pilot investment climate assessment improving the...

Pilot Investment ClimateAssessment

Improving the InvestmentClimate in India

An investment climate assessment prepared

by the World Bank Group in collaboration with

the Confederation of Indian Industries

A product of the Private Sector Development team,

South Asia Region and the Investment Climate Unit,

a joint unit of Private Sector Advisory Services and the

Development Economics Group, World Bank.

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1818 H StreetWashington, D.C.20433USATelephone: 202 477 1234Facsimile: 202 477 6931Telex: MCI 64145 WORLDBANK

MCI 248423 WORLDBANKWorld Wide web: http://www.worldbank.orgE-mail: [email protected]

The World Bank

This report is a pilot investment climate assessmentprepared by the South Asia Region and theInvestment Climate Unit that is joint between thePrivate Sector and Infrastructure Vice-presidency andDevelopment Economics. The report draws heavilyon "Competitiveness of Indian Manufacturing: Resultsof a Firm-Level Survey," which was writtencollaboratively by a team from the Confederation ofIndian Industries and the World Bank, based on large-scale firm survey conducted in ten Indian states bythe team. The project was headed by OmkarGoswami, Chief Economist of CII, and David Dollar,head of the ICU at the Bank. The team consisted ofA.K. Arun, G. Srivatsava, Vishal More, and ArindamMookherjee from CII; and Geeta Batra, GiuseppeIarossi, Mary Hallward-Driemeier, and Taye Mengistaefrom the World Bank. The report here extends theanalysis in two directions. First, it adds comparisonswith China, based on a survey recently completed infive cities there. Second, it brings in additionalsources of information on specific investment climatebottlenecks. This report is part of a larger effort in theBank Group to systematically collect and analyzeobjective indicators of the investment climate in orderto help clients identify priorities for reform and tomonitor progress over time with improvements in theinvestment climate. Many of the important investmentclimate indicators are summarized in the India:Investment Climate at a Glance table that appears atthe front of the report. In this case the comparison ismade with China and Thailand, two emerging marketeconomies nearby to India. As more investmentclimate surveys are conducted, it will be possible toextend the comparison to more countries and to fill insome of the missing pieces of information. This workwas carried out under the supervision of Marilou Uy,Private Sector Director for the South Asia Region.

Preface 3

Investment Climate at a glance 5

Executive Summary 8

1. The Importance of the Investment Climate 17

2. India’s Investment Climate in International Perspective 23

3. Investment Climate Differences among Indian States 45

Annex on the firm analysis and competitiveness survey of India 65

Contents 4

5

Macro environment

GNI per capita (US$, PPP)

Population, mid year (millions)

GDP growth (1991–95 and 1996–2000, avg %)

Openness (Imports+Exports/GDP)

Private investment (% GDP)

Public investment (% GDP)

FDI inflows (net, % GDP)

Investment climate at a glance for China, India and Thailand

1995

2,650

1,205

12.1

45.7

15.8

18.9

5.1

China

2000/1

3,940

1,261

8.2

47.1

16.7

19.2

3.9

India

2000/1

2,390

1,016

6.1

28.2

16.6

7.1

0.5

1995

1,860

929

5.2

25.7

16.9

7.7

0.6

Thailand

2000/1

6,330

61

0.4

124.5

13.6

6.5

5.1

Micro environment

Inputs

Labor force education (avg yrs educ, manufact.)

Excess labor force, %

Suppliers availability (used for main input), median

Stock of inventories of inputs (days of production)

R&D (% sales)

Governance

Control of corruption2

Rule of law2

Political stability2

Number of visits by gvnt officials, avg per year

% of senior manager time with gvnt officials

China

10

—

20

—

2

–0.29

–0.20

0.40

—

9.2

India

10

17.3

4

28

—

–0.31

0.23

–0.05

10.5

16.0

Thailand

11

—

—

—

5.6

–0.17

0.44

0.21

—

—

continued…

1995

6,180

59

8.7

90.2

32.1

8.8

1.2

7,000

3,000

5,000

1,000

China India Thailand

GNI per capita PPP $

20001995

6

Micro environment (continued)

Infrastructure

Share of firms with own generator, %

Excess cost of private electricity, % of public

Days to clear imports, longest in last year3

Cost of shipping4, %

Telephone lines in largest city (per 1,000 people)

Personal computers (per 1,000 people)

Paved roads, % of total

Investment climate at a glance for China, India and Thailand (continued)

China

30

—

12

5.4

294

12

88

India

69

24

21

8.5

131

3

56

Thailand

—

—

24

6.7

371

23

97

Finance

Cost of capital (lending interest rate, %)

Share of credit from financial institutions, %

Credit to private sector (stock, % GDP)

China

5.85

25

125

India

12.29

36

25

Thailand

7.83

47

109

continued…

25

0


PC per 1,000 people

20001995

180

90

0


Credit to private sector (% GDP)

20001995

7

Micro environment (continued)

Entry/exit and operation

Cost of labor5

Import duty on capital equipment6

Median number of days to start a business

Number of permits to start business

backruptcy rate, % of total firms

Uncertainty of expectations in sales7, %

1/ or most recent available year.2 Scale of –2.5 to 2.5. Higher values correspond to better outcomes.3 Average for Thailand.4 Transport cost as share of value of export to US, textiles, 1998.5 Ratio of average wage to average value added, median value.6 On all imports for Thailand.7 % variation of avg expectations.

Investment climate at a glance for China, India and Thailand (continued)

China

0.23

—

30

6

—

—

India

0.21

10

90

10

0.04

14

Thailand

0.30

24

30

3

0.14

—

Source: WDI, ICU firm surveys

During the last decade, major developing countriesincluding India have begun to integrate much morewith the global economy. The countries that areaggressively integrating have grown significantlyfaster than those that are not. In the 1990s, the morerapidly globalizing developing countries (measured interms of increased trade participation) grew at 5.0percent per capita, while the rest of the developingworld posted negative growth of 1.1 percent. Amongthe more aggressive globalizers were Brazil, China,Mexico, Philippines, Thailand, and India.

That globalizing developing countries are doingwell on average is good news. But these averagesdisguise considerable variation in performancewithin this group. China has done spectacularly well,and is the unchallenged leader of the pack. Thecountry has doubled its ratio of trade to GDP over thepast two decades (to 41 percent of GDP in 1999),and has had per capita GDP growth of nearly 8 percent during 1990-99. Malaysia was another winner: inspite of the temporary income compression due tothe Asian crisis, it could still enjoy per capita GDPgrowth of 3.8 per cent during the 1990s. Again,despite the crisis, Thailand’s per capita GDP growthin the 1990s averaged 3.0 percent. However, the percapita GDP growth of another relatively aggressiveglobalizer, Brazil, has only been around 1 per cent for1990-99; and growth in the Philippines was only 0.4per cent. India, with per capita GDP growth of 3.3 percent during 1990-99 is in the middle of the pack ofthe globalizers.

The implication of these variations is striking.Such differences in growth rates sustained for one ortwo decades make a huge difference in livingstandards and the extent of poverty. While China andIndia had comparable levels of GDP per capita(measured at purchasing power parity) in 1990(approximately $1400), over the following decadeIndia’s per capita income nearly doubled, whileChina’s nearly tripled. Thus, today, China’s per capitaincome is about 50% higher than that of India.

Together with its faster growth, China has also hadsignificantly faster poverty reduction.

The raison d’etre of our paper is to examinesome of the reasons for such per capita GDP growthvariations. We argue that openness to foreign tradeand investment is an important, but not sufficient,condition for sustained GDP growth. For India andother developing countries to do well, good macroand trade policies need to be complemented with ahost of other institutional factors and policies thatcan be classified under the broad heading‘investment climate’.

The structure of the report is as follows: First, wedefine in more detail what we mean by investmentclimate: in particular, we want to go down to a microlevel to examine the bottlenecks that deter privateinvestment and productivity growth. Variouscompetitiveness indicators exist that permitinternational comparisons and we make use of these.But one of our innovations is to draw on a large-scaleinvestment climate survey of more than 1000 firms(Firm Analysis and Competitiveness Survey of India,carried out collaboratively by the Confederation ofIndian Industries and the World Bank). The WorldBank is sponsoring comparable investment climatesurveys in a growing number of countries, so thatdifferences in investment climate and productivity canbe measured and analyzed more thoroughly. Usingthese data, the report then examines differentinvestment climate bottlenecks under the categoriesof entry and exit; infrastructure; and governmentregulation and corruption. In a number of importantdimensions the investment climate in India is weakcompared to other emerging market economies suchas China or Thailand. The last section of the reportfocuses on differences across Indian states in termsof the investment climate. The objective investmentclimate indicators are poorer in states such at UttarPradesh and West Bengal, compared to betterclimate states such as Andhra Pradesh, Gujarat,Karnataka, Maharashtra, and Tamil Nadu.

Executive Summary 8

By linking investment climate indicators to firmproductivity and growth, we can estimate the effect ofimproving the investment climate. Specifically, wefind that if each Indian state could attain the bestpractice in India in terms of regulation andinfrastructure, the economy should grow about 2percentage points faster. The gains would beparticularly large in the poor climate states (an extra3.2 percentage points of growth), reflecting the factthat the move from their current state to the bestpractice in India would be a large improvement. Buteven in the better climate states there is significantroom for improving the investment climate in particularareas: moving to the best Indian practice would add1.5 percentage points to the growth rate for thesestates. Note that in many ways this is a conservativecounterfactual scenario, just raising states to levels ofregulation and infrastructure quality already observedin India. If India could achieve Chinese or Thai levelsin distinct investment climate areas its growthacceleration would be even more dramatic. While thespecific estimates have some uncertainty aroundthem, the general point is quite robust: removingbottlenecks that prevent efficient infrastructureservices and private initiative more generally wouldlead to faster growth and poverty reduction in India.

What do we mean by "investment climate"?The quantity and quality of investment flowing intoIndia or any other country depends upon thereturns that investors expect and the uncertaintiesaround those returns. It is useful to think of threebroad and interrelated components that shapethese expectations.

First, there are a set of macro or country-levelissues concerning economic and political stabilityand national policy towards foreign trade andinvestment. By these, we generally refer tomacroeconomic, fiscal, monetary, and exchangerate policies as well as political stability.

Second, there is the issue of efficacy of a country’sregulatory framework. As far as firms areconcerned, these relate to the issues of entry orstarting a business, labor relations and flexibility inlabor use, efficiency and transparency offinancing and taxation, and efficiency ofregulations concerning the environment, safety,health, and other legitimate public interests. Thequestion is not whether to regulate or not, butwhether such regulations are designed inincentive compatible ways, avoid adverseselection and moral hazard, serve the publicinterest, are implemented expeditiously withoutharassment and corruption, and facilitate efficientoutcomes. While such variables are hard tomeasure, our surveys clearly suggest thatregulatory efficacy varies widely across countriesand, as far as India is concerned, across states. Third, and no less important, is the quality andquantity of available physical and financialinfrastructure, such as power, transport,telecommunications, and banking and finance.When one surveys entrepreneurs about theirproblems and bottlenecks, they will often citeinfrastructure issues such as power reliability,transport time and cost, and access andefficiency of finance as key determinants ofcompetitiveness and profitability.

It is common for developing countries to react to asevere fiscal and/or balance of payments crisis byembarking on comprehensive macroeconomicreforms and stabilization programs. India was nodifferent in the first half of the 1990s, and achievedgood results compared with the past. Despite fivegovernments in the 1990s — and four in the last fiveyears — India’s average GDP growth was 6 per centper annum, compared to 5.5 per cent in the 1980s,and much lower rates in the 1970s and 1960s. Forthree halcyon years (1994-95 through 1996-97) GDPgrowth exceeded 7 per cent and peaked at 7.8 per

Executive Summary 9

cent in 1996-97. This growth was spurred to a largeextent by private investment, which grew in real termsat 18 percent per year from 1991 to 1995.

Unfortunately, the growth of private investmenthas slowed since then, to an average of 8 percent peryear between 1996 and 2000, and GDP growth hasslackened as well — to 4.8 per cent in 1997-98, 6.6per cent in 1998-99, 6.4 per cent in 1999-00 and 5.2per cent in 2000-01. Although such growth is high byinternational standards, the deceleration of privateinvestment and growth has emphasized the need forwhat Indian policy-makers are calling ‘secondgeneration reforms’. Growth generated by the firstflush of macroeconomic reforms is likely to peter outunless one moves ahead on critical structural issues— especially institutional, regulatory andinfrastructure reforms – precisely the elements thatbelong to what we call the investment climate. Today,politicians of most persuasions recognize that Indiahas reached a critical point, where the greatestchallenge is to move forward on the institutional andinfrastructure agenda.

India’s Investment Climate in International PerspectiveOne measure of the attractiveness of a businessenvironment is to look at the extent to which foreignbusinesses choose to locate there. With additionalfixed costs associated with operating abroad andwith a multitude of potential locations to chooseamong, entrepreneurs should be responsive to therelative incentives offered by different locations.Factors that will be important are many of the sameones that are associated with higher growth, such asstable macro economic conditions, openness totrade (particularly imported inputs) and a good ruleof law. Local market size and labor costs areadditional important determinants. On these last twodimensions, India is well positioned. It has one of thelargest domestic markets in the world and it has alarge labor force available at relatively low cost. It

also has well educated workers, particularly in areasof engineering and science. If these were the onlydeterminants, India should be very successful atattracting investment. A.T. Kearney publishes anindex of FDI competitiveness that combines theseelements, with an emphasis on market size and laborcosts. India ranks near the top of the list at number7. However, in practice, India does not receive theamount of FDI its market size would predict. In 1999,FDI inflows were a mere 0.5% of GDP. This isconsiderably lower than China (3.9%), Brazil (4.5%)or Thailand (5%).

In order to understand this poor performance interms of foreign investment and the deceleration ofdomestic investment, we have gone down to a moremicro level to examine the overall transaction costs ofdoing business in different Indian locations. Much ofthis analysis comes from the survey of manufacturingfirms conducted by the Confederation of IndianIndustries and the World Bank, though other sourcesof information are brought into the analysis as well.One thing that emerges from the CII-WB survey isthat Indian firms are potentially competitive in arange of labor-intensive industries – the combinationof their labor productivity and their wages makesthem low-cost producers at the plant level. However,in practice this potential competitiveness is oftenoffset by investment climate bottlenecks. Threedimensions of particular relevance for India will bediscussed here. First, getting the most benefit fromthis potential competitiveness requires the smoothoperation of factor markets and exit and entryprocedures. Second, the availability and quality ofinfrastructure services greatly influences the costs (intime as well as money) of producing and deliveringgoods. Third, while regulations are required, theirburden should not be excessive or be a source ofcorruption. Understanding how India comparesinternationally along these dimensions suggestsways that reforms could help the country reach its fullpotential for development.

Executive Summary 10

Entry and ExitOne of the most telling indicators of how competitivethe markets are in a country is to look at theproductivity dispersion of firms within an industry thatoperate there. In a competitive market, withreasonably free entry and exit, the dispersion shouldbe quite low. Higher dispersion levels indicate thatless efficient producers are not being forced toimprove their productivity or exit the market. Firm-levelstudies in a number of countries bear this out.Subsidies or strict regulations that impede entry or exitcan have the effect of bolstering high cost producers.As a result, with such firms still in the market, moreproductive firms may not have had adequate incentiveto further increase their productivity or to expand.However, as competition increases, firms face greaterincentives to innovate and greater penalties for failureto do so. Loss of protection and greater competitionfrom foreign firms can drive inefficient domesticproducers to better exploit scale economies, eliminatewaste, reduce managerial slack or ‘x inefficiencies’,adopt better technologies or shut down. As a result,productivity dispersion should shrink as productivitylevels rise in the face of greater competition.

As noted above, labor productivity adjusted forwages in the typical Indian plant compares favorablyto other countries in labor-intensive sectors. However,there is very high productivity dispersion in India. Intextiles, garments and electronics, higher performershave value added per worker that is 5 times that oflower performers. The dispersion of productivity islower in four East Asian countries where the WorldBank has conducted similar surveys. In Korea, theratios are not much more than 2, and in Malaysia andThailand they are just below 3. These comparisonsillustrate that there is still room to increase competitiveforces in India to spur less efficient firms to improvetheir productivity or exit.

One reason for less competitive markets in India isexcessive regulation of entry and exit. India hashigher requirements for the number of permits and

significantly longer median number of days to start afirm than almost all countries included in the GlobalCompetitiveness Report’s database. Relative toChina, starting a business in India requires 10 permitscompared to 6 in China, and the median time is 90days in India relative to 30 days in China. Thesenumbers are medians – there are many strikingexamples of considerably longer burdens borne byfirms. Some such examples are given by theprocedural hurdles faced by prospective foreigninvestors. The Confederation of Indian Industryreports that a typical foreign power project needs toobtain 43 clearances at the central government leveland 57 at the state level. For mining projects thenumbers are 37 and 47, respectively. Such a systemnot only introduces enormous delays, it also opensthe door to possibilities for corruption. One result isthat the cumulative rate of approved foreigninvestments that were actually realized between 1991and 1999 was only 25%. The point is not that foreigninvestors should receive special privileges, but thatregulations should be streamlined so as to fostergreater productivity and investment for all producersin the local market.

At the other end of the process, bankruptcyproceedings are notoriously cumbersome and drawnout in India. Bankruptcy procedures are outdated andineffective laws have led to large-scale inefficienciesin the system, often resulting in high costs of creditand high accumulation of non-performing assets.Recent estimates show that it is entirely common forproceedings to take more than 2 years, and over 60%of liquidation cases before the High Courts have beenin process for more than 10 years. Not surprisingly,when looking at the share of firms that go bankrupt,India has a much lower share (0.04%) than otheremerging markets, such as Thailand.

For firms to be able to innovate and to takeadvantage of new opportunities, it is important thatentry and exit procedures are complemented by thesmooth workings of factor markets. The movement of


labor and capital from less productive activities tomore productive ones is central to realizing thebenefits of greater competition and openness. ForIndia, significant challenges remain in these areas.The excessive regulation of industrial relations is oftensingled out as one of the reasons why India is notdoing as well as it should in terms of the growth of itsexports. The restrictions on the hiring and firing ofworkers is identified as one of the greatest challengesof doing business in India according to the GlobalCompetitiveness Report – India ranks 73rd out of 75countries (China ranks 23rd). In the CII-WB survey,the typical firm reported that it had 17% more workersthan it desired and that the labor laws and regulationswere the main reason why it could not adjust to thepreferred level. These regulations are a key reasonwhy firms are reluctant to take on new employees.

According to the World Bank BusinessEnvironment Survey, there are problems in financialmarkets that include high interest costs, collateralrequirements, and burdensome paperwork. The endresult is to make finance very expensive and to limitaccess of the private sector to the country’s amplesavings. For example, while both China and Indiahave low-inflation environments, India has much higherinterest rates on loans (12.3% compared to 5.9%).Thus, in firm-level data we find that interest expensesare a higher share of costs for Indian firms. ComparingIndian firms with those in East Asia, interest costs oversales were a quarter higher for Indian firms.

Restrictions and extreme regulatory burdens on theuse and transfer of land are another significant problemin India. McKinsey Co. argues that land marketdistortions account for about 1.3 percent of lost growthper year. Distortions include unclear ownership,inflexible zoning and tenancy laws and counter-productive taxation. About 90% of land parcels aresubject to disputes over ownership, which take decadesto settle in court. Subsidized user charges for water andpower, low property tax rates, and ineffective taxcollection leave local governments unable to recover

investments in infrastructure. On the other hand, highstamp duties, at 8-10% of the value of propertychanging hands, discourages land transactions.Zoning laws, rent controls and protected tenanciesfreeze land in key city centers and restrict competition.

InfrastructureThe status of infrastructure in India is far from satisfactoryas revealed by competitiveness rankings. Under therubric of the quality of physical infrastructure we includethe state of power supply, telecommunication services,transport, and water supply.

TransportationTransportation is clearly an area where India’sinfrastructure does not meet that of its regionalneighbors. The total container volume handled at allthe Indian ports combined is lower than that passingthrough Shanghai. The percent of paved roads inIndia, at 56 percent, is lower than the average of 88percent in most East Asian countries; a comparison ofthe freight traffic of the Indian and Chinese railwaysshows India lagging way behind. Freight as a percentof traffic units is a mere 5 percent in India comparedto 79 percent in China.

Comparing the transportation costs associatedwith shipping a container of textiles to the UnitedStates, costs are over 20% higher for India comparedto Thailand, and 35% higher than from China.Variations in maritime distances explain only a smallpart of the gap. Delays and inefficiencies in the ports,in particular customs, account for a higher share ofthe difference in port productivity.

PowerAccess to reliable power at reasonable cost is a primeconcern for most manufacturing firms. India-wide, theshortfall in meeting demand is conservativelyestimated as 11% for regular and 18% for peak energydemand, although the variation across states issubstantial. In power generation, as well, there is


considerable variation across the country, but onaverage energy costs are relatively high in India. Inpart this reflects the need for a greater proportion offirms, even of small and medium firms, to operate theirown generator. In fact, India is fairly remarkable in thatmost small and medium enterprises that we surveyedhave their own power generator. This is much lesscommon in economies such as China, Thailand, orKorea. Less able to achieve efficient scale with theirown generator, energy costs are high. In our surveys69% of Indian firms had their own power generator,compared to 30% in China. Comparing garments andelectronics with East Asian countries, energy costs aredouble those in Indonesia, the Philippines andThailand. This is a really severe problem for SMEs: thetypical Indian SME has its own generator, tying up one-sixth of its capital. This stunts the growth of the SMEsector, and also makes the country less attractive tolarge-scale investors, who would like to draw on adense network of SME suppliers.

A primary reason for the poor performance of thepower sector is that until the 1990’s power generationand distribution were a monopoly of government ownedenterprises under State Electricity Boards (SEBs).These SEBs have followed a deliberate policy of under-pricing the supply of electricity to households andfarms, only part of which they have managed to pass toindustry through tariffs well above cost and internationalrates. This and the boards’ growing failure to protecttransmission and collect bills, has led to serious under-investment in maintenance and capacity. Recent effortsat attracting private investment as a solution include theopening up of generation and distribution to privatecapital and the unbundling of SEB’s into independentcommercial agencies specializing in generation,transmission or distribution only. In most states theseefforts have yet to bear fruit partly because of theabsence of a regulatory framework in which potentialinvestors have confidence. Meanwhile growingpressure on the existing productive capacity of thesector has meant more and more erratic supply to

which industrial users have been responding throughown generation. Since power supply is an activity ofextremely large economies of scale this has inevitablymeant increases in business costs.

TelecommunicationsBusiness managers do not complain about the qualityof telecommunications as much as they do about thepower supply situation. In this area, India’sperformance is comparable to China, but clearlybehind many East Asian and Latin Americancountries. Particularly on the number of internet hostsper 10,000 people, India still has a fraction of thenumber in the Philippines, Thailand or Malaysia. Thenumber, however, has been growing rapidly. It is justbehind the number in China, and with the highergrowth rate, will likely surpass it soon. On the numberof main telephone lines per 1000 people—both fixedand cellular-- India trails behind Malaysia, Thailand,Philippines, China and Indonesia. While in China thenumber of fixed lines grew at 300 percent between1997-2000, they grew at half the rate, 140 percent, inIndia. The waiting list for a connection is higher nowthan at the start of the decade, at over 2.8 million,around 20% of the present number of lines.

Regulatory burden, governance, and corruptionThe final category of transactions costs that we look atinvolves the regulatory burden, governance, andcorruption. There are a number of cross-countryindicators of governance such as measures of the ruleof law and corruption (from TransparencyInternational, Institutional Investor, and others). It isinteresting that these measures show India in a fairlyfavorable light. India and China rank about the samein terms of corruption, and India is perceived to bebetter than China in terms of the rule of law. However,our sense is that there subjective measures do notcapture very well the real transactions costs ofexcessive regulation and corruption.


More objective measures of the regulatory burdenare the amount of time that plant managers spenddealing with government officials and the number ofinspection visits per year. On the amount of time thatmanagers spend dealing with government officials,India does not compare so favorably. In China theamount of time is just over 9%; in Latin America, it isabout 11%, while it is 12% in transitional Europe. InIndia, it is 16%. Clearly this is an area of relativeweakness for India. The opportunity cost of managers’time is considerable. We have not yet asked thequestion about number of inspection visits per year inmany country, but a point that we will return to in thenext section is that that number varies considerablyacross Indian states, reflecting that much of thebureaucratic hassle is at the local level.

Another objective governance measure is thefrequency of making irregular payments to officials.The share of firms making such irregular payments issimilar (about 90% ) in such diverse countries asIndia, Indonesia, the Philippines, and Thailand. Therate is almost half that in Malaysia. The share thatreported doing so ‘always’ or ‘mostly’ is highest inThailand and comparable in India and Indonesia.What is interesting, however, is that while Thai firmsreport having to make irregular payments morefrequently than firms from Indonesia, this was notnecessarily seen as a larger impediment to doingbusiness. If there is little uncertainty regarding the sizeof the payments and if the payments do secure thedesired services, many report that the corruption isnot much of a problem. ‘Frequency of payments’ ismuch less correlated with ‘business costs ofcorruption’ than is the burden associated with the‘time senior management spends with governmentagencies and regulators.’

One area of regulation that has received particularattention in the past – attention that has helped spurreform – is customs administration. Of the variousregulatory agencies that are seen as obstacles,customs officials ranked second – only behind labor

regulations – as a major constraint to doing businessin India.The issue has two broad concerns. The firstis the typical delay in getting goods cleared. Suchdelays are a significant consideration for firms relyingon imported inputs. The surveys include informationon the number of days it takes to clear customs. Here,India scores poorly relative to Korea and Thailand,with the time about 50% longer in India (and triplewhat many OECD countries report). But the issue isnot just the average time, but also variances inclearance time. The longest delay in the past year fora typical firm in India was 21 days, compared to only12 in China. Such delays function like a tax on firms.With such uncertainty, firms need to keep greaterinventories of materials on hand, incurring significantinterest and storage costs and tying up resources thatcould be otherwise put to more productive use.

In summary, qualitative rankings, quantitativenational indicators and micro-evidence consistentlypoint to priority areas for reform in India. Theproductivity dispersion of firms – large by internationalcomparison – demonstrates the need to continue theprocess of regulatory reform, easing the ability of firmsto enter, expand and exit as they adjust to a morecompetitive environment. The internationalcomparisons demonstrate the clear need to focus onimprovements in infrastructure in the areas of portefficiency, power generation and telecommunications.

Some of these reforms need to occur at the statelevel and will be taken up in greater detail below. Butkey reforms are needed at the union level as well, themost important of which are:

labor regulations: as proposed in the budget, theflexibility to adjust labor use should be extendedto firms in the 100-1000 employee range; land transactions: the tax and regulatory costs oftransferring land need to be reduced;financial sector reform to improve access andreduce the spread between deposit andlending rates;


continued bankruptcy reform to improve theallocation of resources and access to credit; andcustoms administration reform to reduceclearance times.

Investment Climate Differences AmongIndian StatesThe CII-WB survey asked business managers toidentify the states that they thought had a better orworse investment climate than the state in which theywere currently based. They were also asked to tellwhich of the 10 states had the best investment climate,and which had the worst. More than seventy percent ofrespondents thought that Maharashtra had a betterinvestment climate than their own state. About 65percent thought that the investment climate of UttarPradesh was worse than that in their state. In betweenthese two extremes, there was a pretty clear ranking ofstates that enabled us to categorize Maharashtra andGujarat as the "best climate" states; Tamil Nadu,Karnataka, and Andhra Pradesh as "good clime states";Delhi and Punjab as "medium"; and Kerala, WestBengal, and Uttar Pradesh as "poor climate states."

That entrepreneurs actually act on theseperceptions can be seen in the investment rates forthese states. In our sample, the firms in best stateshad high investment rates, increasing their capitalstock at a rate of about 8% per year, while there wasactually net disinvestment in West Bengal and verymodest growth of the capita stock (3% per year) inUttar Pradesh. Macro data on the location of foreigndirect investment in India follows the same pattern:almost all of the FDI in the 1990s has gone to the goodand best climate states. Also at the macro level, therehas been significantly faster GDP growth in the goodand best states (7.2% per year during 1992-98) thanin the poor climate ones (4.8%).

The objective investment climate indicatorscollected by the CII-WB survey show some of theimportant dimensions along which states vary. Itshould be noted that states ranked as ‘best’ do not

necessarily have the best rankings on all dimensions;there is room for reform in all states. The analysishighlights the impact on SMEs. Within a location,larger firms face the same bottlenecks, but ourproductivity analysis suggests that the effect of thesebottlenecks is particularly great on SMEs. The fourareas of focus are:

Regulatory burden: The regulatory burdenappears to be higher in the poor climate states.For example, SMEs receive factory inspectionstwice as frequently in the poor climate states (9.5visits per year on average) as in the best climateones (5.2 visits).Infrastructure I: power: In the poor climate states,73% of SMEs have their own power generator,whereas in the best climate states the figure is31%. These differences reflect the more severeproblems with power supply in the poor climatestates. For the SMEs in poor climate states thecost of generating power on their own is abouttwice as high as the price of power for firms fromthe public grid. So, this infrastructure deficiencyimposes a significant cost on firms. Infrastructure II: ICT: There are also variations ininternet connectivity across states. It isencouraging that 47% of SMEs in the goodclimate states use the internet to conductbusiness, while only 27% of SMEs in poor climatestates do so. One interesting anomaly is that theuse of the internet is also low in the best climatestates (32% of SMEs), reflecting the fact that eventhe better states appear to have investmentclimate problems in specific areas.Industrial relations and regulations: Firms in all ofthe states report problems with having moreworkers than they really want, and as indicatedabove this seems to reflect the heavy regulation oflabor markets. To get some further insight into theproblem of over-manning, we did follow-upsurveys in Karnataka and Andhra Pradesh, which


i)

ii)

iii)

iv)

are good climate states, and Uttar Pradesh, whichis a poor climate one. In Karnataka and AP, theovermanning was partially the result of laborhoarding in anticipation of higher growth in thefuture, and that is a positive indicator about thefuture. Still, nearly one-quarter of firms reportedthat the overmanning was partly the result of laborregulations and 40% indicated that it came frompolitical pressure not to lay off workers. In UP, onthe other hand, there was very little reported laborhoarding in anticipation of better sales in thefuture. Rather, 100% of firms said that they hadtoo many workers because of the effect of laborregulations and 94% said that they face politicalpressure not to lay off workers. So, in terms of theimpact of labor regulations, there also seems tobe a significant difference across states.

In summary, several key aspects of the investmentclimate are controlled at the state level. Growth couldbe significantly enhanced by addressing theproblems at this level. While the specific challengesvary across states, in general the priorities for reformat the state level are:

Reforming the power sector so as to attractprivate investment and ensure adequate andefficient provision of power;Reducing the regulatory burden on firms; andComplementing national reform of laborregulations with administration at the state levelthat permits more flexibility in the labor market.

Reform would spur faster growthThe survey data can be used to estimate the effect ofspecific bottlenecks in the investment climate onproductivity, investment, and growth. Thus, we canprovide a quantitative answer to the question: whatcould India gain from an improved investmentclimate? Specifically, we find that if each Indian statecould attain the best practice in India in terms of

regulation and infrastructure, the economy shouldgrow about 2 percentage points faster. The gainswould be particularly large in the poor climate states(an extra 3.2 percentage points of growth), reflectingthe fact that the move from their current state to thebest practice in India would be a large improvement.But even in the good and best climate states there issignificant room for improving the investment climatein particular areas: moving to the best Indian practicewould add 1.5 percentage points to the growth rate forthese states. Note that in many ways this is aconservative counterfactual scenario, just raisingstates to levels of regulation and infrastructure qualityalready observed in India. As highlighted above, inmany areas India lags behind other emerging marketeconomies, and if it could achieve Chinese or Thailevels in distinct investment climate areas its growthacceleration would be even more dramatic. While thespecific estimates have some uncertainty aroundthem, the general point is quite robust: removingbottlenecks that prevent efficient infrastructureservices and private initiative more generally wouldlead to faster growth and poverty reduction in India.


A. What do we mean by "investment climate"? 20

B. … and why does it matter 21


During the last decade, major developing countriesincluding India have begun to integrate much morewith the global economy. The countries that areaggressively integrating have grown significantlyfaster than those that are not. In the 1990s, the morerapidly globalizing developing countries (measured interms of increased trade participation) grew at 5.0 percent per capita, while the rest of the developing worldposted negative growth of 1.1 per cent.1 Among themore aggressive globalizers were Brazil, China,Mexico, Philippines, Thailand, and India.

That globalizing developing countries are doingwell on average is good news. But these averagesdisguise considerable variation in performance withinthis group. China has done spectacularly well, and isthe unchallenged leader of the pack. The country hasdoubled its ratio of trade to GDP over the past twodecades (to 41 per cent of GDP in 1999), and has hadper capita GDP growth of nearly 8 per cent during1990-99. Malaysia was another winner: in spite of thetemporary income compression due to the Asiancrisis, it could still enjoy per capita GDP growth of 3.8per cent during the 1990s. Again, despite the crisis,Thailand’s per capita GDP growth in the 1990saveraged 3.8 percent. However, the per capita GDPgrowth of another relatively aggressive globalizer,Brazil, has only been around 1 per cent for 1990-99;and growth in the Philippines was only 0.4 per cent.India, with per capita GDP growth of 3.3 per centduring 1990-99 is in the middle of the pack (Figure 1.1)

The implication of these variations is striking. Suchdifferences in growth rates sustained for one or twodecades make a huge difference in living standards andthe extent of poverty. While China and India hadcomparable levels of GDP per capita (measured atpurchasing power parity) in 1990 (approximately $1400),over the following decade India’s per capita incomenearly doubled, while China’s nearly tripled. Thus, today,China’s per capita income is about 50% higher than thatof India. Together with its faster growth, China has alsohad significantly faster poverty reduction (Figure 1.2).


8

6

0

4

2

Percentage GDP

Figure 1.1. Per capita GDP growth rates in globalizing developing countries (average 1990–99)

MalaysiaChina

ThailandIndia

BrazilMexico Philippines

10

6

8

0

4

2

Percent per annum (1992–98)

* India poverty reduction figure is for 1993

Figure 1.2. Poverty reduction in India and China is closely related to the growth rate

GDP per capita growth rate

Poverty reduction

China

9.9

8.4

India

5.4*

4.4

The raison d’etre of our paper is to examinesome of the reasons for such per capita GDP growthvariations. We argue that openness to foreign tradeand investment is an important, but not sufficient,condition for sustained GDP growth. For India andother developing countries to do well, good macroand trade policies need to be complemented with ahost of other institutional factors and policies thatcan be classified under the broad heading‘investment climate’.

In the next section we define in more detail whatwe mean by investment climate. Section 2 then brieflyreviews some of the macro evidence that shows theimportance of investment climate for sustained growthand poverty reduction. While illuminating about theimportance of the investment climate, the macroliterature does not really provide much specificguidance about what aspects of the investmentclimate are important and what specific reforms areneeded in particular countries. For this reason we godown to a more micro level in chapters 2 and 3.Chapter 2 looks at India in international perspective.It draws on a variety of sources of information,including a large-scale firm survey conducted by theConfederation of Indian Industries and the WorldBank. Comparable surveys from China, Thailand,Malaysia, and other emerging market economiesallow for a detailed comparison of the investmentclimate across these countries. In general, India lagsbehind these other countries in specific areas such asthe burden that regulation places on firms – especiallysmall and medium enterprises (SMEs) – and thequality of key infrastructure services such as portsand power.

Chapter 3 examines the investment climateacross ten major Indian states: Andhra Pradesh,Delhi, Gujarat, Karnataka, Kerala, Punjab,Maharashtra, Tamil Nadu, Uttar Pradesh, and WestBengal. Again, it draws on several sources ofinformation, including the CII-WB survey. The mainfinding here is that the investment climate varies

significantly across Indian states, so that we candistinguish among poor investment climate states (UP,West Bengal, and Kerala); medium quality ones (Delhiand Punjab); good climate states (AP, Karnataka, andTamil Nadu); and the best (Gujarat and Maharashtra).We can then estimate the effect of specificbottlenecks in the investment climate on productivity,investment, and growth. Thus, we can provide aquantitative answer to the question: what could Indiagain from an improved investment climate?Specifically, we find that if each Indian state couldattain the best practice in India in terms of regulationand infrastructure, the economy should grow about 2percentage points faster (figure 1.3).

The gains would be particularly large in the poorclimate states (an extra 3.2 percentage points ofgrowth), reflecting the fact that the move from theircurrent state to the best practice in India would be alarge improvement. But even in the good and bestclimate states there is significant room for improving


10

6

8

0

4

2

Annual average GDP growth rate, 1992–98

Figure 1.3. Estimated growth rate gains from improvement in Investment Climate

Good and bestclimate states

8.7

7.2

8.4

6.3

All india

8.0

4.8

Poor climatestates

Potential Actual

the investment climate in particular areas: moving tothe best Indian practice would add 1.5 percentagepoints to the growth rate for these states. Note that inmany ways this is a conservative counterfactualscenario, just raising states to levels of regulation andinfrastructure quality already observed in India. Ashighlighted in Chapter 2, in many areas India lagsbehind other emerging market economies, and if itcould achieve Chinese or Thai levels in distinctinvestment climate areas its growth accelerationwould be even more dramatic. While the specificestimates have some uncertainty around them, thegeneral point is quite robust: removing bottlenecksthat prevent efficient infrastructure services andprivate initiative more generally would lead to fastergrowth and poverty reduction in India.

A. What do we mean by "investment climate"?

The quantity and quality of investment flowing intoIndia or any other country depends upon thereturns that investors expect and the uncertaintiesaround those returns. It is useful to think of threebroad and interrelated components that shapethese expectations.

First, there are a set of macro or country-levelissues concerning economic and political stabilityand national policy towards foreign trade andinvestment. By these, we generally refer tomacroeconomic, fiscal, monetary, and exchangerate policies as well as political stability. As far asthese macro indicators go, India performsreasonably well. Second, there is the issue of efficacy of a country’sregulatory framework. As far as firms areconcerned, these relate to the issues of entry orstarting of a business, labor relations and flexibilityin labor use, efficiency and transparency of

financing and taxation, and efficiency ofregulations concerning the environment, safety,health, and other legitimate public interests. Thequestion is not whether to regulate or not, butwhether such regulations are designed inincentive compatible ways, avoid adverseselection and moral hazard, serve the publicinterest, are implemented expeditiously withoutharassment and corruption, and facilitate efficientoutcomes. While such variables are hard tomeasure, our surveys clearly suggest thatregulatory efficacy varies widely across countriesand, as far as India is concerned, across states. Third, and no less important, is the quality andquantity of available physical and financialinfrastructure, such as power, transport,telecommunications, and banking and finance.When one surveys entrepreneurs about theirproblems and bottlenecks, they will often citeinfrastructure issues such as power reliability,transport time and cost, and access andefficiency of finance as key determinants ofcompetitiveness and profitability.

It is common for developing countries to react to asevere fiscal and/or balance of payments crisis byembarking on comprehensive macroeconomicreforms and stabilization programs. India was nodifferent in the first half of the 1990s, and achievedgood results compared with the past. Despite fivegovernments in the 1990s — and four in the last fiveyears — India’s average GDP growth was 6 per centper annum, compared to 5.5 per cent in the 1980s,and much lower rates in the 1970s and 1960s. Forthree halcyon years (1994-95 through 1996-97) GDPgrowth exceeded 7 per cent and peaked at 7.8 percent in 1996-97. This growth was spurred to a largeextent by private investment, which grew in real termsat 18 percent per year from 1991 to 1995.

Unfortunately, the growth of private investmenthas slowed since then, to an average of 8 percent per


year between 1996 and 2000, and GDP growth hasslackened as well — to 4.8 per cent in 1997-98, 6.6per cent in 1998-99, 6.4 per cent in 1999-00 and 5.2per cent in 2000-01. Although such growth is high byinternational standards, the deceleration of privateinvestment and growth has emphasized the need forwhat Indian policy-makers are calling ‘secondgeneration reforms’. Growth generated by the firstflush of macroeconomic reforms is likely to peter outunless one moves ahead on critical structural issues— especially institutional, regulatory andinfrastructure reforms – precisely the elements thatbelong to what we call the investment climate. Today,politicians of most persuasions recognize that Indiahas reached a critical point, where the greatestchallenge is to move forward on the institutional andinfrastructure agenda.

Two caveats are in order at this stage. First, we arenot interested in the quantity of investment per se.Indeed, recent work on economic growth [Easterly1999] has shown that there is surprisingly littlerelationship between the quantity of investment andthe rate of economic growth. In many instances, this isdue to a distorted and dysfunctional institutional andpolicy milieu — where neither public nor privateinvestments produce the benefits that they should.Our focus, therefore, is not on the quantity ofinvestment, but on the overall institutional and policyenvironment — the ‘investment climate’ — thatdetermines whether or not investments pay off interms of greater competitiveness of firms andsustained growth.

Second, while we recognize that socialinfrastructure is no less important than its physicaland financial counterparts, we have chosen toexclude the provision of education and healthservices from our definition of the investment climate.It is a deliberate choice. The reforms needed toimprove social services are quite different from theissues of infrastructure and regulation of industry onwhich we concentrate.

B. … and why does it matter

Spurred by the endogenous growth theories of Romer(1986) and Lucas (1986), there is now a vast empiricalliterature that investigates the determinants of growth.Some of the empirical results are fairly robust andprovide macro evidence about the importance of theinvestment climate. Fischer (1993), for example,found that high inflation is bad for growth. Thiscommonsense result is hard to dispute. To an extent,inflation reflects exogenous shocks that are beyondthe government’s control. But truly high inflationtypically reflects serious monetary mismanagement.There is also a clear negative relationship betweengovernment consumption and growth, which was firstnoted by Easterly and Rebelo (1993). No doubt, somegovernment expenditures are socially productive, butdeveloping countries with very high governmentspending usually have inefficient bureaucracies andhigh levels of corruption.

A number of studies, most recently Frankel andRomer (1999) and Dollar and Kraay (2001), find thatopenness to trade and direct foreign investmentaccelerates growth. These findings are in the spirit ofthe new growth models, and emphasize theimportance of market size for creating a finer divisionof labor and stronger incentives to innovate. Inaddition to macro and trade policies, financialdevelopment is also a catalyst for growth [Levine,Loayza and Beck (2000)]. All else being controlled for,countries that have more developed stock marketsand/or deeper banking systems tend to grow faster.

Investment climate measures such as the strengthof property rights, rule of law, and level of corruptionare also well correlated with growth [Kaufmann, Kraay,and Zoido-Lobatón (1999); Knack and Keefer (1995)].These studies typically use data generated fromsurveys of private businesses, and reflect the extent towhich investors and/or firms perceive problems withharassment, corruption, and inefficient regulation. Aproblem of these measures, however, is that they are


often based on a small sample of very largeentrepreneurs and hence do not provide a robustassessment of how rule of law and corruption areexperienced by small and medium enterprises, whichform the backbone of the economy.

Thus, the empirical cross-country literatureprovides evidence that growth and poverty reductionare promoted by a good investment climate — anappropriate policy package of private property rights,sound rule of law, macroeconomic stability,government spending that is not excessive and wellfocused on public goods, and openness to foreigntrade and investment. However, most of the macro-indicators of policy and investment climate used inthese studies are quite crude, and are of little help tocountries in identifying what specifically needs to bedone to create a better climate. As we shall see in thecourse of this report, the existing cross-countrymacroeconomic measures are quite similar for Chinaand India (e.g. rankings on rule of law, corruption, oroverall infrastructure quality from differentinternational sources). Both countries ‘fit’ the empiricalgrowth studies in that both have done relatively well.India has grown at about twice the rate of the OECDcountries in the 1990s. Yet, China has grown muchfaster and had much greater poverty reduction.Macro-indices fail to explain such differences. Thus,while the macro evidence is useful as backgroundand motivation for the rest of our work, it suggests theneed to delve at a much more micro level, and tosurvey large numbers of producers, including SMEs,to understand the rich differential relationshipbetween investment climate and growth.

Notes

During the same period, the rich countries grew atabout 2 percent per capita.


1.

A. Introduction: India is falling short of its potential 24

B. Entry and exit 26

C. Infrastructure 32

D. Regulatory burden, governance, and corruption 36

E. Conclusion 42


A. Introduction: India is falling short ofits potential

Beyond good macroeconomic conditions, the extentof investment that takes place, and its effectiveness ingenerating value, are greatly influenced by the overalltransaction costs of doing business in a particularlocation. Three dimensions of particular relevance forIndia will be discussed here. First, the efficientallocation of resources needed to maximizeproductivity and growth requires the smooth operationof factor markets and exit and entry procedures.Second, the availability and quality of infrastructureservices greatly influences the costs (in time as wellas money) of producing and delivering goods. Third,while regulations are required, their burden should notbe excessive or be a source of corruption.Understanding how India compares internationallyalong these dimensions suggests ways that reformscould help the country reach its full potential fordevelopment.

One measure of the attractiveness of a businessenvironment is to look at the extent to which foreignbusinesses choose to locate there. With additionalfixed costs associated with operating abroad and witha multitude of potential locations to choose among,entrepreneurs should be responsive to the relativeincentives offered by different locations. Factors thatwill be important are many of the same ones that areassociated with higher growth, such as stable macroeconomic conditions, openness to trade (particularlyimported inputs) and a good rule of law. Local marketsize and labor costs are additional importantdeterminants. On these last two dimensions, India iswell positioned. It has one of the largest domesticmarkets in the world and it has a large labor forceavailable at relatively low cost. It also has welleducated workers, particularly in areas of engineeringand science. If these were the only determinants,India should be very successful at attractinginvestment. A.T. Kearney publishes an index of FDI

competitiveness that combines these elements, withan emphasis on market size and labor costs. Indiaranks near the top of the list at number 7. However, inpractice, India does not receive the amount of FDI itsmarket size would predict (Figure 2.1). In 1999, FDIinflows were a mere 0.5% of GDP. This isconsiderably lower than China (3.9%), Brazil (4.5%) orThailand (5%).

Micro-data in India2 and five East Asian countries3

help illuminate the shortfall in potential from anotherperspective. Using a comparable survey instrumentand sampling frame, 650-950 firms were interviewedin Indonesia, Korea, Malaysia, the Philippines andThailand in early 1999. Textiles and electronics weresectors included in all 6 countries and garments in allcountries but Korea. Comparing gross laborproductivity, India’s competitive position does notappear that strong. Figure 2.2 plots the value addedper worker of each East Asian country relative toIndia, with the axis intersecting at one, so that bars to


10

6

8

0

4

2

Percentage of GDP

Figure 2.1. FDI as share of GDP, 1998

ChileThailand

MalaysiaChina

Brazil

Philippines

Argen-tina

Mexico

India

Indonesia

the right indicate greater labor productivity in the EastAsian country. As expected, Korea displays thehighest productivity, with value added per workereight times that of India. Malaysia is the next mostproductive, with ratios 3.25-4 times that of India.Labor productivity in Indonesia is very comparable tothat of India, with Indian textiles exhibiting greaterproductivity than in Indonesia.

However, the simple comparison of value addedper worker is not sufficient to conclude that India is notcompetitive in these sectors. While labor productivitymay indeed be lower, so too are wages. Factoring inlabor costs and looking at value added per unit oflabor cost tells a different story. The panel on the rightof Figure 2.2 has the labor cost adjustedcomparisons. Again, the axis intersects at one, butthe scale is much smaller. Now, India does indeeddisplay cost competitiveness, particularly in textilesand somewhat in garments. Yet, despite this costcompetitiveness, Indian exports in textiles andgarments do not rival those of its East Asiancompetitors – China’s garment exports are seventimes those of India’s.

While India may be a cost effective location forseveral industries relative to East Asia, thiscomparison is made at the factory door. Significanttransportation bottlenecks and infrastructure costsremain -- often wiping out what little production costadvantage there had been. A closer examination ofthe investment climate can point to several areas inwhich India can improve and can provide someanswers as to why India has had trouble attractingforeign investment, and in translating its costadvantages into greater productive efficiency.

This chapter argues that three key areas of theinvestment climate where reform would greatlyimprove India’s competitive position are: theregulatory framework surrounding the entry and exit offirms, the availability and quality of infrastructureservices, and the extent of the regulatory burden andextent of corruption.


Value added per worker relative to India

Value added per labor cost relative to india

8

0

2

4

6

Electronics Garments Textiles

Electronics Garments Textiles

Figure 2.2. Value added relative to India, 1999

KoreaIndonesia

PhilippinesMalaysiaThailand

KoreaIndonesia

PhilippinesMalaysiaThailand

1.5

0.5

1.0

Smooth processes for entry and exit are key fordetermining the extent of competition amongproducers. With protected markets, incumbentscan collect substantial rents, but face littlepressure to innovate, to maximize their efficiencyor to price their goods at their marginal costs.Obstructions in factor markets (labor, land andfinance) can also hinder entry as well as theexpansion of firms. Difficulties in firm-exiting (i.e.bankruptcy proceedings, ability to lay off workers)not only make it difficult to resuscitate ailing firms,but also discourage firms from expanding in thefirst place and make potential lenders wary ofproviding resources needed for a firm to increaseits productivity. Infrastructure services are a key component forproduction, affecting the cost and ability tocomplete production, to receive inputs and delivergoods, and to communicate with suppliers andcustomers. While firms can assume the (oftenconsiderable) cost of private provision of some ofthese services, they are primarily under thepurview of the government – and so can bereadily addressed by reform measures. The regulatory burden and extent of corruptiondirectly raise the costs of doing business in alocation. Costs can include additional delays,increased management time spent clearingbureaucratic hurdles, uncertainty in the ability tocarry out decisions in a timely manner, as well asthe direct costs of irregular payments.

In discussing the quality of India’s investmentclimate and putting it in international perspective,this report draws on a variety of measures. As astarting point, several organizations collect theperceptions of business people on a variety ofdimensions for a large number of countries. Whilewidely circulated, these subjective rankings shouldbe interpreted with care: there are serious limitationsin how consistent they are as a basis for international

comparisons and they provide little guidance as tothe relative magnitudes of the impact of problems,particularly across issue areas or over time. Toooften the ordinal ranking is interpreted as a cardinalone, and with no link to outcomes, it is difficult tojudge the relative importance of a given issue withina country. More insightful are the quantitative,objective measures of the business environment –particularly those linked directly to firm performanceor other outcome variables.

This report will not try to provide one overallsummary indicator of the quality of the investmentclimate of a country. One of the points we wish tostress is that there are many dimensions to theinvestment climate and a location can excel in somewhile having substantial room for improvement inothers. Part of the interest in this report is precisely tolook at the trade-offs associated with the differentdimensions. Using a single indicator as a proxy of theoverall level of governance can be hugely misleadingas noted by the large differences in rankings Indiareceives even on elements within a single investmentclimate category.4

B. Entry and exit

One of the most telling indicators of how competitivethe markets are in a country is to look at theproductivity dispersion of firms within an industry thatoperate there. In a competitive market, withreasonably free entry and exit, the dispersion shouldbe quite low. Higher dispersion levels indicate thatless efficient producers are not being forced toimprove their productivity or exit the market. Firm-level studies in a number of countries bear this out:lower productivity dispersion is associated withincreased openness and greater competition withforeign firms (Haddad 1993, Haddad and Harrison1993, Harrison 1996, Hallward-Driemeier, Iarossi,Sokoloff 2001). Subsidies or strict regulations that


i)

ii)

iii)

impede entry or exit can have the effect of bolsteringhigh cost producers. As a result, with such firms stillin the market, more productive firms may not have hadadequate incentive to further increase theirproductivity or to expand. However, as competitionincreases, firms face greater incentives to innovateand greater penalties for failure to do so. Loss ofprotection and greater competition from foreign firmscan drive inefficient domestic producers to betterexploit scale economies, eliminate waste, reducemanagerial slack or ‘x inefficiencies’, adopt bettertechnologies or shut down. As a result, productivitydispersion should shrink as productivity levels rise inthe face of greater competition.

As Figure 2.3 shows, there is considerableproductivity dispersion in India. In textiles, garmentsand electronics, higher performers have valueadded per worker that is 5 times that of lowerperformers. The ratios are even higher in Indonesia,particularly in electronics where the ratio is almost 8.However, the dispersion of productivity is lower in thefour other East Asian countries. In Korea, the ratiosare not much more than 2, and in Malaysia andThailand they are just below 3. These comparisonsillustrate that there is still room to increasecompetitive forces in India to spur less efficient firmsto improve their productivity. Areas to be singled outinclude: regulations regarding entry and exitprocedures themselves, restrictions in factor marketsfor labor, land and finance, and protection fromforeign competition, weak infrastructure and highlevels of corruption.

1) Entry and exit proceduresFigure 2.4 clearly demonstrates that India isparticularly weak on issues related to entry and exit. Ithas higher requirements for the number of permitsand significantly longer median number of days tostart a firm than almost all countries included in theGlobal Competitiveness Report’s database. Relativeto China, starting a business in India requires 10

permits compared to 6 in China, and the median timeis 90 days in India relative to 30 days in China. Thesenumbers are medians – there are many strikingexamples of considerably longer burdens borne byfirms. Some such examples are given by theprocedural hurdles faced by prospective foreigninvestors. The Confederation of Indian Industryreports that a typical foreign power project needs toobtain 43 clearances at the central government leveland 57 at the state level. For mining projects thenumbers are 37 and 47 respectively.5 Such a systemnot only introduces enormous delays, it also opensthe door to possibilities for corruption.

One result is that the cumulative rate of approvedforeign investments that were actually realizedbetween 1991 and 1999 was only 25% (figure 2.5).6

The point is not that foreign investors should receivespecial privileges, but that regulations should bestreamlined that will foster greater productivity andinvestment for all producers in the local market.


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4

2

Ratio of 75th percentile to 25th

Figure 2.3. Dispersion of value added by worker, 1999

India

Thailand

China

Malaysia

Philippines

Korea

Textiles Garments Electronics

At the other end of the process, bankruptcyproceedings are notoriously cumbersome and drawnout in India. Bankruptcy procedures are outdated andineffective laws have led to large-scale inefficiencies inthe system, often resulting in high costs of credit andhigh accumulation of non-performing assets. Recentestimates show that it is entirely common forproceedings to take more than 2 years, and over 60% ofliquidation cases before the High Courts have been inprocess for more than 10 years.7 Not surprisingly, whenlooking at the share of firms that go bankrupt, India hasa much lower share than other emerging markets, andsignificantly less than in the USA. (figure 2.6)8

2) Factor MarketsFor firms to be able to innovate and to take advantageof new opportunities, it is important that entry and exitprocedures are complemented by the smoothworkings of factor markets. The movement of laborand capital from less productive activities to moreproductive ones is central to realizing the benefits ofgreater competition and openness. For India,significant challenges remain in these areas.

LaborThe excessive regulation of industrial relations is oftensingled out as one of the reasons why India is notdoing as well as it should in terms of the growth of itsexports.9 The restrictions on the hiring and firing ofworkers is identified as one of the greatest challengesof doing business in India according to the GlobalCompetitiveness Report – India ranks 73rd out of 75countries (China ranks 23rd) (figure 2.4).

The legal basis for the regulation is encoded in theemployment security provisions of the IndustrialDisputes Act of 1947, the ‘service-rules’ provisions ofthe Industrial Employment Act of 1946 and theprovisions of the Contract Labour (Abolition andRegulation) Act of 1970. The Industrial Disputes Actsets out the rules for settlement of employmenttermination disputes. One of its main provisions


Number of permits to

start a firm

Administrative burden for

startups

Median number of

days to start a firm

Hiring and firing of workers

Ranking out of 75 countries surveyed in the Global Competitiveness Report 2001

Strongest Weakest

Figure 2.4. Entry and exit

0 25 50 75

IndiaChina

10 permits6 permits

90 days30 days

25,000

15,000

20,000

0

10,000

5,000

million US$

Figure 2.5. Foreign Direct Investment: the challenge of improving the realization rate

1991 1998

Actual flowsApproved

requires establishments employing more than 100people to seek the permission of the state governmentfor closure or the retrenchment of workers, whichpermission, critics point out, is rarely granted (Sachset al, 1999). The Industrial Employment Act providesfor the definition of job content, employee status andarea of work by state law or by collective agreement,after which changes would not be made withoutgetting the consent of all workers.10 Zagha (1999)points out that this has always made it difficult forbusinesses ‘to shift workers not only between plantsand locations, but also between different jobs in thesame plant.

One way out of such restrictions would seem tobe for businesses to resort to contract workers,which would fall under the Contract Labour Act. Thislaw gives state governments the right to abolishcontract labor in any industry in any part of the state.A central government directive in 1976 also mademany firms liable to having to absorb any contract

laborers into their ranks of permanent employees. Instates where recourse to contract labor has beenmore restricted, keeping employment below thethreshold level of 100 employees or contracting outjobs has been the only way of maintaining flexibilityin the allocation manpower.

Another important legislative restriction on firmsize stems from the Small Scale Industries reservelists. Eight hundred and thirty-six manufacturinggoods are enumerated and their production isrestricted to small scale firms. Critics point out theconstraints on productive efficiency from restrictingproduction scale and the difficulties such firms have insecuring credit. There have been some recentreforms, with a number of products being de-licensed, including readymade woven garments(although not knitted or hosiery garments). The limiton investments is to double to Rs 1m. While certainsectors are constrained to work at less than efficientscale, SSIs overall do account for 35% of total exportswith 3.2m firms employing almost 18m people andrecording growth rates above those of overallindustrial production growth.11

From employees’ perspective, the structure of thepension system also restricts the incentive to shiftbetween jobs. Pensions are tied to particularemployers and cannot be easily transferred.Employees would risk losing substantial benefits byshifting jobs, greatly reducing workers’ flexibility.

Some progress is being made in this area of laborregulations. The burden on SMEs regarding laborredundancies has been recognized and is addressedin the most recent budget, with proposals that theceiling be raised to 1000 employees (from 100) for thesize of firms which are not required to seekgovernment permission to retrench workers. Inaddition, the Constitutional Bench of the SupremeCourt ruled in August 2001 that companies canemploy temporary workers without the risk of havingto absorb them – providing some greater flexibility inhiring practices. While there is little expectation of a


4

3

0

2

1

Percentage

Figure 2.6. Bankruptcies as a share of total firms

USAHungary

FranceCzech Rep.

TurkeyChile

ThailandIndia

massive dereservation of SSIs, various itemsincluding important export sectors such as garmentsand leather goods are candidates. The 2001 budgetalso proposed facilitating the provision of collateralfree loans and capital subsidies for SSIs upgradingtheir technology.

FinanceAccording to the World Bank Business EnvironmentSurvey, the issue is not access to finance so much asthe high interest costs and the collateral requirements– and burdensome paperwork required – that makefinance an issue (figure 2.7). Comparing the firm-level data from India with East Asian neighbors,Indian firms do report having a higher share of theircapital coming from bank loans relative to firms inEast Asia. Figures 2.7 and 2.8 illustrate thedifferences in the reliance on bank loans betweenIndia and China where the differences are 35% and18% respectively. While both China and India havelow-inflation environments, India has much highinterest rates on loans (12.3% compared to 5.9%).Thus, interest expenses are a higher share of costsfor Indian firms. Comparing Indian firms with those inEast Asia, interest costs over sales were a quarterhigher for Indian firms. This places a burden onfirms, both as they contemplate how to accessexternal finance to take advantage of businessopportunities and as they seek ways to make existingloans more affordable.

This is not to imply that access to credit is not anissue. As noted above, many small firms have greatdifficult securing loans. The practice of lending topriority sectors has also led to inefficient allocation ofcredit. While declining, such directed lending stillaccounts for 40% of credit – and has a 35% highernon-performing loan ratio. One of the biggestobstacles, however, remains the need for furtherlegal reform. Significant legal delays anduncertainty of property rights serve to limit creditorswillingness to extend large loans or to take on

potentially riskier clients. Even for loans that arecollateralized, judgments often take up to 10 yearsand even then may be difficult to enforce. Theestablishment of specialized debt tribunals shouldhelp reduce some of the backlog, but in practiceimprovement remains slow.

LandRestrictions and extreme regulatory burdens on theuse and transfer of land is an enormous problem inIndia.12 McKinsey Co.13 indicates that land marketdistortions account for about 1.3 percent of lostgrowth per year. Distortions include unclear


High interest rates

Bank paperwork

Collateral requirements

Special connections

Inadequete credit

Access to specialized

export finance

Access to non-bank equity

Access to foreign banks

Access to lease finance

Banks lack money to lend

Percent of firms ranking issue as moderate or major obstacle

Figure 2.7. Finance obstacles

0 30 60 90

IndiaChina

ownership, inflexible zoning and tenancy laws andcounter productive taxation . About 90% of landparcels are subject to disputes over ownership, whichtake decades to settle in court. Subsidized usercharges for water and power, low property tax rates,and ineffective tax collection leave local governmentsunable to recover investments in infrastructure. On theother hand, high stamp duties, at 8-10% of the valueof property changing hands, discourages landtransactions. Zoning laws, rent controls andprotected tenancies freeze land in key city centersand restrict competition.

3) Protection from foreign competitionChief among the regulations that lead to highproductivity dispersion are regulations designed toprotect certain industries, particularly from foreigncompetition. While tariffs have been substantiallyreduced in the 1990s, they still remain relativelyhigh. Average rates remained at 30% in India,relative to 15% in China or 10% in Thailand, andnon-tariff barriers are estimated to still cover 30% ofgoods. While this is down from 60% at thebeginning of the 1990s, it is still considerably higherthan India’s Asian competitors. The same can besaid regarding restrictions on foreign ownership.The measures are often justified as protecting infantindustries so that they have the opportunity to beestablished and mature prior to facing fullcompetition. The assertion is that once they aremature, they will be competitive without furtherprotection. The widespread use of such argumentsled to the import-substitution policies followed bymany developing countries in the 1950s-70s. Whilethe failure of this development strategy has curbedthe broad application of protection, individual firmsand specific industries still try to make an exceptionfor their particular case. While appeals are made tothe possibility of learning externalities, in reality,political connections are a prime determinant ofwhich industries receive protection.


India

China

60

0

20

40

<20 20–100 >100

Percentage

Figure 2.8. Sources of finance, 1999

Retainedearnings

Parent Bankloan

Equity Other(largely

other loans)

60

0

20

40

<20 20–100 100+

Retainedearnings

Parent Bankloan

Equity Other(largely

other loans)

Percentage

The distorted incentives such protection puts inplace makes it very hard for such a policy ultimatelyto be successful. Firms will invariably respond tothese incentives, and so make production andstrategy decisions based on them and not the marketsignals that would make them viable in the long run.To the extent that the regulations create economicrents, strong interests are created to maintain theprotection. There is also evidence that onceprotection is lifted, these previously protected firmsare not the ones that excel. If the infant-industryapproach had been effective, the now mature firms

should be the industry leaders on productivity andgrowth. However, in practice the reverse is often true.As protection is removed, these older firms oftensuffer substantial losses as they adjust. The firmsthat emerge best able to compete in the morecompetitive market conditions are often new firmsthat are not hampered by operational structures orhabits created by the earlier distortionary incentives.One example is the Indian machine tool industry. Thesector had received protection through the early1990s. Productivity dispersion was reasonably large.The fall in protection has led to a reduction in thenumber of Indian firms as Taiwanese and Japaneseimports entered the market. Productivity levels havebeen rising, and dispersion falling. Strikingly, it is anew local entrant that has become the mostproductive Indian producer – and its costeffectiveness rivals that of its Taiwanese competitors.(Sutton 2001, figure 2.9).

C. Infrastructure

The status of infrastructure in India is far fromsatisfactory as revealed by competitiveness rankings.Under the rubric of the quality of physical infrastructurewe include the state of power supply,telecommunication services, transport, and watersupply. WBES explored both the overall efficiency ofgovernment in delivering services and the quality ofindividual services. Fifty five percent of the firms inIndia rate the overall efficiency of government as pooras compared with 20 percent of the enterprises inChina. (see Figure 2.10). Turning to specific services,least favorably-rated services were public works/roads.

TransportationTransportation is clearly an area where India’sinfrastructure does not meet that of its regionalneighbors. The total container volume handled at allthe Indian ports combined together is lower than that


11 kW machines

7.5 kW machines

Taiwan

Taiwan – wage

adjusted

India

Number of machines per year per worker (log scale)

Figure 2.9. Reletive productivity in machine tools, 1999

0.1 1 10

Taiwan

Taiwan – wage

adjusted

India

Number of machines per year per worker (log scale)

0.1 1 10


80

40

60

0

20

Percent of firms ranking service as poor

Figure 2.10. Overall quality of public services, 1999

RoadsOverall

gvt efficiency

PowerCustoms

WaterTelephone

IndiaChina

20

15

0

10

5

Thousands of TEUS per annum

Figure 2.11. World’s top container ports, 1999

SingaporeHong Kong

BangkokShanghai

All IndiaManila

100

75

0

50

25

Percentage of total

Figure 2.12. Paved roads, 1999

SingaporeThailand

ChinaTaiwan

PakistanMalaysia India

Market share of freight

Market share of passengers

Route electrified

Freight of traffic units

Percentage

Figure 2.13. Comparison of Indian and Chinese railways, 1999

0 4020 60 80

IndiaChina

passing through Shanghai (figure 2.11). The percentof paved roads in India, at 56 percent, is lower thanthe average of 88 percent in most East Asiancountries (figure 2.12); a comparison of the freighttraffic of the Indian and Chinese railways shows Indialagging way behind. Freight as a percent of trafficunits is a mere 5 percent in India compared to 79percent in China (figure 2.13).

Comparing the transportation costs associatedwith shipping a container of textiles to the UnitedStates, costs are over 20% higher for India comparedto Thailand, and 35% higher than from China (figure2.14). Variations in maritime distances explain only asmall part of the gap. Delays and inefficiencies in theports, in particular customs, account for a highershare of the difference in port productivity (seesection on customs administration).

PowerAccess to reliable power at reasonable cost is aprime concern for most manufacturing firms. India-wide, the shortfall in meeting demand isconservatively estimated as 11% for regular and 18%for peak energy demand, although the variationacross states is substantial. In power generation, aswell, there is considerable variation across thecountry, but on average energy costs are relativelyhigh in India. In part this reflects the need for agreater proportion of firms, even of small and mediumfirms, to operate their own generator. In fact, India isfairly remarkable in that most small and mediumenterprises that we surveyed have their own powergenerator. This is much less common in economiessuch as China, Thailand, or Korea. Less able toachieve efficient scale with their own generator,energy costs are high. In our surveys 69% of Indianfirms had their own power generator, compared to30% in China. Comparing garments and electronicswith East Asian countries, energy costs are doublethose in Indonesia, the Philippines and Thailand(figure 2.15).


50

20

30

40

–10

10

0

Percentage cost advantage compared to India

Figure 2.14. Shipping costs disadvantages—Textiles, 1999

ThailandIndonesia

China SouthKorea

Brazil

East coast West coast USA

4

2

0

3

1

Percentage

Figure 2.15. Energy costs as share of total sales, 1999

IndiaChina

IndonesiaPhilippines

Thailand

Garments Electronics

A primary reason for the poor performance of thepower sector is that until the 1990’s power generationand distribution were a monopoly of governmentowned enterprises under State Electricity Boards(SEBs). These SEBs have followed a deliberate policyof under-pricing the supply of electricity to householdsand farms, only part of which they have managed topass to industry through tariffs well above cost andinternational rates.14 This and the boards’ growingfailure to protect transmission and collect bills, has ledto serious under-investment in maintenance andcapacity. Recent efforts at attracting privateinvestment as a solution include the opening up ofgeneration and distribution to private capital and theunbundling of SEB’s into independent commercialagencies specializing in generation, transmission ordistribution only. In most states these efforts have yetto bear fruit partly because of the absence of aregulatory framework in which potential investors haveconfidence. Meanwhile growing pressure on theexisting productive capacity of the sector has meantmore and more erratic supply to which industrial usershave been responding through own generation. Sincepower supply is an activity of extremely largeeconomies of scale this has inevitably meantincreases in business costs.

TelecommunicationsBusiness managers do not complain about the qualityof telecommunications as much as they do about thepower supply situation. In this area, India’sperformance is comparable to China, but clearlybehind many East Asian and Latin American countries.Particularly on the number of internet hosts per 10,000people, India still has a fraction of the number in thePhilippines, Thailand or Malaysia (figure 2.16). Thenumber, however, has been growing rapidly. It is justbehind the number in China, and with the highergrowth rate, will likely surpass it soon. On the numberof main telephone lines per 1000 people—both fixedand cellular-- India trails behind Malaysia, Thailand,

Philippines, China and Indonesia, (figure 2.17). Whilein China the number of fixed lines grew at 300 percentbetween 1997-2000, they grew at half the rate--140percent in India. The waiting list for a connection ishigher now than at the start of the decade, at over 2.8million, around 20% of the present number of lines.

However, the limitations of aggregate quantitativemeasures is that they mask the variance in themeasures across a country. The average can bemisleading if highly skewed to only a sub-region of acountry. That India has on average 12 fixedtelephone lines says nothing about the relative ease ofaccess in Mumbai or rural UP.


Mexico

Chile

Brazil

Argentina

Thailand

Philippines

Malaysia

Korea

Indonesia

China

India

Internet hosts per 10,000 people, 1999

Figure 2.16. Internet hosts

0 2010 30 40

1999 1995

WaterOf 27 Asian cities with populations over 1 million,India’s four largest cities are ranked among the fiveworst cities in terms of water availability hours per day.Physical losses are typically high, despite lowpressures, ranging from 25% to over 50%. Lack ofavailability of water affects the urban poordisproportionately. In Delhi, for example, even thoughthe official per capita water supply is about 200 litersper day, about 30% of the city’s 9 million people haveaccess to less than 25 liters per day.

D. Regulatory burden, governance, and corruption

The final category broadly looks at the burdens firmsface in complying with regulations, the quality of theservices provided by these regulations and the extentto which corruption is associated with the

procurement of such services. Using data fromKaufman, Kraay and Zoido-Lobaton (1999), weselected five of their composite indicators ofgovernance that best captures the dimensions ofinterest.15 The categories include:

Government effectiveness measures of bureaucraticdelays, competence of officials, the quality of publicservice delivery and the independence of the civilservice from political pressures. This grouping ofindicators covers the elements needed for thegovernment to design and implement good policies.Regulatory burden includes the numbers ofregulations within a market, the number of marketsthat are regulated, competition policy measures,and price controls. This captures more of theoutcomes of the policies and provides a sense ofhow market-friendly the business environment is.Rule of law captures the extent of crime, propertyrights, tax evasion and the legal system’seffectiveness. It indicates the enforceability ofcontracts and the predictability of rules.Graft measures include the frequency and size ofirregular payments.Political instability and violence measures theincidence of coups, assassinations, riots, armedconflicts and provides a measure of the likelihoodof a violent overthrow of a governing party.16

The individual measures of governance are plotted on‘governance pentagons’ in Figure 2.18 for India andselected countries. The outer web indicates the bestperformance, and the inner web the median measurefor the 174 countries for which measures wereavailable. Thus the larger the country’s web, thebetter its governance is measured to be. India scoresrelatively well, near the median for political stabilityand regulatory framework, somewhat below forcorruption and government effectiveness andsomewhat better for rule of law. The comparison withChina does not reveal stark differences. China ranks


20

10

15

0

5

Percentage

Figure 2.17. Fixed line and cellular mobile teledensity in India

ChinaIndia

IndonesiaMalaysia

PhilippinesThailand

Fixed Mobile

better on the stability index, somewhat better ongovernment effectiveness and marginally worse onrule of law. Brazil and Thailand do not showdramatically better governance patterns, despite thefact that they do receive greater FDI.

In term of FDI/GDP, India is closer to Indonesia –although India displays considerably strongerelements of governance.

In addition to these results from qualitativeresponses, there are some quantitative measures ofthe regulatory environment. Two particularly usefulmeasures are the amount of management time spentdealing with government officials and the frequency ofmaking irregular payments.

The amount of time spent with officials provides adirect measure of the regulatory burden faced byentrepreneurs (Figure 2.19), and one that is givenconsiderable weight by firms. The measure is alsocorrelated with general costs of corruption, as timewith officials often indicates the likely openings fordemands of irregular payments. On this dimension,India does not compare so favorably. In China theamount of time is just over 9%, in Latin America, it isabout 11%, while it is 12% in transitional Europe. InIndia, it is 16%. Clearly this is an area of relativeweakness for India. The opportunity cost of managers’time is considerable.

As for the frequency of making irregular paymentsto officials, the rate is about 90% for India, Indonesia,the Philippines and Thailand, while it is almost half thatin Malaysia. The share that reported doing so‘always’ or ‘mostly’ is highest in Thailand andcomparable in India and Indonesia (figure 2.20).What is interesting however, is that while Thai firmsreport having to make irregular payments morefrequently than firms from Indonesia, this was notnecessarily seen as a larger impediment to doingbusiness. If there is little uncertainty regarding the sizeof the payments and if the payments do secure thedesired services, many report that the corruption isnot much of a problem. As can be seen in figure 2.21,


India

China

Figure 2.18. Governance “pentagons”

Source: Kaufman, Kraay and Zoido-Laboton, 1999

RegulationsRule of law

CorruptionGovernmenteffectiveness

Political stability

RegulationsRule of law

CorruptionGovernmenteffectiveness

Political stability

Brazil

Thailand

Indonesia

the ‘frequency of payments’ is much less correlatedwith ‘business costs of corruption’ than is the burdenassociated with the ‘time senior management spendswith government agencies and regulators.’

The discussion so far has been on the overallregulatory environment, but within this there can beconsiderable variation among different areas. Apartfrom its role in the regulation of industrial relations (seediscussion above), the areas that business peoplewere most concerned about were interactions withcustoms officials, tax officials, and inspectorsenforcing a variety of health, safety and environmentalstandards with which all establishments employing 10workers or more must comply.

Customs administrationOne area of regulation that has received considerableattention in the past – attention that has helped spurreform – is customs administration. Of the variousregulatory agencies that are seen as obstacles, customsofficials ranked second – only behind labor regulations –as a major constraint to doing business in India.

The issue has two broad concerns. The first is thedelay in getting goods cleared. Such delays are ofsignificant consideration for firms relying on importedinputs. The surveys include information on thenumber of days it takes to clear customs. Here, Indiascores poorly relative to Korea and Thailand, with thetime about 50% longer in India (and triple what manyOECD countries report). But the issue is not just theaverage time, but also variances in clearance time.The right side of Figure 2.22 shows the longest delayin the past year for a typical firm in three sectors inIndia. While the average clearance time is 11 days,the longest delays averaged almost 28 days forgarments and 25 days for pharmaceuticals. Suchdelays function like a tax on firms. With suchuncertainty, firms are likely to need to keep greaterinventories of materials on hand, incurring significantstorage costs and tying up resources that could beotherwise put to more productive use.


20

15

0

10

5

Percentage of management time

Figure 2.19. Management time spent dealing with public officials on regulations, administration, 1999

Source: World Business Environment Survey (WBES) ©2000 The World Bank Group

China TransitionalEurope

LACIndia OECD

100

0

50

25

75

Percentage of management time

Figure 2.20. Frequency of payments to officials to get things done, 1999

Source: World Business Environment Survey (WBES) ©2000 The World Bank Group

Note: China did not allow this question to be included

AlwaysSharethat pay Mostly

FrequentlyInfrequently

India Indonesia Thailand


Business costs of corruption

Time senior management spends with government

agencies/regulators

Frequency of irregular

payments

Burden of regulations

Unreported profits and

wages

Ranking out of 75 countries surveyed in the Global Competitiveness Report 2001

Strongest Weakest

Figure 2.21. Regulatory burden and corruption

0 25 50 75

IndiaChina

India

12

0

3

6

9

Last time Longest time

Days

Figure 2.22. Days taken to clear goods at customs, 1999

30

0

20

10

Days

Garments Textiles Pharma.

10.6

9.5 9.9

27.8

13.9

24.8

India ThailandSouthKorea

China

10.6

7.07.0

7.8

Tax officialsAfter customs administration, interactions with taxofficials ranked as the next most onerous obstacle inthe regulatory burden facing Indian businesses. Over40% of respondents rank it as a top obstacle, relativeto 30% in China. (figure 2.23) It should be noted thatthis measurement does differentiate betweencomplaints regarding tax rates (a virtually universalcomplaint) and the burden imposed by taxadministration officials. Tax authorities both have agreat deal of power – and discretion – leading tounofficial payments. Complexities in the tax laws alsolead to onerous procedures and uncertainty regardingcompliance. Streamlining the procedures andincreasing the transparency of the system would beimportant areas for reform.

InspectionsNothing is peculiar about India’s legislation on safety,health or environmental standards, and their properenforcement is as much necessary as is that of similarlaws anywhere else. The standards are set out inseveral pieces of legislation including Factories Act of1948, the Water Act of 1974, the Air Act of 1981 andthe Environmental Protection Act of 1986.17 Whilethese too are in the nature of federal law, theiradministration is also mainly the responsibility of stategovernments, who again have a good deal ofdiscretion in enforcement.18 The chief instrument ofenforcement is routine visits to business premises bystate inspectors, who have the power to suspend allplant operations if this is necessary for the purpose ofinspection. However, as in many other developingcountries, business people in India complain thatenforcement is too discretionary, which is a source ofcorruption and harassment (Ahluwalia, 1999).

Legal SystemAccording to the World Business Environment Survey,75 percent of the firms were confident that the legalsystem would uphold their property rights (figure 2.24).

In general, the quality of courts was perceived to bepoor by less than a third of the firms interviewed. Themost obvious characteristic of courts that is regardedas negative is the speed with which they operate: 88%of firms responded that courts were "never", "seldom"or only "sometimes" quick (as opposed to "always","usually" or "frequently"), consistent with the earlierdiscussion in the sections on land and finance. Asecond dimension in which courts were found wantingis their affordability, followed by enforceability andconsistency (figure 2.25).

Thus, while some of the broad indicators of theinvestment climate suggest that India’s profile is notsignificantly different from China’s, Brazil’s or evenThailand’s, despite the gaps in FDI received, thesesubjective rankings are often only crude measures ofwhat matters to entrepreneurs. As demonstratedabove, targeted indices show greater variation inperformance. India has particularly low performanceregarding the regulation of entry and exits of firms.


High taxes

Labor

Customs

Tax administration

Environmental

Foreign currency

Business

Fire

Percentage of firms ranking issue as moderate or major obstacle

Figure 2.23. Regulatory obstacles, 1999

0 4020 60 80

IndiaChina

This is reflected in bankruptcy proceedings thatroutinely extend for years, the extreme difficulty offirms with over 100 employees to gain thegovernment’s permission to retrench workers, thebarriers to land acquisition and delays in opening anew business. This helps explain the low share oflabor in the formal private sector, the shockingly lowlevel of bankruptcies, and the wide dispersion ofproductivity that exists within India The regulatoryburden in India is quite high, although the frequencyof payments associated with corruption appears to beless of an issue.

Clearly the regulatory environment, governanceand corruption can act as barriers to growth andimproved efficiency of all firms. But there is anadditional dimension when considering one of thepuzzles laid out at the beginning of this chapter,namely those concerns that can affect both whetherforeign investors come and how they choose to enterthe market. On the one hand, a maze ofbureaucracy makes it relatively more attractive tohave a local partner, so that multinationals form jointventures. On the other hand, too many fears ofcorruption will deter investors altogether or makewholly owned affiliates seem necessary as a meansof maintaining control of any intangible assets.These effects have been studied using firm leveldata from transition economies in Europe and Asia.The results show that corruption is associated with acountry’s ability to attract FDI and the potential fortechnology spillovers to be realized.19 Overall,countries with higher incidence of corruptionreceived less foreign investment. And those firmsthat did enter countries with greater corruption,displayed less R&D intensity and were more likely toenter as a wholly owned greenfield investment ratherthan through a merger or joint venture. Withtechnology transfer greatest for joint ventures,greenfield investments in less technology intensiveindustries means corruption significantly reduces thescope for spillovers.


100

75

0

50

25

Percentage

Source: World Business Environment Survey

Figure 2.24. Percent firms confident that Legal system will uphold property rights, 1999

PhilippinesIndonesia

ChinaPakistan

MalaysiaIndia Singapore

100

50

75

0

25

Percentage

Source: WBES

Figure 2.25. Percent firms reporting poor judicial system, 1999

FairHonest

QuickAffordable

ConsistentEnforcable

IndiaChina

Attracting foreign investors can have spilloverbenefits for the economy. Demonstration effects canalert local entrepreneurs both to the existence of andprofitability of using alternative technologies andprocesses. Local firms can then simply improve theirproductivity by copying the foreign affiliates’techniques. Forward and backward linkages can bea further source of spillovers if foreign firms assist withnew management or marketing techniques, providetechnical and quality control assistance and provideaccess to improved inputs and capital goods. Thetraining of workers – and their subsequent mobility –can be a further source for spillovers. However,attempts to entice FDI through tax holidays,subsidized land and other benefits can all too oftenbackfire, costing the country more than the value ofbenefits received. Alternatively, improving the qualityof infrastructure and the regulatory environment is astrategy that will both assist the competitive positionof domestic firms, and serve to make the local marketan attractive location for foreign businesses too.

The issue is not whether or not there isregulation. All market economies need regulations– for example covering safety, environment,disclosure rules and competition policy. What, is atissue is the extent and nature of the regulations,their efficiency and transparency. The relativelylarge productivity dispersions in India – as well asthe data on time spent with management, thefrequency of payments and delays in customsindicate continued regulatory improvements will bekey for sustained productivity growth.

E. Conclusion

India is embarking on a path of greater integrationwith the global economy. Openness to greater foreigncompetition will require adjustments, but it holds outthe potential for dynamic gains. Greater competitionwill not just increase productivity levels through the

reallocation of resources. It will also increaseproductivity growth through technology spillovers,improved inputs, and learning effects. An importantcomplement to greater openness to foreigncompetition is to strengthen the domestic investmentclimate in order to maximize these dynamic benefits.This will facilitate the adjustment process, particularlyencouraging the entry of new, more productive firms.The speed of adjustment can be accelerated and thecosts minimized, the fewer distortions and barriers tomovement there are in factor markets and barriers toentry more generally. Strong domestic competitionand well functioning regulations will also increase theability of local firms to benefit from spillovers from thelarger foreign presence in the economy.

The emphasis put on the quality of the investmentclimate as a means of maximizing the benefits ofopenness should not be interpreted as meaningIndia should not liberalize further until all its domesticinstitutions and infrastructure are already in place. Infact, the international market itself can be a sourcefor strengthening aspects of the investment climate.Particularly in infrastructure and some non-tradedservices, foreigners offer expertise that can improvelocal provision, lower prices and improve links toglobal networks. Examples include foreign entry intelecommunications, port administration, pre-shipment inspection certification, and foreignfinancial services. One caveat, however, is thatmany of these areas are natural monopolies.Regulation of the foreign company will still benecessary to ensure that benefits are realized andthat market power is not abused.

This chapter has examined qualitative rankings,quantitative national indicators and micro-evidencethat consistently point to the priority areas for reform inIndia. The productivity dispersion of firms – large byinternational comparison – demonstrates the need tocontinue the process of regulatory reform, easing theability of firms to enter, expand and exit as they adjustto a more competitive environment. The international


comparisons demonstrate the clear need to focus onimprovements in infrastructure in the areas of portefficiency, power generation and telecommunications.

Some of these reforms need to occur at the statelevel and will be taken up in greater detail in the nextchapter. But key reforms are needed at the unionlevel as well, the most important of which are:

labor regulations: as proposed in the budget, theflexibility to adjust labor use should be extendedto firms in the 100-1000 employee range; land transactions: the tax and regulatory costs oftransferring land need to be reduced;financial sector reform to improve access and reducethe spread between deposit and lending rates;continued bankruptcy reform to improve theallocation of resources and access to credit; andcustoms administration reform to reduceclearance times.

Notes

Omkar Goswami, et. al. (2002) "Competitivenessof Indian Manufacturing: Results from a Firm-Level Survey," Confederation of Indian Industry.Hallward-Driemeier, Mary. (2001) "Firm-LevelSurvey Provides Data on Asia’s Corporate Crisisand Recovery", World Bank Policy ResearchWorking Paper No. 2515.For example, Kaufman, Kraay and Zoido-Lobatoncaution, the standard errors on the combinedindices made up of dozens of individual indicatorsare large and "it is misleading to offer very preciserankings of countries according to their level ofgovernance: small differences in country rankingsare unlikely to be statistically - let alone practically- significant." They also argue that while theiraggregated indices give a more consistent pictureof the overall level of governance than anyindividual measure, their indices are most

appropriate for sorting countries into broadgroupings rather than giving strict rankings.Confederation of Indian Industry.Secretariat of Industrial Activities Newsletter(August 1999), Ministry of Industry, India.Mathur, Ajeet N. (1993) "Industrial Restructuringand the National Renewal Fund", AsianDevelopment Bank mimeo.Studies looking at the USA have found that in agiven 5 year period, about 30% of firms will go outof business. Among larger firms (those with 150or more employees) the rate is still high at 16%.This churning can be productive if it allows forinnovative new firms to enter. In their study of anumber of Latin American countries, Roberts andTybout (1996) find similar patterns of firm turnover.See, for example, Sachs, Vashney and Bajpai(1999), who also blame labor market rigidity forthe "shockingly low" share of formal sectoremployment in India’s economy. The authorscalculate that only 8.5 percent of India’s laborforce or 27 million people are in formal sectoremployment of which 70 percent work forgovernment agencies.This too applies for establishments with more than100 employees, but Zaga (1999) notes that somestates have made the provisions mandatory to firmswith 50 or more workers while other states haveabolished the employment size limit altogether.Economist Intelligence Unit, Country Profile 2001,p. 32.India Infrastructure Report, 2001.McKinsey, India: The Growth Imperative, 2000.See, for example, Parkih (1995), who points outthat SEB’s managed to cover only 80 percent oftheir costs through user charges, despite thelevying of high tariffs on industrial users.These governance indices are the compilations ofup to 60 sub-indices from various sources. Somequalifications should be noted when using thesesubjective measures to compare competitive


2.

3.

4.

5.6.

7.

8.

9.

10.

11.

12.13.14.

15.

environments. They revolve around the issue ofthe yardstick used in judging a country’sperformance. First, the point of reference itselfcan vary across country. In one study, Koreanentrepreneurs’ rankings of problems wereconsistently higher than those of Indonesians.Now, few would believe the business environmentin Indonesia to be superior to that of Korea.Rather, a more plausible explanation is that theKorean entrepreneurs had relatively highexpectations of services their government shouldprovide and shortfalls were readily registered. Incontrast, if there are few expectations that aservice will be performed, its failure is not seen asparticularly problematic. Controlling fordifferences in country mean responses offers atleast a partial solution.

Another shortcoming of these measures is thatthey register very little change over time, and donot necessarily reflect that substantialimprovements have been made in the substantivearea over time. Again, this may be due tochanges in the subjective yardstick against whichthey are being measured. For example, as thejudicial system is reformed, expectations will riseas to what role the courts should play. Failure tomeet expectations could lead to low rankings,even as the system improves.

These subjective rankings are more useful formaking comparisons within a single country thanfor attaching great significance to the internationalranking. Thus, one can look among Indianentrepreneurs to see the relative rankings ofproblems, for example infrastructure versuscorruption, rather than looking at perceptions ofcorruption between India and its neighbors.Unfortunately these indicators are rarely used inthis fashion. The political instability measure is primarilyconcerned with the probability of violent shifts inpolitical power rather than constitutionally

sanctioned shifts in policy stance. Certainly civilunrest captures the extreme costs of instability,but ideally, a measure of constancy of policyapproach and measures of uncertainty stemmingfrom policy shifts would be closer to our view ofthe investment climate. The other four are highlycorrelated, with correlations of 0.69 to 0.93. Thesehigh correlations can make it difficult to testeconometrically for the relative importance of thedifferent measures, but each independently doesprovide significant explanatory power.More specialized standards are set in a numberof statutes such as the Building andConstructions Act, the Mines Safety Act, and theChild Labour Act. For example, the government of Tamil Naduexempts the software producers from theprovisions of the Factories Act as long as they donot engage manufacturing activities.Smarzynska and Wei 2000, Djankov andHoekman 2000.


16.

17.

18.

19.

A. Introduction 46

B. Inter-state differences in investment climate 48

C. The Cost of specific bottlenecks in investment climate 56

D. Summary and conclusion 61


‘Spurned by Maharashtra, disappointed by lack ofinterest from Delhi, and wary of the power supplysituation in Karnataka, ... Ford eventually choseChennai to setup its [manufacturing plant] because ofthe availability of a supplier-base, skilled labor, andinfrastructure.’ Business Today, December 22, 1999.

‘ When the government relinquished its power todictate where factories should be built, investorspicked the places where conditions were best.’ TheEconomist, June 2, 2001.

A. Introduction

The location saga of Ford in India in the 1990s isinteresting for at least two reasons. First, it illustratesthe critical role that state-level public policy has cometo play in the regional allocation of foreign anddomestic capital in India. Although the Indianconstitution endows states with substantial economicpolicymaking power, this was largely renderedtheoretical by central planning prior to the onset ofreforms in 1991. Secondly, the menu of locations thatFord is reported to have chosen from is ratherexclusive, given that there are 26 states and Unionterritories in the country. Indeed Ford’s eventualdecision to locate in Chennai, Tamil Nadu, conformsto a trend of the past decade whereby six states thataccount for less than a third of the population haveattracted practically all foreign direct investment andthe bulk of private domestic investment. This nodoubt had a lot to do with industrial clustering: somestates lacked the auto-components-supplier baseFord was reportedly looking for. But it should also benoted that they were in any case inferior to the fourstates it did consider in other key elements ofinvestment climate, namely, labor market flexibility,the state of industrial regulation, and the provision ofbasic (physical) infrastructure.

This chapter examines the cost to Indian statesand the overall economy of deficiencies in these

elements. There is considerable consensus in thebusiness community and among policy-makers inIndia as to where the investment climate is particularlypoor, in what respects, and where even the better-climate states are lacking by international standards.Unfortunately, not much is known about the cost ofparticular deficiencies in terms of unrealizedopportunity for growth or of lost productivity. Everyoneknows, for example, that the high cost and extremeunreliability of power supply has harmed prospectsfor growth. But how serious is this harm compared toadverse effects of poorer transport, poorertelecommunications, malfunctioning labor markets, orexcessive burden of industrial regulation?

We address this question by mapping objectiveindicators of the local investment climate to theperformance of firms in terms of business growth orbusiness productivity and using the parameters of themapping to estimate the cost of deficiencies ininvestment climate in one of two equivalent ways. Inone of these we use the parameter estimates toallocate the performance gap of the average businessestablishment of a region to specific sources in theinvestment climate much in the same way as is donein the literature on "growth accounting" or on "earningsdifferentials". In the second we compare theperformance index of the average establishment witha counterfactual in which the true vector of its climateindicators is replaced by the best attainable alternativevector. Our estimate of the cost of deficiencies in theinvestment climate of an economy is simply theamount by which the actual performance index of itsaverage firm falls short of the counterfactual.

Ideally we would conduct the analysis at the statelevel. However, with ten states to contend with, thiswould have meant too many dimensions to bring outclearly regularities in the data. We therefore decidedto aggregate the states into those in which theinvestment climate was "best," "good," "medium," andrather "poor." The financial press in India has for sometime been ranking states based on opinion polls taken


within the business community, which the FACSinstrument followed by including questions in whichmangers were asked to rank the ten states by keyaspects of investment climate. We classified statesinto the four grades according to votes received inresponse to these questions.

The data analyzed in the chapter come almostentirely from the Firm Analysis and CompetitivenessSurvey (FACS) of India. This survey was carried outduring March-November 2000 as a collaborativeproject of the Confederation of Indian Industry (CII)and the World Bank, covering a total of 1032businesses in eight exporting industries, namely,textiles, garments, pharmaceuticals, electronics,electrical white goods, auto-components (Figure3.1). Establishments were sampled from the statesof Andra Pradesh, Delhi, Gujarat, Karnataka,Kerala, Maharashtra, Punjab, Tamil Nadu, UttarPradesh and West Bengal.20 As already notedsurvey average ranking scores by respondents ledus to classify Maharashtra and Gujarat as "best-climate" states at one extreme and Kerala, UttarPradesh and West Bengal as poor-climate states atthe other. Andra Pradesh, Karnataka, and TamilNadu were far closer to the best climate states thanto the poor-climate states. Accordingly we groupedthem as good-climate states. Punjab and Delhicame in between the good and the poor as mediumclimate states.

In addition to a range of questions of opinion inwhich managers were asked to assess aspects of theinvestment climate of their states and India as awhole, the FACS instrument included extensiveestablishment-focused modules on production,finance, business organization and the economicenvironment within which each establishmentoperated. The modules generated data that we use inthe next section to estimate the cost that excessivelabor market rigidity, excessive regulatory burden,and poor provision of physical infrastructure haveimposed on India’s economy. The main conclusion

we draw from the estimation is that the cost is veryhigh almost everywhere in India when measured asforegone growth or as lost productivity. Exact sourcesof this cost vary by region, and it should be stressedthat states ranked as 'best' are not the best in alldimensions of the investment climate. Thus labormarket rigidity is costing businesses the most in good-climate states while excessive regulatory burden andpoor infrastructure have been far more damaginginfluences in poor-climate states. Not surprisinglyeven the best climate states can improve their growthperformance considerably by bringing up their powerand telecom infrastructure to the standards of thegood or medium climate states.


Best climate

Good climate

Medium climate

Poor climate

Auto components

Drugs and pharmaceuticals

Electrical white goods

Electrical consumer goods

Garments

Textiles

Machine tools

Software

Maharashtra

Gujarat

Andhra Pradesh

Karnataku

Tamil Nadu

Delhi

Punjab

Kerala

West Bengal

Uttar Pradesh

Category

Sectors

State

Figure 3.1. FACS—India state coverage,by investment climate, 1999

The next section will provide more detail in theoverall ranking and growth performance of states,followed by how they compare on specific dimensionsof the investment climate. The third section thenmaps how the differences in investment climate affectbusiness performance. It both provides a means ofquantifying the relative importance of differentdimensions of the investment climate, and indicatesthe scope for enhanced growth and productivity ofstates if they were to make specific improvements intheir infrastructure services and reductions in theirregulatory burdens.

Here are some of our conclusions. Reducing theburden of industrial regulation in poor-climate statesto the current level in Maharashtra and Gujarat-i.e, thebest-climate states—would increase the averagebusiness growth rate in poor-climate states by 2percentage points per annum. This is assuming thatnothing else of consequence would be changed inpoor-climate states from what was observed at thetime the survey. However, if, in addition, power supplyand telecommunication services were improved to thecurrent situation in good-climate states, the averagebusiness growth rate of poor-climate states would riseby a further 3 percentage points a year. Similarlyreducing the burden of industrial regulation in good-climates to the level currently in force in Maharashtraand Gujarat would raise the average business growthrate in good climate sates by just under 2 percentagepoints a year. Business growth in best climate stateswould benefit to a similar degree from improvement inthe provision of infrastructure to the level in good-climate states. In their own right, these figures implythat there exists scope for large increments in thegrowth rate of the Indian economy throughimprovements in investment climate.

B. Inter-state differences in investment climate

Entrepreneurs’ Ranking of RegionalInvestment ClimatesThe Firm Analysis and Competitiveness Survey ofIndia asked business managers to identify the statesthat they thought had a better or worse investmentclimate than the state in which they were currentlybased. They were also asked to tell which of the 10states had the best investment climate, and whichhad the worst. And by how much would the unit costof production of the current business be lower if thebusiness were in what the manager identified as thebest state? By how much would it be higher if thebusiness were, instead, in ‘the worst-climate’ state?

More than seventy percent of respondentsthought that Maharashtra had a better investmentclimate than their own state. About 65 percent thoughtthat the investment climate of Uttar Pradesh wasworse than that in their state. In Figure 3.2 each of theother eight states is ranked between these extremesby the difference between the percentage ofrespondents identifying it as a betterclimate stateand the percentage of those identifying it as a worse–climate state. Alternatively, we can do the ranking bythe difference between the percentage of those whothought a state had the best climate and thepercentage of those who thought it had the worstclimate. Both approaches lead to the same ranking.

Yet another alternative index (also leading to thesame ranking as the other two) is the average costadvantage of a state according to those who thoughtit had the best climate less its average costdisadvantage according to those who thought it hadthe worst climate. The average respondent put a costpremium of about 30 percent to locating in UttarPradesh rather than in Maharashtra. Respondentsalso attach a cost premium to locating in any of thebottom five ranked states in Figure 3.2 rather thanlocating in the top-five, with the premium getting



80

0

40

–80

–40

Percentage of respondents

Figure 3.2. Investment climate: perception of firms outside the state

UttarPradesh

WestBengal

Kerala Punjab Delhi TamilNadu

Karnataka AndhraPradesh

Gujarat Mahara-shtra

Best Better Worse Worst

Net % cost saving by moving to…

–100 –50

UttarPradesh

WestBengal

Kerala

PunjabDelhi

Tamil NaduKarnataka Maharashtra

GujaratAndhraPradesh

15

–15

–30

10050

% ranking worse% ranking better

Figure 3.3. Rankings of investment climate

smaller as the rank gap of a pair gets smaller. Figure3.3 is a scatter plot of the perceived net cost-advantage of a state against the difference betweenthe percentage of those who thought it had a betterclimate than their current state and the percentage ofthose who thought it had a worse climate. It brings outas clear favorites the states of Maharashtra andGujarat, which we will consequently refer to as "best-climate" states in the rest of the report. In contrast,Uttar Padesh, West Bengal and Kerala will be calledthe "poor-climate" states as they come out as the leastfavored investment locations. Although not as favoredas the "best", Karnataka, Andra Pradesh and TamilNadu are our "good-climate" states because a veryhigh proportion of mangers attributed a high costadvantage to them over the remaining statesincluding Punjab and Delhi. Delhi and Punjab fallroughly mid-way between ‘good’ climate states andpoor-climate states and are, consequently, the‘medium-climate’ states.

Perception of Climate and Investment DecisionsThat these subjective ratings reflect beliefs that areheld by our respondents strongly enough to governtheir investment decisions can be seen from Figure3.4. The vertical axis of the diagram measures theaverage rate of net fixed capital formation ascomputed from our survey data for the years 1998and 1999. Controlling for initial capital stock, industryof activity, initial capital intensity and initial debt-to-equity ratio, this figure is far higher for respondents inthe states ranked among the top five in Figure 3.2.The correspondence between the rankings ofFigures 3.2 and the line up in Figure 3.3 somewhatbreaks down for comparisons within the bottom fivestates. In particular average net fixed investment wasin fact negative for establishments sampled from‘medium-climate’ states while it was modest butpositive in ‘poor-climate’ states. Nonetheless, thebroad pattern remains that the rate of investment was

significantly higher in the best-climate states than inthe ‘good-climate’ states, and far higher in the good-climate states than in the medium-climate or the poor-climate states.

How representative of the views and actions of thewider business community is this pattern? In Figure3.5 we show the distribution of the value of proposedforeign direct investment in 1997-8 between the 10survey states. Delhi (not shown) attracted by far thelargest volume of FDI for that particular year,presumably because it is the capital city. Otherwise,the basic pattern of Figure 3.4 -- that the top fivestates of Figure 3.2 attracted far higher investmentthan the bottom four -- is very much in evidence inFigure 3.5 as well.

The ranking of states in Figure 3.2 lines up evenbetter with the relative growth performance of the 10states as observed over the years 1992-97 (Figure3.6). The annual average growth rate of real grossstate domestic product (GSDP) of the period was byfar the highest at 7.7 percent in our best-climate statesagainst a figure of 2.2 to 2.9 percent for the mediumand poor-climate states and just under 5 percent forthe good-climate states.

It is interesting that, although the regions that ourrespondents identify as of ‘best-climate’ or of ‘good-climate’ are relatively high-growth states, they are notnecessarily the wealthiest states. It is the ‘medium-climate’ states that are in fact the richest (Figure 3.7).At an average per capita GSDP of Rs 5672 for 1996-97, these states are slightly richer than the best-climate states and twice as wealthy as the good-climate states. However, the best-climate and good-climate states have been growing two to three timesfaster over the past decade. The relative prosperity ofregions is no doubt an important consideration in thelocation decisions of businesses in as far as it isindicative of the spatial distribution of purchasingpower. The rankings given by our survey respondentsnonetheless suggest that it is the more dynamicphenomena of investment and growth that



0.10

0

0.08

0.06

0.04

0.02

–0.04

–0.02

Rate

Figure 3.4. Inter-state gaps in mean rate of net fixed investment, 1999

UttarPradesh

Mahara-shtra


KarnatakaTamilNadu

Punjab DelhiKeralaWestBengal

5

4

3

2

1

0

Billion Rs

Figure 3.5. FDI in 1997–98 (1980 prices)

UttarPradesh

Mahara-shtra


KarnatakaTamilNadu

DelhiPunjabKeralaWestBengal

entrepreneurs’ perception of investment climatesregisters more and feeds into. From this point of view,the problem about poor-climate states seems to benot that they are the poorest states, or even that theyhave grown far slower, but rather that potentialinvestors currently rate their climates far lower thanthose of other states. Their growth prospects appearto be far dimmer as a result.

Objective Indicators of Investment ClimateGranted that entrepreneurs’ ratings of theinvestment climates of states that we glean from thesurvey data reflect adequately the perceptions of theIndian business community at large, how true toreality could these perceptions be? As part of oureffort to address this question, the FACS instrumentincluded a series of questions probing into thespecific factors that entrepreneurs took into accountwhen rating the investment climate of a state.Answers to one set of questions reveal thatrespondents typically factored their perception of thefunctioning of the labor market, the burden ofindustrial regulation and the provision of physicalinfrastructure into their overall evaluation. One way ofverifying their subjective grading could therefore beto compare the scores with objective indicators ofthese particular aspects of the investment climate. Asecond set of questions sought to generate some ofthe objective indicators that we sought for thispurposes. We will now discuss the indicators andthe extent to which their regional variation matchesup with the subjective grades of investment climatebefore moving on to an analysis of their correlationwith indicators of business performance.

Labor market flexibilityChapter 2 discussed the national level regulation thatmakes it difficult to adjust labor use. Although basiclegislation on labor relations is in the form of nationallaws, there are also amendments or subsidiarylegislation by states. This, plus variation in the


8

6

7.7

4.9

2.9

2.2

0

4

2

Percentage GDP

Figure 3.6. Annual average growth rate(Real GSDP, 1992–97)

Best IC Good IC Medium IC Poor IC

6,000

5017

3024

2413

5672

0

4,000

2,000

Figure 3.7. Per capita GSDP 1996–97(1980 prices)


discretionary enforcement of universal provisions bystates, has led to considerable inter-state differencesin labor market flexibility, by which we mean theconstraint businesses face in adjusting employmentto changes in technology and product marketconditions. In order to capture the extent of suchdifferences the FACS instrument posed the followingquestion to managers.

Given your current level of output, if you were freeto choose without restrictions your current level ofemployment, what percent of the current level wouldyou choose?

We interpret 100 minus the figure given inresponse to this question as the degree to which theestablishment was over-manned at the time of thesurvey, and use it as a proxy for the regulatoryburden businesses bear as a result of governmentintervention in industrial relations. Figure 3.8 showsthat this burden is quite high in all states, but is atleast twice as high in good-climate states as it is inany of the other categories. We do realize that overstaffing could in part be the outcome of laborhoarding that firms could resort to when theyanticipate significant growth in sales in the setting ofa tight labor market. However, a follow upsupplemental survey covering 188 manufacturersoutside of the original FACS sample in the states ofAndra Pradesh, Karnataka and Uttar Pradeshsuggests that labor hoarding was far less importantthan political and legal control as a possibleexplanation of the over manning figures reportedin Figure 3.8. The supplemental survey was carriedout using the same instrument as the original survey,but with new questions that followed up on olderquestions that led to the more intriguing findings.Thus, in the present context, respondents whoindicated that their plants were over staffed wereasked to explain why they found themselves in whatapparently was an unprofitable but avoidable


30

0

20

10

Percentage

Figure 3.8. Average reported over-manning as percentage of workforce, 1999


11.9

27.3

15.4 15.5

26.9

10.5

13.8 14.0

All SMEs

1.2

0

0.8

0.4

Proportion citing reason

Figure 3.9. Reported reasons for over-manning, 1999

Anticipationof salesgrowth

Unions/fear of

litigation

Politicalpressure

Socialnorms

0.32

0.23

0.39

0.23

1.0

0.23

0.94

0.56

Andhra Pradesh / Karnataka

Uttar Pradesh

situation.21 The responses we received aresummarized in Figure 3.9. In interpreting the graph itis useful to think of Uttar Pradesh as representativeof our ‘poor-climate’ states and of Andra Pradeshand Karnataka as ‘good-climate’ states. In bothtypes of states less than a third of those whoreported overmanning indicated that they werestocking up manpower in anticipation of an upturnin sales.

Industrial regulationApart from its role in the regulation of industrialrelations government routinely comes face to facewith businesses through its customs officials, taxofficials, and inspectors enforcing a variety of health,safety and environmental standards with which allestablishments employing 10 worker or more mustcomply. While many of these regulations too are inthe nature of federal law, their administration is alsomainly the responsibility of state governments, whoagain have a good deal of discretion inenforcement.22 The chief instrument of enforcementis routine visits to business premises by stateinspectors, who have the power to suspend all plantoperations if this is necessary for the purpose ofinspection. The cost that businesses incur inconsequence seems to vary considerably betweenstates. In order to measure this variation, the FACSinstrument asked respondents to specify the numberof inspection visits that their businesses had over thepast year. Inspection visits often mean loss ofvaluable management time as well as shop floortime. Even if this direct cost of inspection werenegligible, however, the average frequency of visitsin a state would still be a good proxy for the overallquality of governance or for the overall cost ofregulation. A visit less or a visit more may not makeor break a business in its own. We nonetheless thinkthat, other things being equal, inspection visits wouldbe more frequent in localities of poorer governanceor greater regulatory burden.


12

0

8

4

Number of visits

Figure 3.10. Annual average number of inspection visits by government officials, 1999


6.2 6.1

8.99.7

5.24.7

7.3

9.5

All SMEs

100

0

75

50

25

Percentage

Figure 3.11. Percent of establishments with own generators, 1999

Best Good Medium Poor

45.0

81.185.5

77.8

30.5

71.4

82.8

72.6

All SMEs

On this interpretation, Figure 3.10 suggests that,with an average frequency of 10 visits a year,businesses in poor –climate states seem to bearsignificantly higher regulatory burden than theircounter parts in good-to-best climate states, wherevisits average about 6 a year.23

Provision of physical infrastructureUnder the rubric of the quality of physicalinfrastructure we include the state of power supply,telecommunication services, transport, and watersupply. Of these, power supply is viewed by many asby far the strongest and most widespread bottleneckto investment and growth in the non-farm sector ofIndia’s economy. Given the erratic supply of power,many industrial users have responded by purchasingtheir own generators. Since power supply is anactivity of extremely high economies of scale this hasinevitably meant increases in business costs. It is alsoclearly tying up capital that firms could engage moreproductively in areas of their competence. Accordingto the supplemental survey in AP, UP and Karnataka,the cost of power generators is, on average, about 12percent of total fixed assets.

Although the problem is common to all India, itsgravity varies from state to state. We see in Figure3.11, for example, that 45 percent of all theestablishments we sampled from the best-climatestates have their own generators against acorresponding figure of between 71 percent and 83percent in other states. Figure 3.12 brings outdifferences in the degree of the problem that wecannot see in Figure 3.11, showing that the powersituation is in fact better in good-climate states than itis in the best-climate states. The figure relates to theunit cost of electricity from the public grid and whenown-supplied. Not surprisingly, the unit cost of public-grid supply does not vary much between states.However, the unit cost of own-supply does, and is, forexample, twice as high in poor-climate states as inbest or good climate states.


12

0

8

4

Rs/KWH

Figure 3.12. Cost of electricity, by source, 1999


Private generator all

Public grid SMEs

Public grid all

Private generator SMEs

60

0

40

20

Percent

Figure 3.13. Percent of businesses contacting customers by email, 1999


32.6

55.758.5

31.7

27.0

47.350.3

31.6

All SMEs

Business managers do not complain about thequality of telecommunications as much as they doabout the power supply situation. However, in thepresent context, the quality of services variessignificantly among states. An indicator of thisvariation is the regional pattern in the percentage ofbusinesses that communicate with customers viaemail. Figure 3.13 shows that, on this indicator, thequality of telecommunications is much better in thegood-climate and the medium-climate states than inthe poor-climate states as well as the best climatestates. For example, between 47 percent and 50percent of SMEs sampled from the good or mediumclimate states communicate with customers viaemail against 27 to 32 percent in poor or bestclimate states.

C. The Cost of specific bottlenecks in investment climate

The conclusion that we draw from this regional patternin objective indicators of investment climate is thatthey conform to the subjective ratings of businessmanagers in as far as they discriminate pretty wellbetween ‘poor-climate’ states, on the one hand, and‘good’ and ‘best’ climate states, on the other. Turningto the task of mapping the objective indicators tomeasures of business performance, the main goal ofthe exercise is to estimate the cost to the economy ofthe bottleneck that each indicator measures.However, the procedure is also an alternative way ofverifying subjective ratings of states by investmentclimates. In carrying it out we pick a commonly usedmeasure of performance, estimate the parameters ofits correlation with each climate indicator whileholding other factors of relevance constant, and thenuse those parameters to see how the performancemeasure changes as an indicator varies acrossstates. The underlying assumption is that theinvestment climate is a given from the point of view of

each business. The part of the performance gap ofthe average firm in a state compared to the averagefirm in another state that can be explained in terms ofthe indicators can then be interpreted as a measureof the cost that the economy of the poorer-climatestate incurs on account of failure to reform theirinvestment climate to the standards of other states.The greater is this cost, the more urgent would be theneed for reforms.

There are at least three possible measure ofbusiness performance that we could use here, namely:

the rate of growth of business sales;business productivity; andthe rate of fixed business investment

Of these the rate of business growth is the moregeneral measure in as far as performance in the othertwo ultimately translates into a growth scenario. It isnevertheless to useful to look at all three indictors toincrease our confidence that the findings are robust.If a bottleneck is really a problem, we should be ableto observe this in lower productivity, lower investmentrates, and slower growth of the business.

Regional Gaps in Business Growth Ratesand in Business ProductivityFigure 3.14 shows the average annual growth rate ofsales at constant prices for the FACS sample ofbusinesses for the period 1994-99. The figure controlsfor initial age, initial size, and industry. The poorclimate states not only have lower growth rates, theyactually have negative growth rates for the firms in thesample. It should be noted also that the averagegrowth performance of businesses is in fact 30percent higher in good climate states than in the bestclimate ones.

Would the same conclusion follow from a mappingof subjective ratings to regional patterns in businessproductivity? We see in Figure 3.15 that the answer isnot straightforward, partly because it depends on how


we define productivity. The simplest measure ofproductivity is value added per worker. In the verticalaxis of the figure we show the proportionate differencebetween value added per worker in each group ofstates and value added per worker in medium-climatestates. The regional pattern of this indicator is alsobroadly consistent with entrepreneurs’ ratings in as faras value added per worker is 28 to 45 percent lowerin poor-climate states than elsewhere and about 15percent higher in best-climate states than in good-climate states.

However, we should note that value added perworker itself depends partly on the capital intensity ofa business, partly on the average skill level of itsworkers, and partly on what remains once we accountfor these, that is, on the business’ overall productivity(or total factor productivity). We see from the secondset of bars in Figure 3.17 that, the gap in value addedper worker between poor-climate states and mediumclimate states that we observe in the first set hasnothing to do with differences in capital intensity. Theaverage business in a poor-climate state is as capitalintensive as the average business in a mediumclimate state. On the other hand, more than two-thirdsof the gap in value added per worker between best-climate states and good-climate states arises from thefact that businesses in good-climate states aresubstantially less capital intensive than businesses inbest-climate states and, indeed, than those in mediumclimate states as well.

The third set of bars in Figure 3.15 shows that oneof the main reasons why value added per worker is solow in poor-climate states than elsewhere is thatbusinesses in those states have a less skilledworkforce. Skill gaps also explain a substantial part ofthe gap between best-climate states and good-climate states in value added per worker. But why areaverage skill levels lower in poor-climate states thanelsewhere, or in good-climate states than in best ormedium climate states? One hypothesis is thatpoorer-climate states have poorer social


12

7

11

–4

8

–4

8

4

0

Percent

Figure 3.14. Annual average growth rate of sales, 1994–99, controlling for industry, size and age

Good IC Medium ICBest IC Poor IC

0.10

–0.40

–0.30

0.00

–0.10

–0.20

Proportionate gap relative to Delhi

Figure 3.15. Sources of regional gaps in value added per worker, 1999

Valueadded/worker

Capital/worker

Wages/worker

TFP

Best IC Good IC Poor IC

Sources

infrastructure, that is, have poorer schools and,consequently, do not produce as many skilledworkers as other states. A second is that, to theextent they do, they eventually lose the more skilledthe workers they have produced to better climatestates or to other countries since they would not offerthem as many high-paying jobs. The skill gapbetween good-climate states and best climate statescould also be explained in the same terms.

The sources of skill gaps was one of the questionsthat we followed up in the three-state supplementalsurvey . The follow-up question asked respondents ifthey faced skill shortages, and if they did, could theyindicate whether or not items in a list of possiblereasons accounted for the shortages. Responses offirms that reported skill shortages to the secondquestion are summarized in Figure 3.16, for UttarPradesh and the other two states separately. Althoughaverage wage rates are much higher in AP andKarnataka than they are in UP, more than 50 percentof respondents in AP and Karnataka complained ofskill shortages against a corresponding figure ofabout 20 percent in UP. However, it is clear fromFigure 3.16 that skill shortages in UP can beexplained in terms of poorer schools or loss of skilledworkers to better climate states more readily than theycould be in Andra Prasesh and Karnataka.

The last set of bars of Figure 3.15 shows that aneven more important source of the gap in valueadded per worker between poor- climate states andother states is that overall business productivity is farlower in poor-climate states. The more striking aspectof the result in the same set is, however, thatbusinesses in good-climate states are, after all, moreproductive than those in best climate states. This is inline with what we read from the sales growth rankingof Figure 3.14.

Effects of Selected Aspects of InvestmentClimate on Business PerformanceWhat fraction of the observed regional gaps in totalfactor productivity is explained by regional differencesin labor market flexibility, the burden of industrialregulation or problems in the provision of physicalinfrastructure? The answer is quite a large fraction. Forexample, the first set of bars in Figure 3.17 shows thataverage value added per worker in poor-climatestates is 6 percent lower than that in best-climatestates, and 8 percent lower than that in good-climatestates because of higher per- kwh cost of electricity inpoor-climate states.24 Similarly the fact that the unitcost of electricity in medium climate states is higherthan that in best and good climate states makes theaverage value added per worker of medium climatestates to be lower by 3 to 5 percentage points.25

The second set of bars in Figure 3.17 shows thatpoor climate states are also losing out on account ofinferior telecommunications facilities as much as they


1.0

0

0.8

0.6

0.4

0.2

Proportion citing reason

Figure 3.16. Reported reasons for local skill shortages, 1999

Inferiorschools

Migrationto otherstates

Migrationabroad

Low localdemandfor skills

Other

0.27

0.67

0.820.78 0.78 0.78

0.43

0.16

0.430.47

Andhra Pradesh / Karnataka

Uttar Pradesh

are doing because of poorer power supply.26 A moreinteresting item of information in the set is, however,that the productivity advantage that businesses inbest-climate states have over those in medium climatestates because of their better power situation is morethan wiped out by productivity disadvantages arisingfrom their poorer telecommunications.

The fourth set of bars relates business productivityto labor market flexibility, which we measure by thestate average of reported business over-manning asdefined in connection with Figure 3.8. The setsuggests that inter-state differences in the degree ofgovernment regulation of industrial relations, areprobably the single most important source of regionalproductivity gaps, the magnitude of their influenceexceeding the combined impact of differences inpower supply and in telecommunications. This isparticularly the case in relation to good-climate statesfor which average value added per worker is 18percent lower than that in best-climate states and 13

percent lower than that in medium-climate statesbecause of what appear to be more rigid labormarkets. While better industrial relations are thus themain strength of medium-climate states, they are alsoby far the most important source of advantage of best-climate states. Value added per worker is 5 to 8percentage points higher in best-climate states thanin medium or poor-climate states on account of thisfactor, which is almost twice the productivityadvantage of best climate states on account of abetter power supply situation or better supply ofskilled manpower.27

Not surprisingly, over manning is less of a problemin poor-climate states than it is in good or mediumclimate states. As can be seen from the third set ofbars in Figure 3.17, however, it is in this group ofstates that the cost of other areas of industrialregulation is strongest. Value added per worker isabout 3 percentage points lower in these states thanit is in medium climate states as a result of greaterregulatory burden in the poor-climate states. This iscomparable to the productivity disadvantage of poor-climate states associated with inferior power supply orinferior telecommunications. Good-climate states toolose out on this front almost as much as they do onaccount of problems of power supply.

To sum up, regional gaps in overall businessproductivity are largely explained by inter-statedifferences in labor market flexibility, the burden ofindustrial regulation in other areas, the power supplysituation, and telecommunications infrastructure.However, regional differences in regulatory burden,broadly understood to include the cost of theregulation of industrial relations, explain this gap morethan differences in the quality of infrastructure do. Inparticular the burden of regulation has been a fargreater drag on productivity in good-climate statesthan problems with infrastructure have been.28 Thereverse is the case with poor-climate states.

This regional pattern broadly carries over to therelationship between the rate of business investment


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Figure 3.17. Explaining TFP differences, 1999

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or the rate of business growth and aspects ofinvestment climate. A deficiency in climate that isknown to reduce productivity should also lowerexpansion investments and growth, which is what wesee in Figures 3.18 and 3.19. For example, we see inFigure 3.18 that the mean rate of net fixed investmentis lower in poor-climate states than it is in medium orgood-climate states by 2 to 3 percentage pointsbecause of greater problems with power supply inpoor-climate states. In Figure 3.19 this translates to a0.5 to 1 percentage point shortfall in growth rate forpoor climate states. Similarly, we see from Figure 3.18that the rate of investment is 6 percentage pointslower in poor-climate states than in best-climate statesbecause of the greater burden of regulation in poorclimate states. This translates to a two-percentagepoints growth disadvantage for businesses in poor-climate states. Although we do not see anyassociation between the rate of sales growth andreported over-manning, the correlation between thelatter and the rate of net fixed investment is as strongas the relationship between productivity and over-manning. For example, the higher rate of over-manning in good-climate states relative to best-climate states translates to an 11 percent investmentrate gap in favor of the best climate states.29

What kinds of gains could Indian states achieveby improving the investment climate? We addressthis question through the following counterfactualscenario: suppose each state improved in eachdimension to the best level observed in India. Figure3.20 shows the higher growth that could be expectedin each category of states. Not surprisingly, thepotential gain is by far the highest in poor-climatestates. Improving the investment climate to existingstandards elsewhere in India, would raise the averagebusiness growth rate in those states by fivepercentage points a year. Of this, 2 percentage pointswould be gains from reducing the burden ofregulation, 1.7 percentage points would come fromimproved telecommunication services, and 1.3 would


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Figure 3.18. Climate indicators and regional gaps in net fixed business investment

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Figure 3.19. Climate indicators and regional gaps in mean rate of sales growth, 1994–99

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be due to a more reliable or cheaper power supply(Figure 3.21). The effects of similar improvement ininvestment climate are not as dramatic, but are stillquite large, in better climate states as well. Forexample, the improvements would raise the meanbusiness growth rate in best climate states 2.2percentage points a year while raising thecorresponding figure in good climate state from justunder 11 percent to more than 13 percent a year.

There is inevitably some uncertainty around thesetypes of estimates. But the general point is quiterobust. Problems such as over-regulation, labormarket inflexibility, and poor infrastructure areassociated with low business productivity, lowinvestment, and slow growth. What is plausible aboutour estimates is that they do not say that the poorinvestment climate states would achieve the samehigh growth as the best climate ones. Other things,such as geographical location, matter as well. Butgiven the very large difference in industrial growthperformance, there is real scope to reduce thisdifferential through accelerated reform in the weakclimate states. It should also be noted that ourcounterfactual is in many ways a conservative one: itlooks at what would happen if states can achieve thebest practice that already exists in India. But chapter2 revealed that India as a whole lags behind otheremerging market economics such as China andThailand in many respects. The gains to investmentand growth would naturally be higher if India movedtoward international best practice in key investmentclimate areas.

D. Summary and conclusion

This chapter has been mainly based on an analysis ofdata from a survey of manufacturing establishmentssampled from ten of India’s fourteen largest states.The analysis reveals stark regional differences ininvestment climate that mimic well-documented inter-


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Figure 3.20. Potential gain in the growth rate of business sales, 1999


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Figure 3.21. Sources of sales growth rate gain in poor IC states, 1999

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state disparities in growth rates in the 1990s. As thesurvey results also show, these differences are fullyrecognized by the business community within India.However, we have gone well beyond mere registrationof entrepreneurs’ views of regional gaps in investmentclimates. This we have done in three directions. First,we have used the survey data to assess the linkbetween entrepreneurs’ perceptions and their actualinvestment decisions. For only in as far as such a linkexists do perceptions really matter. Secondly, we havealso used the data to evaluate the realism of theperceptions partly by comparing subjectiveevaluation scores with objective indicators. Thirdly,and most importantly, we have mapped regional gapsin these objective indicators to differences in businessproductivity and growth. Thanks to this we have comeup with what we think are good estimates of the costof major deficiencies in investment climate.

The most important finding of the chapter is thatbusiness growth and productivity in India are beinghampered by three major factors, namely, labor marketrigidity, excessive burden of industrial regulation, andserious deficiencies in the provision of physicalinfrastructure. Excessive regulation and poorinfrastructure are particularly severe handicaps tobusinesses in what we have grouped as poor-climatestates, that is, in Kerala, Uttar Pradesh and WestBengal. Once we control for such determinants of thedynamics of establishments as line of business, scaleof operations, and age, manufacturing businessesappear to have contracted at an average rate of 4 percent per annum in these states during the second halfof the nineties. This contrasts with average growthrates of 7 to 11 percent per annum of establishmentsin "best-climate" or "good-climate" states. Clearlythere are a host of factors other than excessiveregulatory burden and problems with infrastructurethat contribute to the growth gap between businessesin "poor-climate" states and those in other states.However, relaxing the two bottlenecks alone wouldreverse the contraction of the average manufacturing

business in poor-climate states into one of growth at amodest, but nonetheless positive rate. Reducing theburden of business regulation alone to the level of whatis currently in force in best-climate states wouldincrease the average business sales growth rate in apoor-climate state by 2 percentage points a year.Improvement in power supply and telecommunicationservices to the level of good-climate states, would adda further 3 percentage points to the same growth rate.

The same kind of reforms would also increasemanufacturing growth in other states, though not tothe extent they would in poor climate states. Theburden of industrial regulation is significantly higher ingood-climate states than it is in best-climate states.Lowering this burden to the level of the best-climatestates would raise the average business growth rateof good-climate states from the current level of 11 percent per year to 13 percent a year. But our best-climate states are not, after all, really the best withrespect to every aspect of investment climate. Indeedthe mean business growth rate is much lower –at 7percent a year- in these states than in those we havegrouped as good- climate states. The main reason forthis is that telecommunication services and internet-connectivity are significantly worse in the best climatestates as seems to be the case with power supplyalso. Improving power supply andtelecommunications in the best climate states to thelevel of good climate states alone would increase theaverage business growth rate in best climate statesby 2.2 percentage points a year.

These figures suggest large payoffs to the Indianeconomy as a whole from improvement in physicalinfrastructure and industrial regulation. Theirprojection into an estimate of the national payoffwould, however, clearly understate the full potential forgrowth that could be realized through reforms. This ispartly because they assume away gains fromimproving other aspects of the investment climate onwhich we do not as yet have good data.30 It is alsopartly because, even as gains from improvement in


the burden of regulation and the provision ofinfrastructure, their calculation is entirely based onlocal benchmarks. In other words, they are gainsexpected from a hypothetical leveling up ofinfrastructure and the quality of regulation to pointsthat has already been attained in some Indian states.As shown in chapter 2, however, even the best ofIndia’s regional figures leave a lot to be desired byreasonable international standards.

In summary, several key aspects of the investmentclimate are controlled at the state level. Growth couldbe significantly enhanced by addressing theproblems at this level. The largest gains would comein the poor climate states, but even the better climatestates in India would gain significantly by attaining thebest standards in India in each area. Reachinginternational standards would obviously have evenlarger payoffs. While the specific challenges varyacross states, in general the priorities for reform at thestate level are:

Reforming the power sector so as to attractprivate investment and ensure adequate andefficient provision of power;Reducing the regulatory burden on firms; andComplementing national reform of laborregulations with administration at the state levelthat permits more flexibility in the labor market.

Notes

The sample frame was drawn from the 1998edition of Kompass-India. Although we excludedestablishments employing less than 20 workersfrom the frame, just under seventy percent ofparticipating businesses were in fact small-to-medium sized establishments, that is,establishments employing 150 workers or less.The proportion of managers who reported in overstaffing comparable to that of the original survey

at about 45 percent and showed a similar patternof variation across states.For example, the government of Tamil Naduexempts the software producers from theprovisions of the Factories Act as long as they donot engage in manufacturing activities.Visits by sales tax inspectors are excluded fromthese figures. We calculate for firms covered bythe supplemental survey that visits by taxinspectors accounted for 60 percent of all visits bygovernment officials on the average.The comparison assumes that line of business,capital per worker, and average skill levels are allheld constant. This assumption is made in allcomparisons of value added per worker in thissection.The state average of the unit cost of electricity inindustrial use is an indicator of the quality ofpower supply in the state. To see this note that, foreach establishment, the per-Kwh cost of electricityis a weighted mean of supply prices from twosources, namely, the public grid and owngeneration. Since the average per-kwh cost ofelectricity from the public grid does not vary muchbetween states (Figure 3.12), the overall averagecost of electricity in a state can be higher only inas far as the unit cost of own generation or theshare of own generation in total supply is higher.The indicator of the quality of telecommunicationsfacility used here is the percentage of businesses(in a state) that use email as means ofcommunicating with customers.It also more than makes up for the productivitydisadvantage that best climate states have overmedium climate states due to inferiortelecommunications.At the same time lower regulatory burden hasbeen the main source of productivity advantage ofbusinesses in best climate states.There is no necessary conflict between the nearabsence of an over-manning effect in Figure 3.

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21 and the overwhelming presence of a similareffect in Figures of 3,19 and 3.18. The two sets offigures refer to different time periods and differentlengths of duration. Figure 3.19 refers to theannual average sales growth rate for the period1994 to 1999. On the other hand reference is toyearly productivity levels or yearly investmentrates during 1997- 1999 in the other two diagrams.The over-manning figures were observed for 1999.Their variation is therefore bound to be reflectedless and less on those of performance indicatorsas the period over which the indicators areaveraged extends further into the early 1990s.Contract enforcement mechanisms and thefunctioning of financial markets are goodexamples here.


30.

Annex on the Firm Analysis and Competitiveness Survey of India 65

The FACS survey was carried out by theConfederation of Indian Industries in collaborationwith the World Bank. Face to face interviews wereconducted with 1032 managers in 8 sectors across 10states. This annex provides additional information onthe selection of the firms.

Interested to link the local investment climate tointernational competitors, the sectors selected wereall in tradable goods industries. This does not mean,however, that all firms are exporters -- some 55percent of survey participants did not export at all in1999.31 Among tradables goods industries, selectionswere chosen on the basis of their share in the value ofIndia’s non-farm exports.

The selection of states was based on threeprinciples. The first was that the sample should bespread as much as possible between high-incomestates, middle-income states and poorer states.Secondly, the sample should represent what, at thetime of the survey, were seen to be reforming states aswell as states whose policy environment was notthought to be so friendly to business. The thirdprinciple was that a state should have a sizablenumber of establishments in at least three of theindustries the survey was intended to cover. The tenstates covered include 9 of the fourteen largest states.Based on the World Bank’s classification (World Bank,1999), Delhi, Maharashtra, Gujarat, Punjab, and WestBengal represent the high-income group of states.Uttar Pradesh is a low-income state while AndraPradesh, Karnataka, Kerala and Tamil Nadu representmiddle income states.32

Given the volume of information we needed tocollect, sampling from all parts of a selected statewould have been prohibitively expensive and timeconsuming. The sub-sample of each state wastherefore drawn from the metropolitan area of thelargest business concentration in the state.33

Although Kompass-India listed a total of 61000establishments, the restriction on lines of activity, onemployment size and on states of location, resulted in

an effective sampling frame of 6074 establishments.The intended sample size was 1200. Forty-eight ofthese were allocated to the auto-components andmachine tools industries for purposive samplingtowards an international benchmarking exercise. Theremaining 1152 were allocated between the other sixindustries roughly in proportion to shares in India’snon-farm exports. The sub-sample of each industrywas then distributed between states in proportion totheir respective shares in the number ofestablishments of the industry. Each industry sub-sample was randomly selected according to a rule inwhich an establishment’s probability of selectionincreased with its employment size. Because of therelatively small size of listings in the sample frame, thesame rule could not be used in the other industries.We picked every other establishment in eachindustry-state listing in this case.

Notes

However, some 20 percent did export 90 percentor more of their output the same year.Per capita income averaged Rs 4377 in high-income states in 1996-97 at 1980 prices againstRs 2676 in middle-income states and Rs 1840 inlow-income states (World Bank, 1999).The exception to this rule was sampling fromMaharashtra where establishments were pickedfrom Mumbai and Pune.

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pilot investment climate assessment improving the...

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