World Bank neglects the needs of small businesses

Inclusive Economy06 Jun 2013Seth Kaplan

Small business are crucial in creating an inclusive economy. But the World Bank’s Doing Business Report does not focus on the most important issues they face.

Helping entrepreneurs start and grow businesses is crucial for job creation and fostering a more balanced distribution of wealth. Whereas micro businesses and household enterprises are the most important source of income for poor people, and large enterprises are an important source of jobs for the better educated, small and medium-sized enterprises (SMEs) play a crucial role in creating an inclusive economy. Their potential to contribute to overall growth, productivity, innovation, stable employment, and the building of a resilient and diversified economy is much greater than their counterparts.

In its ten-year history, the World Bank’s Doing Business Report has achieved enormous influence. The annual study, one of the flagship knowledge products of the World Bank, is the leading tool to judge the business environments of developing countries, generating huge coverage in the media every year. Several countries, among which Rwanda, have used it as a guide to design reform programs. For its part, the Bank has advised over eighty countries on reforms to regulations measured in the report. Its influence stretches even to academia, with over one thousand articles being published in peer-reviewed journals using data in the index.

But does it focus on the most important issues for companies in less developed countries? Based on my own almost twenty years of experience doing business in places such as Nigeria, Turkey, and China, the answer is no.

The regulatory aspects

The Doing Business reports lean heavily on assessments of the regulatory aspects of business climates in making its judgments. Of the ten indicators that make up its aggregate ranking, at least eight, and conceivably all ten, depend heavily on the nature of the regulatory regime: starting a business, dealing with construction permits, protecting investors, registering property, paying taxes, enforcing contracts, trading across borders, and resolving insolvency. As the current report states, ‘[a] growing body of research has traced out the effects of simpler business regulation on a range of economic outcomes, such as faster job growth and an accelerated pace of new business creation’.

This is certainly true. The easier it is to start a company, the more likely people are going to. The easier it is to register property, the more likely it will be, potentially providing a spur to investment in housing, spending on household goods, and capital formation. The easier it is to get a construction permit, the more likely companies will invest in new projects that involve construction.

But there are many more serious obstacles to doing business in less developed countries that are not addressed in these reports, such as those related to transaction costs. As such, the report’s narrow focus and wide influence distort priorities and lead reformers to ignore key problems.

A better approach would be to actually consider the challenges a typical small-to-medium sized enterprise (containing, say, five to fifty employees) faces in a less developed country. This is what the report is supposed to be doing, but its focus on the formal procedures of government ignores how most companies operate: if they are large, firms use ‘work-arounds’; if they are small, firms operate in the informal economy. Its dependence on ‘local experts, including lawyers, business consultants, accountants, freight forwarders, government officials and other professionals routinely administering or advising on legal and regulatory requirements’ mean that results reflect the needs and perspectives of these respondents, not that of a SME owner, especially in less developed countries where these ‘local experts’ rarely work for SMEs. Limiting data collection to the single, largest city, which may contain only a small proportion of a country’s businesses, further reduces the usefulness of the data.

SMEs in less developed countries have many more important things to worry about than ‘resolving insolvency’ and ‘protecting investors’, which combine to make up one-fifth of the report’s aggregate score. SMEs are operating in the informal economy, generally avoiding contact with government bodies that are not trusted, confronting myriad infrastructure problems and are regularly struggling to get paid for services rendered. Issues with regard to insolvency and the protection of investors are more important to foreign investors than local retail stores, trading companies, manufacturing shops and trucking firms.

The genuine needs

Focusing on the genuine needs of local SMEs would lead to a much stronger emphasis on transaction costs, which weigh heavily on companies in ways that are not reflected in these reports. In many cases, the problems are so severe that small firms cannot do business with strangers or across distance simply because they have few mechanisms to ensure that these transactions will work out satisfactorily, no matter how good or bad regulation is.

Issues that drive up transaction costs include:

  • the high cost and lack of reliability in moving or procuring goods across distance, because of poor infrastructure, petty corruption, the lack of efficient logistics and distribution systems, etc.;
  • the lack of a reliable way to enforce contracts, especially with strangers with which business owners have no common social ties (few small companies would even consider going to the court system);
  • the lack of a place to store savings, to transfer money across distance, or to reliably offer credit;
  • the lack of an independent way to judge the reliability of potential business partners;
  • few ways to penalize anyone who steals goods;
  • the lack of easy or safe way to store goods—especially of quantity—for any length of time.

Some of these issues are the direct product of the large number of market failures and institutional voids that predominate in less developed countries. Even if the regulations are right, countries may offer no way to check the credit histories of companies and families and have overly expensive inputs for certain important products, such as fertilizer for farm goods. Courts are too distant and unreliable to be used by most firms and countries lack financial institutions that serve smaller companies, especially outside the capital.

Others are the product of social divisions, which drive up the cost to do business. In environments with weak social cohesion and weak government institutions, companies may only be able to do business with firms owned by people from the same identity group or with which they have a long-standing relationship. Working with anyone else is much riskier because of the inability to enforce contracts with strangers. Such conditions partly explain why diaspora communities, such as the Lebanese in West Africa, have great advantages over local populations.

Some are the product of how governments operate. But they are less due to faulty regulation — though more rules can make the problems worse — than to the incompetence and petty corruption that infests government bodies. Repeated stoppages on major roads, for instance, are usually not due to bad regulation but to how officials make use of existing regulation to serve their own interests. As long as governments are not robust enough to implement their own rules effectively, the rules are not the most important problem.

Of course there are a number of other issues that matter greatly to SMEs that are not addressed by the report, such as political stability, security, regulatory predictability, financial inclusion and access to important social networks. Larger companies can compensate for most if not all of these issues in ways that SMEs cannot.

A deeper understanding

By missing a lot of valuable information, the report rankings fail to portray an accurate reading of business climates. China, for instance, ranks a somewhat mediocre 91st in the recent report, below the Kyrgyz Republic (70th), Romania (72nd), Moldova (83rd), Albania (85th), and Jamaica (90th), none of which are known for the same dynamism. Indonesia, one of the developing world’s most promising emerging markets, is ranked 128th, right ahead of Bangladesh, India, and Nigeria, all known for their rather difficult business environments. Both Ethiopia (ranked 127th) and Cambodia (ranked 133rd) rank even further down the list even though they have been among the fastest growing countries in the world over the past decade.

These reports do have value, as the issues they address are important and generally should be targets of reform. But the report’s very success has in some ways precluded a deeper understanding of why many states fail to advance. Economists, free market proponents and people whose main experience is in multinational companies or in developed countries may see that relaxing regulation is the most important way to improve the performance of less developed economies, but the average micro entrepreneur or ambitious small business owner in places such as Afghanistan, Nigeria, and Pakistan would focus elsewhere.