This article introduces the concept of investment climate reform and its role in private sector development. It answers the questions: What is the investment climate? What is investment climate reform?
The investment climate covers a broad range of locational elements influencing the decisions of private investors.
Beyond the firm: framework conditions for business growth
Economists often refer to the “framework conditions” for business growth. This is useful because it recognises the role of factors outside of the firm affecting the potential for firm competitiveness and growth.
Internal factors–those within the firm–typically include the resources business owners and managers apply to the enterprise. The external factors are associated with the location of the firm. However, these conditions are typically poorly defined.
Framework conditions generally reference the economic factors that influence the performance of a business in a specific location. Often, these factors affect goods, services and money.
Framework conditions typically refer to variables of the financial state of the national economy. They may include interest rates, exchange rates, inflation, tax rate, and market dynamics (i.e., demand and supply). However, the term is also used to cover several specific issues influencing the decision of private investors (i.e., businesspeople) to invest and how they compete in the market. This is where the investment climate becomes relevant.
What is the investment climate?
In 2005, World Bank dedicated its annual World Development Report to the topic: A Better Investment Climate for Everyone. This is an important document for anyone working in this field.
Interestingly, the report does not provide a clear definition of the investment climate. However, it generally describes the investment climate as reflecting:
“the many location-speciﬁc factors that shape the opportunities and incentives for ﬁrms to invest productively, create jobs, and expand.”
The concept of an investment climate is broad and encompassing. It includes a key element discussed frequently in private sector development. This is the business environment.
This says the business environment is:
“a complex of policy, legal, institutional, and regulatory conditions that govern business activities.”
Figure 1: Relationship between the investment climate and business environment
SOURCE: DCED 2008
In its Handbook on Improving the Investment Climate Through EU Action, the European Union says a conducive investment climate is:
“essential within a country’s path towards inclusive and sustainable growth. It plays a key role in attracting and retaining domestic and foreign investments.”
The European Union identifies three drivers of investment climate:
- Macro level drivers, including stability and governance
- Business environment drivers
- Human-centred drivers such as human development and innovation.
Investors’ decisions to invest, whether international or local, in a country, often depend on their perceptions whether a combination of these factors and the policy-mix to improve investment climate support their confidence.
Other investment climate frameworks
There are a number of other investment climate frameworks of note. These focus on different factors in investment climate.
The Global Entrepreneurship Monitor applies the term ‘National Entrepreneurial Framework Conditions’ which take into account the advancement of each society through the three phases of economic development (i.e., factor-driven, efficiency-driven and innovation-driven).
The World Economic Forum publishes the annual Global Competitiveness Report, which covers 134 major and emerging economies. It assesses the ability of countries to provide high levels of prosperity to their citizens. The Global Competitiveness Index measures the institutions, policies and factors that set the sustainable current and medium-term levels of economic prosperity. This assessment encompasses the “12 pillars of economic competitiveness.”
The benchmarking activity was paused in 2020, as a result of the coronavirus (COVID-19) pandemic, and a special report published for policymakers on responses to the pandemic. This report highlights the importance of the “enabling environment”, which it says encompasses:
“both formal and informal institutions; utilities and infrastructure such as transport, energy, water and telecommunications; as well as the framework conditions set by monetary and fiscal policy, and more broadly, public finances.”
While they have now been abandoned, the World Bank’s Doing Business and Subnational Doing Business assessments also provided indicator-based measures of framework conditions and business environments.
The Organizations for Economic Cooperation and Development (OECD) in its SME and Entrepreneurship, Outlook 2019 report presents empirical evidence on the composition and economic contributions of small and medium-sized enterprises (SMEs) and entrepreneurship on economic performance. This was done, “with a view to exploring national approaches for improving the business environment for SMEs and entrepreneurship.”
The report presents a conceptual framework composed of six pillars, underpinned by a cross-cutting element on SME and entrepreneurship policy governance. This describes how the business environment and ‘strategic resources’ influence SME performance. In this case, the business environment is comprised of the institutional and regulatory framework, market conditions and infrastructure (see the figure below).
Figure 2: SME and entrepreneurship conceptual framework
SOURCE: OCED (2019)
The top three pillars in the above diagram consider the business environment and framework conditions under which SMEs can do business and grow.
The bottom three pillars consider the extent to which SMEs can access and make use of strategic resources: financial capital, human capital and knowledge-based capital.
The OCED highlights:
“SMEs are typically more dependent on their business ecosystem than larger firms. Smaller firms are more vulnerable to deficient framework conditions, market failures and economic shocks, while inefficient infrastructure hampers their access to markets and the strategic resources they need to operate.”
What is investment climate reform?
Just as the concept of the investment climate is broad, so too are the areas where investment climate reform is possible and prioritised.
The work on Growth Diagnostics is relevant here. Proponents of growth diagnostics seek to develop a:
“unified framework for analysing and formulating growth strategies that is both operational and based on solid economic reasoning. The key step is to develop a better understanding of how the binding constraints on economic activity differ from setting to setting.”
European Union support for investment climate reform focuses on three areas of action:
- Deepening strategic market analysis
- Enhancing structured public-private dialogue mechanisms
- Supporting sustained policy reforms
These largely reflect the EU-defined drivers of the investment climate, presented earlier.
Often, investment climate reform programmes focus on the business environment. This topic is addressed in a separate explainer article. This focus arises because the more narrowly defined business environment presents a clear framework for identifying reform priorities.
Beyond business environment reforms, investment climate reforms address specific concerns identified as barriers to private investment or binding constraints to economic growth.
For example, improvements in infrastructure are often a priority in many developing and emerging economies. Infrastructure development is a major area of development programming in its own right, often encompassing private sector development and the use of public-private partnerships.
Similarly, poor technical skills development and vocational education are common investment climate problems. These are also addressed through a comprehensive range of developing programming interventions including private sector development, the development of technical and vocational education and training (TVET) institutions and support to labour labour systems.
The investment climate contributes to our understanding of the external factors that affect investment decisions and firm performance. It highlights the importance of locational conditions in private sector development.