Why do some locations in the developing world grow so rapidly, while others stagnate? Drawing on firm-level surveys in Bangladesh, China, India, and Pakistan, this paper from the World Bank investigates the relationship between investment climate and firm performance. It explores the hypothesis that variations in ‘investment climate’ across locations can explain much of this variation in growth rates.
Investment climate means the institutional, policy, and regulatory environment in which firms operate – factors that influence the link from sowing to reaping. If the local government is highly bureaucratic and corrupt; if government’s own provision or regulation of infrastructure and financial services is inefficient so that firms cannot get reliable services – then returns on potential investments will be low and uncertain. On the other hand, in developing locations that create a good governance environment, returns and accumulation should be high.
Indicators of investment climate include: the number of days for clearing import and export customs, the share of sales lost due to power outages, the number of days needed to get a new phone connection, and the share of firms with an overdraft facility. The case studies show that the total factor productivity (TFP) of garment firms is systematically related to these investment climate indicators. The indicators also suggest that firms in the best investment climate can be nearly twice as productive as those in weaker environments. Investment climate indicators are related to other variables, including:
- Payment of higher average wages to workers. The investment climate has a positive effect on wages.
- Rate of profit. Whether using initial capital stock or initial employment as variables, the relationship between investment climate and gross return of capital is clear.
- Growth rates of output. After controlling for firm characteristics, the investment climate indicators have a significant effect on output growth.
- Growth rates of fixed assets. There is a significant negative coefficient on power losses and a positive on the availability of overdraft facilities.
- Growth of employment. Employment growth is negatively related to the age of the firm and initial employment level. Beyond that, investment climate is a significant factor.
The government’s role in providing a framework for very specific services that firms need – infrastructure, access to the international market, and finance – seems more important than general issues of governance and corruption.
- The role of governments in providing a good regulatory framework for infrastructure and access to international markets are particularly important.
- Geographic variables such as distances from major ports and markets are also significant, although they can be easily undone by poor local governance.
- For productivity and profitability, power outages and customs delays are the most serious bottlenecks.
- The availability of financial services has a strong positive effect on growth rates of assets, employment, and output.
