FOREIGN AID AND THE PRIVATE SECTOR

By William Fisher and Ludwig Rudel


Since the beginnings of foreign aid programs following WWII, there has been a growing appreciation of the role of the private sector as the only sustainable engine of economic growth, job creation and poverty reduction. It is the private sector that gives rise to a middle-class. And historically it is the middle class that serves as the catalyst for social reform and political stability. Yet today, despite the billions in donor funds invested in private sector development, in only a few countries is there evidence of the emergence of either a robust private sector or a significant middle class. On the contrary, in most developing countries, the rich have gotten richer while the poor have remained relatively poor. Why? And what can be done about it?

The Beginnings

How do we explain why building robust private sectors and free market economies have proved to be such intractable problems? In the 1950s and early 1960s, most donor initiatives were intended to stimulate Foreign Direct Investment (FDI) in developing countries. But these investment flows did not immediately materialize because these societies, newly emerging from their former colonial status, were seen by potential investors as too risky. The result was that, in this period, it was governmental foreign aid flows that provided the capital needed to finance the new governments’ initial start-up efforts.

Often these resources were used to build state-owned and operated enterprises. But as these investments came online, it became clear that they suffered from the usual maladies of state enterprises. But the growing Cold War competition between the USSR and the Western Nations offered aid recipients a political choice between Capitalism and Socialism. Notably in India, but also in many other aid recipient nations that joined the so-called Non-Aligned bloc, there was growing resistance to private sector investment. The ‘commanding heights of the economy’ were reserved exclusively for public sector investment. Some sectors were designated for ‘mixed investment’, but only a few sectors were designated for the private sector. Those of us who were stationed in these countries at that time can remember the prevailing attitudes among government policy makers against the private entrepreneur as they waited for Marx’s prediction to be fulfilled for capitalism to crumble of its own weight. Many countries nationalized entire industries and economic sectors (Jute in Bangladesh; banking and insurance in India; most major companies in Egypt). Multinational corporations were specifically singled out for restrictive controls. Only export industries seemed to be exempt from these pressures because it was obvious that, other than in China, government-run companies could not compete in the international markets. It was not until the change in policy in China to privatize agriculture, the break-up of the Soviet Union and the subsequent privatization of industry (about 1990) that these attitudes began to dissipate in the developing world.

Therefore, the case could be made that donor assistance in these early years actually blocked private sector development in many of the countries that received huge inflows, because the focus was on building up the state and state services, which tended to weaken the private sector's role, and gave the government an alternative to taxes on business and local growth to generate cash. This also reduced the incentive to press for private sector growth. Donors also turned a blind eye to corruption and over-regulation.

For these and other reasons, Western aid donor nations began to seek ways to stimulate and support the energies of indigenous private sectors for economic development. These efforts gained considerable momentum after the election of Ronald Reagan as President in 1981. Since then, billions of dollars have been invested by the world’s donor community in initiatives designed to stimulate and strengthen the private sectors in developing countries, often in the face of strong resistance from recipient government decision makers. But major flows to recipient countries were not FDI but portfolio or bank lending, opening the host country to financial instability—notably in Mexico, SE Asia, Argentina, and Peru.

Moreover, this new strategy opened a broader question for developing countries: how to use public resources to help individual entrepreneurs without being accused of misappropriating government funds for private individual gain? The designers of these early private sector aid programs were usually bureaucrats. They may have had the best of intentions, but few had the private sector experience needed to fully understand how to design an intervention in the cycle of growth without being disruptive. The principal reason is that the ground rules for expenditure of public resources are diametrically opposed to those used when operating to make a profit. Private lending flows most easily to those who can assure repayment - normally the most affluent. Public sector funded credit facilities are intended to serve the neediest. Public effort and resources require full public disclosure; private companies operate in as much secrecy (certainly from their competitors) as possible.

Even where developing country governments were able to resolve this philosophical and ethical dilemma, building a functioning private sector proved to be a ground-up task of gargantuan proportions. With the occasional exception of the largest companies, business skills were in very short supply. Commercial infrastructure such as roads and transport services were often non-existent. Capital was unavailable to most. Bureaucracy and permitting procedures placed incredible obstacles in the path of private entrepreneurs. And public and private corruption was rampant.

Finally, the building of sustainable private sectors was – and is—dependent upon a complex interplay of many other factors, not the least of which included security, and a healthy, educated workforce, the local bureaucracy, the countries’ prevailing business ethic, and the fact that when change takes place, it is almost always generated from within a society.


Donor Approaches

What tools have donors used to influence such change? What kinds of activities have been funded with public resources to support private sector development? The following are examples of activities donors have undertaken in some countries (though not all in any country):

§ Policy advice to get governments out of their operational role or one that is unduly restrictive in order to allow them to perform a regulatory function in their markets.
§ Collaboration with host government ministries and agencies to adopt policies and regulations to remove obstacles to private sector growth and promulgate pro-growth policies and regulations.
§ Programs, often with special lending packages funded with governmental resources, to reform banking practices to make credit accessible to smaller companies.
§ Provision of firm-level technical and managerial assistance to thousands of individual companies.
§ Training programs for business people on a wide range of management topics, including improving human resources management, competitiveness, quality, pricing and delivery standards, writing and implementing business plans, and making presentations to banks.
§ Low cost systems for entrepreneurs to access global information sources on available technology and foreign markets.
§ Institution building of technology research and development facilities in the recipient country to encourage such institutions once staffed with qualified trained local technical personnel, to develop links to local companies or industries.
§ Programs to help groups of local business people to organize themselves into Business Support Organizations – BSOs – to provide market and technology information and services to their members, and recommend ways their governments might remove constraints to private sector development.

What does the world have to show for its billions? What does the aid-to-the-private-sector balance sheet look like?

On the credit side:

It is virtually impossible to establish a cause and effect relationship between donor assistance and private sector – or any other -- development at anything save a micro level. But many of the private sector strengthening programs were and are precisely at this level. Therefore, it is clear that much private sector improvement can be traced directly to donor assistance. As a result, even in many of the poorest countries, many more private companies are far better prepared to be competitive. In some developing countries, there have been modest policy and regulatory changes to create a more pro-business operating environment. Many of these changes have been facilitated by business support organizations – trade associations and chambers of commerce – who have been recipients of financial grants, training and support from donor representatives. Some of the very large private companies in developing countries have become successful exporters – helping to earn the foreign exchange needed to purchase the equipment and other inputs they need for their production. A few large companies in some developing countries have been able to attract multinational corporations as joint venture partners or subcontract suppliers. The production standards required by multinationals have resulted in adoption of some ‘best practices’ in management, and in some transfer of know-how and technology. In other developing economies, poor people are perhaps less poor in real terms, not merely in financial terms, but also in a variety of quality of life indicators. But there are many exceptions, notably Russia, where infant mortality, health indicators and longevity have been moving in the wrong direction since 1990.

Perhaps the classic success stories remain South Korea and Taiwan, both of which received tremendous assistance from the US and others in the 1960s and 70s. Later, in the so-called ‘middle income’ countries -- for example, Turkey, India, Thailand, and many of the ‘Asian Tigers’ -- middle classes have begun to emerge. But some of these countries already had a private enterprise infrastructure in place that donor assistance was able to build on. In other countries that have made progress – for example, Poland, the Czech Republic and others in Eastern Europe – the task was made infinitely more difficult since these countries were attempting to transition from centralized command economies to free markets. Yet, even under these circumstances, there has been some evidence of progress. In Poland, for example, State-run banks have become private commercial institutions, and many are lending to small and medium private companies. There is an embryonic but vigorous trade association movement. An increasing proportion of GDP is being generated by the private sector. Poland weathered a deep recession and emerged as a serious player in international markets. In Poland and other Eastern European countries, there also were strong incentives for reform -- preparing for membership in the European Union.

On the debit side:

In the poorer developing countries, if there have been some private sector successes, they have most often occurred because the owners of successful businesses have had personal access to friends in the commercial banking arena, or to public sector decision makers. This pattern of ‘crony capitalism’ is pervasive in virtually all poor countries. Most often, the conditions impeding private sector growth have sadly continued to prevail despite specific interventions of aid donors directed to address these constraints.

Most private companies in most developing countries struggle with pitifully inadequate and shamefully bureaucratic public policies and regulatory practices. These practices are often not consciously targeted at crippling today’s private sector; rather, they the result of a traditional mind-set or are based on laws in place from prior periods. The result is a litany of constraints that often defeat even the largest potential foreign investors. As just one example: it takes two days to form a new business in Canada; the average for developing countries is 63 days.

For the smaller and medium-sized companies in developing countries -- which often provide more employment than all of the (few) large companies combined – getting product from farm or factory to customer is a journey down an unpaved road battered by craters. Seemingly senseless and often contradictory restrictions are placed on imports of inputs ranging from seeds to computers. Exports, especially agricultural perishables, frequently fail because of mismanagement or corruption in the customs services, or for lack of cold store and other necessary facilities at airports and docksides. Infrastructure, particularly transport, is either nonexistent or slow and exorbitantly expensive. Freight rates are no less than extortionate. Thus, if a product is destined for export, it must jump even more hurdles.

During the 1980s, donors, including the US Agency for International Development (USAID), began responding to the frustrations of would-be investors by creating the ’one-stop-shop’ concept. The one-stop-shop was a single physical location where both local businesses and potential foreign investors could go for all licenses and permits, and for information on tax policy, investment incentives, labor conditions, laws and regulations, and much more. Some of them worked and some are still working. But in too many developing countries, permitting procedures remained Byzantine. Moreover, the ‘one-stop-shops’ were often staffed by bureaucrats who had neither the motivation nor the information resources to be helpful.

In the 1990s, USAID began to take a new approach to persuading host governments to create a more positive enabling environment for private sector actors. In Egypt, for example, USAID and the Government of Egypt were able to agree on a series of extensive benchmarks for policy and regulatory changes affecting agriculture. Each time the government met a benchmark, it received a cash transfer payment from USAID. Numerous valuable changes were made, but the program was not renewed last year due, reportedly, to budgetary restrictions.

The commercial banking systems in most developing countries tend to lend to firms owned by friends and relatives. Donor training has taught many companies how to apply for credit. But almost all developing country lenders are extraordinarily risk averse – even if the borrower has 200% collateral or has opened an irrevocable letter of credit. The World Bank and the International Finance Corporation for the last few years have sponsored training programs to help developing country bankers to understand how to manage credit to smaller companies. But this is a very long and tortuous road. Other donors have initiated programs to make the banking and capital markets systems in developing countries more inclusive. But most of these programs have not been nearly intensive enough.

Donors, particularly USAID, have recognized the value of helping groups of business people to start and/or develop Business Support Organizations (BSOs) – trade associations and chambers of commerce. For example, the Center for Private Enterprise (CIPE), an affiliate of the US Chamber of Commerce, has dispatched numerous consultants experienced in this field to many developing countries to train local business groups in the formation of BSOs. High on their list of priorities is helping local business groups to develop capacity to analyze policy and regulatory constraints to business, recommend solutions, and lobby their respective government agencies to implement changes.

In most developing countries, donors have provided consultant contractors to educate their host governments in the principles and details of privatization. But the funds to hire such consultants remain principally under the control of the government bureaucracy of the host governments. And many governments are still reluctant to privatize bloated and inefficient state-owned or controlled companies because it equates with a loss of bureaucratic power. Where privatization has taken place, control has too often simply passed from the public sector to the criminal underworld.

Most of the USAID officers who design and administer private sector aid programs still lack business experience and knowledge of the private sector decision-making process. Moreover, they lack the permanent staffs to implement these programs, resulting in an almost total dependence on private contractors. Thus, the aid process is heavily contractor-driven, with hired (temporary) consultants staffing the programs.

These contractors (consulting firms) have done much outstanding work under difficult and frustrating conditions. But contractors are usually seen as representatives of donor governments or institutions, and host governments are often reluctant to listen to or follow the advice of other governments. They are far more likely to listen to the recommendations of indigenous business support and advocacy groups trained by experienced private sector volunteers, as is now being demonstrated in the Russian Federation by President Putin. Yet relatively little use is being made of this potentially rich reservoir of volunteer skills.

Foreign aid has traditionally been an instrument of the donor government’s foreign policy. This has led to a ‘go it alone’ mentality among donor nations, which tend to use their largesse to seek individual credit and increased influence. This, in turn, has led to the virtual absence of any coordinated program planning among donors, wasteful duplication of effort, and lack of prioritization of needs. Not only does this occur between donor organizations; it often occurs within the same donor organization. This usually results from lack of an effective communication structure within the organizations and, just as frequently, from ‘turfing’ for program funds.

Finally, bilateral aid agencies are traditionally funded by their law-making bodies, parliaments and congresses. In the US particularly, Congress has over the last decade shown increased interest in the details of individual aid proposals, not simply their cost. The problem is that the US Congress wants quick results, and development is by definition a long-term undertaking. This has put enormous pressure on those charged with implementing these programs. It has too often caused them to focus on projects that have a higher probability of showing rapid results. That, in turn, has worked in favor of the wealthiest business people in almost every developing country – arguably the people who need help least. Compounding this problem are the relatively short tenures of USAID Mission Directors and supporting personnel in any given country. We should not be surprised that each Mission Director wants to show his agency and the Congress the most demonstrably positive results in the shortest possible time.
What Can Be Done?

Individual enterprise, as defined by Joseph Schumpeter, one of the world’s most respected students of entrepreneurship, manifests itself in every society, whether it is ruled by a Marxist political structure or not. Someone is always trying to find a way to better him or herself. Where the official government policy prohibits private economic activity, it falls to criminal enterprise to meet this demand. Black markets during periods of shortage, medical service in clinics in the USSR prior to its break-up, sale of permits to move from rural to urban centers in China, all in plain view and well documented, bespeak of this entrepreneurial spirit.

If this is true, one would expect that simple interventions to support these indigenous dynamic forces would have resulted in significant growth of entrepreneurship in a developing nation. Then why is it that we have such difficulty in identifying the impact of assistance efforts to stimulate private sector growth in developing countries funded by aid donors?

There are two principal reasons. First, there is no scientific “experiment and control”. We cannot measure the impact of an effort because there is no way to determine what would have been the case if the effort had not been undertaken. But, perhaps more to the point, we simply have not been able to come up with really effective interventions, given the ground rules that govern the administration of public funds. Those efforts we have funded have somehow often benefited the wealthier and more powerful elements of the society being aided.

Secondly, the private sector does not exist in a vacuum. It is of and from the society in which it operates. That society has multiple high-priority needs—health, education, infrastructure, and so forth. All of these impact the private sector and vice versa. So building or strengthening the private sector in any given country frequently requires nothing less than a total change in mind-set, work ethic, national priorities, and cultural norms.

Thus the authors have no ‘one size fits all’ template, no cookie-cutter, and no quick fixes. But we offer the following suggestions for the consideration of both donors and recipients:

1. Conditionality: As disruptive as it may be diplomatically, donors have every right to insist that aid to the private sector be accompanied by pro-business policy and regulatory changes. They also have a right to encourage transparency and accountability from host governments for the funds they receive, and appropriate actions to ensure that mafias or corrupt officials don’t profit from aid dollars. Finally, once a program and its goals and benchmarks are accepted by recipient governments, these hosts should understand that the size of next year’s aid budget will depend on how well this year’s benchmarks have been met. This approach has been tested by USAID in a number of countries, and with some success. The World Bank and the IMF have imposed conditionality in all of their so-called ‘structural adjustment’ programs, but have usually been perceived as acting with a heavy hand. One of the critical keys to all-party acceptance of conditionality is the fostering of an environment of partnership between donor and host. This is difficult and time-consuming. Yet without it, little can be achieved.

2. Donor Know-How: Those who work for governmental aid agencies have little or no private sector experience. This has led both to errors in judgment and to a general lack of interest in private sector development. Donor personnel charged with administering funding to the private sector urgently need training in business management and business decision-making. And donor agencies need to mount a concerted effort to attract staff from the private sectors of the industrialized countries.

3. Capital: Sales, profits and employment cannot be created without capital. Reform of the commercial banking systems in virtually all developing countries needs to be a much higher priority among donors. Loan guarantee programs by donors have helped. But the truth is that commercial banks in developing countries are comfortable lending to prominent figures and to friends and relatives, and distinctly uncomfortable lending to others – especially the small and medium-sized companies who employ so many and who represent such great potential for economic growth. This is an area in which bilateral donors could profitably collaborate with the bank training programs of the International Finance Corporation. Moreover, Central Banks need to be encouraged to adopt more sympathetic approaches to proposed international joint ventures, including allocation of foreign exchange for travel abroad and other needs.

4. Inside-out, bottom-up change: In almost all countries where the private sector has been empowered to do what it does best, the catalyst has been less about pressure from donors, and more about the actions of indigenous business support groups that have learned to make their case to government and kept the pressure on until reasonable policy changes have been made. Donors need to devote more resources to the development of trade associations, chambers of commerce, and cooperatives.

5. Volunteers: President Bush has recently announced a new program to utilize the talents of volunteer business people in the foreign aid arena. While NGOs and PVOs have been used abroad in the past, they have usually been placed in subservient roles to contracting firms. Yet host governments and host country business people may well respond more positively to volunteers than to paid consultants. This is an approach worth expanding. Similarly, there is virtually unlimited scope for expansion of public-private partnerships – companies from developed countries acting in their own self-interest to assist companies and other constituencies in poor countries. To this end, the Bush Administration has initiated the Global Development Alliance. Other donors should carefully monitor this program’s progress to benefit from the lessons it will teach.

6. Donor Coordination and Cooperation: Multilateral and bilateral donors should be encouraged to leverage their resources and potentially optimize their positive impacts by more collegial planning and implementation of programs to strengthen the private sector in poor countries. We refer here not only to the need for greater cooperation among donors from different countries, or between bilateral and multilateral donors. Frequently, there is a pitiful lack of cooperation and coordination between contractors implementing different programs for the same donor. This has led to serious duplication of effort and waste of scarce resources. This is an issue that is well within the control of the donors who hire the contractors.

7. Access to Information Systems: The Internet offers an unprecedented opportunity for individual entrepreneurs in developing countries to obtain information about the latest technology and market information from around the world. It has and can be used to help developing country business people to identify prospective joint venture partners or subcontracting customers. And it can help business support organizations to establish contacts with their counterpart organizations in other parts of the world, and thereby gain access to ‘best practices’ in business advocacy and a wide range of other subjects. Donors, including USAID, have sponsored a number of programs to reach these goals, but much more needs to be done to encourage host governments to provide their private sectors with low cost access to these global resources and training on how to use this tool.
8. Corruption: Corruption exists in every developing country (and many developed ones as well). If there ever was an issue for which there is no ‘quick fix’, this would have to be that issue. Corruption comes it many forms. It is often blatant (your goods will rot on the dockside unless the Customs Officer and his colleagues get their payoff). Sometimes it is more subtle (companies in developing countries often hire Customs Officers to do their paperwork in their ‘spare time’, thus ensuring expedited shipments). In whatever form, corruption is pervasive and costly (the American Chamber of Commerce in Egypt estimates that corruption adds 25-30 per cent to every commercial transaction, often with the result that Egyptian products and services become uncompetitive). Corruption hurts smaller companies most; in the words of a prominent Egyptian business owner: ‘Large companies don’t have problems; we can afford to pay to get them solved’. But the problem is broader and deeper than its effects on small companies. A reputation for corruption poisons the environment for major transnational companies as well. It is true that developing country civil servants (who, in many countries, once made up much of the respected middle class) are painfully underpaid. They need more money, and those who deserve it on a merit basis should receive it. But that alone will not fix this deeply ingrained problem. At the end of the day, it is a matter of political will: host governments need to be prepared to take swift and serious criminal action against corrupt officials, from the top down, and against the business people who keep this sordid tradition alive.
Why Should We Care?

What are the interests of the US and other donors in making private sector aid more effective? Three are paramount:

First, donors need to understand the relationship between private sector growth and political and social stability. Historically, a robust private sector has been the crucible for the growth of a middle class. And it has been from a robust middle class that pressures for political, economic and social reform traditionally arise.

Second, private sector development in poor countries is in the economic interests of rich countries. Unless more developing countries can learn to produce well enough to export, they will unable to earn the foreign exchange needed to buy the products the US and all other donor countries need to sell.

Finally, standing astride the depressing catalog of problems faced by developing country businesses is one additional overarching factor of monumental proportions: globalization. This demands that poor countries be able to make and sell some products and services better than rich countries can. Globalization presents very real and very immediate challenges to private industry in developing countries. Some donors, including the United States, and a number of multilateral institutions, have initiated programs to help developing countries to negotiate more effectively with the World Trade Organization. But by all accounts, most of these countries are nowhere near ready to meet this free trade challenge.

Failing to meet the challenge will put emerging economies at clear and present risk of being flooded by a tidal wave of imports, further loss of jobs, and the very real possibility of civil unrest and political instability. It is in the national interest of the United States and other donor countries that this is not permitted to happen.

Perhaps USAID Administrator Andrew S. Natsios sums it up most succinctly. “Unless the private market economy gets revived”, he says, “our programs are not going to work.”






THE AUTHORS
WILLIAM FISHER

William Fisher has more than 30 years experience as a principal, senior manager and consultant to both public and private sectors in industrialized and developing countries. In the public sector, he has completed several dozen long- and short-term assignments for USAID, the US State Department, the European Union and other bi- and multilateral development assistance organizations. These assignments have been in the Middle East, North Africa, Central and South America, Africa, Asia and Europe. He has served as team leader or senior advisor on donor projects involving the design, assessment, management or evaluation of programs designed to strengthen private enterprise. In the private sector, Mr. Fisher has advised the Boards of Directors and senior managements of numerous major multinational companies and organizations. During the Kennedy Administration, he served in the international affairs area and played a prominent role in managing the US export expansion program.

LUDWIG RUDEL

Ludwig (Lu) Rudel served for 25 years in the Foreign Service with the US Agency for International Development, specializing in export industries expansion, technology transfer and foreign investment in countries lying between Turkey and India. Since his retirement, he has performed more than 40 short-term international consulting assignments to design and evaluate aid programs and projects funded by World Bank, the United Nations Development Program (UNDP) and USAID. He received an MA in Economics from the University of Michigan (1965) and an MA in Government (International Policies) from New York University (1959). He received his BA from City College of New York (1952). His private sector activities included serving as President and CEO of The Glendale Corporation, a land development company, for 30 years. He served as an officer in the US Army from 1953 to 1955.