53 48 32 51 14 49 14 57 27 61 9 KOSOVO 71 12 63 , 7 100 0 72 12 44 61 75 10 Madagascar 49 35 51 25 50 30 67 4 50 42 55 12 Nicaragua 65 19 52 23 44 12 74 5 48 39 63 10 Oman 16 23 36 23 17 14 36 10 40 40 33 6 Philippines 60 12 47 32 61 15 70 8 49 29 47 18 SouthAfnca 65 55 64 41 62 19 69 18 62 19 69 39 Zambia 60 22 52 30 52 28 60 7 54 46 63 13 SampleMean 53 42 50 25 48 14 59 9 50 20 61 21 Source: World Bank InvestmentClimate Survey (2005). 115 32. In Costa Rica, amongthe few firms that havequality certification,exportingand foreign ownershipseem to be the mostcommontraits.Incontrast, incountries like China or South Africa where certification i s a much more common practice, foreign ownership, licensingtechnology, importing inputsand investing inR&D(except for South Africa) are common characteristics o fthese firms (Table 4.5). Hence for the sample o f firms from the seventeen countries as a whole the most notable difference between quality-certified and non-certified firms seems to be the share o f firms that report being foreign owned (4 1versus 12 percent). Table 4.5: Quality Certification versus Non-Innovative Firms YOFirms with Key Characteristics - Country Offersd Formal Training Expoftedpnvious year Fomign Ownership Paid for Lmnsed Use Imported Inputs Made R8D Expmdifures Technology fromForeign Finns FQualify i n s w/ Other Firms Firms w/ Other Finns Finns w/ Ofher Finns FQUdlty I N w/ Ofher Finns Firms w/ Ofher Finns Finns w/ Other Firms Quality Quality Qualify Quality Certification Csrt,fic.tlo" Certrficdmn Certification Certification Certrfirufion Brazil 26 58 38 14 74 2 47 5 31 8 23 43 Cambodia 10 21 10 42 8 38 13 16 8 46 8 8 Chila 32 61 33 27 38 13 47 12 38 14 31 15 China 54 23 48 24 55 18 75 2 60 5 65 26 Costa Rica 18 42 32 18 43 6 23 27 21 28 14 10 Ecuador 21 66 27 70 34 10 28 20 23 38 18 38 Egypt 32 8 27 15 32 3 36 7 20 17 32 6 El Salvador 8 35 11 36 5 8 8 13 7 35 6 17 Guatemala 5 41 5 32 11 8 8 18 7 31 4 36 Honduras 8 40 8 32 14 14 18 13 10 33 7 12 Kosovo 18 21 25 8 0 2 33 18 13 58 I 3 21 Madagascar 11 41 8 32 8 37 21 7 10 50 10 16 Nicaragua 5 25 3 22 2 10 10 8 5 35 5 13 Oman 21 17 16 24 17 11 45 7 21 42 50 3 Philippines 40 12 30 30 45 15 46 10 30 27 25 17 South Afnca 58 46 55 35 68 11 70 12 58 14 47 46 Zambia 2 28 7 28 4 28 0 9 8 47 10 16 Source.World Bank InvestmentClimate Survey (2005). 33. Overall, the descriptivemicroeconomicdata provides a mixed pictureof CostaRica's performancein terms of commonmeasuresof innovationoutputs at the firm level.Onthe one hand, inour sample o f seventeen countries, Costa Ricaoutperforms the sample average interms o fthe percentage o f firms that introduced new products and product upgrades, but underperforms interms of changes in productionprocesses and quality certification. Regardingthe bivariate correlations between innovation outputs and inputs, the descriptive data suggest strong positive correlations o f innovation outcomes concerningthe development o f new products, product upgrades, and changes inproduction processes with innovation inputs, especially licensing and R&D investments. Butthere are other firm characteristics that appear closely associated with innovation, namely the status o f being an exporter and being foreign owned. Inthe case o f quality certification, its strongest bivariate correlate i s foreign ownership rather than innovation inputs.As mentioned, few strong policy recommendations can be derived from these descriptive statistics, since it i s impossible to know from this evidence whether exporting or being foreign owned cause innovation or even ifincreases in innovation inputs will lead to greater innovation since innovation itself can lead to innovation investments, such as training programs for employees or additional investments in licensingor R&D. Moreover, the firm-level data does not easily provide evidence o f the existence or magnitude o f market failures that justify government interventions to spur private-sector development. We now turnto a discussion o fmacroeconomic evidence that might move us inthat direction. 4.4 MacroeconomicEvidence on the Role of InnovationinPromotingEconomicDevelopment 34. The use of macroeconomicor national-leveldatato assess the impactof innovationon development has multipleadvantages.One is that nationaldata allows for transparent comparisons across a large number o f countries, which is not usually the case with firm-level or microeconomic data. The data and corresponding analyses presented in section 5 o fthis chapter below includes data from 17 countries and even there it is questionable that this sample i s truly representative o f firms operating in 116 developingcountries, althoughwe assume that this is the case. Another important advantage of macroeconomicanalyses is that they can capture economy-wideeffects. When the phenomenonbeing studied is characterizedby market failures andthus by social returns beinghigherthan private returns, thenthe developmentaleffects of suchphenomenais easier to capturewith aggregate data. 35. Here we addressthree policy relevantquestions.First, are indicatorsof innovation outputs, such as patents, associatedwith improvementsinthe level of developmentacross countries?Second, what are the social returns of innovation inputs, such as investmentsin R&D?Third, do marketfailures really affect the frequency of simple, non-scientific innovationssuch as the introduction of new export products or export "discoveries"? We tackle each questioninthe following paragraphs. Does PatentingActivity Improve a Country's Prospectsfor Development?89 36. To examine the role of innovationinthe context of institutionalweaknesses on long-run development it is appropriateto estimatethe effect of innovation outcomesat the nationallevelon GDPper capita.To approachthis questionthe subsequent analysis follows an academic literaturethat examines the empirical determinantsofthe levels of GDP per capitaacross countries-this literature is briefly reviewed in Box 4.1. Infact, there are strongtheoreticalreasonsto expectthat certain factors, such as geography, trade, institutions, and even innovation might explain levels of developmentbut not necessarilythe observed growth rates of GDP per capita. For example, intheoreticalmodelsby Aghion and Howitt (1998), Howitt and Mayer (2002), and Klenow andRodriguez-Clare (2003), all countries grow at the same rate intheir steady states, but those with higher innovative activity havehigher steady state levels of development.These dynamics are due, intheory, to the way in which technological improvementsare diffused across borders. Innovationleaders pushthe technological frontier forwards, and subsequently the followers can benefit from the growth of productivity. Butthe leaders are permanentlyricher in these models and thus there is not convergence of income levelsbetween followers and leaders. Inany case, here we follow this academic empirical literature. This section is taken from Lederman and Saenz (2005). 117 Box 4.1: An EmpiricalLiteratureon Long-Run Development An important challenge inthe empirical literatureis to identify the impact of exogenous components o f different variables o n the level of development. Frankel and Romer (1999) used a model to estimate the share of trade over GDP that i s due to geographical factors, such as distance to the major consumption markets. Inturn, they estimated the effect of this exogenous portion of trade shares on GDP p.c. Acemoglu et al. (2001) instigated a number o f studies that used settlers' mortality rates inthe 17thand 18th century as a historical determinant o f institutional quality. Other studies that followed this line of inquiryinclude Rodrik et al. (2002) and Easterly and Levine (2003). These studies also control geographic factors such as the condition of being a landlocked territory and latitude. Dollar and Kraay (2003) have raised some doubts about the ability of these models to identify the impact o f trade and institutions on levels o f development due to the fact that the instrumental are highly correlated among them and with the existing indicators o f institutional quality (see Kaufmann and Kraay 2002). Sachs (2003) further argued, "institutions do not rule" interms of being the only statistical significant determinant of levels o f development. In spite of the potential pitfalls o f this literature, we follow it inorder to assess the extent to which levels o f innovation outputs are good predictors of the level o f development. W e use Park`s (2001) index of intellectual property rightsas an instrument for patents p.c. Barro (1999) suggested usingthis variable as an instrument o f innovation. W e also include the explanatory variables suggested by the aforementioned authors. Methodology and Specification Tests The results discussed below include a series o f specificationtests to assess the adequacy of the instrumental variables, which we use to capture the exogenous components o f determinants o f the level of GDP p.c. across countries. The models contain two endogenous explanatory variables: the index of rule of law provided by Kaufmann and Kraay (2002) and our indicator of the stock of patents received from the US.PTO and the EPO. T o identify the exogenous component of rule o f law we try two other instruments: Acemoglu et al.'s (2001) settlers' mortality rates and Rodrik et al's (2002) portion o f the population that speaks European languages. W e use the (log o f the) average of Park`s (2001) index o f IPRprotection during1960-1995 t o capture the exogenous portion o f the accumulated stock of patents p.c. since the 1960s.The variable to be explained i s the (log of the) PPP-adjusted GDP p.c. capita in2000. To assess the validity o f the instruments, the exercises include a set of specification tests. First,the Hausman test compares the O L S to the IV coefficients. If the nullhypothesis of similar coefficients cannot be rejected, then it i s questionable that the rules o f law and/or patents p.c. variables are endogenous. Second, we present results from an auxiliary regression concerning the direct impact of the portions of rule o f law and patents that are not explained by the instruments o n GDP p.c. This i s an alternative test of the endogeneity of these explanatory variables. If these residuals are not significant, then it i s possible that rule of lawlpatents are not endogenous, and thus the OLS regression results are informative. Third,we present the coefficient o f the partial effect of the chosen instruments on the supposedly endogenous variables. The instruments are adequate if they are significant determinants of the explanatory variables. Fourth, the analysis includes an estimate of the partial correlation between the instruments and the dependent variable. If there i s a significant correlation, then the instruments themselves are either endogenous or shouldbe included as direct determinants of GDP px. Fifth, the final specification test i s due to Shea (1997). This statistic i s the "partial R-squared," which i s an indication of h o w much o f the variance o f the endogenous variables (rule o f law and patents) are explained by the chosen instruments. "High" partial R-squares are an indication that the chosen instruments are relevant inthe sense that they do explain a significant portion o f the variance o f the endogenous variables after controlling for the correlation between the instruments and between them and the endogenous variables. This i s important to consider, (Dollar and Kraay 2003), because if there are high correlations among the instruments, between them and the two endogenous variables, it i s possible that the remaining variance of the endogenous variables might be too small to really be helpful inidentifying a major portion o f the endogenous variables. The results o f these exercises and the corresponding specification tests are presented inTable 4.6. 118 Table 4.6: RegressionsResults: Determinants of Long-Term Development-Institutionsversus Innovation DeDendentVariable: Logof GDPDer CaDita in 2000 fPPP adi Ited) - - Hausman Sig. of - Slg.Of for IV OLS Test for teslduala Coefflclent of 1st. istrumei lelevance Coeff. J Coeff. Endogenell (rule, Stage Regression t i n (adj. Obs. Y lpats) In Income - - Income partial R"Z) 0.60 * 1.14 Fail to rejec No -0.30 * No 66 Null 0.46 0.57 Hypothesis landlock -0.29 * -0.14 Sub-SaharanAfrica -0.60 ,7061 * malaria -0.51 -0.29 2) rule lmort 0.63 0.95 Fail to rejec -0.34 * No 53 Null ' oil 0.35 * 0.39 * Hypothesis latitude -0.01 * -0.02 landlock -0.34 " -0.27 Sub-SaharanAfrica -0.51 * -0.52 * malaria -0.74 * -0.66 rule lpats 3) rule lmort 0.55 * 0.45 ** Failto rejec -0.34 -0.76 ' No 0.25 53 Log(patentsper capita) lip 0.17 * 0.24 * Null 0.06 1.31 ' No 0.31 Hypothesis oil 0.36 * 0.38 latitude -0.01 * -0.01 * landlock -0.36 -0.36 Sub-SaharanAfrica -0.36 -0.33 - 4)lruie leurfrac 0.60 1.26 * Fallto rejec No 0.36 " No 106 Null oil 0.44 0.58 Hypothesis landlock -0.29 * -0.15 Sub-Saharan Africa -0.60 -0.59 malaria -0.47 * -0.20 - 5) rule eurfrac 0.80 * 1.16 * Failto rejec 0.38 No 66 Null oil 0.35 * 0.52 * Hypothesis landlock -0.22 " -0.15 Sub-SaharanAfrica -0.59 -0.55 malaria -0.65 * -0.45 - - rule lpats 6) rule eurfrac 0.50 * -0.01 0.37 " 1.75 ' No 0.14 Log(patentsper capita) lip 0.15 * 0.23 * Failto rejec 0.04 1.26 * No 0.17 86 Null oil 0.40 * 0.26 Hypothesis landlock -0.34 * -0.47 Sub-SaharanAfrica -0.44 -0.41 malaria -0.41 " -0.49 0%. All rearessions I dude a constant. c imv for net exDc !rs of non-oil commodities, absolute value of latitude,and the log of Franiel and Romer's(1999) constructediradeshares. InstrumentalVariable Definition: lmort: Settler's mortality rate; lip: PR Index; eurfrac: Fraction of the population that speaks a European language. Source: Lederman and Saenz (2005). 37. The evidence suggests that innovation is as important for long-run development as the quality of governance, if not more. The first column of Table 4.6 above lists the explanatory variables that were statistically significant. Some variables that were not significant in any specificationare not listed.The second column lists the instrumental variables used ineachof the six regressions. The rest of the columns containthe estimatedcoefficients for eachexplanatory variable andthe specificationtests discussedabove. 119 38. The results reportedinthe first two rowsshow that the resultsreportedin most studiesthat followed Acemoglu et al. (2001) are reproducedwith our data and sample. The impact o frule o f law on income per capita is positive and significant in both OLS and IV estimates. Also, the IV coefficient is larger than the OLS coefficient, which might indicate that the OLS estimates suffer from attenuation bias possibly due to measurement error inthe rule o f law indicator. Furthermore, the Hausmann specification tests suggest that the whole set o f estimated coefficients from the OLS and IV estimates are not statistically different. Hence, it is not absolutely clear that the OLS estimates suffer from severe endogeneity problems. This is also suggested by the fact that the residuals o frule o f law are not significant inthe auxiliary regression that includes this portion o f the institutional indicator. When the patents per capita variable is included (row 3), the results change a bit with respect to the second regression, which is based on the same sample o f countries. Of particular relevance i s the findingthat in both OLS and IV estimates, the magnitude o fthe rule o f law coefficient i s significantly below those previously obtained from the models that ignoredthe role o f innovation. 39. The result that innovationis key for long-termdevelopment is robust to various methodologies. Ifreaders do nottrustthe OLS estimates, even though the endogeneity tests cannot reject the possibility that the explanatory variables are exogenous, the subsequent specificationtests associated with the validity o fthe instruments are satisfactory. The settlers' mortality rates are good predictors o f rule o f law; the log o f the IPR index i s a good predictor o f patents per capita. Also, the instruments themselves do not seem to be correlated with GDP per capita. Furthermore, Shea's partial R-squares are quite high.The unexplained (by the other exogenous variables) portion o f settlers' mortality.rate seems to explain about 25% o f the variance o f the unexplained portion o f rule o f law. Similarly, the unexplained portion of the log o f the IPR protection index explains about 30% o fthe unexplainedpart o f the log o f patents per capita. Thus the instruments seem quite relevant interms o f having strong partial effects on the endogenous variables. 40. Given the currentCostaRicancontext, the result that innovationis at least as important as governance for long-termdevelopment meritsfurther sensitivity analysis.To check for robustness o f these results, the regressions reported inrows 4-6 were derived from a different sample and a different instrumental variable for rule o f law, namely the fraction o fthe population that speaks a European language, which could be a suitable instrument if a fundamental source o f the quality o f public institutionstoday depends on historical colonial ties with Europe and that such ties affected all colonial territories equally. This latter assumption has come under attack by Acemoglu (2005) for obvious reasons, and thus we should treat the results with much care. The results inrows 4 and 5 show the same result concerning rule o f law when patents are not included. That is, the estimated impact o f rule o f law on the level o f development is larger inthe IVmodels than in OLS. Similar to the previously discussed specifications, we cannot reject the possibility that the explanatory variables are exogenous, which is suggested by the Hausman test and the lack o f significance o f the residuals o f rule o f law (and patents p.c. inregression 6) as direct regressors o fincome. Inthe OLS regression, the magnitude o fthe rule o f law coefficient maintains its significance when patents are included, but, again, its magnitude is curtailed. However, when patents p.c. is included - row 6 -rule o f law is not significant inthe IV regression. 41. The magnitude of the effects of governance and innovationon long-termdevelopmentseem to be comparable, and innovationis perhapsmore importantthan governance.Since we have two competing explanatory variables -rule o f law and log patents p.c. - it i s worthwhile to assess the economic magnitude o f the estimated effects o f each o f these on the level o f development. To accomplish this, the coefficients reported inregressionthree and six could be usedto simulate the impact o fa one standard deviation increase in each ~ariable.~'The standard deviation (reported inthe Annex) o f rule o f Dueto the fact that these two variables are measuredin differentunits, it is not economicallymeaningfulto assessthe impact o f a unit change or even of a percent increaseineach. 120 law is 0.92, whereas the standard deviation o f log patents p.c. is 3.14. Multiplication o fthese values with the corresponding OLS and IV coefficients indicate that inall specifications the magnitude o fthe effect o f innovation on the level o f development i s either slightly higher than that o f rule o f law or much higher. The OLS estimates o f model 3 imply that a standard deviation improvement inrule o f law is associated with a 0.51% increase inincome P.c.. The same improvement ininnovation is associated with a slightly higher 0.53% increase in the level o f development. The corresponding IV estimates imply a much larger difference: 0.41% increase from rule o f law versus 0.75% increase in GDP p.c. as a consequence o f a one standard deviation improvement in innovation. Very similar estimates o f the magnitude o f these effects are obtained from the coefficients from model 6, except that inthis case rule o f law would have no impact on development ifwe consider the IV estimates. Insum, innovation seems to be positively and significantly correlated with the level o f development, and its impact seems to be either similar or much larger in economic magnitude than that o f institutions. Thus innovation should be considered a fundamental determinant o f long-run development, which is at least as important as one o f the most popular explanatory variables. We now turnto the analysis o f the social rates o f return to investments in research and development. WhatAre theSocialRates ofReturn toR&D InvestmentsAcross Countries? 42. Any publicexpenditureshould bejudged interms of the social benefitsthat it brings to its population,especially inthe context of fiscal policy challenges.Itcannot be overstatedthat the descriptive benchmarkingo f Costa Rica interms o f its innovation outputs and inputs i s insufficient for justifying public expenditures inthis area. Hence estimates o fthe potential social returns, which includes the returns to private firms as well any spillovers, are important factors to consider in discussions about policy priorities. 43. Robust estimatesof the social rates of return of nationalR&Dinvestment requirethe use of macroeconomicdata that are not readilyavailable.Our empirical analysis relies on the R&Ddata collected by Lederman and Saenz (2005) covering 1960-2000 combined with GDP, labor, and investment rates from WB databases. Lederman and Maloney (2006) estimatedthe social returns to total R&D investments across countries and over time during 1960-2000, but allowed for the rates o f return to vary across countries, depending on their level o f development. The underlying intuition o f this exercise i s that aggregate or national effects o f R&D investments can capture the corresponding benefits as the positive spillovers across firms can only be measuredat the aggregate level. Furthermore, the magnitude o f these spillovers can depend on the infrastructure o fthe national innovation system, which includes the ties among firms through labor and other markets, between the private sector and universitieshesearch centers, as well as institutions such as intellectual property rights and enforcement. Since all these features are probably highly correlated with the level o f development, then we expect that the social returnsto R&Dwill vary across countries with different levels o fdevelopment due to these factors. In addition, the rates o f return will vary across levels o f development ifthere are diminishingreturns to R&Dcapital. This consideration leads to expect that the rates o freturnto R&Dcan be higher inpoor than inrich countries, butthe factors relatedto the quality o fthe national innovationsystem leadusto expect that poor countries can have lower rates o f return to R&D. Hence it is an empirical question whether developing countries such as Costa Rica can experience highrates o f returnto R&D. 44. Technicaleconometricanalysisis unavoidable for estimatingreliablesocialreturnsto innovationinvestments. The main results provided by Ledermanand Maloney and discussed herein were derived from econometric techniques that may help deal with potential endogeneity biases. More specifically, the results presented come from the GMM system estimator proposed by Arellano and Bover (1995) and Blundell and Bond (1998). Three different specifications are reported for all regressions: (1) usinga basic model with R&D, investment, labor, GDP p.c. as explanatory variables; (2) includingthe 121 initial output gap as definedby Loayzaet al. (2005) as a measureof convergencetowardeachcountry's steady-state levelof incomeP.c.'~; (3) includingtime dummiesto controlfor time specific effect^.'^ 45. The social rates of return to R&Dinvestments in countries with a similar levelof developmentas Costa Rica seem to be huge. Figure4.9 presentsthe estimatedreturns to R&D at different levelsof GDPp.c. It is interestingto note: First, for developing countrieswe observe a positive slope as GDP p.c. increases. This mighthaveto do with "efficiency problems inherentto the processof development". Second, as GDPp.c. reaches a certain level,the returnsto R&D gets to a maximumpoint, which coincideswith the levelofdevelopment of countries like Spain, Korea, Italy andothers (as of 1996). This meansthat CostaRicais fast approachingthe levelof development (`just underUS$lO,OOO in 1996), where in generalwe observethe highestpotentialsocial ratesof returnto R&D investments across the globe. Third, these resultsare also consistent with Griffith, ReddingandVanReenen(2001) who find decreasingreturns for developingcountries. Fourth, it is worthmentioningthat the predictedreturn magnitudes are inaccordance with most ofthe studies inthe literature. Thus this evidence suggeststhat Costa Ricamay benefittremendously inthe future from significantincreases inR&D investments, which should preferablycome fromthe privatesector andunlikelyto surgewithout public assistance.The remainingquestion is whether there are marketfailures deterringinnovations which are morecommon among developingthan industrializedcountries, andthus canbe consideredto bethe most commontype insidethe globaltechnologicalfrontier. Figure 4.9: PredictedReturnsto R&D UsingSystem GMMEstimators Return t o R&D / \ \ GDP per Capita 10000 20000 30000 40000 Source:Lederrnan and Maloney (2006). Based on a band-pass-filter developed by Baxter and King (1999) to assess the magnitude of deviations of GDP per capita from a long-runtrend. 92All the regressions pass the Hansen-Sargantest for the validity o fthe instrumentsandthere is no evidencethat they suffer from residual second order serial correlation. 122 Do MarketFailuresHinder InnovationInside the GlobalTechnologicalFr~ntier?~ 46. Since developingcountries are inthe processof diversifyingtheir economies,we expect countries at relatively low levelsof developmentto have more frequentepisodesof export "discoveries," as defined by Klinger and Lederman(2006), and discussedin previoussections above. As income rises, the frequency o fthese events declines, particularly at highlevels o f development when economies experience risingspecialization. 47. The datasupport the view that developingcountriesintroducenew export productsmore frequentlythan richcountries, and CostaRicais not an exception.To examine these effects inour data, we estimate the relationships between both inside-the-frontier innovation(export discoveries) and on-the-frontier innovation (U.S. patent counts from Ledermanand Saenz 2005) and the level o f development. Table 4.7 shows the results from Negative Binomial estimators, which are appropriate for count data. As expected, the frequency o f discovery falls as countries develop, after peaking at the lower- middle income level. Although low among the world's poorest countries, the frequency o f discovery rises quickly, reaching a maximum somewhere inthe neighborhood of GDP p.c. o f $4000 USD (inPPP adjusted and constant dollars o f 2000) as countries undergo productive diversification. As the level o f development continues to rise, inside-the-frontier innovation is replaced by on-the-frontier innovation, which increases exponentially with GDP per capita. Table 4.7: The ChangingNature of Innovation Inside-the-Frontier: On-the-Frontier: Discoveries Patents In(GDP P.c.) 8.667 -16.237 (6.53)*** (2.96)*** In(GDP P.C.)` -0.514 1.059 (6.67)'- (3.43)- Constant -32.289 65.872 (5.71)*** (2.74)- Observations 73 68 Notes: Absolute value of z statistics in parentheses. *** Significant at 1% Source: Klinger and Lederman (2006). 48. These relationshipsare illustratedinFigure4.10, which shows the estimated relationships of export discoveries,patents, and export diversificationwith respect to the levelof de~elopment.'~ Discovery activity peaks early inthe development process, and declines as the process o f diversification slows. At higher levels o f development, economies begin to specialize, and innovation is driven by on- the-frontier advances that are patented. This relationship between distance to the frontier, the nature o f innovation, and the stages o f productive diversification reveals that we must control for the level o f development (in quadratic form) when testing the model o f innovation and imitation. 93This section draws heavilyfrom Klinger and Lederman(2006). 94Eachis scaledby its maximumvalue for illustrativepurposes. 123 Figure 4.10: Diversification& Innovation 0 5000 10000 15000 20000 25000 30000 35000 1996 GDP Par Capita (PPP) Source: Klingerand Lederman(2006). Box 4.2: EconometricIdentification of Market FailuresAffecting the Introduction of New Exports As mentioned, because our innovation indicator inthis case is the number of discoveries with a substantialnumber of zeros, we estimate the following model with an exponential functional form using anegativebinomial estimator. Subscripts i and c correspondto Learner's commodity groups and countries, respectively. q,,, is the aforementioned commodity-group and country fixed effect, which is unobservedand capturedby the pre-sample number of export discoveries. i s an index of barriers to entry measured at the country level, based on data concerning five labor market regulations and other regulations that raise the costs of entry by f m s . Xis a vector of other control variables discussed below, and D, is a dummy variable for each Learner commodity group. The latter controls for unobserved sector-specific effects but also captures the number of product lines in each category, which affects the number of observeddiscoveries across commodity groups. As is commonplace in count-data models, the explanatory variables were transformed into their natural logarithms or were included in growth rates, which then allows for the estimation of the relevant elasticities. The exceptions were the commodity-group dummies, the indicator of comparative advantage of each country in each of the commodity groups (proxied by net exports per capita), and the barriers index. The latter was calculated as the first principal component of the five regulatory indicators discussed above, after they were normalized to have means equal to zero and standard deviations equal to one. The sign and significance ofB2 in (6) encompass our test of the market failure hypothesis. oum:Klingerand Lederman(2006). 124 49. Technical econometric analysis suggests that market failureshamperthe introductionof new export products,thusjustifyingpublic subsidiesfor export diversification.Box 4.2 discusses the technical aspectsof the statistical analysis utilizedto test for the presenceof market failuresand their deleterious effectson new exports and table A1 inAppendix 1shows the basicestimation results. 50. Evenafter controllingfor marketfailuresand other factors, the expected inverted-U relationshipbetweendiscoveriesand GDP p.c. persistsand is highlysignificant acrossall specifications.Inaddition, historicaldiscoveries enter as positive and significant, signaling that we are effectively correcting for fixed countryhommodity effects leadingto discovery. As suggestedby the similarity inmaximum points across Learner categories shown in Table 4.8, factor endowments are not significant, a resultthat persists without controlling for historical discoveries (not reported). 5 1, The returnsto discovery, measuredas the growth rateof the Learnercommodity cluster export growthminus non-export GDP growth,enters as positiveand jointly significant with the interactionterm in all specifications,as predictedby the market-failurehypothesis.Given that we tested a variety of additional control variables that were mentionedabove, these results suggest that the predictions of the market-failure model are robustly supported bythe data. That is, export growth has a positive and significant effect on the frequency of export discoveries, but the magnitude of this effect seems to rise with barriers to entry. Inaddition, the direct effect of barriers to entry on discovery frequency is largely insignificant and not robust, which was also predicted by our model, where barriers only affect discovery either through their impact on export profitability as inequation (3) or through its interactionwith export returns as inequation (2). This result does not imply, however, that barriers to entry do not have an impact on discovery through its negative effect on export growth, giventheir offsetting stimulus to discovery through increased suitability and drag on discovery through higher costs for the first mover. Furthermore, the results suggest that barriers to entry raise the magnitude of the effect of export profitability on discovery counts, but this comes at the cost of reducingthe social gains from imitation, and thus worsening the regulatory burdenon the private sector is not a good policy stance. appropriate 52. The evidencedoes suggest, however,that the suitability problemis a realconcernfor promotinginside-the-frontierinnovations,and thus the clear policy implicationis that developing countriesshould experimentwith policies designed to stimulate private-sector attempts to introduce new export products,which might not be protected by various forms of intellectualproperty rights. Ingeneral, therefore, this evidence canbe interpreted as supporting the role playedby export promotion agencies and PROCOMER inthe case of Costa Rica, which provides servicesto aid new exporters. Unfortunately, there is little empirical evidence concerning what types o f export-promotion activities work best and thus this should be an area for future re~earch.'~Nonetheless, the conclusion could be generalized to policies designedto stimulate new product development by private firms. The following section takes a microeconomic look at the correlates of firm-level innovation inseventeen developing countries, including Costa Rica, and Section 6 provides a close examination ofthe performance of related Costa Rican policies. 95The Office of the Chief Economistfor Latin America andthe Caribbeanof the World Bank is currentlyundertakinga study of the effectivenessof export promotionagencies inthe regionand elsewhere. 125 4.5 Costa Rica's Current InnovationStructure,Policies, and Programs EmpiricalStrategy 53, In estimatingwhat influencesfirm-levelinnovation,researchersface two serious challenges. First, many o fthe potentialfactors o f interest, especially R&Dand licensingexpenditures as a percentage of sales, are notoriously difficult to measure in developing country firm surveys. This is due to the fact that local entrepreneurs can have different perceptions o f what is "R&D" or a licensing payment. In addition, the value o f sales are also difficult to measure accurately ifthe survey does not get the right firm managers, and often the answers provide only a ballpark o f the range o f sales values. Second, as mentioned earlier, our empirical models are meant to test for partial correlations and linksbetween innovation outputs and inputs, but it i s not an attempt to identify causal effects between these variables. The problem o f endogeneity clearly arises with certain variables, most notably with training, also mentioned earlier. But there i s a deeper problem o f endogeneity with respect to omitted variables. For example, entrepreneurial talent i s not measured in firm surveys, and thus it i s possible that positive partial correlations between innovation outputs and inputs are due to entrepreneurial talents, which lead firms to innovate and invest innovation input, but it is the talent that drives the relationshipbetween these variables. Consequently, even error-free partial correlations cannot be interpreted as causal effects, and thus cannot bythemselvesjustify any type o fpolicy intervention. 54. Estimatingrobust partialcorrelations (which are not equivalent to causal effects) helps us characterize the relationshipbetweeninnovationoutputs and inputs, but measurement errors in the responsesfrom firms about how muchthey spend inR&Dand other innovationinputs blurs the true relationshipbetween innovationoutputs and inputs and complicatesany rigorousanalysis. Ifthere were no measurement errors inany ofthe variables, standard regressionmodelswould suffice to estimate partial correlations. Unfortunately, we know that this is not true. Indeed, we estimated, but do not report the partial correlation between innovation outcomes, R&D, and licensing investments, which were unsatisfactory. Box 4.3 describes the technical analyses that were pursued to uncover the true relationship between R&D, licensing, and firm-level innovation outputs. 126 Box 4.3: Uncoveringthe Role of R&D and Licensingin Non-PatentableFirm Innovations We first estimated the following model with the data for Costa Rica, combined with data from the other sixteen developing countries listedabove: InnovationOutput = Bo + B1CountrylSectorIndexhize + B2InnovationInput+B3 FirmCharacteristic + E. where InnovationOutput represents one of our four innovation proxies-the introduction o f a new product, upgrade product, process change or quality certification. Three categories o f control variables are relevant, starting with InnovationInputs, which includes variables that directly contribute to an innovation outcome, such as: education and training o f the labor force, measured as the average years o f schooling o f the workforce; and the percentage o f skilled and unskilledworkers who received formal training; investment in R&D, measured as R&D expenditures over sales; licensing o f foreign technology, measured as a dummy variable equal to 1 when a fm licenses technology; purchases o f foreign inputs, measured as the percentage o f direct and indirect imported inputs from a foreign-owned company; and sales to multinationals, measured as the percentage o f domestic sales to multinationals. The second category FirmCharacteristics, refers to fm-level traits that may affect a f m ' s proclivity to innovate, such as: firm size or scale, measured as the natural logarithm o f the average number of permanent and temporary workers or as the square root o f this same variable to test for a nonlinear relationship; a f m ' s exporter status, measured by a dummy variable equal to 1 when a fm exports; fm ownership, measured by a dummy variable equal to 1 for foreign ownership; capacity utilization, measured as the average utilization over the last year; and firm location, measured by a dummy variable equal to 1when a fm i s located inthe capital city. Lastly, CountrylSectorIndize are variables generated from the interaction o f country, industry, and labor-force size dummies to create the variable indexi, included in each regression. Inother words, this allows us to capture the effect on innovation o f operating in a specific country and a specific industry-Le., the effect of the investment climate, after controlling for fm-level characteristics. In this specification, R&D investments as a share o f fm sales never appeared with a significant partial coefficient, due to the presence o f severe measurement errors that producedthe well know problem o f "attenuation bias" (see Hausmann 2001). "Reverse regressions," as suggested by Learner (1978), are used to estimate true partial correlations between innovation outputs and inputs inour sample o f f m s fiom developing countries. This approach entails the estimation o f the reverse regression o f the previous model, which canbe re-written as follows by solving for InnovationInput: InnovationInput = (1/B2)*InnovationOutput-(Bo/B2)-(B1B2) CountrylSectorIndize - (B3B2) FirmCharacteristic + E. With certain types o f measurement errors and since the outputs are measured without errors (or at least with less error than the R&D and other input variables) this coefficient does not suffer from attenuation bias. A smaller and significant coefficient implies a larger and significant corresponding partial correlation from the original direct regression model. In addition, we substituted a set o f ICAConstraint variables instead o f the CountryjSectorIndex/size to explore the relationship between the investment climate and fm innovation inputs (as well as other relevant firm characteristics). The investment climate constraints used in this analysis refer to five factors: corruption, infrastructure, regulation, transport, and finance. Table 4.8 contains the relevant results from these reverse regressions, based on a sample o f over 5,000 f m s from the aforementioned seventeen countries. The sample from Costa Rica, which i s part o f the global sample, covers 327 firms. Due to this small sample, estimations conducted with the Costa Rican sample alone were not satisfactory. For example, in the regressions with R&D as the dependent variable, only 34 f m s in the sample reported some R&D expenditures. Consequently, the sample does not have enough variance for the regressions to reveal useful information. Finally, the largest possible international sample o f f m s was required to identify the effects o f the investment climate variables, which logically must be measured at an aggregate level. 127 55. Firm size and the average educationof the work force employed are positivelycorrelated with the probability of innovationby the firm. The coefficients ofthe size of the firm measuredby (natural logarithm of) the number of employees and the average education of the employees are not reported inTable 4.8. We did find, however, that firm size (measuredbythe log of number of employees) had a positive effect on all of dependentvariables, thus suggestingthat scale is a factor to consider inthe context of innovation policies. Also, the averageyears of education of the employees is positively correlated partially with licensingpayments and sales to multinationalcorporations only. (1) (2) (3) (4) (5) (6) (7) (8) Share of Share of Foreign Dependent Skilled Unskilled E ~ Ownership ~ ~ Licensing ~Makes ~ Share of Sales to r Share of R8D in Share of Variable Workers Workers Receiving Receiving Status Payments MNCs Sales Inputs Training Training (=I) (>50%=1) (=I) Estimator Tobit Tobit Probit Probit Probit Tobit Tobit Tobit 1 Investment-Climate Marginal Effects on Firm Innovation Inputsand other Characteristics (measured by. groups of firms clustered by I size (mediumllargev s others), 7 sectors, and 17 countries) - Corruption 1 0.598*** I 1.025*** I -0.003 I -0.002 I -0.002 I -1.155*** I 0.005** 1 -1.509*** [0.136] [0.174] [0.003] [0.002] 1 [0.002] I [0.266] 1 [0.002] [0.192] Regulation 0.102 I -0.100 1 0.003** 1 -0.002* I 0.000 1 -2.174*** I -0.002 1 -1.253*** I 1 [0.099] 1 [0.133] I [0.001] 1 [0.001] I [0.001] 1 [0.219] 1 [0.002] 1 [0.141] I Transport 2.783*** -0.116 -0.006 -0.009* 0.012*** 0.109 -0.015* 2.261*** [0.427] [0.618] [0.011] [0.006] [0.004] [0.851] [0.009] [0.612] Finance 0.007 -0.005 0.000 o.ooo* -o.ooo** 0.032"** 0.000 0.026**" [0.005] [0.010] [O.OOO] [O.OOO] [O.OOO] [0.008] [O.OOO] [0.007] INew Product I I 4.680*** 1 2.485 I 0.008 I -0.005 I 0.005 1 13.227*** I 0.127*** I 8.361*** I [1.368] 1 [1.759] I [0.023] [0.008] [0.008] [2.722] [0.023] [1.964] I I [1.808] 1 [2.420] I [0.019] 1 [0.011] I [0.011] 1 [3.564] 1 [0.032] I [2.445] I Notes: Robuststandard errors in brackets;errors clustered aroundfirm groups used to measurethe investment-climateindicators at an aggregate level. significantat 10%; ** significantat 5%; *** significant at 1% These are results from the "reverse"regressionsdiscussed in the text. The inverse of the coefficientsof innovation"output" can be interpretedas the true partial coefficient of each innovation input in the corresponding"direct" regression when the inputs are measuredwith error.A common intercept, log of number of employees,log of average years of educationof employees, dummy for full capacity utilization,dummy for firms in a capital city. The sample of firms is drawn from 17 countries with comparable data. Source: Klinger and Lederman (2006). 128 56. The evidencesuggests that bothlicensingand R&Dexpendituresare significantly and positivelycorrelatedwith three of our innovation output variables.Licensing, which is the main channel through which local firms adopt and adapt foreign technologies is also significant, except for the case of probability of innovation through a product upgrade. Moreover, the reverse-regression coefficients of R&D divided by sales are not only significant but very small compared to those on the reverse regressionsfor sales to multinationals and the share of imported inputs.These findings suggestthat the true partialcorrelationbetween R&Dandthe corresponding innovation outputs tendto be quitelarger than those ofthe other aforementioned continuous variables. Inthe case of the reverse regression with the licensingvariable as the dependent variable, the coefficient of the new product variables is smaller than the corresponding one for the exporter dummy. This suggests that at least for the case of new products, the true partialcorrelationbetweenthe probability of introducing a new product and licensing is stronger than the one of being an exporter. 57. Regardingthe investment climatevariables, the most robust effects on firm-levelinnovation inputs and other characteristicsthat are correlated with innovationoutputs comefrom the availabilityof non-transportinfrastructure,althoughtransport infrastructurealso seems to be a constraint for R&Dinvestments.Ifthese are not causaleffects, the coefficient can be interpretedas an indication that firms that invest less inR&Dtendto see problems in infrastructure. Ifthese results reflect causal effects, and since R&D i s also correlated with innovationoutputs, this evidence suggests that indeed the investment climate as captured by our infrastructure variables tend to deter firm-level innovation indirectly by reducing their investments in innovation inputs (R&D) and by limiting their links with multinationals, which mightalso be an important source of local firm innovation. 4.6 The CostaRicanExperiencewith InnovationPolicies Matching GrantsandPROPYMEBd 58. There are theoreticaland empiricaljustificationsfor governmentto promote private . investment inR&Dand innovation.Section 4 provided empirical evidence suggestingthe developmental gains of these policies can be substantial. Inaddition, macroeconomic evidence suggested that there are notable market failures that limit the private sector's investment inthe development of new export products. Whereas an assessment of the performance of PROCOMER or of the Ministry of Science and Technology as a whole falls well beyond the scope of this study, the following paragraphs take a closer look at one of Costa Rica's public programs designed to stimulate both private-sector investments in R&D as well as closer links between firms and research organizations. 59. Internationalexperience suggests that best practicesin publicfinancingof private-sector innovationentailthe use of matchinggrants, ratherthan tax incentives,unmatchedsubsidies, the establishment of public researchcenterswithout private-sector participationor protectionfrom internationalcompetition. Examples o fwell knownmatching grant subsidiesrange from the TEKES program in Finland to the Costa Rica's own program, which i s discussed inthe followingparagraphs. Maloney (2005) and Hall (2005) discuss various internationalexperiences. These programs have several positive features. First, they do not requirethe public sector per se to have the scientific or technical expertise to make decisions about the potential benefits of different types of innovations or sectorsthat could produce the next big idea. Second, whereas tax incentives require that tax auditors know a lot about innovation investment inorder to differentiate betweentrue innovation investmentsand capital investments that firms can argue are part of the innovation process, matching grants systems do not require auditing the accuracy o f tax-related information. However, given the fact that Costa Rica must 96This subsectiondraws heavily from Monge-GonzalesandMonge-Arifio (2005). 129 soon reform its EPZ incentives to make them compatible with WTO norms, it worth considering the use of these tax incentives that already exist to promote private-sector innovation by firms established inthe EPZs. Again, while this option is definitelynot ideal, the current context couldjustify the use of tax incentives. Third, when the matching grants are offered on the conditionthat private firms work together with universitiesor the scientific community, they help by providing concrete incentives to innovators in these venues that do not usually face market incentives. Finally, whereas trade protection has well known detrimental effects on innovation by reducingthe extent of internationaltechnology diffusion, matching grants can be targeted for commercial innovation, regardless of the geographic origin of the idea. 60. In CostaRica,the government hassupported investmentinR&Dsince2000, through a MatchingGrant System(FRC, for its Spanish initialsFondo de RecursosConcursables). This program was modified in 2002 and replacedwith the SME StrengtheningLawg7that created PROPYME-a comprehensive programto promote and facilitate the management and competitiveness of Costa Rican SMEs, through innovation and technology development without targetting any particular industry.PROPYME is funded by Costa Rica's Public Budgetand resourcesare allocated bythe Incentive Commission at the Ministerof Science and Technologyg80nan annual basis. The National Council for Scientific and TechnologicalResearch(CONICIT, for its initials in Spanish) administers the funds to avoid problems of political influence, corruption or moral hazard due to discretion. 61. PROPYME resourcescan be usedto finance various projects. These include technology development, innovation patents, technology transfer, human capital development, technological services, or combinations of these objectives. The program operates intwo phases: first, a firm or consortiumof firms submits a project proposal to the Incentives Commission, which evaluates it accordingto specific criteria concerning the targeted activity or technological area, expected impact on firm and country productivity, scientific and technological capabilities of firms, and management ca acity of the tender, among others. Second, projects that qualify are submitted to ResearchUnits(RU)9 ,f who then place bids for the development of these projects. Winningbids are selectedaccording to the quality, capabilities, and overall conditions offered by the RU, as well as any other criteria introduced by the Incentives Commission. Once a RUis chosento undertake a project, PROPYMEmay finance as much as 80% of its total cost with the SME financing the rest of project. The main objective i s to encourage entrepreneursto invest more in R&D linkedto the national scientific and researchcommunity. 62. In a previous review of the MatchingGrant System(FRC) Rodriguez-Clare(2003) claims that the system hasthreeinteresting features:(i) demand comes from the private sector and not from the researchunits,as was the case before; (ii) competition i s created amongst researchunits for each project (inthe past, researchunits presentedtheir own projects, making it hardto select among projects and follow objective criteria); and (iii) the formal nature ofthe system leadsto the generation of information about the projects that are presented and those that eventually get financed. This information serves as input to the country's Science and Technology Policy and allows for periodic evaluations that provide feedback on how to improve the system. 63. There is insufficient informationto properlyevaluate this program,but thereare clear indications that it can be improvedincludingan apparent recentfall indemand for these subsidies 97Ley de Fortalecimientode las Pequellasy MedianasEmpresas, in Spanish. According to the Ley de Fortalecimiento de las PequeAasy Medianas Empresas, this Commissionconsists of the Minister of ' Science and Technology, three representatives from the Board of Public Universities(CONARE), one representative from the Ministry o f Agriculture, one representativefrom the Ministry of Economy, IndustryandCommerce,two representativesfrom the Ministry of Finance, one representative from the Manufacturing Chamber, one representative from CONICIT, and one representativefrom the PrivateSector Unionof Chambers (UCCAEP). 99This Research Unit may belongto either a public or private university from Costa Rica or abroad, as well as can be a private researchunit independentfrom any university, e.g. NGOs or the own RUfrom afirm. 130 by the private sector. Although a formal evaluation ofthe MatchingGrant System exceeds the scope of the presenteffort, Monge-Gonzales and Monge-Ariiio (2005) provide relevant information concerning the program's performance since 2000. According to CONICIT's database, 50 projects have been financed through FRC and PROPYME, with government grants accounting for US$2.6 million since the program's inception. It is worth notingthat a back-of-the-envelope calculation of the government's contribution to the program between 2000 and 2004 represent a little more than 1percent (1-34%) of Costa Rica's total investment inR&Dduring the same period.'" This result should be carefully considered, since the MatchingGrant System is the only programthat explicitly promotes investment in R&Dthroughjoint venture innovationprojects between researchcentersand firms. 64. The Matching Grant System has financed all types of economic activities but the most important ones are manufacturingand agriculture, livestockand fishing, but services firms seem to be gaininginterest.Some basic data are on the sectoral distribution of the grants are shown inTable 4.9. Since PROPYME's inception, no new projects have beenfinanced on agriculture, livestock and fishing, while the services sector has increasingly beenfunded, especially firms engaged insoftware development. Table 4.9: MatchingGrants by Activity and Year _. am0 -w# m TceJ SFedCr NJ wla NJ -wla am I\h -wu? mp NJ-wu? m3 NJ NJ -wu? M r g 1 91,893.61 4 333,587.35 2 123155.75 0 0 0 0 7 6363.71 pgialtve& Wak 536,270.73 5 473,331.57 1 l&?l3.41 0 0 0 0 12 1,190,865.70 FccdRazssirg 3 297,W.S 5 116,51295 1 123,717.65 1 M,133(P 1 7,086.96 11 B,4%17 Mnfaduirg 1 94,9e845 5 483,155.52 1 19,134.25 2 B,233W 3 81,724.37 12 704,21364 sB\.icfs 0 0 0 0 1 191,841.24 5 156,21679 2 56,956B 8 405,@471 Taol 11 l,M,lP37 19 Im637.S 6 644067.30 8 ls6lSaS 6 9D 3,467,Bl.B Source: Matching Grants Program, CONICIT (2005). 65. The apparent decline in demand started around 2002, which might have beendue to the design of the program. Figure 4.11 shows the growth of the Matching Grant System between 2000 and 2001, as well as the decline since 2002. According to Monge-Gonzales and Monge-Ariiio (2005), CONICIT representatives explained that this decline might be due to uncertainty inproject co-financing. Since the amount of co-financing is determinedonly duringthe project approval phase and once it is assignedto a RU, firms do not have this information inadvance and may not agree with the financing terms proposed by the IncentivesCommission after the fact. Infact, during 2000 firms did not execute six projects because they disagreed with the share of financing set by the Incentive Commission. Still, this information is clearly insufficient to firmly identify the causes of the reduced demand for the funds in recent years, because said decline could be due to number of reasons, including the fixed-date systemthat establishesthe dates when firms can apply for the funds and the rather limitedscope allowed for the use of the funds. That is, demand could be low because it funds only innovations that are conductedjointly with researchcenters, rather than other forms of innovation, such as new product development that is not basedon the diffusion of knowledge from researchers. looThis result was estimated using the fact that in Costa Rica, the average GDP between 2000 and 2004 was $17,082 billion dollars. Besides, according to statistics obtained at www.ricvt.org (Inter-American Network o f Indicators on Science and Technology), the public investment in R&D accounts on average for 0.22% of GDP (the total national investment in R&D correspondsto 0.39% of GDP, 56% of which correspondsto public investment inR&D). 131 re 4.1I;Total Size of 1 2 ~ ~ , 0 0 0 1~ 0 ~ 0 ~ ~ 0 0 I 800,000 600,000 400,000 200,000 0 2000 2001 2002 2003 2004 Firm's tion gram COlJlG proceduresand criteria for project preparationand proposalpresentationto the IncentivesCommissionso that bothpublic andprivate universitiesare more inclinedto participate. Table 4.10: Numberof MatchingGrant Projectsby ResearchUnit I Research Number of Projects Funded Center 2000 2001 2002 2003 2004 Total Universidad de Costa 7 5 1 0 2 15 Rica Universidad Nacional de 1 4 3 0 0 8 Costa Rica lnstituto Tecnolbgico de Costa 2 3 1 0 0 6 Rica NGOs a 1 7 1 6 0 15 Firm's Own R&D Units 0 0 0 2 4 6 Total 11 19 6 a 6 50 ~~~ ~ ~~~ a Centro de ProduccibnMhs Limpia, Centro de Gestibn Tecnolbgica e lnformhtica Industrial (CEGESTI) and Centro de Formacibnde Formadores (CEFOF). Source: Matching Grants Program, CONICIT (2005). 68. Since the Marching Grant System becamePROPYME,largefirms cannot participatein the program, althoughthe extent to which this criteria is worrisome depends on the definitionof small and medium enterprises.Since the vast majority of firms inCostaRicatend to have less than one hundredemployees, the focus on SMEs might not be an issue. Nevertheless,CostaRican authorities could consider usingother R&D-oriented grant programsadministeredby CONICIT to offer funding for innovation projectsby largefirms. Although this may be abit controversialfrom an income distribution (and political) viewpoint, it is valid from atechnological progress perspective.Infact, the results discussed in Section5 above suggest that scale is an important correlateof innovation inputs and outputs, thus suggestingthat largerfirms tendto be more innovative.This impliesthat limiting innovation subsidiesto SMEs might be reducingthe developmentaleffect of such policies, since the mainobjective should be to subsidizethe creationof innovationsthat can then be widely imitated throughoutthe economy.Iflarge firms are more able to undertakethese types of innovations,thenthe overall effectivenessof publicly-funded innovation programscan be enhancedby allowing large firms to participate.Moreover, their participation could be subjectto higher co-financing requirements,thus makingthe whole package ofpolicies more equitable and more effective inthe long run. 69. I n terms of types of innovationthat are beingfinanced by the Matching Grant System, there has been a recent trend toward specializingon certaintypes of innovations.Initially, the program's inceptiongrants were evenly distributed across different innovationtypes. However, during the last years mostresources have been allocatedto investmentprojects aimed at protectingthe environment and increasingthe sophisticationof productiveprocesses (Table 4.11). 133 Table 4.11: MatchingGrants by Type ofInnovation(US$) - 2000 - 2001 - - 2002 2003 Sector No. Value No. Value No. Value No. Value Protection of the Environment 1 122,026 7 696,206 3 497,772 0 0 Sanitation & Innocuousness 2 119,594 1 33,902 0 0 0 0 Biotechnology Improvement 3 175,215 2 222,989 1 94,580 0 0 Quality Improvement 2 264,580 0 0 0 0 4 56,532 Sophistication Production Processes 3 337,706 9 510,540 2 47,715 4 142,084 Total 11 1,091,121 19 1,463,637 6 640,067 8 198,616 Source:Matching Grants Program, CONICIT (2005). 70. Most of the program's funded innovationshave not been protectedby any type of IPRs rights, which poses a riskof imitation. Indeed,this couldbe another reasonwhy demandfor the funds hasfallen inrecentyears.The terms andconditionsofthe grant contract stipulate that the firm must transfer to CONICITas muchas 80% ofthe revenuegeneratedbythe commercialexploitationofany intellectualpropertyrights.Onthe one hand, this is a desirable feature o fthe programbecause such subsidies arejustified especially incases where resultinginnovationsare not patentable. Ifthey are patentable,thenthe privatesector canuse IPRsas the vehicles for appropriatingthe returns to their investments in innovation.Onthe other hand, this contract obligationmay be creatingperverseincentives for firms to skippropertyrightprotectionin order to reducethe profitsthat wouldneedto bereturnedto CONICIT, and it couldalso be limitingthe demandfor the matchinggrants. 71. I t is also worth notingthat Monge-Gonzalesand Monge-Ariiio (2005) argue that IPRs in Costa Rica are underutilized, perhapsdue to a lack of private-sector awareness about the numerous types of IPRs, only one of which are patents.Other IPRsincludetrade secrets, trademarks, andprotections for experimental data. Hencean alternative explanation for the lack of demandfor matchinggrants is the fact that awardedresearchprojectsmayhave little patentable results, andwhen they do attainsuchresults, a large share of the correspondingrewardsare transferredto CONICIT.'" Thus, one may expect that the interest to engage inthe systemdecreasesas the sophisticationofthe innovationincreases.Inany case, changingthis requirementmaybe difficult for legalandpolitical reasons. 72. In sum, Costa Rican authoritiescould revise the current procedures and the institutional framework of the Matching Grant System in order to promotea broader use-by both firms and RUs-and increase investmentin R&D.Among the features that couldbereviewedare: (i) the limits on the participationof large firms; (ii) narrowscope ofthe grants, whichare currentlytargetedon the joint ventures betweenfirms andresearchcentersthat are notchosenby the firms themselves; and(iii) the fixed-timegrant competitions, which limitthe grant applications to those submittedby certaindates, couldbe changedto an openwindow allowingfirms to submit proposalsat any time. However, it is difficult to derive strongrecommendationsfromthe available data, andthus the it is arguablethat the mainreform inthe near future shouldfocus onthe future monitoringandevaluationofthe program. lo'By patentable we refer to the propensity of an innovationto be protectedby patents or any other form of IPR. 134 Future Monitoring andEvaluation of theMatching GrantsProgram 73. The CostaRicanmatchinggrants programhas not beensubjectto any form of formal evaluation beyondthe evaluations of the grant proposalsthemselves and existing mechanismsfor monitoringtbe use of funds to limit the scope for corruption.Ideally, any suchprogram shouldalso be evaluatedinterms ofthe impactthe grants haveon firm performance, particularlyinthe context of setting budgetaryprioritiesin order to achieve fiscal consolidation.Itis likelythat futurerigorousevaluations of this modestly financed programwill addto its legitimacyas a worthwhilepublic investment. 74. Most of the empiricalwork evaluating the effectivenessof subsidy programs for innovation policiesaroundthe world has centeredon "after-the-fact" evaluation.This approachattempts to infer the effects of subsidies usingobserveddatacollectedafter the implementationof a grant (Jaffe 2002). "After-the-fact" evaluations are hamperedby a "selectivity bias" due to the fact that public fundinggoes to proposalsjudgedin advancedto be the most likely to succeed. Inother words, the projectsthat are the best candidatesfor funding-in the sense ofmaximizingthe impact ofpublic support-are also the projects that would havethe largest expectedR&Doutput inthe absenceoffunding.Thus, the after-the-facteffect ofthe subsidy canbe confusedwith the performance of the best firms, whichare alsothe ones that receivethe grants. Inother words, the bestperformingfirms are also the most likely to presentthe best grant proposals, andex-post evaluations canthus be misleading. 75. There are other alternative methodologiesfor evaluationmatching-grants programs,which can requiresubstantial additionalinformation.Jaffe (2002) proposesan alternative to evaluate matchinggrants basedon regressionanalysis.This approach entailscollectinginformationabout firm performancefrom all applicants, includingthose who didnot get funding, after the grants havebeen implemented.With the collectedinformation,regressionanalysis canbe applied to determine the effect of the grants on the performanceofthe winningfirms by comparingtheir performancewith that ofthe firms that didnot receive a grant. Figure4.13 belowillustratesthis idea.The selectivityproblemis capturedby the positiverelationshipbetweengrant selectionrankandfirm performance, whichcouldbemeasuredby productivityindicators,such as the value ofproductionper worker, adjustedby the amount ofcapital investedby the firm. As shown, the bestproposalshave bothhigherexpectedfirm performanceswith or without the effect of a grant, andonly the proposalsthat surpassathresholdare funded.Inother words, boththe pre-grantandpost-grantschedule show a positiverelationshipbetweengrant rankandfirm performance, while the effect ofthe grant itselfcouldbe capturedby an upwardshift ofthe performance schedule. Figure 4.13: Dealing with the SelectivityProblem in Evaluating Matching Grants Programs Firm P e r f o r m a n c e P o s t - G r a n t s c h e d u l e with P ost-G r a n t ............................. imitation ..................../ s c h e d u l e i I - I G r a n t P r o p o s a l R a n k Source:Adapted from Jaffe (2002). 76. This evaluation approach basedon regressionanalysisundoubtedly has some weaknesses. First,the informationrequirements for conducting this type of evaluationmightbe a further deterrent for 135 firms to apply for grants. Moreover, the data collection requirements after the implementationof grants can be costly, since unsuccessful firms would needto be surveyedon site after they have been rejected. However, the costs might not bethat large. 77. Second,this methodologyrequiresa large numberof participatingfirms in order for the assessment to be robust. Giventhe scantparticipation inthe current program, itprobably cannot be implementedfor some time untilenough firms have participated andthe appropriate information has been collected. But the information collection should be initiated as soon as possible inorder to achieve a large sample for meaningful evaluation inthe near future. 78. Third, there is no guaranteethat the impactof the grant onthe successfulfirmswill be characterizedby a shift inthe performanceschedule.Itcould be characterized by the change inthe slope of the schedule. This possibility is easy to capture through regression analysis, and thus it is not a major concern. 79. Fourth,imitationby other firms that did not get the grant can result inchanges intheir performance,which could muddle the evaluation. Ideallythe innovationprojects funded by the matchinggrants programwould be imitatedby unsuccessfulapplicants, and hopefullyby numerous firms that did not apply, as it is this imitationprocessthat yields highrates of social returns.Consequently it is desirable to observe a shift inperformance bythe unsuccessful firms, as shown inFigure 4.13 by the dotted portion of the post-grant schedule. This implies that firm-performance data collected after the implementationofthe grants might capture not only the effects o fthe grants on the successful firms, but also the imitation by the unsuccessful firms. Ifso, a simple regression would not be able to identify the impact of the grants. This challenge could be overcome ifperformance data on both groups of firms is collected after grant implementation in a sufficiently highfrequency to be able to capture the impact of the grants on the receiving firms before the innovations are imitated by others, assuming that such a lag exists. Again, this consideration raisesthe data collection requirements. 80. Fifth, it is possiblethat the rankingsof the grant proposalsare not satisfactory indicatorsof quality differencesamongthe proposals.For example, thejump inquality betweenthe thirdbest and second best might be different than thejump between the secondand the best proposals. Hence it might be best to use scores rather than the rankings ofthe proposals, thus attemptingto capture the magnitude of the quality differences among the proposals. This suggestion should be easy to implement. 81. Sixth, ifour previoussuggestionconcerningthe use of an openwindow for receiving grant applications is implemented,then the data collection from applicantfirms would notcoincide,thus complicating the evaluation of impactsacrossfirms.This mightbe a problemover time, as market conditions that are unrelated to the matching grants program might affect firm performance. This could be dealt with ideally by implementing economy-wide firm surveys to collect the necessary performance information, which could then be usedinregressionanalysis (through "differences in differences" estimations, for example) to control for economy-wide fluctuations. Ifthistype of survey is not possible, data on industrial production or sectoral production could be usedto control for factors affecting all firms ina given industryover time. 82. This brief review of technical issuesconcerningthe designof rigorousevaluationsof the matchinggrant programclearly suggeststhat evaluation is not an easy task. But it can be done. If the program succeeds and grows over time, the needfor rigorous evaluation would also become more pressing. Fortunately, as the program succeeds and more firms participate, a number of challenges become easier and relatively less costly to overcome. Our hope is that our readers have at least gained some insightsabout the potentialbenefits of public subsidies for innovation, but also about how difficult it is to design suchprograms inorder to maximizetheir developmental effects. 136 4.7 Summary and Policy Recommendations 83. Enhancingthe educational attainmentof the work force by emphasizingsecondary school enrollmentis a key challengefor Costa Rica's long-termgrowthand innovationagenda.Existing empirical evidence suggests that overall educational attainment affects the rates of return to R&D investment across countries and over time. Also, microeconomic evidence presented above suggeststhat there is a strong association between the level of education of employees and private-sector innovation outputs and inputs, although it i s difficult to establish the direction of causality. Nevertheless, it seems prudentto prioritize achievingfull coverage insecondaryenrollment as part ofthe innovationagenda, because the country's secondary enrollment gap threatens Costa Rica's long-term ability to raise the overall educational attainment of its workforce. 84. It is difficult to conclude that CostaRicashould prioritizethe innovationagenda based purelyon descriptivestatisticsthat comparethe country's performanceinterms of innovation outcomesand inputs with similar economies.This is so because it is unclear what the benchmarks mean interms of policy implications since the benchmark can be a mediocreperformance inthe presence of market failures. Moreover, benchmarking alone says little about the potential social rates of returnto national investments in innovation inputs. 85. Macroeconomicevidence presentedabove, however, suggeststhat in fact CostaRicashould put innovationat the top of its developmentagenda.First, innovationoutcomes, measuredby the accumulated number of patents over a long time period, seem to be positively correlated with the level of development across countries ina causal sense. Infact, inthis context, innovation seems to be perhaps even more important for long-term economic development than governance or the quality of public institutions. O f course, it is unlikelythat innovation policies will have a highrate of social return ifthe institutions and organizations that encompassthe national innovation system (public sector policies, researchcenters and universities, and the private sector) are not well integrated. 86. Second, the social ratesof return to R&D,one of the key innovationinputs, seem to be quite high, especially for countrieswith levelsof developmentjust abovethat of CostaRica.This evidence suggests that ifCosta Rica can provide the correct incentives and institutionalframework, the social returnsto R&D can be incredibly high, andthe payoffs from innovationpolicies can be substantial. 87. Third, marketfailuresseem to hamper the mostcommontype of innovationindeveloping countries, namely the introductionof export products that already exist aroundthe globe. Consequently, the benchmarkingexercisesthat portrayed Costa Rica as an under-performer in R&D, scientific publication, and export discoveries become worrisome when the empirical evidence suggests that the potential gains from improving either the level o f investments in innovation inputs or improving the quality of public policies and institutionsthat affect the efficiency with which the country uses its scarce innovation inputs. 88. Contraryto the conventionalwisdom, non-patentable private-sector innovationoutputs are strongly associatedwith investmentsinR&Dand licensingpayments, but the directionof causality remainsmurky. To aid the targeting of innovation policies in Costa Rica, this study provided a comprehensive empirical assessment of firm characteristics and innovation inputsthat are associatedwith various indicators of innovation outputs, namelythe introductionof new products, product upgrading, changes in production processes, and meeting international product-quality standards. Inspite of severe measurementerrors inthe data, the internationalfirm-level evidence suggest, that there are in fact strong positive partial correlations between innovation inputs and outputs, and the strongest correlations are those of investments in licensing of foreign technologies and investments inR&D. As discussedat length inprevious sections, these variables tendto measuredwith error indevelopingcountries, whichcauses 137 standarddirect regressionsto underestimatethe magnitudeand significanceofthe partialcorrelationsof R&D and licensingwith respectto innovationoutcomes. Oneofthe analyticalcontributionsofthis chapter is, therefore, the applicationofreverseregressionsto estimatethe true partialcorrelations betweeninnovationoutcomes andcritical inputs, whichare oftenfoundnotto be significant in developingcountries. 89. Private-sectorcosts associatedwith transport and non-transportinfrastructureappearto be associatedwith key innovation-relatedpractices, includingworker trainingand R&D investmentsin developingcountries, includingCosta Rica.Thus, combinedwith the evidenceand policiesdiscussedinthe previous chapter, an importantpolicyimplicationis that dealingwith infrastructurechallengeswill be an importantfactor determiningthe country's long-termgrowth prospects. 90. AlthoughCostaRica's matchinggrants programthat subsidizes private-sector innovation projects is consistentwith global best practices,various aspectscan be reformedin order to improveits performance.Someof the features that couldbe reviewedare: (i) the limits onthe participationof large firms; (ii) narrowscope of the grants, which are currentlytargetedonjoint the ventures betweenfirms and researchcentersthat are not chosenbythe firms themselves; and(iii) the fixed-time grant competitions, which limitthe grant applicationsto those submittedby certaindates, couldbe changedto an openwindow allowingfirms to submit proposalsat any time.However, it is difficult to derive strong recommendationsfromthe availabledata, andthus it is arguablethat the main reforminthe near future shouldfocus onthe futuremonitoringand evaluationofthe program. 91. The future performance of the matchinggrants programas well as of the activities of PROCOMER and of the Ministry of Scienceand Technology in generalshould be monitoredand evaluatedwith as much rigor as possibleso that their designand areas of operationscan be improvedover time. Suchevaluationsare technically difficult to designand mightrequiresubstantial firm-levelinformationto be collectedat various stages.For various reasonsdetailed inthis chapter, we do not necessarily recommendthat suchan evaluationsystembe implementedimmediately,especially not in the context of lacklusterdemandfor the matchinggrants system, but data collectionfrom participants shouldcommence soon, so that rigorousevaluations can be appliedinthe mediumterm. 92. Similarly,a detailed evaluation of the effectsof EPZ tax incentiveson CostaRica's economic performanceis not feasible for the currentstudy, butthe option of transformingsaid incentivesinto R&Dincentivesshould be considered carefully.Onthe one hand, tax incentives are clearlynot a first-bestpolicy optionfor promotingprivate-sectorR&D.Onthe other hand, such incentives already existto promote exports, whichwill soonbecomeincompatiblewith WTO norms. 93. Finally, education, innovation,and infrastructure,seemto beworth prioritizinginthe country's publicpolicyagenda. The evidenceset forth inthis chapter stronglysuggeststhat Costa Rica's public expendituresrelatedto secondary schooling, the matchinggrants program, andperhapsthe budgetofthe Ministry of Science andTechnology, as well as those expendituresrelatedto improvingthe quality of its infrastructure,should be protectedas muchas possibleinthe context of fiscal consolidation. Ifbudgetcuts inthese areas are requiredto maintainthe country'scherishedmacroeconomicstability, then the recommendationsregardingthe efficiencyofpublicexpenditureoutlinedabove and inthe previouschapter become evenmore important. 138 Notes: 1) Robust z statistics in parentheses 2) * significant at IO%, **significant at 5%; ***significant at 1% Source: Klinger and Lederman (2006). 139 Table 4.12 above shows the basic estimation results under the first column, and the remainingcolumns show the results of additional regressionsthat test their robustness.The secondcolumn shows the basic specificationbut usingthe barriers indexthat excludes the costs of starting a new business, which was basedon questionable data. Column 3 contains estimates basedon the same composite indexof barriers, but also includes the interactionbetween barriers and (log) GDP P.c., which is a rather strong robustness test of whether the key estimated effect of the interactionbetween barriers and export profitability is not due to an interactionwith the level of development. Column 4 shows the estimated coefficients after controlling for unobserved regional characteristics. The interpretation ofthe corresponding regional dummy variables needs to be done with care, since the model already controls for the pre-sample discovery counts by country/commodity groups. They reflect any additional impact emanating from time invariant regional characteristics. Finally, column 5 shows the results after adding interactive variables between the regional dummies and the barriers indexto help us ascertain that the interactionthat matters i s the one with export profitability rather than some other regional factor. 140 Chapter 5. Governancelo2 5.1 Introduction 94. Governancematters for investmentdecisions of private entrepreneurs. Governance is broadly defined as the norms and procedures which govern the relations between private firms and the government with respectto business operation, licensing, permits, labor and taxes, dispute resolution and crime prevention. Numerous studies across a wide set of countries point to good governance being beneficial for growth, investment and finance, and bad governance leading to detrimental effects on economic outcomes. Countries which have more transparent and responsive governments, with less bribery, routinely outperform countries where the governments operate ina non-transparent and often openly corrupt manner.'03 95. This chapter assessesthe effects of four specific areas of governance in Costa Rica. These are: i)the regulation of business activity (taxes, labor, inspections, registration, licenses), ii)the public enforcement of contracts and resolution of private firms' disputes incourt; iii)the incidence o f corrupt practices in the relations between private firms and the Government, and iv) the incidence of criminal activities in society, which affect private businesses through direct lossesof physical and human capital, and indirectly through higher security costs. We utilize available data from the Costa Rica ICs, as well as additional sources of informationto assess the current state of affairs, benchmark Costa Rica against other comparator countries inCentral America, make intra-country comparisons, and then provide some possible recommendations to address existing problems. It is worth notingthat the information usednot only includes objective measures and indicators but also perceptions, which, by definition are subjective and can be influencedby the economic environment at the time o f the survey. The next sections deal with each of the 4 areas in succession. 5.2 Business-Government Relations 96. According to the public interesttheory of regulation,regulationsare adoptedand enacted to achieve socially desirablegoals (e.g. to reducethe number ofwork-related accidents or the number of food poisonings) but recenttheories of regulationand growing empiricalevidence challenge this theory. Thus, a number of recent empirical studies (e.g. Djankov et al. (2002), Djankov et al. (2003), Glaeser and Shleifer (2003), Shleifer (2005)) find that a heavier regulation o f business registration-measuredinboth the time requiredto register a firm and its cost - is associatedwith worse rather than better economic outcomes. For example, Djankov et al. (2002) employ data for the time, official cost and number of procedures to start a new firm in 85 countries, and establish that countries with heavier regulations of entryhave a larger unofficial economy andmore corruption, but not better quality of private or public goods. Similarly Botero et al. (2004) find that a heavier regulation of labor is associatedwith lower labor force participation, and higher unemployment, especially among the young. Heavier regulation is also found to have negative macroeconomic effects: ina sample of industrialized and developing countries Loayza et al. (2005a and 2005b) link a heavier regulatory burden in product and labor markets with a larger informal economy, and lower economic growth. 97. The expandingWorld Bank DoingBusinessdatabase and the three DoingBusinessReports publishedthus far go a step toward collecting data on regulationpractices across a large number of lo'This Chapter was written by StefkaSlavova, with inputsby CamilaRodriguezandDanielChodos. IO3See Mauro (1995). 141 countries, and arguingfor policy action aimed at easingthe burdenof regulation.The Doing Business in2004 report, for instance, arguesthat only two registrationprocedures -notification of company existence, and a tax and social security registration -are sufficient for business regi~tration"~. As reported there, however, most countries impose more registrationprocedures such as labor registration (87% of DoingBusiness sample countries), administrative registration(76%), bank deposit (68%), notarization(62%), healthbenefits registration(62%), etc. Ina similar fashion, governments impose a plethoraof other regulations and registrations on private firms: tax regulations, labor regulations, health and sanitary regulations, environmental regulations, and permitsto export and/or import. 98. The presentchapter will utilize availabledataon the regulatoryburdenfor privatefirms in CostaRicafrom the InvestmentClimate Survey, DoingBusiness,and other data sourcesto describethe CostaRicanbusinessregulatoryenvironment, make internationaland intra-country comparisons, presentstatistical analyseswhich link Costa Rican regulatoryburdenindicatorsto firm performance, and suggest policy recommendations. 99. CostaRicanmanufacturingfirms surveyed inthe ICs have generallyfavorableperceptions of the way government officials interpretand apply regulations,especiallycompared to other CentralAmerican countries. Yet, 29 percent of CostaRicanfirms express serious doubts about the predictability of government interpretations of rules and regulations (Figure 5.1). This i s much lower than in comparator countries, such as Guatemala, Brazil, Honduras and Nicaragua. Ifwe look at trust in government officials' interpretations -the other side of the same question -we findthat within the set of comparator countries used inthis chapter Costa Rica fares among the top three along with Chile and China. Figure5.1: Interpretationsof Government Figure5.2: The Time Tax: Share of Senior RegulationsAre InconsistentandUnDredictable ManagementTime Devotedto Government Regulations,Inspections, Taxes, Customs Guatemala 7 China Brazil Guatemala Honduras Nicaragua Nicaragua India India Honduras El Salvador Costa RiCa Costa Rica El Salvador Chile Brazil China Chile Percent of Finns Percent of Senior Management Time Source: World Bank Investment Climate Surveys Source: World Bank InvestmentClimate Surveys 100. On the time tax -the timespent dealingwith differentgovernment regulations-CostaRica does not rank as well, with firm managersspendingon average 11.8 percent of their time dealing with red tape and regulations(Figure 5.2). This is comparable to Honduras, where firms spend 12% of their time on regulations, and considerably less than time spent inNicaraguaand Guatemala buthigher than the same measure for El Salvador, Brazil and Chile. The time tax not only quantifies one aspect of the regulatoryburdenbut also correlates with other measures ofregulation andproperty rights.The higher the time spent on regulations, the higher the probability that a firm will make informal payments "to get IO4 See Doing Business (2004). 142 things done", and the higher the size of the informal payments made to obtain government contracts. In Costa Rica there are no substantial differences inthe amount o f management time spent on government regulations across differenttypes of firms, with the only exception of small firms spending longer than micro and large firms. Incontrast, inthe rest of Central America and Chile, larger firms' managers typically spenda higher percent of their time dealingwith regulatory matters. InCosta Rica it is the mid- size firms -rather than the large ones -which bear the highest burden of time spent on redtape. 101. CostaRicadoes betterthan the other four CentralAmericancountriesand Brazil, but worse than Chile on the incidenceof bribes paidout to secure the award of governmentcontracts during public procurement bids(Figure 5.3). This type o f bribe is an indicator of corruption and a measure of the regulatory cost to firms. A little over a quarter o f Costa Rican firms (26 percent) report that making informal payments to secure government contracts is common intheir industry. Incontrast, the share of Honduran and Salvadoran firms which reportthe same is morethan twice that o fCosta Rica. The same -albeit to a lesser degree-applies to the size of procurement bribes -these constitute 10 percent of contract value inCosta Rica versus 14-15 percent inCentral America, and 16 percent inBrazil. Yet, compared to Chile, the Costa Ricanincidence o f procurement bribes is high-only 4 percent of surveyed Chilean firms reportthat procurement bribesare common against 26 percent inCosta Rica. Figure 5.3: Procurement Bribes:Prevalence and Size Figure 5.4: Number of Days to Registera Firm: A by Country Comparisonof Different Data 1 ._.. - __ . ... ' Oi N L S r n g U 81Salvador Guatemala i Honduras CostaRica 84 0 10 20 30 40 50 60 70 SO 90 102. CostaRican firms spend, on average, 77 days getting registeredand startinga new company accordingto the DoingBusiness2006 database. This is the longest among the five Central American countries (Figure 5.4). Infact, Costa Rica ranks 83`d out of 155 countries on the Starting a Business index, which depends on the number of days to start operation, the number of procedures a new entrepreneur must go through, the official cost of so doing, and the minimumcapital, ifany, requiredto start a business. This bottom-half ranking is principally due to the long duration of the process of opening a business (the Latin American average is 63 days). Except for a slight fall inthe number of days to register a firm, there are no differences inthe DoingBusiness data for 2003,2004 and 2005 in Costa Rica, which means that no particular reforms inthis area have been undertaken over the past 3 years. 103. The total durationof a first-timeregistrationas recorded by CostaRicanrespondentsthat registeredfor the first time inthe 2 years precedingthe survey follows the patternof the Doing Businessdurationof startinga businessdata. CostaRican firms indicatedthat ittook them 84 days to register for the first time, including obtaining all the requiredlicenses and permitsto beginoperations. This is only a week more than the DoingBusiness numberof days to register a limitedliability company 143 in SanJose as of January 1, 2005. The ICs total numberofdays to start operations is highestinCosta Rica among the 5 Central American countries (followed closely by Honduras). 104. Of the twenty-two Costa Rican firms interviewedin the ICswhich registeredfor the first time in the two years beforethe survey, 82 percentappliedfor a municipallicenseand for an insurancepolicy with the National InsuranceInstitute (INS). As show inFigure5.5, between 68 and 73 percent were entered into the Commercial Register,got Social Security and Tax registrations, obtained a health permitby the Ministryof Health, and were publicly incorporated. Only 18 percent applied for an environmental assessment, and none requiredan import or an export license. 105. Althoughwaiting times to obtain licensesand permitswhen registeringfor the first time differ among agenciesin Costa Rica (F'igure5.6), they are longerthan in Chile. The lengthiest waiting times were experienced in: SETENA for environmentalassessments (107 days), the Ministryof Health for sanitary operation permits (78 days), the municipalities for municipal licensing (74 days), and the CommercialRegister (70 days). The shortest delays were reported inthe tax and social security registration(15 days), and getting insuredagainst work-related accidents with the National Insurance Institute(INS) (8 days).'05 Waiting times are longer inCosta Ricathan inChile, the clear leader (along with Panama) inLatinAmerica interms of starting a business.For instance, while interviewedChilean firms wait, on average, 8 days to get a municipal license, Costa Rican firms wait 9 times longer (74 days). Also, getting the firm entered into the Commercial Registertakes 10-daysinChile but 7 times longer in Costa Rica. Eventax registration -one of the least time-consumingprocessesin Costa Rica-takes twice the time oftax registration inChile (15 versus 8 days). Figure 5.5: First-Time Business Registration: Share Figure 5.6: License Renewaland Re-registration, of Applicantsand Time to Register Share of Firms That Applied for Renewals, Average Days to Get Licenses Renewedand Informal Payments Incidence I 120 90 107 77 Ino 80 70 80 60 50 60 40 40 30 20 211 10 0 106. A relativelylarge proportionof interviewed firms renewed different operatinglicensesand permits in the two years precedingthe ICs. These includedmunicipal (operating) licenses, permits by the Ministryof Health, social security registrations, andpurchasedinsurance from the NationalInsurance Institute(INS). Other permitsand licenseswere less sought (Figure 5.6). The waiting times, on average, to renew the four main licenses and registrations mentionedabove were between 1week and over 2 months (8 days on average for purchaseof insurance from the INS, and 68 days for gettingan operational permit by the Ministry of Health). 105 Despite the long delays in some of the agencies, very few interviewed f m s report any incidents of requested informal payments or bribes. 144 107. As with first-time registration,CostaRicanfirmswait, on average, longer than their Chileancounterparts to get their licensesand permitsrenewed but less thanin other Central American countries.This is especially true for construction permits-77 days inCosta Ricavs. 39 in Chile - and permits issued by the Ministryo fHealth (sanitary conditions, special phyto-sanitary permits for food, beverages and pharmaceuticals). The differences inthe waiting times for the other types of licenses and permits are less pronounced (export licensing and getting insured take virtually the same time inboth countries). Costa Rica ranks worst among the five Central American countries on the time to renew municipal (operating licenses), and health and environmentalpermits. Interviewed Costa Rican firms reported spending 28 days on average renewing licenses and permits in order to continue being in business, lower than inGuatemala and Honduras (34 and 42 days respectively), and close to that of El Salvador (26 days). Therefore, Costa Ricaranks better on renewals than on first-time registration.lo6 108. Only a quarter of CostaRicanfirms hirelawyersand/or other professionalagentsto get their licensesand permitsrenewed(26 percentof respondentsindicatedhavingdone so in the two years beforethe survey), which is lowerthan inHondurasand Guatemala(47 and 37 percent respectively),and the same as in ElSalvador. The hire o fprofessional agents is another proxy for the procedural burden o f starting a business and getting licenses and permits. Presumably, the longer and more burdensome the process, the higher the likelihood that firms would hire an intermediaryto provide these services. The inefficiency would most likely be inraising costs, thus barring new entrants, as well as maintaining a non-level-playing field among different firms. Inall 5 Central American countries the proportion o f firms hiringan agent to conduct first-time registration i s substantially higher than the proportionhiringan agent to get licenses renewed (41 versus 26 percent in Costa Rica). Again, Costa Rican firms report lower hire o f agents compared to Guatemala, Honduras and El Salvador. In Guatemala, for example, 88 percent o f interviewed firms hired an intermediary to facilitate their first-time registration - a sign o f the costs and complexity o f the process. E-Government 109. Making registrationand licenseapplicationprocesses availableonline -through a system of electronic government (e-government )- reducesthe time to obtainlicensesand permitsand lessensthe cost of registration). Reforms toward online registrations all over the world over the past few years have garnered a lot o f support. Some o fthe countries with fastest registrations allow for it be done online - e.g. Canada and New Zealand.'" In line with these best-practice cases, the Costa Rican government has made several procedures available online - declaration o f corporate income and payment o f taxes before the Ministry o f Finance (Tax Division), and the payment o f corporate insurance before the INS. The survey showed that respondents are aware o fthe possibility to do business with the government online - 88 percent o f those interviewed indicate so. Yet, less than one third o f interviewed firms report having declared taxable income, paid taxes, or paid insurance through the Internet. Medium and large f i r m s as well as exporters are the heaviest users o f online procedures. 110. A comparison of the use of online regulatoryproceduresin CostaRicawith Chile reveals that Costa Ricanfirms use the Internet to declare incomeand pay taxes far less often than Chilean manufacturingfirms. While the difference inthe level o fe-government awareness among Costa Rican and Chilean firms is small (88 vs. 99 percent respectively), the use o f online services to declare taxable income and pay corporate taxes i s markedly lower inCosta Rica (21 vs. 83 percent for income It must be notedthat the first-time registrationdatashouldbe takenwith cautionas the average numbersreportedare basedon very few observations 21 at most. Inthat sense, the licenserenewal data are much more representativeas they cover -- approximately140-150firms per license, and272 firms inthe aggregatenumber. lo' See the series o f Doing Business reports of the World Bank, for examples of such efforts andwherethey haveproven to work well. 145 declaration, and 20 percent vs. 79 percent for payment of taxes)."' Costa Rican firms who are aware of online procedures also report usingthe Internetto pay public services (electricity, water and telephone) and payroll taxes (social security contributions) to the Costa RicanInstitute of Social Security (CCSS). These firms represent 8 and 6 percent of respondent firms respectively. Inspections 111. Inspectionsare another cost of doingbusiness.They add costs to the firms interms of lost managerial and worker time, as well as direct monetary costs of fines, penalties and bribes. InCosta Rica the most common inspection inthe 12months precedingthe survey was bymunicipal authorities. Just over one-third of interviewedcompanies (34 percent) reported at least one visit by a municipal inspector. An even smaller share of firms was subjectedto inspections by other government regulatory agencies: a quarter had an inspection by the InternalRevenue Service, and 27 and 28 percent respectively received inspectors from the Social Security and Sanitary and EpidemiologicalControl offices (Figure 5-7). Figure 5.7: Share of Firms Subject to Inspectionsby Different Government Agencies, YOof RespondingFirms Municipal inspector 34 ' I Sanitary and epidemiological control 28 , 1 Social Security (CCSS) 1 21 Internal RevenueService (Direccion General de i Tributacion Directa) 25 Ministry of Labor and Social Security (labor issues) 21 II FireMational InsuranceInstitute (workplace risks) 20 Center for the Promotion of External Trade (PROCOMER) Environmental Technical Secretariat(SETENA) I 0 5 I O 15 20 25 30 35 40 % Source:World Bank Investment Climate Surveys 112. Mandatory meetingswith officials from the Center for Promotionof ForeignTrade (PROCOMER) were the most frequent on average for the subset of inspected firms, with 6 meetingshisitsper annum, while tax inspectionswere the lengthiest per single visit -- at6 hourson average for those inspected (Figure 5.8). Inthe aggregate, for those firms which reported inspections, the total duration (number of visits times durationof a single visit) was highestfor PROCOMER meetings and for tax inspections (at 16 and 15 hours spent on eachon average inthe year before the survey). The finding that tax inspections were among the most time-consuming is no surprise since tax authorities generally conduct on-site visits to audit tax statementsand tax information filed. Surveyed firms report that tax inspections are also among the most burdensome inspections for other comparator countries in Central America. IO8One caveat is in order here: the Costa Rica number refers to payment of any taxes (VAT, corporate income and profit taxes, etc.). In Chile, however, the number refers to the payment of value-added tax (VAT) only. In fact, few Chilean firms pay taxes other than VAT online. 146 Figure 5.8: Number of Inspectors' ate Dura 1 14. 'The average ~ u n ~ bofr~ns~eC~~onsper year e~perien~edby Costa Rican firms is also Iowrr e than in the rest of Central America, Not only did tax ~nspzction~ affect the highest share of firms in the rest of'Cenzra1America, they also took the Iongest number of daysthere. Thus, ~ ~ c a r a g ~ ~ a nspent 4 firms times ~o~igcr tau: ~ ~ i ~ p e c(12~daysiper a n I ~ ~than~Cosla Ricari firms did (3 visits daqsl. oti t i ~ ~ s I i ~ S ~ ~ l ~arid~~~L~aEema~anfirms spent 3 Cimcs lorigerwith tick inspectors (Q days each per a n ~ u m ~ ~ ~ r a [ ~ than their Costa Kican c~un~crpa~s. Social security, s a ~ ~ iand~c n ~ ~ i r ~ ~ ~i n m ~ n~~~alsoilasted~longer t a ~ s c at~ o ~ on average:in the 4 ~ o ~ p a r ~~o~I~i~ries,even though the d~f~eren~esare not as p r ~ ~ ~asointhe case~ c c ~ ~ ~ t o r ~ ~ ~ oftax ~ [ i s ~ e ~'Ifie~~~ ~ r ui of days spcnt~with n~ ~ ~ r~ ~~nsp~ctars the same in Costa Kica and ~ s ~ ~ c i p a ~was El S~~~vador (3 days per year), but longer elsewhere. Finally, hispectors b j officials ofthe Fire and ~ r o r ~ p Safctq~de :~ p a cvere ~ ~ e.vet.ysvhcre~(2-3 dags) ith the exceptionof ~uatemala~ f ~ ~ ~ similar ~ n ~ \t where they took 6 days. T~ierefore"i I ~ ~ e r t ~co~~par~soi~s a ~ ~ ~ ~ ~ a 1 ofthe d ~ r a ~ ofodi~ferei~ti~~spections ~ n and ~ ~ ~ amce~~iigs~ ~g ~ ~r ~ eofficials~painttona~l o ~ eburdcri on Costa Ricanfirms than in the n d ~with ~ r ~ e r other 4 CentralA~er~caiicountries since a lower ~ ~ o p o ~ofoCasta %can fims were inspectedinthe i n first place, arid amongthose that were ~ ~ i ~ p ethe t ~ d . ~ duration o fz isits arid meetings was shorter in Costa Kica. I15, ~ e n ~ tins~eC~~ons~ ~ s ~with aihigheri en ~~i d ~ ofcbribe requests BC~QSSthe 5 h ~ ~ r are ~ ~ t n ~ Centrat ~ ~ ~ ecountries,a'I''1iw.~ i ~ a r a g firms wliich were exposedeo the highest number (iftax r ~ ~ n ~ a n i ~ ~ s ~ e ~(12idayssper year) also repor~edia higher incidence of ~ n o f f i ~payments (bribes) requested r o ~ ~ a l 141 duringthese inspections(with 3.5 percentofthem havingencounteredsucha request). Incontrast, none ofthe Costa Ricanfirms which hadtax inspectionsinthe year priorto the survey, hadto dealwith such a request(Table 5.1). The highest incidenceofbriberequestswas reportedinGuatemalawhere 8.6 percent of firms inspectedby municipalityofficials were askedto pay ontop of other, official fines. InCosta Rica, the correspondingfigurewas 2.6 percentof firms. Table 5.1: Percentof Inspected Firms Which Were Asked to Make an InformalPaymentduring Inspections, by Country Nicaragu Costa Rica El Salvador Guatemala Honduras a Sanitary and epidemiological control/public health 3.2 0.0 2.7 0.7 3.5 Municipal 2.6 0.0 8.6 1.3 2.4 Social Security 2.2 0.6 5.5 0.0 2.4 Fire and workplace safety 1.5 0.0 0.0 1.5 0.0 Environment 0.0 0.0 1.8 0.0 0.0 Internal Revenue Service (Taxes) 0.0 0.8 2.6 0.0 3.5 Source: World Bank Investment Climate Surveys Labor Regulations 116. Costa Rica ranks 72ndout of 155 countries worldwide on the DoingBusinessindexof Hiring and Firing Workers, meaningthat labor legislationis not very flexible. The Hiring andFiringIndex measuresthe difficulty with whichfirms mayhire or dismiss workers, the rigidity ofwork hours, andthe costs of hiringandfiring as stipulated innationallabor laws and is composedby six sub-indexes(see Table 5-2). CostaRicascores worse than its neighbors, except for Guatemala, onthe Difficulty of Hiring sub-index, which is also abovethe LAC average. Additionally, CostaRica's HiringCosts"' are 24 percentofthe averagesalary, which makesthemthe highest inCentral Americaandabovethe LAC average.Rigidity of Hoursis also high, andbetter only than inNicaragua. Yet, on some ofthe sub- indexes CostaRicafares muchbetter than its neighbors andthe LAC average. Infact, DoingBusiness 2005 cites CostaRicaamongthe top ten countries worldwidewhere firing i s easiest. CostaRicaperforms well regionallyinterms ofthe value ofthe Difficulty ofFiringsub-index (whichis zero inCostaRica, as opposedto 30 across LAC) and firing costs. Firingcosts, measuredas the number ofweeks of salary that employers must pay as severancepay when dismissinga redundantworker on legitimategrounds, equal 34 weeks in Costa Rica, which i s lowerthanthe LAC averageand costs elsewhere inCentralAmerica except for Nicaragua. 'lo Hiring Costs accordingto the DoingBusinessmethodology comprise all social security payments (pension, sickness, workplace injury, maternity,etc.) andpayroll taxes associated with hiring aworker. 148 Table 5.2: Regulationof Labor in Central America Country Difficulty of Rigidity of Difficulty of Rigidity of HiringCost(% FiringCost Hiringlndex Hours index Firinglndex Employment of salaryl (weeks of (0-100) (0-100) (0-100) lndex salary) (0-100) Guatemala 61 40 20 40 13 100 Costa Rica 56 60 0 39 24 34 El Salvador 44 60 20 41 15 86 Chile 33 20 20 24 3 51 Honduras 22 40 40 34 10 46 Nicaragua 11 80 50 47 17 24 LAC average 41 51 30 40 16 63 Source: World Bank Doing Businessdatabase, 2006 Note: Higher values indicate heavier labor regulations 117. I n the hypotheticalscenario of less rigid labor regulationsthat would allow making changes without permission or notificationof the labor regulatory authoritiesandwithout payingseverance or additionalcosts, two-thirds of interviewedCosta Rican firms would keep the number of their permanent employees constant and most of the remainingfirms would increase it (Figure5.9). The number offirms who wouldmakeno changesis in line with the other CentralAmericancountries, except for Guatemala.Among the other one-third,the overwhelmingmajorityof respondents(88 percent) indicatedthey would increase the number ofworkers andthe desired increases inthe number ofworkers are nottrivial - if labor regulationswere to beeased, the 30 percent of CostaRicanfirms who would increase workers, would double, on average, their present levelof employment. Thus, ICs data seem to suggest that, other things beingequal, about 30 percent ofCostaRicanfirms are under-employed(Le. would ideally operate at a higher levelofemploymentevenassumingthe same firm outputlevel) and is very likely that this is due to the costs associatedwith labor regulations. Amongthe firms that would increasethe number of permanentworkers ifregulationswere eased, 40 percent say they wouldnot do so due to highhiringcosts (minimumsalary, other benefits), and 31percentdueto highfiring costs (Figure 5.10). Only 4 percent(Le. 13 companies) offirms indicatedthey wouldreduceemploymentandmost of them pointto highfiring costsfor notdoingso.111 'I'The results on firing decisions should be interpretedwith cautiondue to the smallnumber of observations (only 13 firms say that they would reducetheir number of permanentemployeesiflabor regulationswere made more flexible). 149 Figure 5.9: Percent of Firms which Would Keep Figure 5.10: High Firing Costs and Minimum the Number of Workers Constant or Change It I f Salary and BenefitsDeter Changesin the Number Permanent Workers Could Be Hired Without of Permanent Employees Additional Regulatory Costs 1w 70 w 80 60 70 60 50 r 50 40 40 /o 30 30 10 20 10 0 10 n Guatemala Honduras Coal8Rica Nicaragua El Salvador Maintainnumberof employeesconstant 0 Increw numberof employees ODecrearenumberofemployees Source: World Bank Investment Climate Surveys. 118. On average, surveyed CostaRicanfirms reportthat firms intheir sector declare 69 percent of their employeesto the authoritiesfor labor,socialsecurity and other tax purposes, performing better than the DominicanRepublicbuttrailing Chile (with reportingpercentagesof 60 and 96 respectively). InCosta Rica, over 30 percent of employees are not officially declared, andvery likely lose out on adequate social security and other benefits. Inthat sense, labor laws and regulations designed to protect workers end up actually hurtinga sizeable proportion of them. Among different types of Costa Rican firms, large, exporting, and foreign companies reportthat firms intheir sector declare the largest proportion of workers to the authorities for social benefits and taxes (78-79 percent on average). For other firms the fraction is inthe mid-to-upper sixties. Therefore, highhiringcosts and other labor regulations in Costa Rica appearto deter firms from registeringall their employees for social security and taxes, and while data on percent of reported labor are not available for other CentralAmerican countries, the comparison to Chile and the Dominican Republic does point to Costa Rica's labor regulations being more restrictivethan those in Chile, and only marginally better than those inthe Dominican Republic. This conclusion is borne out by the Doing Business rankings of these countries on the regulation of labor.112 TaxRegulations 119. CostaRicadoes not performwell onthe DoingBusinessindex ofPayingTaxes- rankingat number 129 out of 155 countries. This low ranking is due to the highnumber o f payments neededfor a firm to comply with taxes (41), the longtime neededto accomplish that (402 hours per annum), as well as to the heavy taxation burden(54 percent of gross firm profits). Although the required number o ftax payments is lower than the LAC average and Central American averages, i s highcompared to Chile's, where a considerable number of tax payments can be executedonline (Table 5.3.).'13 The time neededto prepare, file and pay (or withhold) corporate income tax, value-added tax (VAT), and social security contributions is long and among the highest inCentral America butby no means the highest inLAC. Finally, the taxation burden is higher than inLAC and elsewhere inCentral America except for Nicaragua. 'I2 Chile ranks 37Ih, CostaRica-72"d,and the Dominican Republic - loothon the overall Hiring and Firing index. The Chilean Internal Tax Service (Servicio de Impuestos Internos) has a top-rate webpage (httD://www.sii.cl/) and provides Chilean firms with the opportunity to easily submit income declarations, and pay their tax bill via the Internet. 150 Table 5.3: PayingTaxes in Central America and Chile Payments (number) Time (hoursperyear) Totaltax payable (% of gross Country profit) Guatemala 50 260 53 Costa Rica 41 402 54 El Salvador 65 224 32 Chile 8 432 47 Honduras 48 424 43 Nicaragua 64 240 54 LAC average 48 529 53 Source: World Bank Doing Businessdatabase (2006). Note: Higher values indicate heaviertax regulations. 120. Although there are differences in the perceived percent of sales reported to the tax authoritiesby type of firm, Costa Rican firms under-report their taxable income, possibly reflecting the levelof taxation burden. InterviewedCosta Rican firms report that firms intheir sector only declare 69 percent of their sales income to the tax authorities (Figure 5.1l), is comparable to the share of which reported sales inHonduras, Nicaraguaand Brazil but lower than that of Chile, El Salvador and Guatemala. Large, foreign and exporting firms in Costa Rica report that firms intheir sector declare a higher fraction oftheir sales revenuefor taxation purposes(Figure 5.12), which is normally found inother countries too.114Other things beingequal, the higher the share of profits payable inthe form of taxes and social security contributions, the lower the incentiveto declare the true level of income earned. Therefore, through maintaining a hightax burden on firms governments actually lose potentialtax revenue from the under-reportingthat occurs. One way to deal with this problem i s to inspect and audit firms' filed tax statementsto catch cases of illegal and legal under-reporting. Another - and we would argue more effective - is to reduce the tax burden, Figure 5.11: Percent of Sales Reportedto the Tax Figure 5.12: Percent of Sales Reportedto the Tax Authorities, by Country Authorities, by Type of Firm Chle 90 Guatemala 80 70 El Salvador 60 it 50 CostaRica 40 30 Handurn 20 I O Brazil 0 Nicaragua Ch"a 0 10 20 30 40 50 60 70 80 90 100 /a Source:World Bank Investment Climate Surveys. 121. Among interviewed Costa Rican firms only 17 percent had to pay a fine to the Tax Authority in the year precedingthe survey, with a higher percentage oftax fines among large, small 'I4 Since larger firms are more visible and subject to tax inspections,they have stronger incentivesto declaretaxable income. It i s also true, however,that reportedsales can be decreasedby legalmeans(e.g. throughcleverly usingexemptions, accounting, etc. to manipulate taxable income) and largefirms may be better suitedto reducetheir taxable income by available legitimate means. 151 and domestic firms and a higher burden among micro firms. About 19percent of domestic firms paid tax fines, and only 3 percent of foreign ones. About 19and 20 percent of small and large firms respectively were fined, as opposedto 11percent of micro enterprises. Firmswith some past export experience were also more likely to be fined than firms with no such experience or current direct exporters. Finally, a lower fraction of firms in San Jose were fined than inthe rest of the country. Even though micro firms are less likely to get fined by the Tax Authority, the burden o fthe tax fine is heaviest for them compared to larger firms. Thus, tax fines averaged 1percent of annual sales across micro firms, but only 0.6 percent across small firms and 0.1 percent across mediumand large firms. Fines as a share of sales are also higher among non-exporting firms (86 percent ofthis group comprises micro and small firms), among f i r m s in rural areas rather than the capital city and Alajuela and domestic companies as compared with foreign firms. 122. Tax inspections and tax fines are positivelycorrelatedand the association is statistically significant. Thus, firms inCosta Rica which were subjected to an inspection by the Tax Authority are also more likely to be charged a fine. For example, 30 percent o f inspected firms were fined by the Tax Authority as opposedto only 13 percent of non-inspected firms. However, firms which received more visits by tax inspectors were less likelyto be fined. Thus, 14 percent of firms which had morethan 2 visits (the median) by tax inspectors per annum were made to pay fines. Incontrast, 30 percent of the f i r m s that experienced less than 2 visits per annum were fined. Therefore, it appearsthat more visits were associatedwith less fines collection by the tax inspectors. 123. Tax inspectionswere also associated with more negative perceptions by interviewed firms about tax ratesand tax administration. Thus, havinghadto pay a tax fine in 2004 was positively and significantly associatedwith a view that tax rates and tax administrationhad beenthe main obstacle to firm operation and growth. For example, only 7 percent ofthe firms that hadnotbeenfinedby the tax authorities in 2004, perceived tax rates and tax administrationas the top obstacle to their doing business. Incontrast, 17percent ofthe firms that hadbeenfined sharedthe view that tax ratesand administration were their chief problem in doing business. 5.3 Recommendations on Business-Government Relations 124. Costa Rica has already undertakensubstantialreformsaimed at improvingthe procedures and regulatory environment inwhich the private sector operates. Back inthe secondhalf ofthe 1990s, the attraction of foreign investment into Costa Rica broughtto lightthe needto facilitate procedures for foreign trade. Some of the new legislation adopted at that time contains clauses exclusively aimed at reducingunnecessarybureaucratic practices and redtape. Thus, Law No. 7472 on Consumer Protection and Competition was modified in 1997 to createthe first NationalDeregulation Commission (Cornision Nacional de Desregulacion (CND)) through executive decree. The Commission, which became operational in 1998, had the goal of coordinating and leading efforts indifferent areas of deregulation of simplification of procedures andwas responsible for proposingnew laws and regulations where necessary. 125. Severallaws and regulationswere passedand odamendedto carry out regulatory simplification. One ofthe important achievements inthe simplification ofregulations was achieved in 2002, with the entry into effect of Law for the Protectiono f Citizens from Excessive Requirementsand Administrative Procedures(Law No. 8220). This Law established important instruments such as the principle of "positive silence", to consider a request or permit approved when the authorities have not resolved or communicated the outcome within the term for its resolution. At the same time, important advances were made in areas such as regulation of exports, imports, foreign investment,domestic competition policy and tourism and constructionpermits among others. For instance, the monopoly position of the Registerof Fertilizers and Similar Products was eliminated andthe costs and time for 152 obtainingphyto-sanitaryandveterinaryregistrations were reduced. The Law ofFreeZones (LaLey de Zonas Francas) was strengthenedwith newregulations for its application.A webpage with a Manualfor ForeignInvestorswas establishedin2001(inEnglishand Spanish). 126. Despitethese positivedevelopments, there is a perceptionthat some of the earlier reform momentumhas beenlost over the past 4 years. Delgado(2005) conductedinterviewswith various government and privatesector officials and found that the advances since 2002 to date are perceivedas somewhat limitedand insufficient. Itis notedthat the Governmenthas not definedhow to advancethe processof improvementofbusinessregulationthroughrationalizingthe legalframework, which is often citedas the mainreasonfor excessiveproceduresandcorruption. 127. In the area of businessregistration,the Government should undertakereformsaimed at reducingthe time of the processto start a company. This couldbe achievedthroughthe removal of requirements for the annual renewalof operating licenses, andthe introductionofstandardizedforms to enter the business inthe Commercial Register. Some ofthe mainbottlenecks lie inthe steps mandatedby law, butother lengthyprocedures are observedinthe Commercial Registerandthe municipalitiesfor obtainingan operational license. Infact, ittakes 25 daysto enter the company inthe Commercial Register, 18 days to get anoperational license from the municipality,andanother 18 days to legalizethe company's books. Thesethree procedures sumup 61 days (out ofthe 77 ittakes to register a firm). Two types ofrelevant reforms couldbe pursued: (i) the introductionof standardizedforms to enter the firm in the Commercial Register, which hasworkedinothercountriesto reducetimes andrejectionrates; `15and (ii) streamliningofmunicipallicenseissuesbytheirstandardization,theprovisionofformsand the informationonline, andthe eliminationoftheir annualrenewalrequirement. 128. The Governmentshouldalso take measuresto reducethe time for obtainingconstructionpermits and environmental assessments, which at presentare time-consuming.A possibleway to overcome long delays in constructionpermitissuance is to give buildersstep-by-step procedurechart so that they do not haveto visit the municipalityseveraltimes to find outthat new requirements mustbe incorporated into the buildingplan. Another possiblereformis to consolidate all buildingprojectclearances withinthe municipalityto avoidvisitsto different governmentagenciesthat must approve buildingspecifications. Some steps inthis directionhave already beentaken. For example, during 1998-2001the principleof "silence is consent" was adopted inthe area of constructionpermitissuance inCostaRica.'16 129. Labor regulationsand lawscan also be reformedto reduce the costs of hiringand firing for Ricanfirms. While firing and its costs are consideredless of a problemaccordingto the DoingBusiness data, Costa Ricanlabor regulationsare morerigidwith respectto workinghoursandhiringnewworkers. Existingrestrictionson nightwork, weekly holidaywork andthe maximumnumber of workinghoursper day couldbe removed. Second, at presentterm-contractscan only beusedifthe work is seasonalor requiresspecial skills.This couldalso beamended. Minimumwages are highrelativeto va1ue:added per worker (54 percent), whichraises hiringcosts andpreventsfirms from hiring. 130. The Governmentcould also promote availableelectronic procedures (such as intax-related matters)and also make more informationavailableon the Internet. The experienceof Chile and other countries aroundthe worldwhich havesuccessfullyadoptede-Government for registration,permits andtax paymentscan be utilizedto implement such a reform. This is especially true for tax payments, where CostaRicais foundto be laggingbehindcomparatorcountries onthe ease ofpayingtaxes. `Is See chapter on "Starting a Business" at World Bank (2006~). ` I 6For smaller buildings (less than 300 sq. m.) on 1 to 2 floors ifthe permit was not issuedwithin the requiredperiodof 5 businessdays, the "silence is consent" ruleapplied. Similar rules were adoptedfor largerbuildings. 153 5.4 ContractEnforcementand the Judiciary Perceptions oftheJudiciary 131. CostaRicanfirms are confident that the courtswill defendtheir propertyand contractual rights incommercialdisputes.For example, perceptions of interviewed firms about the workings ofthe courts indicate that among the five comparator CentralAmerican countries as well as a group of South American countries, Costa Rican courts are viewed as most likelyto uphold firms' contractual and property rights incommercial court cases (Figure 5.13) as only 17 percent of interviewed Costa Rican firms believethat the courts will not support their property and contractual rights incommercial disputes. Conversely, 40 percent of interviewedCosta Ricancompanies express confidence that the courts will uphold their contractual and property rights-the highest among the comparator countries (Guatemala (14 percent), Honduras and El Salvador (20 percent), or Brazil (35 percent), for example). Figure 5.13: Firms which Do Not Believe that the Figure 5.14: Rankingsof Judicial Independence and Courts Will Uphold Their Contractual and JudicialCorruption Property Rightsin a CommercialDispute, YOof Interviewed Firms ComRica 5 3 Costa RICE ElSalvador Brazil 3 2 Peru G"8tFd8 El Salvador HOnd"IE8 Honduras Nicaragua 41 NlCElUgua Guatemala 40 0 1 2 3 4 5 6 Ecuador 50 Ulmgulir p i y ~ n tnpdisml dooiaionr(I-paymcnta made: 1-paynxnu not made) U U l u d m d Indrpsndsne. (I-not mdepsdsnt. 7-indrpcndsnt) Source: World Bank InvestmentClimate Surveys. 132. CostaRicancourts are also perceived as the most independentand least corrupt amongthe 5 CentralAmerican countries according to the rankingsof the World EconomicForum (2005)'s Index of PublicInstitutions. As shown inFigure 5.14, Costa Rica scores 4.9 on a 1-to-7 scale (where higher values stand for higher independence) on the sub-index of Judicial Independence, ranking 331d among 104 countries. The next best ranked CentralAmerican country is El Salvador in7lStplace. It also ranks well on the sub-index of Irregular Payments inJudicial Decisions -with a score of 5.3, Costa Rica is well above the rest of Central America, and occupies 40* place among the set of 104 countries. In addition, the World Economic Forum (2005) also reports that the efficiency of the legal system isjudged as the highest in Costa Rica among the same comparator group of countries inFigure 5.14. 133. The World EconomicForumalso finds that the legalframework for economic activityis seen as the most efficientinCostaRicaamongthe five CentralAmerican countries, scoring4.2 and ranking39th out of 104 countries (Figure 5.15). Similarly, the HeritageFoundation's Indexof Economic Freedom assigns a score of 3.0 (on a 140-5 scale, with lower values indicating better 154 outcomes) for the Property Rights regime in Costa Rica.'" It also mentions that although courts are considered honest and independent, contracts are generally upheldand investments secure, legal complaints filed over contracts take an average of 550 days to resolve and court cases are said to be expensive. 134. While only 10 percentof surveyed firms identifiedpropertyrightsas a major or severe constraint to growth,22 percent perceived the efficiency of the courts as a major or severe constraint (Figure 5.16). Again, however, from an internationalperspective Costa Ricaperforms on these perception-based measures better than other neighboring or LAC countries. One conclusionthat emerges from the different sources measuring court efficiency and legal systedproperty rights protection is that while the latter is considered broadly adequate, the former raises more doubts among firms and investors -especiallywithrespecttothetimeandcosttoresolvecontractualdisputesincourts. Figure 5.15: Rankingsof Property Rights and Figure 5.16: Percentage of Firms that Perceive Efficiency of the Legal Framework Property Rightsand Court Efficiencyas a Major or Very Severe Obstacle to DoingBusiness El Salvador CostaRica 22 Hondvras 22 Ecuador GUWlUh BFyll Nicaragua 0 5 I O I5 20 25 30 35 40 %offurns 1CounEfficiencyand ConllictRewluhonSPmpertyRightsand ContrastExecution/ Source:World EconomicForum, Global Competitiveness Report Source:World Bank Investment Climate Surveys,various years 2004-2005. Note: Data for Property Rights and Contract Execution are not available for Brazil. Court Use 135. Medium and largeCostaRicanfirms filed more court cases relatedto payment disputes than small and micro firms inthe 2 years prior to the survey; so did companiesinAlajuela compared to companies locatedinthe rest of the country (Figure 5.17). About 38 percent of medium and large firms bring at least some oftheir payment disputes to court and they also file the highest share of their payment disputes with the courts - 6.5 percent. The fact that medium and large firms are the principal court users is consistent with findings inother countries as court use i s often expensive. Exporting and foreign firms also usedthe courts more than their non-exportingand domestic counterparts. '"The Property Rights index -as defined by the Heritage Foundation's methodology -takes into accountthe independence of the courts, the time to resolve contractual disputes andthe legal ownership of landthe registrationof landtitles. See Costa Rica country profile at: httr,://www.heritaae,ora/researchlfeatures/index/countrv.cfm?id=CostaRica. 155 Figure5.17: Share ofFirmsUsingthe Courtsto Figure5.18: Share ofFirms Usingthe Courtsto Resolveat LeastSome ofTheir Payment Disputes Resolve at LeastSome of Their PaymentDisputes, by Country 40 35 Costa Rlca 30 j 2 l ;20 1 25 El Salvador 21 L 15 Honduras 20 10 5 Nicaragua 19 0 Quaternala 17 Source: World Bank InvestmentClimate Surveys. 136. Across the subset of interviewedCosta Rican firms with paymentdisputes in the 2 years beforethe ICs, the percentof payment disputes filed in courtwas about 4.7 percent,which is high by LAC and Central American standards, where court use normally ranges in the low single digits (e.g. 2.3, 2.1 and2.0 percent inNicaragua, HondurasandEl Salvador respectively,1.3 percent in Guatemala, 1.2percent inBrazil, etc.). CostaRicahadthe highestfractionoffirms whose payment disputes were filed with the courts inCentralAmerica (Figure 5.18). Therefore, CostaRicanfirms interviewedthrough the ICs are the heaviestcourt users inCentral America-a larger share ofthem bring payment disputes to court, andthe percentageofpaymentdisputesbroughtto court is also the highest(4.7 percent)."' 137. Court use is often low due to lengthy,costly court proceedings. Accordingto the surveyed time to resolvea court case-from filing untiljudgment - was 431days. Althoughthis is lowerthanthe CostaRicanfirms that filed paymentdisputes incourt inthe 2years precedingthe survey, the average number of days to resolveapayment case inBrazil,it is the secondhighest amongthe comparatorgroup of countries and substantiallyhigherthan inthe rest of CentralAmerica(Figure 5.19). The durationof a court case over payment inCosta Rica rangesfrom 1day to 4 years and one third of courtusers indicate that it took them morethan one year to obtain a courtjudgmentover their dispute. 'I8Among the subset of firms which brought payment disputes to court, the share is also the highest in Costa Rica. Thus, 106 interviewed Costa Rican firms went through a payment dispute inthe 2 years before the ICs. Of these 24 (or 23 percent) filed some of their cases in court. The fraction filed across these 24 firms only was 20.7 percent of disputes. In contrast, the same figure rangedbetween 9.5 and 12.2 percent inthe other 4 CentralAmerican countries. 156 Figure5.19: Number of Daysto Resolve a PaymentDisputein Court, by Country Chile Nicaragua El Salvador 0 100 200 300 400 500 600 days Source: World Bank InvestmentClimate Surveys. 138. Costa Rica ranksvery low 141Stout of 155 countries covered inthe DoingBusiness - database- onthe index of EnforcingContracts (Table 5.4). Comparedwith the average inthe Latin Americaregion,it takes longerto enforce contracts inCostaRicaand is morecostlyto do so. Although the number ofcourtprocedures is within the LAC average, court cases are amongthe mostprocedurally . burdensomein LAC comparedto other regions. Thetime to enforce a commercial contract -according to DoingBusiness- is 550 days,'lg andabovethe LAC averageof 461 days. The processcosts 41-2 percentofthe claimamount (as comparedwith 23 percent inLAC), andencompasses34 procedural steps (in line with the LAC average of 36). Table 5.4: EnforcingContracts: Time, Cost and Procedures Country or region Number of procedures Time (days) Cost (% of debt) OECD: High income 20 226 11 Latin America & Caribbean 36 461 23 Costa Rica 34 550 41 Brazil 24 546 16 Chile 28 305 10 El Salvador 41 275 13 Guatemala 37 1459 15 Honduras 36 545 33 Nicaragua 20 155 16 Source:World Bank Doing Businessdatabase (2006). 139. Aside from the problemof court delays, the decisionsof the court are reportedlynot regularlyenforced. Thus, less than half(46 percent) ofthe courtjudgments on paymentcases reported by the ICs hadtheirjudicial decisionsenforced-i.e. the debt was collectedandpaidto the creditor. In contrast, 79 percentof courtjudgments over payment disputes inChile were reportedby ChileanICs respondentsto havebeenenforced. One likely causefor this lackofcompletionofjudgmentexecution in CostaRica is the automatic suspensionofexecution uponfiling of an appealonthe first-instancecourt judgment, which provides incentivesfor debtorsto file appealsto delay the paymentofthe debt. ' I 9This is close to the average of 431 days reportedby the ICs. The average for Costa Rica is higher (532 days) if one outlier is not omitted. 157 Labor Disputes 140. Disputeswith employees are anothertype of businessdisputes which firms often face. On average, 22 percentof interviewedCostaRicanfirms enteredintodisputeswith dismissedworkers over the dismissal inthe 2 years prior to the survey (Figure5.20). Incidence of such labordisputesvaries considerably by firm size. For instance, while only 6 percentof microfirms experiencedlabor disputes over layoffs,43 percentofmediumand large firms hadlabor disputes over layoffs. Foreigncompanies also entered into more labor disputes than their domestic counterpartsand so did exporters versus non- exporters. 141. Twice as many labor disputes over the conditionsofworker dismissalsin Costa Rica are resolvedthrough mediationin the Ministry of Labor than through court action (4 vs. 2 on average). Only amongforeignfirms the averagenumbersof labor disputes broughtto court andto mediationinthe Ministry ofLaborare aboutthe same. Ofthe firms whichexperiencedlabordisputes over dismissal in the 2 years priorto the survey, almost two-thirds(63 percent) reportedthat at least some ofthese labor disputes were resolvedby mediationinthe MinistryofLabor. About 51percentofthe same subsetof firms reportedat leastsome labor disputes to havebeenresolvedthroughcourt action. As with the incidenceof paymentdisputes, mediumand large firms and exportingfirms reportedhavingmoreof these cases resolvedby either means. Figure 5.20: Percentageof FirmsWhich ExperiencedDisputeswith Workers over Layoffs 43 43 Source:World Bank InvestmentClimate Survey, 142. As with disputed payments, the handlingof disputed firing decisions by the courts is not fast in Costa Rica as reportedby surveyed firms. The averagetime was reportedto be 11months, with a median of 7 months andonly one-thirdof the cases broughtto the courts, a decisionandagreement betweenthe worker andthe firmwas reachedwithin 3 monthsor less. Fromthe remainingcases takento court, 42 percentwere reportedto take between6 and 12months, but some other cases were reportedto take muchlonger-upto 3 years. 158 143. Despitethe delays of court resolutionof labor disputes,less than one-third ofthe disputes brought to court usedan out-of-court settlement betweenthe companyand the dismissedemployee. Thus, only 10 out of 33 firms took their court disputes out ofthe courts, andultimately resolvedthem in that manner and most of them resolved all of their court cases through out-of-court mechanisms. How Do CostaScanFirmsAvoid Disputes? 144. Firms often try to avoid commercialdisputes,especiallyin countrieswhere contract enforcement is slow and unpredictable. For example, incountries wherethe courts are slow and judgments hardto execute, firms will avoid runninginto disputes by interactingonly with known suppliers and clients, and by structuring transactions with a view to avoid the emergence of disputes such as requiringpre-payment or payment at the moment of sale. Many authors have argued that the share of pre-paid sales i s higher incountries with worse contract enforcement regimes, and among firms which do not have easy.access to the courts or to alternative mechanismto resolve disputes(e.g. Hendleyand Murre11(2003)). 145. About half of the value of sales of CostaRicanfirms (48 percent) was either paidinadvance by the buyer,or at the time of deliveryof the purchasedgood a signthat firms do try to reduce - the risk of non-payment. According to the ICs data 9 percent o ffirms' sales requiredpre-payment by the buyer, which is 50 percent higherthan the percentageof pre-paid sales inBrazil and Guatemala and three times than that of Chile (Figure5.21). The share of sales paid at the moment o f delivering the good inCosta Rica-at 39 percent oftotal annual sales on average-is comparable to that of its Central American neighbors, but higher than in Brazil, Chile and Ecuador. Thus, the percentageof sales on credit (52 percent) is not that highin Costa Rica, which i s comparable to El Salvador, Guatemala and Nicaragua but lower than in other LAC countries suchas Brazil, Chile and Ecuador. One possible interpretation of the relatively high usage ofpre-payment andpayment onthe spot is that firms inCosta Rica are less confident that they would be able to collect their debts inthe case of non-payment by the buyer. 146. Almost one-third of CostaRicanfirms (31 percent) requireat least some of their sales to be paidinadvance, and morethan threequarters(79 percent) requestat least some part of their sales to be paidby clients at the time of purchase,which revealsa conservative stance on the part of sellers (creditors) (see Figure 5.22). Across firms that requireat least some of their sales to be paid in advance, pre-paid sales constitute 28 percent of total sales. Across firms that demand payment on the spot for at least some o f their sales, these sales represent on average almost halfof their total sales. Finally, three quarters of Costa Rican firms (75 percent) also make at least some o f their sales available to buyers on credit. Across these firms, sales on credit are 70 percent o ftotal sales. Boththe share of firms which allow credit to customers and the average percent of sales made on credit inCosta Rica are lower than the same numbers in Braziland Ecuador, but higher than the same indicators for Nicaragua, Honduras and Peru, where sales on credit are even lower. 159 aid UofarcDelivery, ,b! Country Before Delivery, at D Gountry Source World Bank ~ n v e s t rClimateSurveys n ~ ~ ~ Source World Bank ~~~ci:~trnent Survey. Ciimatci: equipment sector are madeto specificationbythe client, andthe product wouldbeof little value to the manufacturershouldthe client fail to pay at some point inthe future. To protectthemselves fromnon- payment, producersof suchequipment wouldusuallyrequire partialpaymentex-ante. 149. Overall, micro firms in CostaRicawere less likelyto encounter delayed paymentsby customersthan small, medium and largefirms, and a lowerfractionof their monthlysales were paidwith some delay in2004. Thus, 68 percentofmicrofirms hadclientslateon payments, as opposed to 81percentof smallfirms and 77 percentof mediumand large ones. Furthermore, microfirms encounteredpaymentdelays in26 percent oftheir monthlysales while paymentdelays for small, medium and large firms represented32 to 33 percentofmonthlysales. 150. However,all types of firms appear to be able to exact payment from privatecustomers when there are delays (only 4 percent ofdelayed paymentson average are never collected) but microfirms are less successfulincollecting outstandingpaymentsthan largerfirms. Micro firms were unable to collecta higherfractionof delayedpayments-7 percentofthem are never repaidas opposedto 3 percent for mediumand large firms, and4 percentfor smallones. UnlikeinChile, where mediumand large firms manageto collectdelayedpaymentsfaster than smallandmicrofirms (in33 days vs. 44 days), inCostaRicathe reverseholds-microfirms collectfaster (in 30 days on average) than mediumand large (53 days) and smallfirms (45 days). 151. Although almost half of the firmswho belongto businessassociations in CostaRica report havingreceiveddispute-resolutionservicesfrom their associations, businessassociation membershipin CostaRicais amongthe lowestinCentralAmerica (43 percentof surveyedfirms). Business associations in many countries playan importantrole inhelpingfirm membersresolvedisputes with other firms, workers or the Government. 152. Businessassociationmembershipis unevenly distributedamongdifferent types of Costa Ricanfirms (Figure 5.24). A substantiallyhigherfraction of mediumand large firms belongto a businessassociation comparedto micro and smallones. Exportingandforeign-ownedfirms are also more likely to belongto a business associationthantheir non-exportingor domestic counterparts. Non- membersmostlycitedlack of informationandbenefitsfor their businessesas reasonsfor notbelongingto an association. Figure 5.24: Percent of Firms Belonging to aBusinessAssociation, by Type of Firm 90 63-- ~~- 80 80 80 - 70 - g 60 - 50 -43 47 45 40 42 39 % 5 4 0 - 32 30 - 29 20 - 10 - Source:World Bank InvestmentClimate Survey. 161 5.5 Recommendationson Contract Enforcementand the Judiciary 153. While CostaRica rankswell internationallyon measuresofjudicial corruptionand firms expressgreater confidenceinthe courtsthan elsewhereinCentral America, the Governmentcould undertakereforms to improvethe time it takes to resolvea commercialcase incourt. One way to do so is through reforms ofthe Civil and Criminal Procedure Codes Disputedclaims are normally decided inCosta Rican courts inacriminal lawsuit but it is normal ractice for creditors to also file a civil claim against the debtor (the so-called accidn civil resarcitoria).'" The highnumber of procedural steps that are involved ina simple payment dispute (34) indicates that the process is burdensome with the relevant procedural codes mandating many of these steps. The most time-consuming part of the court process, according to Doing Business 2006 data, takes place from the moment of filing defense to the issuingof thejudgment (300 days). Filingand notifications only take 10days and enforcement ofthe issued judgment takes 240 days. It mightbe advisable to use the DoingBusiness team's expertise inanalyzing possible steps which could be eliminated from the process. 154. The Governmentshould also consider streamliningcourt execution procedures,which are also lengthy. Ittakes 200 days to executejudgments and lessthan halfofjudgments are reported to have been enforced by ICs respondents. One way to streamline procedures, as mentioned earlier inthe chapter, is to facilitatejudgment execution by removing the automatic suspensionof the first-instance courtjudgment, which kicks in once appeal i s filed. Another way to cut the execution time i s to open the processto private competition -with private firms acting as enforcement agents. 155. I t would be usefulto improvejudges' incentivesby administeringcourt case management reform,and to allow for specializedproceduresandjudges in the regulartrack courts,who could review smaller claims or commercialcases only. As reported inDoingBusiness2006: CreatingJobs World Bank (ZOOS), there are four reforms to reduce times to disposition o f court cases: (i) better using case management practices (with onejudge following the case from start to finish), (ii) introducing summary proceedings whereby the creditor only needs to presentevidence of the transaction and non- payment to obtain ajudgment against the debtor, (iii) simplifyingprocedures for gettingand hearing evidence in court; and (iv) usinglower courts to hear simple claims. While at present Costa Rica has a summary procedure available (procesosumario) for commercial cases, it can be utilized only for small claims. 156. The Governmentcould also consider further development of alternative dispute resolution (ADR) mechanisms,such as mediation. Recognizingthe overloadingo fthe courts, the SupremeCourt and other public institutions have started promotingthe resolution of conflicts outside o fthejudicial system. Inparticular, the Supreme Court andthe Chamber o f Commerce of Costa Rica are promoting arbitration and conciliation. To that end the Chamber of Commerce createdthe Center for Conciliation and Arbitration to deal with commercial conflicts.'21Nevertheless, there still is room for increasing the use of ADR. Inthat respect, business associations could have an important role to play as 46 percent o f business association membersinterviewedreportthat they use associationsto resolve disputes with the Government, workers, or other firms. This is also confirmed by regression analysis shown inTable 5.5 at the end of this chapter -business association membership is negatively and significantly associated with court use. Mandatorymediation for small payment cases and other civil cases can reduce case backlogs ifadministered well.'22 IZo "' Information based on Doing Business database. InCostaRica, ADR are rules by the constitution and aspecific law (Law No. 7727 Ley sobre ResolucidnAlterna de - Conjlictos y Promocidn de la Paz Social) sanctioned in 1997. lZ2Ithas had success ina World Bankjudicial pilot project inArgentina (see World Bank (2001), World Bank (2004b)). 162 157, ~ ~ r r ~ p-tthe eo ~n~ ~ i o ~ t aoft public affice for private gain-can increase the cast of ~ i Q n doing business aid create a n o n - l e t r e ~ - p ~field ~ n ~ ~ for ~ ~ f f e rfirmst a f f ~ c byeit. A s pointedout e ~ ~ ~ by thc ~ o r Bank's 3005 World ~ c ~ ~ c ~ oReport,tthe~major^^ of firms indevelop~~gcountries ~ d p m e ~ expect to paj bribes on a regular basis and deal with ctientclism, state patroiia~~ and redfaputo "get things done" ~ ~ ~ tthis a u gbe~c o~~ ~ ~ d ethed~ ~ might r e ~ ~ J ~ ~ for sdoing business in less . ~~~~~~~~~~ ~ ~ s ~ c~~ ou ~p ~ero~~ ~e~~~p,its.ai doe~~~r i ~ ~ rpractice that affects thc ~ n ~ e s fetimatctitr several c i t a l ~ ~ n ways. When c o r r ~ ~ is ~ ~ ~ ~ n p practicedamong the highest levels of~overtimeIit,it can distort po~icy~ak~ng and ~ ~ I ~ d cthem ~i ~s ~~~~n 1 t ~cer endt .j b r ~ s ~ ~When public of~icjat~the tower lewis of governi~entact i ~ . at in corrupf \.iajs, tlrerc can be a negative effect. on e~~~reprene~ria~ and private sector growth. activity 1S8. Cases Rica has t r a ~ ~ t ~ ~enjoyed a~ reputat~onfor tr~nsparencyand fares well relative to n a 1 1 other regional peers in ~ ~ t e r ~ ~~ r~i r~r n~ aprankings. ~a~ifmaIinSI.'$ ~ 2 0 i~I ~5d ~~c ~oft otfte ~t ~ o n et r control of c ~ r r ~ ~placesi oCosta Kica in an eiitiabfr:pos~tioIiagainst some of its Central A I ~ e ~ i c ~ ~ ~ ~ t . ~ ~ I ~ e j ~ h ~ ~Ast rseen in Figure5.25, the courtrsl, stands inthe 77th pe~cent~~eof a s a ~ ~of204 countries, s . i ~ ~ e tthereas other countries in the rcgiart rank bcfoxv the.50th ~ ~ r c e nA~similar.~ I ~ demergcs from thc i ~ ~ ~ n g ~ o r r ~ ~~ t i ~~ n ~Index c c {CPX) by Trat~sparencyInternaf~onal~which shctws CostaRim p e ~ ~ r m i n ~ ~ ~ ~ a ~ ~ 5 b 160. Other ( ~ ~ ~ ~data on~ther prct&iwe~ aft ~ o r ~ u p tsuch~as that c o l ~ e ~by~the ~ e ~ ~ d j a ~ t d World ~ c Q ~ oForum (WEF) paint to ~ h a ~ l e nineareas related to red tape, as welt as i ~ i c ~ s ~ ~ ~ p a ~ ~ c in ~ s n pubtic utilities, exports, imports, and tax collect~o~. Figure5.26 depicts areas whcre Costa Rica performs relatrwly poorly ~ ~ ~ t ~topsome a r eof~its peers. For instance. in the area of irregular p a ? ~in~P ~~X ~~O andS~~ tt ~~ ~El~Saltador, ""l~ndura~ ~ i c a r a rankabettcr than Costa Rica; and T~~ o ~ s and ~ ~ Figure 5.26: Red tape c-7. h . C c'1 FiON lrreyulai paymerrtsio tan eoiiectmn Irregular payments inaxpans and impart* h C kOh C H .V.*WA PA&* G".A h\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\X :I.L hjC r+CN CV. 0 20 40 ea 80 1Q0 120 Country Rank Source WorSd Ecoriomic Forurn. Executive ~ ~ i nSurvey i ~ n(2005) Data for *"extentof Bureacretc Red Tape is from 2004 161 Recentcorruptio~iscandals also shed light on the incidence of public corrupt~o~within the highest eehelans of ~ o ~ e ~ n ~and t , e nexplain the possible~ e ~ e r of~somerof~these indicators.~ o ~ ~ ~ ~ In 2004, a scrics of c o r r ~ i p ~ ~ ao ~ ~that~i ~ ~ ~ p ~hi&-level~ t~e do ~ ~officials ~i ~ e b ~~l ~thea t~e ~~ c d a s ~ c ~ r ~ m ~t c r e d ~ bof ~ o~ ~t ~e r ~ ~andeexposed an a l a r ~ itrend ~ m I ~ t n ~ of incrcasjngc o ~ u p ~ini ~the country. These n scaridals also revcald rhc p~r~~asi~eness of illegal c o ~ n ~ i s s iatidnbribes paid by private c o ~ ~ ~ p ain ~ i e s ~ ~ s ~ e ~ c ~ for actions~that Irad j ~ i ~ ~ ~the~~c ~ d~ of~public~tenders. ~ a ~ e e c c m c I62 The l n ~ e ~1~~~~~~~ Survey ~ ~ ~ ~ e ~that c ~ ~ r ~ p~~isolower in Costa Rica than ~ o i n e ~ t in n ~ i ~countries,yet bribes **toget things done" seem to be the h ~ ~ r ~ ~ ~ ~ ~for firms and ~ ~ a ~ ~~~~~~ rep~e~ent a sizeable portion of firm sates (Figure 5.27). With respectto corruption s t e ~ I ~ ~fromgthe i n i n ~ o r i s i s ~arid~usn ~ r c d j ~ t a bof~ ~ i ~ y ~ n rc~u~a~jon,Costa Rica docs a lot bcttcr than its peers: only 29 percent of firms r~~~~~~~ haviiig problems with this issue. This compares f a ~ ~ ~ rtoa thel ~occ~~rrence b of such r e ~ ~ ~ ~l ~a~t ior dr ~ine~s ~ ~ ~ such asr~i ~ ~a t cM~here 7~Ipercent, of surveyed finns a c ~ ~ ~ o ~ l e d g e ~ n t e ~ ~ a having to deal tltit11 ~ n ~ o n sandsL~i ~~p~~~~ d~~ c~ t ae~ l~e ~ On the other~ fiand,~thenfrequency witti i ~ a ~ ~ . which c ~ n ~ p a nhaves to pay bribes"'lo get things done" is still rcfativcly high -45 pcrcent of Costa i ~ Ricm firm reportede n ~ ain~this type~ ~~ i ~ ~ ~on a regular~basis.u~ ~ pl t hthissfraction ~is ~ t~ ~~ ~ h ~ r ~ ~ a t ilowerl than cvhat is often ~ o ~ in other coun~~iesthe rcgion, such bribes rcprcscnt a srnall ~ e ~ n d in portion of companies' sales (Figure 5.28). On average, Ccssfa Kican firms report pa) irigclose to 2 percent offlteir ~~1i~~~i;iIin~orInalpaymentsor bribes "to get thiripsdone" - :in ~~~~~~u~~~which is not stilus in trivial. I64 Figure 5.27: GovernanceInefficiency (Percentage Figure5.28: Bribes "To Get ThingsDone" and to Win of Firms) PublicContracts 71 Costa Rica China El Salvador Honduras Nicaraoua Guatemala Ecuadoi Costa Rica Ei Salvador Nicaragua Honduras Guatemala HBribes "to et thingsdone"(Ohof sales) !!iBnbeo in Zov. Procurement(Ohof contract amount) H Interpretationsof regulationsinconsistent8 unpredictable Source:World Bank Investment Climate Surveys Bribes"to get things done"consideredcommon Source: World Bank Investment Climate Surveys 163. A closer look at corruptionin CostaRicashows that governmentservicesofferedby the Health Ministry and sanitarycontrolpermitsare the proceduresmostcommonly affected by bribery. For those firms that usually requestthe list o f services detailed inFigure 5-29,services offered by the Health Ministrywhere cited as having the highest incidence o f bribery. As illustrated, 6 percent o f firms that require services from this Ministryreported paying or having been asked to pay bribes to obtain such a service. Similarly, sanitary control permits, mainline telephone connections and registrationwith the Costa Rican Social Security Fund(Cuju Costarricensede SeguroSocial (CCSS)) were reported by f i r m s as being affected by bribery. Figure 5.29: Percentof Firmsthat Paidor Were OfferedBribesto Obtain GovernmentServices (Subset of Firms that Requestedthe CorrespondingServices) Ministry1 6 3 Sanitary control 3.2 Registration at "Caja Costarricense" for - Main Line Telephone Connection 2.6 Social Security 2.2 Internal Revenue Service 0.0 Municipal Patent 0.0 Electricity Connection 0.0 Construction Permits 0.0 Import License 0.0 5 Source: World Bank Investment Climate Surveys 164. SMEs in CostaRicaare more affected and channela greater portionof resourcesindealing with corruptionrelatedto government procurementand businessprocedures. Bribes bite harder at micro and small enterprises in Costa Rica. Whereas medium and larger firms report paying close to 8 percent o f the cost o f a government contract to influence procurement decisions, this figure is considerably higher - 10 and 11 percent respectively - for small and micro enterprises. Likewise, the share o f sales paid out as bribes varies from 4 percent for medium and large firms to 6 and 7 percent for 165 small and micro firms respectively. For those small and micro firms that hadbeenaskedto pay a bribe, 11percent reported that this incident happenedwhen dealingwith the Health Ministry, 6 percent reported this from the public social security system, 5 percent from the sanitary registry, and finally 4 percent when dealingwith the maintelephone service provider. 165. Corruption is costly as firms that pay bribes to "get things done" are usually the ones that report paying bribes for publiccontracts, under-reporttheir taxableincomeand generally distrust the courts. As shown inTable 5.6 at the endofthe chapter, firms that report paying bribes"to get things done" are more likelyto report that procurement bribes are routinely expected to win a public contract. Similarly, distrust inthe courts (measured by firms which do not believe that the court will upholdtheir property and contractual rights in disputes) is positively and significantly associatedwith payingbribes "to get things done". Finally, firms which report ahigh fraction of their sales to the tax authorities are significantly less likely to report bribes for procurement purposesor "getting things done". While these arejust correlations, they reflect that the effects of corruption are re-enforcing. 166. CostaRicashould not be complacentwith its relativelywell establishedpositionas one of LAC'Smosttransparentcountries, but should aim to create an environmentof good governance that is more comparableto that of other developed nations. Although corruption is less entrenched in Costa Rica than in some of its neighbors, the country still faces important challenges interms of increasing the quality of governance to levels that are closer to those found inindustrialized countries. Recent corruption scandals and the slide insome perception-based corruption indicators couldjeopardize the country's attractivenessto foreign investors and become an additional obstacle to investment and growth. Measuresto deal with corruption will not only improve the investment climate but also increase the country's attractivenessto foreign investors. The country faces the particular challenge of balancing out the risks that stem from state control over large sectors of the economy, as this increasesthe hazard of misallocation of resources or rent-seeking behavior inthe formulation of policy. These potential risks have only become visible by the recent corruption scandals, which centered on procurement practices at the Costa RicanElectricity Institute(ICE) and the CCSS. 167. The country still hasan incipiente-Government strategy and procurementpractices that should be enhancedin orderto contributeto the efficiency inthe management of public resources. Since fewer public services have been privatized inCosta Rica than inother neighboring countries, this has direct implications for public procurement practices and the amount of public resourcesthat have to be mobilized. Indeed, between 2003 and 2005, the average budget for public procurement of goods, works and services amounted to US$3,687 million, representing more than 20 percent o f GDP, and 77 percent of the budgeted expenditures of the g~vernment.'~~However, public procurement is still not fully recognized as a key aspect of public expenditure management inCosta Rica and is not fully streamlined into the financial management system. Also, as emphasized in Costa Rica's recent Country Procurement Assessment Review (CPAR), further progress inthe development o f e-procurement shouldimprove the efficiency and transparency of procurement outcomes, by first enhancing the dissemination of information, and subsequently introducingmore transparent transaction procedures. 5.7 Recommendationson Corruption 168. One way to dealwith corrupt practices in differentgovernmentagencies such as the- HealthMinistry and the Social Security Fund,where this seems to affect relativelymore users is - to adopt a system of transparency and goodgovernance,which have alreadybeen adopted in other countries (e.g. Mexico). For example, through announcing time limits for issuinglicenses and permits and guidelines for applications on the web or inthe national media, it would bepossible to enhance World Bank (2005b). 166 transparency. Furthermore, user surveys and scorecards can be introducedto monitor how different government agencies comply with the rules on the issuance of permits and licenses. The results ofthese could be made publicly available on a regularbasis. 169. With respectto grand corruption,whichappears to have tarnished the reputationof successive CostaRicanGovernments in recent years'", itwould be usefulto implementthe recommendationsof the CPAR mentioned earlier and to strengthen public procurement. International experience suggests that usingelectronic government, publishingprocurement guidelines and procedures and announcing tenders and their results on the Internet can go far toward reducingthe scope for corrupt practices. The fact that certain industrial sectors (e.g. wood, paper and publishing,and metal products) are more likely to report procurement bribes indicates that the problem mightbe more acute in some government agencies than others. Inany case, strengtheningpublic procurement systems and audits of the process could be a remedy for the observed level of procurement bribes. 170. While CostaRicaperformswell ininternationalrankingsofjudicial corruption,evidence suggeststhat bribes that are not relatedwith the judiciary are associatedwith a more negative impressionof the judiciary and less trust inthe courts. This could signal that administrative corruption reducestrust ingovernment services in general, including the provision of dispute resolution services by the state courts. It could also mean, however, that when thejustice system is slow and costly, there is less opportunity to punish corrupt officials and more administrative corruption. Findingways to address both state corruption and the operation of thejudiciary can have beneficial effects for government transparency. 5.8 Crime and Violence 171. I t is widely recognizedthat crime and violence representan important obstacleto economic developmentin Latin America and the Caribbean. Many studies (e.g. Ayres (1998) andLederman et a1(1998) have stressed that crime and violence inLatin America and the Caribbean have a significant negative impact on economic growth and, thus, increasepoverty, which inturn breeds crime. Inthis sense, Latin America is caught in a vicious circle: on the one hand, economic growth is hindered by high crime rates, and on the other hand, insufficient economic opportunities stimulate and incite crime. This fact has become important not only in societies that experienced political and civil conflicts, such as Guatemala, El Salvador, and Nicaragua, where levels of crime and violence are particularly high, but also incountries with a long-standing democratic tradition, such as Costa Rica. 172. Today a strong emphasis is puton crime and violence as a negativefactor for the 'investmentclimateof a country. Crime is one ofthe major concerns of foreign investors inLatin America, It deters companies from investingas it weakens investors' confidence and increasesfirms' costs, both directly through criminal attacks on infrastructure as well as on firm employees, and indirectly, through the need for security costs and losses of new productive investment opportunities for the corporate sector. 173. CostaRicaexhibits low homiciderates compared to Central and Latin Americancountries. One of the major obstacles to determiningthe level of crime ina country or region is which measure of crime and violence to use. Moreover, comparisons across countries and regions are difficult because of the existence of potential differences incrime definitions among them and should betaken with caution. Although the homicide rate is not the only indicator of crime and violence, it is one o fthe most frequently used since it constitutes the most serious and publicly visible o fall violent criminal acts, even though it mightsuffer from problems ofunder-reporting. Comparisons across Central and LatinAmerican `25One of the administrationsofthe late 1990shas been accusedof improperhandlingoftelecom contracts. 167 countries reveal large differences inthe rates of homicide. Figure 5.30 shows estimated homicide rates for most Latin American countries by the PanAmerican Health Organization(PAHO) in2002. Costa Rica displays a rate of 6.2 homicides per 100,000 inhabitants, similar to countries such as Uruguay (5.2) and Argentina (7.0). These are among the only Latin American countries with homicide rates close to those inadvanced industrializedcountries. Onthe other hand, countries like Guatemala, Brazil, El Salvador and Colombia registeredwell over 20 homicides per 100,000 inhabitants over the same period o f time. The worse Latin American cases are Venezuela, El Salvador and Colombia with rates of 32,43 and 85 cases per 100,000 inhabitants respectively. Figure 5.30: Estimated Mortality Rate from Homicide 2002, per 100,000 pop. 84.6 Source: PAHO Regional Mortality Database (2005) 174. Nevertheless, crime has been growingsteadily in CostaRica over the past severalyears. This growing trend is generating some serious concerns. Infact, inrecent years, Costa Rica's growth rates of crime and violence are catching up with those of other historically violent countries inCentral America. According to police statistics ofthe Department of Planning, Costa Rica has seen a significant increase inthe number of violent crimes: sexual aggressionsincreasedby 438 percent, from 108 cases reported in 1990to 581 cases reported in2004 (Figure 5.31). Similarly, the number of assaults and auto thefts have risenby 275 and 234 percent respectively duringthe same period, and more than tripled in 15 years. Rapes more than doubled, escalating by 197 percent, while intentional homicides increased by 91 percent between 1990 and 2004. 168 Figure5.31: Violent Crimesin CostaRica" 600 500 ............................................................................................................. ........................................................................................... 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 - + Sexualagression -+*-Damages *' * Intentional homicides Car theft -=O--Asault I' A Rape * Index of the number of cases registeredat the police office of the Judicial InvestigationEntity (1990=100 base) Source Departamentode Planificaci6n,Secci6n de Estadistica, Area Policial 175. Survey data at the firm levelsuggests that CostaRicais no longer an exceptionalcase in Central America with respectto crime and violence, since it presentssimilar rates of criminal activityas its neighboringcountries. Once notably better than its neighbors interms o f crime and violence, nowadays Costa Rica suffers from many o f the same problems of violence that plague the rest of Central America. Costa Rica's firm victimization rate, measuredas the percentage of firms that have experienced any losses due to criminal actions such as theft, robbery or vandalism, i s comparable to that of other countries such as El Salvador, Guatemala, Honduras andNicaragua, all of which have long- lasting history of criminal and civil conflicts. As shown inFigure5.32, the percentage of firms reporting a criminal act in Costa Rica (33 percent) is lower than inGuatemala (52 percent) andEl Salvador (41 percent), but higher than inNicaragua(26 percent) and Honduras (3 1percent). 176. Likeinother Central.Americancountries,mostinterviewedCostaRicanfirmshave security costs but they are less likely to consider crimeand violence as a major constraint. Interms of costs, the Costa Rica InvestmentClimate Survey found that costs for security purposes, such as hireof professional security services, purchaseof security equipment or payments to organized crime to provide protection, are incurredby most interviewed Costa Rican firms. Thus, 57 percent of all surveyed Costa Rican firms revealthat have incurred such security costs. Similar figures can be found inNicaragua and Honduras, with 55 and 65 percent of manufacturingfirms respectively reporting security expenses. Higher values are reported in El Salvador and Guatemala, with 72 and 78 percent of firms respectively spendingon enhancing security. Finally, Costa Ricanfirms perceive crime and violence as a less significant constraint in comparison to firms inHonduras and Guatemala. Only 28 percent of the interviewedfirms inCosta Rica consider themselves constrained by crime; incontrast, in other Central American countries crime and violence are perceived as a major constraint by a considerably larger share of interviewed private firms. 169 Figure 5.32: Victimized Firms and Firms Constrained by Crime 8' 711 Nicaragua Honduras Costa Rica El Salvador Guatemala Source: World Bank Investment Climate Surveys 177. Within CostaRica, microfirms areless likelyto bethe victims of criminalactivities and spend on security costs. Almost one inthree manufacturingfirms reported having experienced a loss due to criminal actions inthe year preceding the survey (Figure 5.33). The rate o fvictimization during the mentionedperiod i s considerably higher for small firms and medium and large firms (37 and 40 percent respectively) than for micro firms (17 percent). Onthe other hand, the percentage of firms spending on security increases with firm size. While 78 percent o f medium and large firms invest in security, only 32 percent o f interviewed micro firms do so. Figure 5.33: Victimized Firms and Firms Constrained by Crime, by size and region 70 58 I Mcro Smsll Nediu1116 Large San Jose Alajuela ahei mVictirfized (%I.:Constrainedby crim (%) etS o m Sec. Costs (%) I I Victinized (%) :.:Constrahed by crim (%) a Som?Sec. Casts (%) Source: World Bank InvestmentClimate Surveys 178. Although crime and violence are usually regarded as a largelyurbanphenomena,in Costa Rica, the victimization rate inthe capitalcity area of SanJose is lowerthan the nationalaverage (31versus 33 percentof firms) (Figure 5.33). A slightly higher percentage o f companies situated outside o f San Jose suffered losses from criminal acts (34 percent on average). A majority o f firms in San Jose said that crime and violence was a "major" or 'kevere" obstacle to doing business. There are no significant disparities interms o f investment in security across regions. InSan Jose, an average o f 57 percent o f firms face expenses assigned to security versus 54 and 59 percent inAlajuela and other regions respectively. 179. Despitethe fact that smaller firms are less likelyto bevictims of criminalactivities, they bear relatively higher losses and spend a relativelylargeramount of resources (as percentof sales) on security expenditures (Figure 5.34). The proportion o flosses suffered by firms decreases with firm size, with victimized micro firms reporting that they lose up to 0.8 percent o ftheir sales due to property crime, versus 0.7 and 0.4 percent for small, and medium and large firms respectively. Investments in security also are inversely related to firm size: the share o f security costs intotal costs i s larger in smaller firms. Among the firms that report at least some security costs, micro firms invest 3.2 percent o f their 170 total costs insecurity against 2 percent for small firms, and 1percent for mediumand larger firms (Figure 5.34). Figure5.34: Crime Losses and Security Costs,by firm size 4.0 3.0 2.0 1.o 0.0 Micro Small Medium & Large Total Source: World Bank Investment Climate Surveys 180. Crime losses and security costs are significantlylower in Costa Rica than in comparator Central American countries and Costa Ricanfirm perceiveto be less constrainedby crime than their companies in Central America. Crime lossesand security costs remain lower in Costa Rica compared to other Central American countries. Since the variable "constrained by crime" i s a perception variable at the firm level, the fact that crime losses and security costs remain lower inCosta Rica might explain why Costa Rican firms report they are less constrained by crime (Figure 5.35). According to the ICs data, Costa Rican firms spend significantly less than their counterparts inCentral America. Security costs (as percentageof total costs) in Costa Rica represent approximately one-fourth of the same expenditures in El Salvador and Guatemala. We get similar results ifwe restrict our sampleto only those firms that do spend on security. Inthe latter case, Costa Rican firms report that 1.9percent of their total annual costs correspond to security costs, while firms inNicaragua, Honduras, El Salvador and Guatemala report 5.3, 5.1, 5.8 and 6.1 percent of total costs spent on security measuresrespectively. Likewise,the average crime-related loss as a fraction o f sales is lower for Costa Ricanfirms. However, inthis case, the differenceacross countries is less pronounced, with crime lossesaccounting for 0.7 percent of sales in Costa Rica on average, and 1 percent on average inthe remaining 4 countries. Figure 5.35: Crime Losses and Security Costs-International Comparison 5.6 6.1 Costa Rica Nicaragua Honduras El Salvador Guatemala Source: World Bank Investment Climate Surveys 181. Costa Rican firms are more reluctantto report crimes to the police and the effectivenessof the Costa Rican police in solving crimes is lower than in other Central American countries. The 171 propensityto report a crime is lower in Costa Rica than inother Central American countries: only 58 percent of interviewed firms in Costa Rica reported criminal activities against their business, compared with 78 percent inElSalvador and Guatemala. Ina similar manner, 41percent of crimes are reportedto the police inCosta Rica. Incontrast, Salvadoran and Guatemalan firms that have suffered from criminal actions report about 78 percent of the corresponding crimes to the police. The lower reportingrate could relatedto the fact that the Costa Ricanpolice is less effective in solving crimes reported by firms (only 4 percent ofthe reported crimes are actually solved) compared to Nicaragua(36 percent) and elsewhere in Central America (Figure 5.36). Figure5.36: Crime Reportingby Victimized Firms,by country 78 78 58 Costa Rica Nicaragua Honduras El Salvador Guatemala I Crimes solved (%I::.:ReDort rate (avs.) Any reDorts (% of firms)I Source: World Bank Investment Climate Surveys 5.9 Recommendations on Crime and Violence 182. Costa Rica should work toward reversingtheworsening trends of crime recordedin recent years by adoptinga nationalstrategy to dealwith crime and makingit operational. The National Police, thejudiciary, the business community and the public at large should be consulted and included in implementing such a strategy. Countries with highcrime rates, such as Colombia or some o f the Caribbean islands (e.g. Jamaica) have adopted similar approaches havingreasonable success. 183. Collectingcrime statistics and improvinginformationsystems within the Police and the Judiciary are crucialto identifywhich types of crime affect private firms the most, in which areas, etc. While the gathering of information on crime against persons is well established, the recordingof crime against firms is not. To remedy that, business surveys runby the statistical authorities could be used to ask firms about crime acts against them. 184. A useful and tested way to reduce crime directed at private firms is to get firms' efforts in communitypolicing,educationaland preventionactivities,dealingwith youth-at-risk, etc. Costa Rica's business associations could have a potential role to play insupporting such efforts. 185. Regionalcrime-preventionefforts could also helpwith respectto cross-border criminal activity such as drug trafficking, illegalarms dealing, among others. While these are not identified as problems,the Government could seek ways to cooperatewith the other Central American governments to enhance regionalsecurity. 172 Firms pay some Firmsreport 75% Firms' managers Firmis a taxes andlor or more oftheir spendmore than business social security sales for tax 5% oftheir time association online purposes on regulations member ' 1to 5 workers (omitted category) 6 to 29 workers I 0.118 I -0.109 I 0.162** I 0.116 (0.075) (0.076) (0.066) (0.079) 30 plus workers ** (0.o89) 0.388*** 0.022 0.173** 0.429* (0.097) (0.079) (0.081) Never exported(omitted category) Directly exported in 0.202** 0.212** 0.08 1 0.320*** 2003 and 2004 (0.085) (0.085) (0.084) (0.083) Some export experience 0.001 0.037 -0.007 0.019 (0.097) (0.098) (0.094) (0.106) Foreign ownership -0.122 0.169 0.113 0.173 dummy (0.085) (0.121) (0.105) (0.127) Log FirmAge -0.002 -0.005 -0.051 0.083** II (0.034) (0.036) (0.033) (0.040) Pseudo R-squared I 0.17 I 0.10 0.07 I 0.28 Number of observations I 330 I289 II328 I 330 I Nofe Probit regressions include industw and region dummies. Robust standard errors are in parentheses below coefficients. significant atI<;**means ***means significant at5%; *meins significantat IO%.. 173 Table 6: Correlation f InformalPa] ientsand Dist 1st in the Gove ment and the Courts Firms report Firmsmake Firmsmake Firmsreport Firmsdistrust I Firmsmake 75% or more informal informal 78% or more the courts informal of annual payments to paymentsto oftheir paymentsto sales for tax "get things get workers for re-registeror purposes done" government social obtain contracts security and licenses or tax purposes permits Firms make -0.1636*** informal (0.0045,300) paymentsto "get things done" Firms make -0.1511 *** 0.2940** * informa1 (0.0089,299) (0.0000,342) paymentsto get government contracts Firms report 0.6420* ** -0.1353 ** -0.1235 ** 78% or more (0.0000,285) (0,0194,298) (0.0334,297) oftheir workers for social security and tax purposes Firmsdistrust -0.0953 0.1270** 0.0692 -0.0442 the courts (0.1079,286) (0.0216,327) (0.2129, 326) (0.4600,282) Firms make -0.1174* -0.0236 0.1044 -0.1548** 0.1353** informal (0.0927,206) (0,7155,240) (0.1067,240) (0,0267,205) (0,0390,233) paymentsto re-registeror obtain licenses or permits Firms make -0.0810 0.0186 0.0488 -0.1262* -0.0003 0.2283*** informal (0.23 15,220) (0,7685,254) (0,4393,253) (0.0600,223) (0,9964,245) (0.0017, 186) payment during inspections I Note: The U-value t 1number of observi 3ns for each uair-w :correlationisinK entheses below the efficient. The significance level is marked by'asterisks next to the correlation coefficient.;** means significant at thk 1% level;**means significant at the 5% level; and* means significant at the 10% level.. 174 Table 5.7: Correlates of Some of the Contract Enforcement Variables: Costa Rica Note: Probit regressions include industry and region dummies. Robust standard errors are in parentheses below coefficients. significant at 1%;** meanssignificantat 5%;* ***t~ means significant at 10%. 175 ANNEX 1 BackgroundInformationon the Investment Climate Survey Overview 1. The Investment Climate Survey (ICs) covered 343 manufacturingand 44 hotel establishments and was applied between March and November 2005. Survey data was collectedby means o f face-to-face interviews of company management, under the supervision ofthe World Bank. The results provided by the BusinessSurvey were importantto understandthe current situationofinvestmentclimate inCosta Rica, particularly on the business investment, cost structure and productivity areas. 2. This annex describes the general basic framework ofthe sample designofthe survey.Further, it mentions the eligibility criteria for selecting sub-sectors and for categorizingfirm size within the manufacturing sectors. Inaddition, the annex addresses some of the problemsfaced with the universeof manufacturingfirms and how it affected the sample design and selection. The last part ofthis annex shows the final sample characteristics o f manufacturingfirms, stressing that the overall representativeness and estimation error of the sample were preserved despite the problems. SampleDesign 3, The sample covered establishments in7 manufacturingsectors and three geographical regions. The sample was framed from a list of establishmentsofthe CCSS provided bythe Ministryof Finance, and it was representative at the level of economic sectors, with sample sizes chosento ensure that variables can be estimated with a 90 percent confidence and sampling error of almost 7 percent. The sample of the survey was divided in two parts according to two general sectors o f activity. 4. The first part corresponded to the Tourism Sector, particularlythe Hotel and Accommodation Sector. The sample for this sector was subtracted from the universeof Hotel and Accommodation businesses list inCosta Rica which is managedby the NationalInstitute of Tourism (NIT). The list includes all registeredhotels updated untilJanuary, 2005. The selection of the sample for this particular sector was straightforwardbecausethis list i s unique and accurate. The total universehad 394 registered hotels inthe NIT list. Based on that universe, the sample size was of 44 hotels with a maximum estimation error of 13.9 percent at 95 percent level of confidence. 5. The second part ofthe survey sample correspondedto the manufacturing sector. The design ofthe sample for this sector turnedout to be rather complex. It was difficult to set a sample size to this sector because of several problems that ranged from data source and classification inconsistencies to setbacks in the applicationof the survey. 6. The list of firms for the manufacturingsector was providedby the CajaCostarricensedel Seguro Social (CCSS) updated untilFebruary 2005. The list provided the contact information and telephone number for each firm so that an interview can be arranged directly with managers or accounting personnel. The universe of firms basedon the CCSS listing was inaccurate, yet it was complemented and improved usingthe list of manufacturing firms from the Costa RicanCentral Bank (BCCR). 7. The sample of firms selectedfrom the manufacturingand hotel lists were subject to responda multi-section questionnaire that lasted approximately 3 hours. Eachfirm had 2 to 3 persons interviewed. The sections encompassedby the questionnaire were the following: 176 InvestmentClimate- For this section the interviewees filled general information on firm's characteristics, sales and inputs, as well as business environment, finance, conflict resolution, among other topics. 0 Productivity- This section included general inputs and outputs o f firm productivity. Data Collection 8. The collection o f data involved three steps. Firstmanufacturingfirms met eligibility criteria to be selected as part o f the universe. Second, based on contact information o f firms included inthe CCSS listing, firm's personnel was contacted to schedule an appointment for an interview. Thirdthere was a review o f firms that had not answered the questionnaires fully and o f firms which contact information was corrected through the use o f telephone directories and other sources. With these review more appointments and interviews were held. Eligibility Criteria 9. There were stratification criteria within the manufacturing sector that narrowedthe universe o f available firms. The sub-sector stratificationo f firms was selected based on the following conditions: 0 To contribute with 2% or more to the employment o fthe sector 0 Firmsthat were insub-sectors that represented2% or more ofthe total firms o fthe manufacturing sector 0 Firmsthat had a classification code consistent with previous classifications 10. With these conditions 11sub-sectors within the manufacturingsector were selected. The next step was to stratify each sub-sector according to the size o f the firm. The ranges for determining a firm size were the following: 0 Micro--- 1to 5 0 Small- 6 to 30 0 Medium --- 3 1 to 100 0 Large --- more than 1000 Problems SampleFramework 11. The sample design, presented above, faced problems due to changes inthe universe o fthe manufacturing firms. As a consequence, a lower number o f firms inthe universe forced changes inthe sample selection o f firms. Overall from the original 2064 universe o f firms recorded at the CCSS, 82% had genuine information to be considered for an interview round or to schedule an appointment. Inthe end 1,687 firms constituted the final universe from which a sample was to be selectedto apply the survey'26.The specific problems that affected the universe o f firms were the following: 12. Duplicity o f Firms The source o f the universe o f manufacturingfirms is based on the business registrationlist from the Social Security Service o f Costa Rica (CCSS). This service registers and manages pensions from businesses employees. However, this listing had inconsistencies because firms were More precisely,26 firms were eliminatedfrom the universe list due to duplicity,around 100 were eliminateddue to classificationinconsistencies(5%), andthe rest were eliminated due to inexistentcontact information,non-responseto appointment requestor when the firm was listedbut never found. 177 duplicated inthe CCSS for administrative purposes. For instance, many firms were registered twice because blue-collar workers were registered separately from white-collar workers even thoughthey belonged to the same firm.Also, the same firm could have been registered with two different names. The Central Bank of Costa Rica provided a detailed list of firms inthe manufacturingsector to verify the accuracy of the CCSS data and thus eliminate duplicated firms. 13. Inaccurate Contact Informationof Firms Many firms registeredat the CCSS or at the BCCR were outdated or with inaccurate contact information. Almost 27% of the lists of firms within the manufacturing sector did not have telephone or contact information. Telephone directories were usedto retrieve the contact information of firms and minimize the number o f firms that had any contact information whatsoever. Moreover, for firms that indeedhad contact information some hadwrong or inexistent telephone numbers.The list of firms was reduced becauseonly those which had genuine andverifiable contact information could be includedto schedule appointments for interviews. 14. ClassificationInconsistencies When the CCSS list was verified with the BCCR list, several firms inthe universeneededto be eliminated because the 4-digit code of the industrial classificationof the BCCR did not coincide with the sub-sectorregisteredat the CCSS. This was the case for 5% ofthe firms. Inaddition, two sub-sectors neededto be eliminated. The automotive and electronic sub-sectorswere not considered a manufacturingbusinessbecauseless than 50% of their sales were not attributed to manufacturingactivitie~'~~.Since many interviewswere already carried out inthese two sub- sectors and other "not-defined" businesses were also interviewed, the sub-sector "Others" was createdto include information on those firms. 15. Size Stratification Since the first three problems mentionedabove reduced the universesize, the firm-size stratificationwas also affected. The mediumand large stratawere mergedto only one stratum because they included few firms inthe new universe. Firmsizes were rearranged to: micro (1-5 workers), small (6-30 workers), and mediumand large (more than 31workers). Rearranging the size strata of firms led to review and increasethe quality of information for particular sub-sectors. For instance, with the new rearrangement it was found that 41% of the businesses within the confection sub-sector had a lower number of employees that the originally reported. For the paper and printing sub-sector 44% o f the firms had a different number of employees that the one reported originally. Correcting these inaccuracies inthe information also changed the structure of the size stratawithin these sub-sectors. Survey Application 16. Field work was more complicatedthan expected. The problem of highnon-response rates was a concern because the universe, and therefore the sample, had been reduced due to sampling frame inconsistencies. Inorder to minimize this problem, the World Bank collaborated with the survey firm to increase the likelihood of interviewresponse. Two main organizations helpedinencouraging firms to participate inthe survey. The Unidn Costarricensede Ccimaras de la EmpresaPrivada (UCCAEP) and the CcimaradeIndustrias de CostaRica (CICR), which arethe two largest commerce chambers inCosta Rica, remarked firm's managersthe importance of completingthe survey. The support of the UCCAEP The inconsistency is explainedby the heterogeneity in the definition of manufacturing.These firms are most of the time structured as intermediategoods ofproductionand sometimesas amanufacturingfinal product. 178 ?ise and reduce the of the 1CA ttic 2. PeriodicSurvey oftfre BCCI.2 3 .Logistic Survey ~ ~ o rBank) l d 4. Surveys from ~ ~ ~ r kAgenciesn g ~ ~ i Finlrt Sample 179 20. Figure2 summarizesthe mainchangesinthe sample sizes for the initial andthe final universeof firms.Althoughthe sample size was reducedaround25 percent it was rearrangedto fit consistency and accuracy within size strata and sub-sector.Moreover, the reclassificationofthe "Other" sub-sector and the eliminationof "Equipment andMotors" and "Electronic" sub-sectorspartiallyexplains the drop inthe sample size. Initial Sample Slze Final Sample Sire 3 MEDIUM Subsector/Size Strata MICRO SMALL MEDIUM IARGE TOTAL Sub-sector/SizeStrata MICRO SMALL AND TOTAL LARGE Food and Beverages 12 12 15 18 57 Foodand Beverages 12 14 19 45 Textiles 11 10 9 6 36 Textiles 6 9 7 22 Confection 11 11 6 4 32 Confection 17 9 2 28 Wood and Furniture 12 12 12 6 42 Wood and Furniture 21 21 8 50 Paper and Printing 12 12 11 11 46 Paper and Printing 17 14 13 44 Chemicals and Plastics 12 12 15 14 53 Chemicalsand Plastics 9 21 21 51 Non-metalic Items 12 11 8 7 38 Non-metalicItems 11 17 0 36 Metalic Items 12 12 12 6 42 Metaiic Items 13 15 14 42 EauiDmentand Motors 12 12 7 8 39 Other 11 5 9 25 Eiecironic 11 10 9 10 40 Not-defined 12 11 5 3 31 TOTAL 129 125 109 93 456 TOTAL 117 125 101 343 21. Ingeneralthe eliminationoffirms fromthe universeandthe subsequentre-estimationofthe sample size didnot alteredsubstantially the estimatederrors ofthe samplewithin each sub-sector(see Figure3).By identifyingthe problemsthat affectedthe universeandunderstandinghowthe problems affectedthe sample size, contributedlargelyto rearrangethe strata and sub-sectorsofthe sample so that the maximumerrors of estimationandrepresentativenessofthe manufacturingsamplewere preserved. Figure 3. Maximum Estimation Errors by Sub-sector Manufacturing Firms Initial Final Sample Sample Food and Beverages 0.104 0.118 Textiles 0.118 0.163 Confection 0.128 0.138 Wood and Furniture 0.122 0.111 Paper and Printing 0.114 0.117 Chemicals and Plastics 0.104 0.106 Non-metalic Items 0.119 0.122 Metalic Items 0.118 0.118 Equipment and Motors 0.123 _-__- Electronic 0.113 _--__ Other _-_-_ 0.155 Total Average 0.116 0.124 Source: Author Calculations 180 ANNEX 2: BackgroundInformation on the LogisticSurvey 186. Inaddition to the ICs, we conducted aLogistics Survey (LS) for this studywith the objectives o f (i)identifyinglogistics problems which raisethe price of national productionand which diminishfirm competitiveness, inorder to present suggestedchanges inthe corresponding public policies; (ii) assessing the relative importance ofthe logistics costs inthe firm production costs; (iii) identifyingthe current or potential production lines so as to be able to create mechanisms to strengthenthem. The LS, which allows these objectives to be assessed, targeted Costa Rica's business sector and investigated the following elements: Logistics costs structure inexporting Infrastructure impact on logistics services 0 Logistics chain cost structuring (transportation, stocks, warehousing and so forth. Transportation will be classified bytype: maritime, air and so forth) 0 Quality perception and access to logistics services 1. Selection of Supply Chainsand IdentificationofFirmsto be Surveyed 187. The main focus ofthe L S is investigatingthe perception of infrastructure and logistics demand by Costa Rican firms inthree selected supply chains. Inthis regard, the L S collected information from firms about logistics and shippingservices inthe: a) flowers and vegetable products, such as plants; b) medical supplies; c) processedfood, such as flour by-products. These three supply chains were selectedbasedon their share intotal nationalexports, nationalimports, and GDP. Processedfood 188. Over the past decade, the food, beverage and tobacco sector is the second most important sector inCosta Rica's total industrial production, surpassed only bythe tax-free zone and active improvement industry.Such is its importance that, between 1993 and 2003, the addedvalue ofthe food, beverageand tobacco sector grew at an average annual pace of 2 percent, climbing from 65.53 billion colones in 1993 to 77.97 billioncolones in2002. In 1997, its GDP participation was 7.2 percent, and in2002, it was 5.8 percent. 189. Within the sector, the most important i s food production, followed by beverages.Inthe 1993- 2002 period, the two most important products for the food industrywere the slaughtering o f livestock and meat preparation and producing dairy products. Eventhough it is true that in2001 and 2002 the food industryregistered a reductionof its gross addedvalue by 2 billion colones, this was mainly dueto reductions in fruit bottling and preservation and the cacao, chocolate and candy production. And one cannot overlook the fact that, between 1993 and 2000, the gross addedvalue of the food industry displayed an upward trend and production increasedto an annual average rate of 3.7 percent (Figure 1). 190. The upwardtrendpresentedover the past 10years by food consumption(presenting an annual average variation of over 3 percent), has mainly presenteditself inthe consumptionof produced foods, which haves beenrisingat an average annual pace of 3.4 percent. 181 al ha 993- 2002 1995 1995 1997 1998 1999 2000 2001 2002 Table 1 and 55 percent of the market, respectively. Additionally, it supplies 10percent ofthe imports of cuttings and stakes. The UnitedStates is the secondmost important market for Costa Rica, for which it supplies 8 percent ofthe orchids, 37 percent of the cuttings, stakes and grafts, 11percent ofthe chrysanthemums and 35 percent of the live trees and busheswhich the UnitedStates imports. Furthermore, Costa Ricais Japan's main supplier of greenplants, Indian cane andyucca. It possesses 34 percent of the cuttings and stakes market (Indian cane and yucca) and 15 percent of the plants market. 193. In 1996, exports of decorative plants, flowers, andplants represented 33.6 percent ofagricultural exports, 8.2 percent of non-traditional exports, and 3.3 percent oftotal exports. In 1989, it accounted for $43.26 million of total exports. In 1995, exports totaled $112.79 million, which means that these exports rose 160 percent over these seven years (PROCOMER -Promotoradel Comercio Exterior -Costa Rica's Foreign Trade Promotion Office). In 1995, daily exports totaled: 91,000 fern branches, 70,000 kg. of cuttings and stakes, 20,000 kg. of tropical flowers and approximately 19,000 rose stems, not counting the exports of other flower varieties, such as carnations, or other plants, such as orchids, marginatas and bromeliads (PROCOMER). Additionally, over 10,000 people are involved inthis activity and the payroll totals close to 5 billion colones annually, proving that this is an interestingeconomic activity for the study o f logistics and competitiveness. 194. The destination for Costa Ricandecorative plants, flowers andplants is varied: 63 percent of exports headto the European Union, 30 percent to NorthAmerica, 5 percent to Asia, and 1percent to Latin America and 1percent to other countries. Medicalsupplies 195. The recently signed Central American Free Trade Agreement (CAFTA) will provide a definitive boost to the sales of medical items and equipment. Latin America's economic recovery and the government's plans to improve health services will also boost sales of medical supplies inthe region. According to the US.Department of Commerce (DOC), the lowering of tariffs becauseo f the CAFTA will ensure that over 80 percent of US.medical supply imports will come from CentralAmerica. Inthis regard, the DOC expects that medical equipment trade betweenthe United States and Central America flows inboth directions, particularly the more that US.producers resort to subcontracting, in an attempt to lower production costs. Latin America, and especially Costa Rica and Mexico, are important countries for U.S.manufacturers of medical items and equipment despite the growing interest in China and other parts of Asia where salaries are lower. This is due to the fact that the difference in salaries i s offset by lower transportation and logistics costs, swifter delivery times and tax breaks. 196. According to business statistics, the tendencies of the US.manufacturers is to continue launching new products inthe UnitedStates andthen sendproduction southward, as their products mature. Mexico i s the most important exporter and importer of medical items. In2002, the sector represented $2.3 billion o f the bilateral commerce, according to the US.InternationalTrade Commission. Costa Rica i s the second most important importer of medial merchandise, with sales risingover 257 percent, from $185 million in 2000 to $476 million in 2004. 2. SelectionCriteria for Firms 197. To select a sample of firms for the three supply chains, we constructed a sample frame by combining information from the following four databases: a) PROCOMER'S directory o f exporters, b) members of the Chamber of Food Industry(CACIA - Camara de la IndustriaAlimentaria); c) members o f the Association of Producers of Plants and Ferns; and the d) list of producers inthe Costa Rican Coalition of Development Initiatives (CINDE -Coalicidn Costarricense de Iniciativas de Desarrollo) tax free areas. A total of 283 firms were identified for the sample frame: 83 inthe processedfood sector, 183 150 inthe flowers and vegetable products, and 50 inthe medical supplies sector. A sample size of 100 f i r m s was selected, taking into account economic sector (supply chain), export history, use of transportation services, location inCosta Rica, and size (large, medium and small-medium according to the numberofemployees hired inthe last quarter). 3. Questionnaire and Data Collection 198. Firmswere interviewedface-to-face usinga questionnaire with 79 questions or about 245 fields ina database. The field work started atthe endofJune 2005, followingatraining of interviewers. A total of 121 firms were contacted, of which only 65 firms provided information. The remaining 56 firms were f i r m s that refusedto provide information, had been mergedwith other firms that were already selected for the survey, or hadclosedtheir operations. Starting on August 2005, firms that didnot collaborated with the surveywere substituted by others firms with similar characteristics (same economic activity and size). Because some economic sectors were too small, the sample frame was exhausted. 199. One of the findings of the L S is that ineach of the three sectors, firms have important demand for land, maritime and inter-modal transportation services. As such, logistic services couldhave an important effect on the competitiveness o f Costa Rican firms inthe three selectedsupply chains. Processedfood 200. Figure 2 below summarizes the import flows and imports o f processedfood inCosta Rica, the means of transportation usedineach stage of the chain, inaddition to the origins and destinations of supplies and products. The main findings are: a Supplies usedare 52 percent imported and 48 percent of national origin. a Most imported supplies come from the UnitedStates (13 percent) and Guatemala (7 percent) a Guatemalan supplies are imported via ground transportation and, without havingto make any transshipment, they continue theirjourney to processing plants via ground transportation. a 18 percent of the supplies imported from the UnitedStates are done so by maritime transportation and, then, are taken to the plants by ground transportation. The other 82 percent is imported by air transportation and from there, transported to the plants by ground transportation. a Processedfood production plants are mainly located inthe major metropolitan areas. a National supplies come from the central region and are groundtransported to the processing plants. a Production is sold to local and foreign market distributors (64 percent of the production is exported) a Only 50 percent hire outsource shippingservices inorder to get the products to the markets. a Orders are ground shippedto local purchasers. a Regardingexports, orders are ground shipped to purchasersinneighboring countries or to Puerto Lim6n where they are finally shipped abroad. a The main destinations for exports are the UnitedStates, which receives 21percent o fthe exports, and Honduras, Guatemala, El Salvador and Nicaragua, which get 67 percent of the exports. 184 Figure 2: Import Flows and Imports of ProcessedFood SUPPLY CHAIN- PROCESSED FOODSECTOR 1 I - Guatemala ' I FOOD I 'RODUCTION I 1 FOREIGN MARKET I pNeighborin&atemala, countries Metropolitan u r a s region dicaragua,,El Salvador) - I I L ~~ ~ ~~~ ~~ ~ I)Ground transportation I)Maritimetransportation Air transportation 0 National port National airport MedicalEquipment 201, Figure 3 summarizes Costa Rican import flows and medical equipmentimports, the means o f transportation used in each stage and the origins and destinations of supplies and products. The production ofMedical supplies is centered inSanJosb. Demanded supplies inthis chain are 34 percent of national origin and 66 percent foreign. Most supplies originate from the metropolitan area and are ground shipped. Imported supplies mostly come from the UnitedStates (28 percent), Europe (17 percent) and South America (6 percent). Imported supplies are mainly air transported. This chain's production is mainly sold to end consumerswho transform or assemblethem. The chain exports 83 percent of its production. The main export destinations are the UnitedStates (purchasing 18 percent ofthe exports), and Honduras, Guatemala, El Salvador and Nicaragua(these four countries account for 75 percent o f the exports). Orders are transported via ground shipmentto local purchasersand, inthe case of orders for internationalmarkets, these are mainly done via air transportation. 185 Figure 3: Import Flowsand Medical EquimnentImports SUPPLY CHAIN- MEDICAL EQUIPMENT SECTOR FOREIGN SUPPLIES !8% MARKET UnitedStates - UnitedStates MEDiCAL SUPPLIES 17% MATERiAL PRODUCTION Europe - Neighboringcountries (Honduras,Guatemala, Nicaragua,El Salvador) San Jos6 I '1- LOCALSUPPLIES 1- 34% LOCAL r)Ground transportation I)Maritimetransportation 4 Air transportation 0 National port Nationalairport ource: LogisticsSurvey (2006). Flowersand plants 202. The schemeof CostaRicanimport flows andflower andplantimports, the meansof transportationusedat each stage andthe originsand destinations of supplies andproducts are shown in Figure4: The flower andplant supply chainfocuses its productioncenter inareas closeto the metropolitan central region. It uses75 percentnationalsupplies and25 percent importedsupplies. Nationalsupplies are ground shipped. Importedsuppliesmostlycome fromthe UnitedStates (8 percent) andEurope(14 percent). Suppliesare shipped either by air or maritimetransportation. 88 percent of the supplies from the UnitedStates are shipped by air transportationas are almost all Europeansupplies. Almost the entire chainproductionis exported(100 percentaccordingto those surveyed) and distributorsare their mainpurchasers. 186 Fipure 4: Import Flowsand Flower and Plant Imports SUPPLY CHAIN- FLOWER AND PLANTS SECTOR - I 25Yl FOREIGN MARKET United States FLOWER FOREIGN PLANT PRODUCTION 744 ME:I Metropolitan SUPPLIES 750 0 Nationalport National airport oum: LogisticsSurvey(2006). 187 ANNEX 3: The Effectsof InvestmentClimate Indicatorson Productivity, Exports, ForeignDirect Investment,Wages, and Employmentin Costa Rica'" 1. Introduction 203. The objective ofthis annex is to identifythe main investment climate variables that affect economic performance (productivity, exports, foreign direct investment, employment and wages) through econometric analysis. Labor productivity should be enhancedtogether with policies that increase employment and control the population growth. Total factor productivity (productivity), together with the inputsofthe production function, is the key element explainingthe evolution of labor productivity. Therefore, improvingthe investment climate (IC) i s a key policy instrumentto promote economic growth and to mitigate the institutional, legal, economic and social factors that are constrainingthe fast convergence of per capita income and labor productivity o f Costa Rica relative to more developed countries. 2. Summary of the EconometricMethodology usedfor the InvestmentClimateAssessmentin CostaRica'" 204. The productivity approach that we follow here is basedon the robust econometric methodology o f Escribano and Guasch (2005). Productivity (P), or multifactor productivity, refers to the effects of any variable different from the inputs --labor (L),intermediate materials (M)and capital services (K)--, affecting the production (sales) process.Ingeneral, we expect productivity to be correlated withthe inputs L,Mand K,and therefore the inputsmustbetreated as endogenousvariables when estimating production functions. The list of industries and regions, the list of inputvariables of the production function and the list of other dependent variables (exports, foreign direct investment, wages, employment, f i r m s in a holding, f i r m s in an industrial zone and ownership) with the indication on how there are measured are included in Table 1 and 2. 2.1 Brief Descriptionof the CostaRica'sInvestment ClimateSurvey (ICS) DataBase 205. The Costa Rica's ICs allows constructing an unbalanced panel data basewith 994 observations as shown inTable 3. The panel i s short inthe time dimension, with only three years o f observations, but longer in the cross section dimension with 323 plants inyear 2002, 331inyear 2003 and 340 plants in 2004. However, for the long list IC variables, we only have observations for the year 2004. Inthe empirical application we assume that the investment climate characteristics for this short period of time (say three years) are constant at the plant level and therefore we treat them as observable fixed effects. This assumption has important econometric advantagesfor the empirical estimation. 206. We estimate the productivity elasticities and semi-elasticities of IC and other firm control (C) variables, adding always dummy variables to control for the three years and the eight industrieso fthe manufacturing sector. After appropriate handling o f outliers and missingobservations we were able to save many IC variables by using region-industry averages instead of individual observations. As will This annex was preparedby Alvaro Escribano, J. LuisGuasch, Jorge PeAa, andManuelOrte, and is a summaryofthe backgroundpaper preparedfor this study. 188 become clear later on, this region-industrytransformationhelps us also reducingthe degree of endogeneity o f IC variables. 2.2 EconometricMethodology:Robustness of theEstimatedProductivity-IC Elasticitiesand Semi- elasticities 207. Inpreviousrobust IC analysis done atthe World Bank, for other LatinAmerican countries, Escribano and Guasch(2005) proposed to pool observations across several countries when estimating productivity in levels (logs). Inthe case of Costa Rica, to estimate the IC elasticities and semi-elasticities on productivity, we pooledthe observations from eight manufacturingindustriesto estimate common IC (log) productivity, the probability of exporting, the probability of receiving foreign direct investment,the . coefficients. For the sector by sector evaluation we compute the impacts of IC variables on: the mean mean (log) wages and the mean (log) employment. 208. ...,qD) annual dummy variables (Dt,t = 1,2, ...T) and a constant term (intercept). Furthermore, we include seven dummy Inall the panel dataregressionswe use several sector-industry (D,, j = 1,2, variables for the eight sectors, two year dummies for the three years of data and a constant term. 209. To address the endogeneity problem of the inputs (labor, intermediate materials and capital) and of the IC variables, we follow the approach proposed by Escribano and Guasch (2005). That is, we proxy the usually unobserved firm specific fixed effects (which are the maincause ofthe endogeneity ofthe inputs)by a long list of firm specific observed fixed effects coming from the investment climate information. To correct for the endogeneity of the IC variables, we use the region-industry average of the plan level investment climate variables, instead of the crude IC variables, which is a common solution in paneldata studies at the firm level. Furthermore, taking industryaverages, and not the individual IC variables, is also usefulto mitigate the effect of missingindividual IC observations at the plant level. This is an important issue in most of the ICA surveys done in developing countries. Tables 1and 2 present the list of investment climate (IC) and control variables (C) included inthe analysis. 210. Since there is no single salient measure of productivity (or Pj,it), any empirical evaluation onthe productivity impact of IC variables might critically dependon the particular way productivity i s measured. Therefore, for policy recommendations we want the elasticities, or semi-elasticities of IC variables on productivity to be robust (equal signs and of similar magnitudes) to the 10 productivity measuresused. The alternative productivity measures considered inthis paper come from considering (see Table 4): 0 different functional forms ofthe production functions (Cobb-Douglas and Translog), 0 differentset of assumptions (technology and market conditions) to get consistent estimators basedon Solow's residuals, or OLS, RE, etc. and, 0 different levels of aggregation inmeasuring input-output elasticities (at the industry level or at the aggregate country level). 211. Inthe empirical analysis, we found robust results for allthe productivity measuresused(10 in total). Inthe case of Costa Rica, when we consider the correlations between the Solow residuals and the productivity measuresthat comes from estimating restricted production functions, the correlations are very similar in all the cases, ranging from 0.98 to 0.90. However, the correlations are lower for the unrestricted production functions. The correlations between the Cobb-Douglas productivities and the Translog productivities are very highfor the restricted aggregate case (the correlation is around 0.92) and lower for the unrestricted case. 189 212. Because of robust productivity measures, we can concentrate on the analysis of two of the productivity measures; the Solow's residuals (TFP) from the restrictedcase and from the unrestricted by industry case. The two-step estimation procedure is the following: First, we obtain the Solow's residuals with constant input-output elasticities, at the aggregate level and second we estimate the equation to evaluate the impact o f IC variables on those total factor productivity measures (TFPiJ. 213, First-step, generate Solow's residuals (see Solow (1967)) as residuals from the production function equation, where Fr is the average cost share of each input r = L,Mand K, over the last two years givenby -s, 1 =-(- 2r 2 s r , f+ , f - l ),and 3 isthe averagecostshare ofeachinputtakenacrossthe entiresampleof r,f plants from the seven countries (restricted case) inyear t. This is a nonparametric or index number approach basedon cost-shares from Hall (1990) to obtain the Solow's residual inlevels (logs). 214. Inthe unrestricted TFP case, we allow the coefficientsofthe inputs(L,Mand K)ofthe production function to vary industryby industry.For this (unrestricted) case we obtain the cost share (Tv,) of each inputr = L, Mand K, for each of the eight sectors, j=1, 2,..,,8. 215. Inorder to modelthe relationship between infrastructure and other IC and control(C) variables on several measuresof economic performance we use the following simultaneous equations system. 216. Second-step. Once we have estimated productivity inequation (1)' we can estimate the following structural simultaneous equations system for paneldata to estimate the IC elasticities and semi- elasticities: The productivity equation, (2.la) = a',,IC, +ag,+vp,i . (2.lb) Probability of exporting equation, (2.2a) (2.2b) Probability of receiving foreign direct investment equation, (3.3a) 190 (3.3b) `FDI,i= P`C IC, +`FD1,i +PAci ' The wage (earnings) equation, LogWj,it P w + aw,i + PP LogPj,it +PAP, + Phot+ Ewj,it (4.4a) aw,i= p`,ICi +/3'cCi +vw,i . (4.4b) Labor demand equation, LogL,,it = YL +aL,i + yp LogPj,,t + y, LogWj,it+Yb,Dj +& - D+ , ELj,it (5.5a) aL,i = fLIC, + y'cci +vL,i. (5.5b) 217. By substitutingthe usually unobservedfixedeffects components by their corresponding equation we can simplify the system of equations to: Theproductivity equation is, 1% q,,,= a P +a`,cIC, +4c,+ absD, +(vp,, +&pJ Theprobability of exporting equation is, yExP ,,It=4Exp +4logP,,,, +S'ICIC, +SAC, + w,+ GTD,+(VEXP,,+E,,,,,,,,) Labor demand equation is, 218. Notice that since the variable y'j,it,with r = Expor FDI, i s a binary random variable taking only 0 and 1values, then P(yr,,,,=l/x) = E(Y~,,,~ /X) ,the conditional probability is equalto the conditional 191 expectation which is usually assumedto follow a PROBIT or a LOGIT model, and the conditional variance (heteroskedasticity) is equal to product of the conditionalprobabilities o f the two events. In general, the linear probability models (LPM) approximate well the PROBIT and LOGIT nonlinear models whenthe variables are evaluated at their sample mean. Since we are interested inthe mean I C contribution relativeto the mean values ofthe dependentvariables of (6.1) to (6.5), we will concentrate on linear probability specifications, like (6.2) and (6.3). However, later on we will evaluate how well the linear probability model approximates the corresponding PROBIT specification.The mainadvantage of the LPM is inits simplicity since the parametersofthe explanatory variables of(6.2) and(6.3) measure the change inprobability when one o fthe explanatory variables changes, holdingthe rest ofthe explanatory variables constant. This i s important for the economic interpretationo the coefficients obtained inthe empirical section. 219. We assume that the error terms of eachequation (vr,i+Erj,it) are uncorrelated with all the explanatory variables of each equation r, where r=P, Exp, FDI, W and L.However, for certain explanatory variables this exogeneity condition is not satisfied. The endogeneity o f certain IC variables induces a correlation between those IC variables and the errors (vr,i+Erj,it) of the system of equations (6.1) to (6.5) and creates simultaneous equation biasesand inconsistencies in least squares estimators, like pooling OLS or inrandom effects (RE) estimators. This correlation is in general mitigatedby replacing those plant-level IC variables by their region-industryaverages (Error! Objects cannot be created from editingfield codes.), as we have seen before. However, for some other explanatory variables like productivity, wages, exports and FDI, the endogeneity is intrinsic due to the simultaneous structure of the systemof equations. Therefore, we will estimate eachequation by instrumentalvariables (IV) techniques based on two stage least squares (2SLS) procedures using heteroskedasticity-robuststandard errors. We could have used3SLS, which i s more efficient than 2SLS under correct specification. However, since with systemof equations estimation techniques the misspecificationof one equation affects the whole system, we believe that the results from 2SLS are more robust. 3. The Olley and Pakes Decompositionsof AggregateProductivity:Average Productivityversus Efficiency 220. To complement the productivity analysis basedon regression techniques we perform the allocation efficiency decomposition of Olley and Pakes (1996). This analysis i s especially interesting when the number of firms in some sectors have small number of observations onI C variables. Inthose cases, we cannot give much credibility to the sector-by-sector regression estimates of the impact of IC variables on productivity since they are basedon very small samples. This decompositionprovides additional information which is useful for the sector or industryefficiency allocation analysis within each country. 221. The Olley and Pakes (1996) decomposition of aggregate productivity, (O&P), has two elements; the averageproductivity andthe allocative efficiency or covariance term. Ifthe efficiency component is positive thenthe larger is share of sales that are among the most productive firms, see Figures6 and 7. 4. Summary of the RobustResults on EstimatedIC-ProductivityElasticities and Semi-Elasticities 222. Before discussing the effects of differentIC variables on productivity, it i s important to take into account that the economic interpretation of each investment climate coefficient i s contingent on the units of measurementof each IC variable and on the transformations performedon them (logs, fractions, percentages, qualitative constructions, etc.). Since productivity measuresare always inlogs, when the IC variable is expressed in log terms, the estimated coefficient is the constantproductivity-IC elasticity; and when the IC variable is not expressed inlog form, the estimated coefficient is generally described as a 192 productivity-IC semi-elasticity"'. While the constant productivity-IC elasticity measures the percentage change inproductivity inducedby a percentage change inthe IC variable, the semi-elasticity coefficient multiplied by 100, measures the percentage change inproductivity inducedby a unitary change inthe I C variable. 223. The econometric analysis is based on the 10 different productivity (P) measures. The empirical results are robust since the signs o f all o f the I C A variables are equal andthe range o f values o f the elasticities is reasonable. A summary o f the estimated values o f the elasticities and semi-elasticities of productivity with respect to investment climate variables is provided inFigure 1.For each significant investment climate variable, we represent the average value o fthe pooling OLS elasticity estimates. 224. We found robust IC results for all productivity measures (10 intotal). Therefore, for the general economic performance evaluation we only concentrate on the two most convenient productivity measures; the Solow's residuals (log Pj,it) from the restricted and from the unrestricted by industry cases and we will report, see Tables 5(I) and 5(II), the average value o f the estimated coefficient of each IC variable. Inparticular, to evaluate the relationship between I C variables (infrastructure, redtape, corruption and crime, finance and corporate governance, quality and innovation, labor characteristics and other control variables) on several economic performance measures (productivity, probability of exporting, probability o f receiving FDI, wages and employment), we estimate by instrumental variables (2SLS) a simultaneous equations system in structural form. 4.1 Productivity and IC variables Main Findings (see Figure 1) - 4.I.1Inzastructure. Days to clear customsfor exports.Deficiencies ininfrastructures slow down productivity growth. The value o fthe elasticity is -0.07; therefore ifthe number o f days waiting to clear customs increase by 1 percent productivity could decrease by 0.07 percent. Average Duration ofpower outages.Ifthe average duration o f power outages (inhours) suffered by the plant increases by 1percent, productivity decreases by 0.03 percent. Water outages.The elasticity is -0.2. The interpretation is the following: ifthe number o f water outages suffered by the plant increases by 1percent, productivity will decrease by'0.2 percent. Waitfor electric supply.The value o fthe constant elasticity is -0.11;this means that ifthe days waiting to obtain an electric supply grows by 1percent, productivity will decrease by 0.11percent. 4.1.2 Red Tape,Corruption and Crime. Sales declared to taxes. The percentage o f sales that firms are declaring for tax purposes has a positive impact on productivity. The value o f the elasticity i s 0.01; thus, ifthe percentage o f sales declared to taxes rises by 1 percent, productivity could increase by 0.01 percent 0 Number o f inspections. Bureaucratic formalities constraint firm's development and therefore productivity as well. Ifwe are willing to decrease the total number o f inspections a firm has to deal to by 1percent, then we could obtain an increase on productivity by 0.3 percent. e Payments to obtain a contract with the government. The value o f the semi-elasticity i s 0.28; inother words, those firms that operate in sectors inwhich it is common to pay an extra amount of money to obtain a contract with the government are on average 28 percent more productive than other firms. I 3 OWhile it is sometimesnaturalto express an IC variablein logform, for sometypes of IC variables it is more appropriate not to do so. For example, if IC variables are fractions or percentage numbers with some data equal to 0. However, expressing IC variables in fractions allow us to approximatetheir coefficientsas constant elasticitiesandnot as semi-elasticities. 193 Sales never repaid. The more percentage o f monthly sales to private costumers that were never repaid, the less productivity; ifsuch percentage increases by 1percent, productivity could decrease by 0.01 percent. Absenteeism. Obviously, the number o f days o f production lost due to absenteeism o f workers has a considerable negative impact on productivity. Ifthe number o f days lost grows by 1percent, productivity could decrease by 0.03 percent. 4.1.3 Finance and Corporate Governance. Trade association. Joining a trade association has a positive impact on productivity. The value o f the constant semi-elasticity is.0.45; therefore, ifa firm becomes member o f a trade chamber its productivity could increase by 45 percent on average. Credit line. Having a credit line permit firms to finance their investments what stimulates productivity. Those firms that are enjoying a line o f credit are on average 5 percent more productive than other firms (semi-elasticity). Debts with creditors. If suppliers allow firms to postpone payments, firms' productivity could increase by 24 percent (semi-elasticity). Profit. Iffirms' profit measured as percentage o f total sales increases by 1percent, productivity will grow by 0.14 percent. Owner o fthe lands. Ifthe firm is the owner o f almost all its lands, productivity could decrease by 14.7 percent (semi-elasticity). 4.1.4Quality, Innovation and Labor Skills. I S 0 certification. Firms with an I S 0 certification are on average 26.7 percent more productive than firms without such certification (semi-elasticity). New technological license. Those firms that obtained an agreement to use a new technological license last year are on average 19.4 more productive than other firms (semi-elasticity). Computer controlled machinery. Plants usingcomputer controlled machinery are on average 0.2 percent more productive than other firms (semi-elasticity). Design and engineering. Ifthe number o f firm's employees designatedto deal with tasks related to design and engineering grows by 1percent, productivity could increase by 0.2 percent. Immigrant workers. It seems that employing immigrant workers has a negative impact on productivity. The value o f the constant elasticity is -0.1; therefore, ifthe percentage o f immigrant workers increases by 1 percent, productivity could decrease by 0.1 percent. Training to unskilled employees. Ifthe percentage o f unskilled workers that received formal training duringlast year increases by 1percent, productivity could increase by 0.005 percent. . . Staff with computer. Ifthe percentage o f workers usingcomputer atjob increases by percent, productivity could increase by 0.002 percent. 4.1.5 Other Control Variables. Foreign direct investment. Receivingforeign direct investment is profitable interms LEproductivity. Firmsreceiving foreign direct investment are on average 15 percent more productive than other firms (semi-elasticity). Number o f competitors. Competitive pressure stimulates and accelerates productivity growth. Ifthe number o f competitors inthe main market increases by 1 percent, productivity could increase by 0.12 percent. 194 Trade agreements. Those firms that obtained any profit from agreementssigned by its government related with free trade during last year are on average 11.3 percent more productive than other firms (semi-elasticity). Capacity utilization. Ifthe percentageof capacity utilization increasesby 1 percent, productivity could rise by 0.003 percent. Importer. Importer firms are on average 21.9 percent more productive than other firms (semi- elasticity). 4.2 Probability of Export andIC variables Main Findings (see Figure 2) - 4.2.1Productivity Productivity. More productive firms are likely to export more. Ifproductivity increasesby 1percent, the probability of exporting increasesby 0.22 percent 4.2.2Infrastructures. Days to clear customs for imports. The more troubles to clear customs the less probability to export. Ifthe numberofdayswaiting to clear customsto import grows by 1percent, the probability of exporting decreases by 0.22 percent. 0 Wait for cellular phone. Ifthe number of days waiting to obtain a cellular phone connection grows by 1 percent, the probability of exporting decreases by 0.03 percent. 0 Web page. Probability of exporting is 10 percent greater for firms usingregularly their own web page to communicate with its clients and suppliers (semi-elasticity). 4.2.3Red Tape,Corruption and Crime. Criminal attempts. Ifthe firm suffered any criminal attempt during last year the probability of exporting decreases by 15 percent (semi-elasticity). Security. Ifthe cost insecurity (equipment, staff, etc) increases by 1percent, the probability o f exporting increasesby 2.3 percent (semi-elasticity). Manager's time spent inbureaucratic issues. Ifmanager's time spent dealingwith bureaucratic issues grows by 1 percent, the probability of exporting decreases by 0.001 percent. Labor costs declared. Ifthe labor cost declared to tax authorities rises by 1 percent, the probability of exporting decreases by 0.004 percent. Delayedpayments. Ifthe percentage of monthly total sales to private customers that were not paid within the agreedtime rises by 1percent, the probability of exportingcould decrease by 0.002 percent. 0 Civil protest. Ifthe number of days of production lost due to civil protests grows by 1percent the probability of exporting could decrease by 0.05 percent. 4.2.4Finance and Corporate Governance. Trade association. Firmsthat belongto a trade association are more likely to export. The probability of exporting is 6.8 percent greater for firms that are members of a trade association (semi-elasticity). Loan. Having access to a loan line facilitates exporting activities. The probability of becoming exporter is 7 percent larger for firms enjoying the benefits of having a loan line, relative to firms without a loan line (semi-elasticity). 195 0 Loan - interest rate. The larger interest rate appliedto the loansreceivedthe less probability of exporting. Ifthe interest rate applied during lastyear to the last loanreceived increasesby 1percent, the probability ofexportingdecreasesby 0,008 percent. Reinvestment.Ifthe percentage of profits that were reinvestedinthe own firm during lastyear increases by 1percent, the probability of exporting rises by 0.003 percent. 4.2.5 Quality, Innovation and Labor Skills. Joint venture. The probability of exporting is 23.8 percent greater for firms that establisheda new joint venturewith a foreign partnerduring lastyear (semi-elasticity). LACOMET. Ifthe plant has obtaineda certification of assessment of equipmentsand installations (LACOMET) during last year, the probability of exporting could increase by 10 percent (semi- elasticity). Design and engineering.Ifthe number of plant's employeesdesignatedto dealwith tasks relatedto engineeringand design increases by 1percent, the probability of exporting could increase by 0.07 percent. Training to skilled employees. Ifthe Percentageof skilled workers that receivedformal training during last year increases by 1percent,the probability of exportingrises by 0.001 percent. Educationof the manager. Ifthe manager ofthe plant has a bachelor or higher educationdegree, the probability of exporting is 6.2 percent larger when comparedwith other firms (semi-elasticity). 4.2.6 Other Control Variables. Incorporatedcompany, Incorporatedcompaniesare more likelyto export. The probability of exporting increases is 4.1 percent larger for incorporatedcompanies. Industrialzone. The probability of exporting increases by 17.3 percentwhen firms are locatedin industrial zones, relative to firms locatedoutside of industrialzones (semi-elasticity). ICC. Ifthe firm has obtainedany profit from the trade agreement signedwith the United Sates "Iniciativa de la Cuenca del Caribe" (ICC), the probability of exporting increasesby 17.3 percent, comparedto firms that hadnot receivedany profit from such agreement (semi-elasticity). Age. Ifthe age of the firm increasesby 1percent,the probability of exporting could also increase by 0.28 percent. 4.3 Probability of Foreign Direct Investment and IC variables Main Findings (see Figure 3) - 4.3.I Productivity Productivity. More productive firms attract foreign direct investment(FDI). Ifproductivity increases by 1percent the probability of receiving FDIincreases by 0.24 percent. 4.3.2Infiastructures. 0 Wait for water supply. When foreign firms want to invest inCostaRica choose firms without problemsto obtainbasic supplies. Ifthe number of days waiting to obtaina water supply grows by 1 percentthe probability of receiving FDIdecreases by 0.03 percent. Wait for internet connection.The value ofthe linear probability coefficient is -0.04, this means a negative impact.Ifthe number of days waiting to obtain an internet connectionrises by 1percentthe probability of receiving FDIdecreases by 0.04 percent. 196 4.3.3 Red Tape, Corruption and Crime. Manager's time spent inbureaucratic issues. The value o f the constant coefficient i s -0.004; therefore, ifthe percentage ofmanager's time wasted dealingwith bureaucraticconstraints increases 1percent the probability o f receiving FDIdecreases by 0.004 percent. Civil protest. Ifwe are willing to reduce the number o f production lost due to civil protests, then the probability o f receivingFDIcould increase by 0.23 percent. 4.3.4 Finance and Corporate Governance. Loan. Having access to a loan line is positively correlated with the probability o f receiving FDI. Particularly, such probability increases by 17.2 percent iffirms have access to a loan, relative to firms without loan (semi-elasticity). Loan - interest rate. The more interest rate appliedto the loans the less FDI.Ifthat interest rate grows by 1percent the probability o freceiving FDIdecreases by 0.002 percent. Owner o f the buildings. Firmsthat are owners o f almost all o f the buildingsthey are usinghave a probability 4.2 percent larger o f receivingFDIthan other firms (semi-elasticity), 4.3.5 Qua& Innovation and Labor Skills. New technological license. A firm that has obtained a new agreement o f technological license has a probability o f receiving FDI22.2 percent higher thanother firms (semi-elasticity). External R+D.The probability o f receivingFDIincreases by 30.5 percent ifthe firms performed external R+D activities during last year, relativeto firms that did not perform external R+D (semi- elasticity). Computer controlled machinery. The probability o f receiving FDIgrows by 0.3 percent for those f i r m s that are usingcomputer controlled machinery in the productionprocess, compared to firms that do not use computer controlled machinery (semi-elasticity), Designand engineering. Ifthe number o femployees designatedto tasks related with design and engineering increases by 1percent the probability o f receiving FDIincreases by 0.24 percent. Weeks o f training to unskilled employees. Ifthe number o fweeks o f formal training received by unskilled workers grows by 1percent the probability o f receivingFDIincreases by 0.004 percent. Strikes. The value o f the constant elasticity i s -0.54; that is, ifthe number o f production days lost due to strikes increases by 1 percent the probability o f receiving FDIdecreases by 0.54 percent. University staff. Ifthe percentage o fworkers with at least one year o f university education increases by 1 percent the probability o f receivingFDIincreases by 0.002 percent. Experience o f the manager. Ifthe number o fyears o f experience o f the manager increases by 1 percent the probability o f receivingFDIincreases by 0.004 percent. 4.3.6 Other Control Variables. Trade union. Ifthe percentage o f unionizedworkers increases by 1percent the probability o f receiving FDIrises by 0.12 percent. Industrialzone. Ifthe firm i s located inan industrial zone the probability o f receivingFDIis 19.1 percent higher than firms located out o f an industrialzone(semi-elasticity). ICC. The value o f the semi-elasticity is -0.001; therefore ifthe firm has obtained any profit from the trade agreement signed with the U.S. "Iniciativa de la Cuenca del Caribe" the probability o f receiving FDIdecreasesby 0.1 percent compared to other firms (semi-elasticity). 197 0 Age. Ifthe age of the firm increases by 1percent the probability of receivingFDIdecreases by 0.005 percent. 4.3 Real WagesandIC variables Main Findings (see Figure 4) - 4.4.1 Productivity 0 Productivity. The value o f the constant elasticity i s 0.56; therefore, ifproductivity increases by 1 percent real wages increases by 0.56 percent. 4.4.2 Infiastructures. Shipment losses (domestic sales). Ifthe fraction o f the value o f the plant's average cargo consignment that was lost in domestic transit due to breakage, theft, spoilage or other deficiencies of the transport means used increases by 1percent real wages decreases by 0.06 percent. 0 Wait for internet connection. Ifthe number o f days waiting to obtain an internet connection grows by 1 percent real wages decreases by 0.08 percent 4.4.3 Red Tape,Corruption and Crime. 0 Security. Iftotal cost in security (equipment, staff, etc) increases by 1percent real wages increases by 0.07 percent. 0 Sales declared to taxes. Ifthe percentage o f total sales declared for tax purposes increases by 1 percent real wage decreases by 0.006 percent. 0 Cost o f entry. Ifthe cost o f entry to the market interms o f days spent waiting for permissions and licenses increases by 1percent real wages decreases by 0.23 percent. 4.4.4Finance and Corporate Governance. 0 Trade association. Firms ina trade association pay wages 14percent higher than other firms (semi- elasticity). 0 Owner o fthe buildings.Ifthe firm i s owner o f almost all o fthe buildingsused real wages could increase by 12 percent, relative to firms that rent almost all the buildingsused (semi-elasticity). 4.4.5 Quality, Innovation and Labor Skills. LACOMET. Firmsthat obtained a certification o f assessment o f equipments and installations (LACOMET) pays wages 23.4 percent higher than other firms (semi-elasticity). External R+D.Firmsperforming external R+D activities have wages 32.2 percent lower than other firms on average (semi-elasticity), Computer controlled machinery. Firmsusingcomputer controlled machinery at the production process pay wages 0.6 percent lower than other firms on average (semi-elasticity) New technology. Ifthe firm has acquired any new technology with important implications inthe production process real wage could be 20.8 percent higher than other firms on average (semi- elasticity). Skilled workers. Ifthe percentage o f skilled workers increases by 1 percent real wages could rise by 0.007 percent. 198 Female workers. Ifthe percentageof female workers increasesby 1 percent real wages decreases by 0.57 percent. Training to unskilledworkers. Ifthe percentageof unskilledworkers receiving formal training increases by 1 percent realwages could increaseby 0.002 percent. 0 Experience of the manager. Ifthe number o fyears o f experience ofthe manager grows by 1 percent real wages could increaseby 0.007 percent. 4.4.6 Other Control Variables. 0 Open incorporated company. Open incorporated companies pay wages 47.7 percent lower than other firms on average (semi-elasticity), Public. Realwage is 66.6 percent higher for state-owned firms, relative to no state-owned firms (semi-elasticity). Number of competitors. Ifthe number of competitors increasesby 1percent real wages decreases by 0.11percent. 0 Trade agreements. Ifthe firm has obtained any profit from any agreement signed bythe government related with free trade realwages could increase by 23.1 percent relative to other firms (semi- elasticity). 4.5 EmploymentDemandEquation and IC variables Main Findings (see Figure 5) - 4.5.1Productivity Productivity. More productive firms are probably capital intensiveand therefore employ less workers. Ifproductivity grows by 1percentwe couldexpect adecreaseoftheemploymentdemandby0.54 percent. 4.5.2Real Wages Real Wages. Employment demand will decrease by 0.12 percent ifrealwages increaseby 1 percent. 4.5.3InJFastructures. Days to clear customs for imports. A 1 percent increase inthe number of days waiting to clear customs for imports implies a decrease inemployment demand by 0.4 percent. Shipmentlosses(domestic sales). The value ofthe elasticity is -0.057. Meaningthat a 1percent increase inthe fraction ofthe value of the plant's average cargo consignment that was lost in domestic transit causes a decrease in employment demand by 0.057 percent. 0 Wait for fixed phone. Ifthe number of days waiting for a fixed phone connection increasesby 1 percent employment demand decreases by 0.07 percent. E-mail. Employment demand i s 30.9 percent higher for firms usinge-mail with clients and suppliers (semi-elasticity). Web page.Firmsusingweb page to make business demand 53.2 percent more employmentthan other firms (semi-elasticity). 4.5.3Red Tape, Corruption and Crime. 199 Manager's time spent in bureaucratic issue. A 1percent growth inthe percentage o f manager's time designatedto deal with bureaucratic constraints could cause an increase o f the demand o f employment by 0.01 percent. Payments to deal with bureaucratic issues. Ifinthe firm sector it i s common to pay an extra amount o f money to obtain a contract with the government, employment demand increases by 33.9 percent relative to other firms (semi-elasticity). 0 Cost o f entry. Ifthe cost o f entry to firm's market interms o f days waiting for permissions etc increases by 1percent employment demand could decrease by 0.14 percent. 4.5.4Finance and Corporate Governance. Trade association. Demando f employment i s 41.7 percent higher infirms that belongto a trade association than in other firms (semi-elasticity). 0 Debts with creditors. Ifthe firm has debts with its suppliers employment demand could increase by 38.2 percent, relative to other firms (semi-elasticity), 0 External auditory. Ifthe firm is engaged in a process o f external auditory employment demand could increase by 13.9 percent relative to other firms (semi-elasticity). 0 Owner o f the lands. Ifthe firm i s the owner o f almost all o f the lands used employment demand decreases by 58.3 percent relative to other firms (semi-elasticity). 0 Owner o fthe buildings.Employment demand increases by 92.7 percent for those firms that are owners o f almost all o f the buildingsused, relative to other firms (semi-elasticity). 4.5.5 Qualiq, Innovation andLabor Skills. I S 0 certification. Ifthe firm i s engaged ina process o fI S 0 certification employment demand could increase by 50.8 percent relative to firms without I S 0 certification (semi-elasticity). Product improvement. Ifa firm has developed a product improvement employment demand could increase by 12.3 percent (semi-elasticity). New technological license. Firmsthat have obtained a new technological license employment demand increases by 12.3 percent (semi-elasticity). Computer controlled machinery. Usingcomputer controlled machinery inthe production process cause an increase inthe employment demand by 0.8 percent (semi-elasticity). Professional workers. Ifthe percentage o f professional workers increases by 1percent employment demand decreases by 0.006 percent. University staff. A 1percent increase inthe percentage o f staff with at least one year o funiversity education implies a decrease o f employment demand by 0.008 percent. Education o fthe manager. Firmswith managers that have a bachelor or higher education degree employ on average 70.3 percent more than other firms (semi-elasticity). Experience o f the manager. A 1percent increase inthe number o f years o f experience o fthe manager could cause an increase o f employment demand by 0.02 percent. 4.5.6Other Control Variables. 0 Incorporated company. Incorporatedcompanies employ 32 percent more workers than other firms on average (semi-elasticity) 0 Public. State-owned firms o f Costa Rica employ 156 percent more workers than other firms on average (semi-elasticity). 0 Foreign direct investment. Firmsreceiving FDIdemand 82 percent more employment than other firms (semi-elasticity). 200 Trade agreements.Firmsthat obtainedany profit from any agreement signedbythe government relatedwith free trade demand35.5 percentmoreemployment (semi-elasticity). Capacity utilization.A 1percentincrease ofthe percentageofcapacityutilizationimpliesan increase of employment demandby 0.005 percent. Exporter.Demandof employment is 33 percenthigher inexporter firms relativeto non-exporter firms (semi-elasticity), Importer.Ifa firm becomes importeremployment demandcouldincrease by 29 percentrelativeto non-importerfirms (semi-elasticity) Age. Ifthe age increasesby 1percentemployment demandgrows by 0.014 percent. 201 x t2 L ; B 0 2 0 f 0 3 s 0 0 0 ;clI- x 00 c) 2 m 0 r4 ! m4 N 9 0 D/d x a b .-S ;e 2 ch * ; N 0 II t N A c I t x r" r- 0 t a W 2; e 1 3 - 0.014 0.290 0.330 0.005 0.355 0.824 1 0.320 c 0.016 0.703 I -0.008 -0.006 0.008 0.224 0.123 0.508 1-1 1 0.9271-1 L 1-0.583 0.139E 0.382 E 0.417 1 0.339 = -0.140 I E 0.010 0.532 1 0.309 I 1-0.071 = 1-0.057 -0.400 -0.121 -0.454 1 3 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 Age Figure 7 E L 2002 2003 2004 fPro Figure8 ICA Percentage Absolute ContributiononEconomic PerformanceVariables Productivity Equation ExportsEquation 5% 13% 17% 20% FDI Equation Wage Equation 41% Employment Equation Log-Product ivit y Real Wage 0Infrastructures 13% ORed Tape, Corruption and Crime .Finance and Corporate Governance Quality, Innovation and Labor 11% Skills .Other Control Variables 209 Table 1: GeneralInformationat PlantLeveland ProductionFunctionVariables.' 'All seriesfigures in US dollars. 210 Table 2 (I): InvestmentClimate (IC) and Control(C) Variables. Infrastructure Average duration of fixed phone Average durationof fixed phoneoutagessuffered by the plant inhours. outages Losses due to fixed phone outages - I Value ofthe lossesdue to fixed phoneoutages as apercentageo f sales Cellularphone outages II - I (conditionalon the plantreportingfixed phone outages). Numberof cellular phone outages sufferedby aplant in2004. Average durationof cellular phone Average durationof cellular phone outagessuffered by the plant inhours. outages Losses due to cellular phone outages Value ofthe lossesdue to cellular phoneoutages as apercentageof sales (conditionalon the plantreportingcellular outages). Internetoutages Numberof internetoutaees sufferedbv aulant in 2004. Average durationof internetoutages I Average durationof internetoutages sufferedby the plant inhours. I applicationto the day the servicewas received(number of days) Wait for cellular phone Numberof days waiting for acellular phone supply since the moment ofthe applicationto the day the servicewas received(number of days) Wait for internet connection Numberof days waiting for an internetconnectionsince the moment of the applicationto the day the servicewas received(number of days) E-mail Dummyvariablethat takes value 1ifthe firm use regularlythe e-mail to communicatewith its clientsandsuppliers. Web page Dummyvariablethat takes value 1ifthe firm use regularly its own web pageto communicatewith its clients and suppliers. Paymentsthroughinternet Percentageof firm's salesthat has beenpaidthroughinternetin2004. 211 Table 2 (10:InvestmentClimate (IC) and Control(C) Variables. I Red Tape, I Criminalattempts IDummyvariablethat takesvalue 1ifthe plantsufferedany criminal Corruption attempt duringlastyear. and Crime Lossesdue to criminalactivity Value of losses due to criminalactivity. Number of criminalattempts Total number of criminalattempts sufferedby the plant duringlastyear. things done" with regardto customs, taxes, licenses, legislations,services, Numberof inspections Inthe lastyear, totalnumber of inspectionsregardingwith taxes, 212 Table 2 (In):Investment Climate(IC) and Control(C) Variables. Finance and Trade association Dummy variable that takes value 1 ifthe plant belongsto any association or Corporate trade chamber. Governance Credit line Dummy variable that takes value 1 ifthe plant reportsthat it has a credit line. Debts with creditors Dummy variable that takes value 1 ifthe firm has any debt with suppliers. Loan Dummy variable that takes value 1ifthe plant reportsthat it has abank loan. Loan - Collateral Dummy variable that takes value 1 ifthe firm has a loan line and this loan has collateral. Loan Value of the collateral Total vale ofthe collateral as a percentage of total value of the loan. Loan Interest rate -- Average interest rate applied to the loan during last year. Dummy variable that takes value 1 ifthe last loan obtainedcomes from formal institutions e.g. state-owned banks, domesticprivate banks, foreign private Loan - From formal institutions banks, off-shore banking, etc. Dummy variable that takes value 1ifthe last loan obtained comes from non- Loan From informal institutions - formal institutions e.g. family or money lenders. External auditory Dummy variable that takes value 1iffirm's annual statements are engaged ina process of externalauditory. Profit Firm's profits after taxes as apercentage of total sales. Reinvestment Percentageof profits that were reinvestedinte firm last year. Owner of the lands Dummy variable that takes value 1ifthe firm is the owner of almost all its lands. Owner of the buildings Dummy variable that takes value 1ifthe firm is the owner of almost all its 213 Table 2 (IV):InvestmentClimate (IC) and Control(C)Variables. Quality, Innovation and Labor Skills takes value 1if the plant performed internal R+D 214 Other Incorporatedcompany Dummy variable that takes value 1ifthe plant is an incorporated Control company. Variables Open incorporatedcompany Dummy variable that takes value 1ifthe plant is an open incorporated company. Public Dummy variable that takes value 1ifthe firm belongsto the government. Foreigndirect investment Dummy variable that takes value 1ifany part ofthe capital ofthe firm is foreign. Number of competitors Number of competitors inthe main market (log). Industrialzone Dummy variable that takes value 1ifthe firm is locatedinan industrial zone. ICC Dummy variable that takes value 1ifthe firm has obtained any profit from the trade agreement signed with the United Sates "Iniciativa de laCuenca del Caribe" (ICC). Trade agreements Dummy variable that takes value 1ifthe firm has obtained any profit from any agreement signed by its governmentrelated with free trade. Capacityutilization Average percentage of capacity used during last year. Exporter Dummy variable that takes value 1if exports are greater than 10%. Importer Dummy variable that takes value 1if imports are greater than 10%. Age Difference betweenthe year that the plant started operations and current year. Trade union Percentage of workers that belongs to a syndicate. 215 Table 3: Number of Observations that Enter into the I C Regressions by Industry and by Year. Table 4: Summary I 1 1.l.aOLS Two Step 1.1 RestrictedCoef 1.1.b RE 2 (Pit) measures 1, Solow's Residual Estimation 1.2.a OLS 4 (IC). elasticities . 1.2 UnrestrictedCoef 1.2.b RE 2.1.a OLS Single Step 2.1 RestrictedCoef 4 (Pi,) measures 2. Cobb-Douglas Estimation 4 (IC) elasticities 2.2 UnrestrictedCoef 2.2.b RE 3.l.aOLS Single Step 3.1 RestrictedCoef 3.1.b RE 4 (Pi,) measures 3. 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