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After the Spring$

Magdi Amin, Ragui Assaad, Nazar al-Baharna, Kemal Dervis, Raj M. Desai, Navtej S. Dhillon, Ahmed Galal, Hafez Ghanem, Carol Graham, and Daniel Kaufmann

Print publication date: 2012

Print ISBN-13: 9780199924929

Published to Oxford Scholarship Online: May 2012

DOI: 10.1093/acprof:oso/9780199924929.001.0001

Transforming the Private Sector

Chapter:
(p.106) Chapter 5 Transforming the Private Sector
Source:
After the Spring
Author(s):

Magdi Amin

Ragui Assaad

Nazar al-Baharna

Kemal Derviş

Raj M. Desai

Navtej S. Dhillon

Ahmed Galal

Hafez Ghanem

Carol Graham

Daniel Kaufmann

Homi Kharas

John Page

Djavad Salehi-Isfahani

Katherine Sierra

Tarik M. Yousef

Publisher:
Oxford University Press
DOI:10.1093/acprof:oso/9780199924929.003.0005

Abstract and Keywords

The agenda for private sector reform is enormous and varied. Arab enterprises have benefited from protection, subsidized access to inputs (land, fuel, and credits), and lax enforcement of labor laws. Most have a complex structure of administrative controls, and many of these regulations operate at cross-purposes and with considerable bureaucratic discretion, giving rise to corruption and deterring investment. Citizens and businesses have recourse to these problems. The Arab world ranks last among all regions in the world in terms of protection of property rights. The result is a large informal sector along with a share of manufacturing in GDP that is half the average for comparable countries at a similar stage of development. Past efforts at liberalization did not have a strong supply response primarily because of a lack of reform credibility. Some economies in the region need to “break into" world markets, while others face the challenge of moving up the value-added chain. Oil producers, on the other hand, need to diversify. This chapter proposes broad strategies for fostering competition and controlling of corruption; financial, judicial, and labor market reform: and more focused initiatives that focus on information and communications technology, tourism, logistics, and education.

Keywords:   private sector, investment, corruption, manufacturing, enterprises, labor markets

Since the beginning of the Arab Spring, discussions of private-sector reform imperatives in the Arab world have been dramatically changed by events. Countries such as Egypt, Libya, and Tunisia that are entering transitional periods have little choice but to unlock the potential of their private sectors to create jobs, attract investment, and to take steps toward developing globally competitive economies. Countries in which rulers continue to survive, similarly, have little choice but to address long-term causes of public anger—in particular, a persistent lack of good job opportunities (especially among the young and other marginalized groups)—alongside the sources of other political frustrations.

The challenge facing Arab economies is that, while the private sector is essential to growth and employment, it is also seen as party to the corruption and inequities that prevailed in the old order. In this regard, the context in the Arab world is similar to that in East Asian countries faced with a crisis on crony capitalism in 1997 and 1998. Efforts to aggressively pursue past corruption in the name of justice risk alienating large entrepreneurs, chilling the investment climate, and precipitating capital flight. Administrators have frozen approval processes for investments out of concern for the potential for future investigation. But condoning past corruption would send (p.107) the wrong “business as usual” signals and generate moral hazard. Finding the right balance will not be easy.

The private sector in the Arab world is saddled with a number of problems. Arab economies enjoy less competition than other regions. Firms tend to be older and less competitive than their counterparts in Asia, Latin America, or eastern Europe. New firms find it harder to enter markets, and inefficient firms are less likely to exit. As such, the dynamism and innovation that companies bring—the “creative destruction” process so essential to productivity—is occurring at a much less rapid pace. The response of private investment to past reforms has beenweaker than in other regions.1 The ratio of private to public investment is far lower than in other regions. To make matters worse, in the wake of the Arab Spring, key industries such as tourism, construction, retail, and banking have been deeply affected, while trade flows and lines of credit have been curtailed. Labor strikes and protests set back a number of industries, further disrupting economic activity. The Institute for International Finance estimates that $16 billion was withdrawn by investors from Egypt in the first quarter after the revolution. The foreign reserve position of the central bank remains comfortable for the time being but has seen substantial decline.

To boost employment and sustain growth, the Arab world needs more high value added firms, ranging from agroprocessing to manufacturing to tradable services. These are precisely the industries that have bypassed the region in the past 15 to 20 years. Whether judged by the diversification of industry and exports, technological sophistication, the level and sectoral composition of private investment, or the productivity and innovation of firms, the Arab world has not undergone the kind of economic transformation seen in countries that have successfully sustained growth and job creation.

(p.108) A Structural Deficit in the Nonoil Sector

The Arab private sector largely consists of microenterprises, livelihood businesses, and small and medium enterprises (SMEs). Perhaps 26 million adults participate in some form of entrepreneurial activity, including nearly 6 million in Egypt alone, according to a recent representative survey.2 The vast majority of these small firms has less than five employees, is family owned, and has little to do with the sectors that have been the subject of official policy initiatives.

The private sector primarily serves local markets. The Arab region's nonoil exports represent less than 1 percent of world trade, which is the lowest share of any developing region. The low ratio of nonenergy exports to GDP among countries in the Arab region is among the clearest signs of a lack of global competitiveness and indicates that a key potential source of job creation has not been tapped. A few countries, such as Morocco, have made tangible steps toward penetrating the European market, but with very few products relative to its GDP, as a whole the region is far below its potential.

While a number of factors have contributed to this poor export performance, analysts cite high average tariffs, behind the border investment climate constraints, and the low quality of Arab-produced goods.3 Low-performing transport infrastructures and the low quality of services in many countries of the region have (p.109) dversely affected trade flows through higher costs, delays, and uncertainty, along with low productivity. For some countries, particularly Algeria and Libya, high labor costs, the high costs of nontradables, and overvalued exchange rates combine with a dominant state enterprise sector and a restrictive regulatory environment to create limited prospects for nonoil exports.

A Burdensome Policy Environment

The overarching feature of the business environment in the Arab region is a complex structure of administrative controls that remain as a legacy of state-directed development. In the course of implementation and enforcement, this structure has created a logjam of overlapping requirements, prevented transparency, and created conditions for corruption and excessive administrative discretion. In the most common institutional model in the region, the presidency is the authority that issues the most important regulations, but many others are issued at the ministerial level, by parliaments, or, where relevant, through guidance from the crown. The combination of new orders, decrees, and regulations, mixed with previously issued ones that are not typically withdrawn, has created overlaps of authority and confusion and frustration for the private sector. The Egypt Regulatory Reform and Development Activity (ERRADA) has identified and catalogued more than 36,000 regulations from 10 ministries. In Tunisia, a recent effort has quickly catalogued more than 500 regulations in the Ministry of Finance alone, and the ministry is now taking steps to remove all except those supported by law or necessity.

These requirements, and the resulting opacity, have undermined policy. Firms in Egypt have consistently highlighted the need to address corruption and to encourage greater transparency and accountability, while reducing the incentives and scope for (p.110) bureaucratic discretion and informality.4 Macroeconomic uncertainty, regulatory policy uncertainty, informal competition, and corruption were identified as four of the top five constraints on firms in the World Bank's 2009 Egypt Investment Climate Assessment: Forty-three percent of surveyed firms said that officials expected an informal payment or gift to get a construction permit. More than half of hotels reported such payments to get an import card; twenty-six percent of manufacturers and 33 percent of services providers report the need for informal payments for access to running water. These results are consistent with evidence from around the world indicating that excessive, top-down regulations increase corruption, raise costs for the private sector, reduce the ability to create jobs, and force firms into the informal sector where they do not pay taxes.

Many reforms are well designed but not implemented at the point of contact with the private sector. A telling example is the modern building code that Egypt has introduced. It would sharply reduce the number of onsite inspections which the private sector reports is a cause of informal payments. These inspections are undertaken by officials from governorates and new urban communities. However, the private sector reports that these levels of government are still subjecting industry to the same inspections and procedures, despite the new law. A vertical coordination of policy across levels of government is missing.

In some countries, the control mechanism to ensure proper implementation of the law is through accountability to local communities, which can be enhanced by the use of citizen scorecards and other forms of monitoring. In the current environment, federal-local relationships are not clear, and the local capacity (p.111) to enforce delegated responsibilities is weak. As a consequence, the response to several reforms has sometimes been to introduce additional control mechanisms that then result in a further administrative burden on private firms.

A Financial Sector That Benefits Few

Financial intermediation by the banking system is weak by international standards. Most of the credit extended to the private sector goes to a small number of large firms with most firms, especially small and medium enterprises (SMEs), receiving little financing from banks. Policies governing the financial sector also reduce private sector efficiency and favor resource allocation to large firms. Only 20 percent of SMEs have access to finance, a level far lower than other regions, except for Africa, and the share of the population covered by microfinance is half that of Latin America. On the other hand, large firms have perhaps excessive access to finance. Arab banks have the highest average loan concentration ratio in the world, at 242 percent, as measured by their exposure to the 20 largest borrowers as a share of total equity.

The causes are several. Competition in the financial sector between banks and between banking and nonbanking sources of finance is limited. The Egyptian financial system, for example, has suffered from significant entry and exit barriers; as a result competition was limited and inefficient banks were allowed to continue operating. State-owned banks, which dominate the banking system, lag in efficiency and in risk management practices compared to their private counterparts.

A modest shift in market share from state banks to private banks is a step in the right direction, but the financial sectors of the Arab world remain less competitive than those in other regions, due to stricter barriers to entry, weak credit information systems, (p.112) and the lack of competition from capital markets and nonbanking institutions.5

In any economy, it is hard for the private sector to develop without reliable institutions that address market failures, including in the financial sector. Arab countries are still overly dependent on public registries with limited coverage and poor quality of information. Collateral regimes are limited in the type of assets that may be used as collateral, enforcing security interests takes a long time, and in a bankruptcy, secured creditors do not have a sufficiently clear priority. The region ranks last in a ranking of the legal rights of creditors in the World Bank's Doing Business Index.6 Overall, the Arab financial infrastructure is poor.

Meanwhile, insolvency regimes are largely in their infancy. Bankruptcy is considered a criminal offense in several Arab countries, and business failure is associated with considerable personal stigma, thus creating a strong disincentive for entrepreneurship. In Tunisia, these weaknesses were circumvented by the creation of an effective offshore regime to attract foreign investment, but that in turn has prevented effective linkages with the domestic economy.

A Failure to Industrialize

The impact of a small, informal private sector and a burdensome regulatory environment can be seen in the partial and incomplete development of the non−oil sector. Economies that have successfully generated growth in output and employment and made the transition from low-income to high-income status typically have experienced significant changes in their economic structure.

(p.113) Although structural transformation has been under way in Arab economies for at least four decades, the region's current economic structure differs significantly from comparable middle-income countries. Taking as a benchmark the structural characteristics of a sample of non-Arab countries at the time at which they crossed over from lower- to upper-middle-income economies, the small share of manufacturing in total output is both striking and worrisome.7

The sectoral shares of value added for selected Arab countries appear in Table 5.1 along with the simple average of the benchmark middle-income countries. Even Tunisia, the region's industrial success story, trails the benchmark by nearly 12 percentage points of its GDP in its share of manufacturing. Limited evidence suggests that the share of manufacturing in total employment, as well as the volume of employment in the manufacturing sector, has been stagnant in Arab economies since the 1990s.8

Agriculture constitutes a larger portion of the economy in Arab economies than in the benchmark, and it continues to employ large numbers. This also reflects the slow progress of structural change in the region. The service sector is also larger than in the benchmark and has absorbed much of the increase in the labor force. Services in Arab economies are highly diverse, ranging from high productivity sectors, such as banking, insurance and finance, to low productivity street vendors. Employment in high productivity service activities has been growing very slowly in the last decade. Trade (p.114)

Table 5.1 Arab Country Structural Deficit 2005

Value Added Share of Agriculture

Value Added Share of Manufacturing

Value Added Share of Services

Benchmark Middle-Income Country

8.7

28.1

49.3

Egypt

13.7

15.7

49.0

Morocco

16.4

15.9

55.1

Tunisia

7.8

16.5

62.3

Notes: Benchmark middle-income country as defined in text.

Sources: Margaret S. McMillan and Dani Rodrik, (2011), “Globalization, Structural Change and Productivity Growth,” Working Paper 17143 (Cambridge, MA: National Bureau for Economic Research); Marcel P. Timmer and Gaaitzen J. de Vries, (2009), “Structural Change and Growth Accelerations in Asia and Latin America: A New Sectoral Data Set” Cliometrica 3 (2): 165-190.

and small-scale repair shops (motor as well as household goods) are the only service activities that have grown rapidly, but a large proportion of these activities in the labor-abundant economies are informal and characterized by low productivity and low wages.

The structural deficit mainly reflects a failure of Arab countries to industrialize. Table 5.2 presents some basic indicators of industrial development for the Arab region as a whole and for Egypt, Morocco, and Tunisia. The Arab states lag other developing countries in three measures of industrial dynamism. Manufacturing output per capita ranges from 53 percent of the developing country average for Morocco to slightly more than the global average for Tunisia. The region's share of manufacturing in its GDP is low, relative both to developing countries as a whole and, especially, to East Asia. Most disturbingly, the rate of growth of the manufacturing (p.115)

Table 5.2 Selected Indicators of Industrial Development, 2005–2008

Manufacturing Value Added Per Capita 2008 (US$)

Share of Manufacturing in GDP 2008 (%)

Rate of Change in Manufacturing Share of GDP 00–08

Arab Average

381.4

12.1

0.85

Egypt

278.9

15.7

−0.68

Morocco

219.0

15.9

−0.81

Tunisia

414.7

16.5

−1.12

Developing Countries

412.9

21.7

1.14

East Asia

632.5

29.5

1.49

Source: United Nations Industrial Development Organization, Industrial Statistics Database database; author's calculations.

share of value added is negative, indicating that the manufacturing sector is declining in relative importance in all three countries.

The global industrial economy has undergone major changes in the last quarter century. Developing countries—especially industrializing nations in East Asia—have become the center of global manufacturing. Between 2000 and 2008, manufacturing growth in industrialized economies was only about 1 percent per year; in developing economies it was more than 7 percent.9 Arab economies—with the possible exception of Tunisia—largely missed the transformation of the global industrial economy. Whether they (p.116) can now compete successfully to attract global industry is likely to depend on how well they are able to deal with four key drivers of global industrial location: trade in tasks, firm capabilities, agglomeration, and industry without smokestacks.

First, in many manufacturing activities the production process can be disaggregated into a series of steps, or tasks. As transport and coordination costs have fallen, it has become efficient for the production of different tasks to be located in different countries, each working on a different step. Task-based production has expanded dramatically in the past 20 years and has been a major driver of the rapid industrialization of the new generation of Asian export manufacturers. It has also propelled Tunisia's relative export success. Because task-based production is highly mobile, it represents an important first step through which countries can enter global value chains but also presents a challenge in retaining task-based investment.

Second, success in the global market depends on achieving a minimum competitive standard of productivity and quality. In most industries, these depend on a set of interlocking elements of tacit knowledge or working practices possessed jointly by the individuals who comprise the firm's workforce. These firm capabilities are the know-how or working practices that are used either in the course of production or in developing new products.10 Low capability firms lack a mastery of the complex and interrelated bodies of knowledge and patterns of behavior that are needed to achieve competitiveness, and, because high capability firms tend to locate in environments that are rich in tacit knowledge, attracting high capability firms to low capability environments is difficult.

Third, manufacturing and service industries tend to concentrate in geographical areas—usually cities—driven by common needs (p.117) for raw materials, intermediate goods, access to markets, knowledge flows, and specialized skills.11 Because of the productivity boost that agglomerations provide, locations that have achieved a critical mass of industry have a built-in advantage over new industrializers in attracting further industry. Starting a new industrial location is a form of collective action problem: If a critical mass of firms can be persuaded to locate in a new area, they will realize productivity gains, but no single firm has the incentive to locate in a new area in the absence of others.

Finally, manufacturing increasingly shares a broad range of characteristics with agroindustry and high value added, tradable services. Activities such as the global agricultural value chain in flowers and horticultural crops, remote services, or tourism require firm capabilities that differentiate them from traditional agriculture and services. Such industries without smokestacks offer countries an opportunity to expand the sources of growth-enhancing structural change.

Breaking In, Moving Up

Arab countries face at least three industrialization challenges, shaped by the way in which the income levels and factor endowments of its economies interact with the global determinants of industrial location. For the region's labor-abundant, resource-poor economies—such as Egypt and Morocco—the challenge of breaking into global markets in task-based production is likely to be the most urgent. The region's resource-poor middle-income economies—Jordan, Lebanon, and Tunisia—face the challenge of moving up the value chain, increasing exports by improving their (p.118) product sophistication if they are going to compete globally. The oil exporters—the GCC countries, Algeria, and Iraq—confront a diversification challenge in the face of Dutch disease. Industry without smokestacks widens the scope of possibilities for attracting high value added industries for all three categories of countries.

Today, new manufacturing ventures are competing with East Asia, which now assumes the role previously played by the advanced economies of western Europe, the United States, and Japan. Asia has the scale and agglomeration economies that make it competitive against new entrants, despite rising production costs. One scenario, which cannot be wholly dismissed, is that the differences in wages between East Asia and the labor-abundant economies in countries such as Egypt may not be sufficiently large enough to offset East Asia's productivity advantage, making it impossible for Arab countries to compete. There are at least two reasons to think that the future is less bleak than this suggests. First, both real wages and congestion costs are rising in China, and second, growing domestic demand and policy responses to the global financial crisis have reoriented demand in Asia toward internal markets. These trends may provide a window of opportunity for labor-abundant, low-wage Arab economies.

For the region's upper-middle-income, non−oil economies, the industrial development challenge is somewhat different. Real wage levels are sufficiently high that, with the exception of Tunisia, they have not been attractive as final stage producers in task-based trade. At the same time, the region's nations, including Tunisia, have failed to keep pace with the rapidly growing industrial economies of Asia in more sophisticated industrial exports. This pressure in the middle has prevented Arab economies from making the transition from lower to higher sophistication manufacturing, limiting output and employment growth. The good news is that pressure in the middle is not uniform. Timeliness is emerging as a critical factor in the geographic distribution of global production. This may (p.119) open up space for those economies with close proximity to Europe, such as Tunisia, to master more complex tasks as part of the global trend toward “reverse outsourcing.”

Diversification is made difficult by the relative price changes that occur in a resource-exporting economy. Dutch disease cannot be avoided, but it can be addressed by public policy. Tradable goods production depends not only on the exchange rate but also on the investments and institutional innovations that governments make to enhance competitiveness. An effective diversification strategy, therefore, depends on identifying policy changes and investments that have a high likelihood of increasing firm-level productivity.

Guidelines for Industrial Development

Appropriate policy responses to the Arab countries’ three industrialization challenges will vary. One set of public actions is cross-cutting. This includes mainly policies and investments directed at improving the investment climate: the regulatory, institutional, and physical environment within which firms operate. But investment climate reforms alone may not be sufficient. For countries to break in, move up, and diversify, strategic initiatives aimed at pushing exports, building capabilities, and supporting industrial clusters will be needed.

In all labor-abundant Arab economies, the export market represents the only option for rapid growth of manufacturing, agroindustry, and high value added services. Countries such as Egypt, Jordan, Morocco, and Syria face the challenge of breaking into the global market. Tunisia's export challenge is somewhat different. It needs to move from low-end final-stage assembly operations to more sophisticated exports. For this to occur, it will need to attract higher capability firms and facilitate the transfer of capabilities to domestic manufacturing.

(p.120) In both cases, success in export markets in a world of task-based production and agglomeration will require more than piecemeal improvements in the investment climate. It will need an export push: a concerted set of public investments and policy and institutional reforms focused on increasing the share of industrial exports in the GDP. These initiatives will need to range from further efforts to reduce antiexport bias to the successful operation of export processing zones (EPZs) to institutional reforms and infrastructure investments aimed at improving trade logistics.

Capability building is complementary to the export push. All Arab economies need a strategy to attract high capability firms. Because foreign direct investment (FDI) is an effective means of introducing high capability firms into a lower capability environment, policies and institutions for attracting FDI are a key tool in capability building. Arab economies from the Gulf to Morocco have an unfinished agenda on the promotion of FDI. Autonomous, professional, and results-oriented FDI promotion agencies can make a major contribution to building capabilities in the region. Within an economy, vertical value chains are a major source of learning for firms. Removing obstacles to the formation of vertical value chain relationships should therefore be a major objective for public policies aimed at domestic capability building. Here again the challenges facing each Arab economy are distinct, but a central objective, equally valid in Egypt or Tunisia, should be to design an open architecture for special economic zones that permits free movement of labor, capital, management, and goods between the zone and the domestic economy. For Tunisia, in particular, a liberal offshore regime to attract FDI was not compatible with the excessive regulations governing the domestic economy, so that few firms benefiting from the FDI regime developed strong linkages with domestic suppliers.

Appropriate spatial policies to attract a critical mass of industry are likely to be a prerequisite to breaking into global markets. Case (p.121) studies indicate that governments can foster industrial agglomerations by concentrating investment in high-quality institutions, social services, and infrastructure in a limited physical area such as a special economic zone (SEZ). In East Asia and Latin America, spatial policies have been explicitly linked to an export push through the use of export processing zones that are properly viewed as industrial agglomerations designed to serve the global market. The Arab world's experience with spatial industrial policies has been mixed. Tunisia's special economic zones appear to have been a partial success. Egypt's EPZs have generally been regarded as failures.

Because of the variety of industrialization challenges faced by the Arab economies, there is no single appropriate industrialization strategy for the region. It is likely that all three of the policy areas outlined here will need to be implemented in each country, but the nature of the policies will vary by the level of industrial development, the resource endowment, and the capabilities of enterprises in each country. Table 5.3 sets out a typology of industrialization challenges and strategies for three classes of Arab economies.

The most challenging reforms may be in rich countries trying to diversify. This will depend, to a great extent, on their ability to empower citizens with the required knowledge and their capacity to support innovation. These economies are challenged by an insufficiently trained workforce, unproductive SMEs, and weakness in innovation and entrepreneurship.

First, upgrading and enhancing workforce skills are essential measures to improve the capacity for competitiveness and to increase its productivity. Educational reforms, an emphasis on job training, and appropriate incentives are needed.

Second, SMEs are unproductive, in part, because they lack access to capital and to good infrastructure that tends to be (p.122)

Table 5.3 Industrialization Challenges and Responses

Breaking In

Moving Up

Diversifying

Country Examples

Egypt, Morocco

Lebanon, Tunisia

Algeria, Libya, GCC

Industrialization Challenge

Lower end task-based trade and agroindustry

Mastering more sophisticated products and tasks

Finding niche markets for high value-added manufacturing and services

Investment Climate Reforms

Regulation; trade-related infrastructure; skills

Regulation; trade-related infrastructure; skills

Regulation; skills

Strategic Components

Export Push; EPZs; Aggressive FDI policy

Spatial policies linking skills, knowledge, and capabilities; FDI; production knowledge initiatives

Linking industrialization to the resource; spatial policies linking skills, knowledge, and capabilities; production knowledge initiatives

(p.123) concentrated in special zones. They also lack linkages to larger firms through value chains that could help them absorb new technologies and to innovate.

Third, innovation and entrepreneurship are limited because they rely on investments in developing the skills and advancing the knowledge of the workforce rather than just on investments in infrastructure, which have been comparatively easy to put in place.

A range of policy instruments is being experimented with across the region, in particular:

  • investing in education, training, and educational development

  • expanding SME's access to capital and technical assistance

  • establishing entrepreneurship grants

  • establishing microfinance schemes for small-scale startups and individuals

  • creating venture capital funds, establishing and expanding business incubators, and investing in new technology startups

  • partnering Arab countries with selected foreign “knowledge centers” to establish ties on innovation, education, and intellectual property

  • initiating new sectors or clusters within a short period of time12

It is still too early to assess the cost benefit of these interventions, but it would be useful for countries in the region to pay close attention to these efforts and to exchange information about what works and under what circumstances. Such lessons would be easier (p.124) to develop if program evaluation were done in a systematic way across the region.

Can the Arab World Compete?

To many, the Arab private sector is seen as synonymous with corruption. Yet there is no sustainable response to the aspirations of youth without the private sector playing a leading role and without governments in the region taking needed steps to build confidence in the private sector. That requires a substantial reform agenda, including private sector leaders who focus on production and innovation, rather than on seeking rents. Reform must come from both directions. The public sector must give up control, and the private sector must concentrate on its productive capacity and not renew attempts at state capture.

Unless it is possible for enterprises to succeed without paying bribes, no amount of dialogue or prosecution will end the practice. For many small and microenterprises—including the self-employed, as in the case of Mohamed Bouazizi—with short-term funds borrowed at high interest rates, the option of waiting for long bureaucratic processes simply does not exist.

Governments are starting to take action, but more must be done. In Egypt, the prime minister recently removed requirements for new industrial projects to get approval, simplified the process of registering branches of foreign companies, removed the requirement for media companies to register with security services, made import certificates valid for three years rather than requiring frequent renewals, and established new branches of the Investment Authority. Tunisia, perhaps furthest along, has launched a regulatory “guillotine” process through which hundreds of obsolete regulations in the Ministry of Finance are (p.125) being eliminated. Morocco has established the Comité National de l’Environnement des Affaires (CNEA), which has coordinated reform across ministries, leading to the nation being named the most improved investment climate in the annual Doing Business ratings. Most countries in the region could move to online registration of businesses, online payment of VAT and social insurance contributions, and combine tax and social insurance registration services at a single site.

None of these issues is new, and several previous efforts have been made at reform. But those have typically relied on the political will of an enlightened minister, president, or prime minister. They produced important results, but for the most part the effects were fleeting and reversible. In the case of Jordan, elites have blocked reform initiatives that would raise the quality of life for the average Jordanian but reduce the power of those elites, and this probably describes the situation in other countries as well.13

Past reform efforts, however well intentioned and initially successful, have mostly been weighed down and overcome by an administrative culture without modern alternatives, partial reform, and the strength of vested interests. For the private sector at the street level, the net result has been to reduce revenue and raise costs—a recipe for business failure, which under the current legislative regime in many countries of the region is a criminal offense. For governments, the net result has been to reduce the size of the formal private sector and, therefore, the tax base. Without tax revenues, public services and institutions suffer, civil service salaries are lower, and fresh incentives for corruption arise. While this was never the policy intent, the new governments in the region need to reverse these trends.

(p.126) Moving Forward with Private Sector Reform

While governments have long voiced support for the private sector, this has been belied by significant government intervention in markets through public sector employment and state control of industry. The Arab world's traditional approach to economic management has offered a minority of workers security of employment but at the expense of declining wages and overall standards of living. It sustained redistributive policies that mitigate inequality but are underfunded and increasingly ineffective. Moreover, private sector reforms in the region have often produced backlashes against private investors and entrepreneurs rather than against the public policies that enabled the past abuses.

Conditions, of course, have changed dramatically in recent years. With fewer opportunities for labor migration, less regional circulation of oil revenues, and intense competition for foreign investment, Arab governments will increasingly depend on globally competitive domestic private sectors to sustain desirable social policies. To move the private sector reform process beyond its current limits, governments will need to revive national conversations about labor markets, service delivery, regulation, and the problems of cronyism. Governments will need to rebuild trust across the citizen sector and the private sector as part of a coalition for reform that is sustainable and built on mutual accountability. Governments will need to make strategic choices about their role and perform that role well while empowering other actors to also contribute to the transformation.

The Role of Public-Private Dialogue

Public-private dialogue is a key tool in prioritizing the competitiveness agenda. The industrial sector growth and diversification agenda (p.127) has moved toward pragmatic, evidence-based, and market-driven processes of problem solving through public-private partnerships. This approach to competitiveness recognizes the processes through which successful industries have emerged, particularly in East Asia. Whether an initial set of competing firms becomes a competitive industry depends both on firm-specific factors as well as on an “ecosystem” of public and quasipublic goods outside the firm. Promising sectors that are new to a country or region inevitably place new demands on the investment climate in terms of regulation, infrastructure, standards, skills, or finance.

As the industry moves toward the competitive frontier, more specialized demands emerge and require solutions. In this view, building competitiveness is essentially a search for technological, policy, institutional, and financial solutions to problems facing an industry at each successive stage of its growth. The experience of newly industrialized countries suggests that this problem-solving process is often led by public-private partnerships.

Correcting the Antiyouth Bias

Young people's labor market prospects have suffered greatly from the antiyouth bias of the structural adjustment period. The youth-led uprisings of the Arab Spring provide a unique opportunity to adopt more youth-friendly labor market policies. The policy framework must strive to increase access to formal jobs with social protection without reverting back to creating unproductive public employment or overly rigid labor market rules. In the long run, this will depend on the adoption of policies that boost labor demand through a healthy investment climate and rapid growth and that improve the quality and composition of the labor supply through stronger, more responsive education systems. However, there are a number of short-run interventions that can make labor (p.128) markets more hospitable to youth. Active labor market policies, such as job search assistance, employability training support for apprenticeship and internship programs, and on-the-job training subsidies are needed to ease the transition of youth into formal employment.

Governments have traditionally spent significant resources on vocational training for new entrants, but these resources have generally been wasted because they did not cater to the needs of private employers. Public sector training centers that supply most of the training simply have no mechanism to respond to market needs. What is needed is a more market-oriented approach to training that allows employers to shape the kind of training they need with financial support from the government. This can be done through the use of training vouchers that can be redeemed with accredited private sector training providers or through industry-led training centers such as the Penang Skills Development Center (PSDC) in Malaysia. PSDC is a nonprofit, industry-governed training center started in 1989, which serves the needs of the Penang manufacturing industry on the basis of a tripartite partnership between industry, academia, and government. The key to such training institutions is responsiveness to the training needs of private employers, including SMEs.

Finally, the avoidance of the high rates of informality that characterize many labor markets in the Arab world will depend on choosing institutional arrangements that do not impose excessive costs on employers who hire workers formally. These include regulations that set minimum wages, determine social insurance contributions, and protect job security. As Santiago Levy argues in his book on Mexico—Good Intentions, Bad Outcomes—when access to social benefits is linked to an individual's labor status, salaried or nonsalaried, and is paid for by wage-based contributions from workers and employers, there is a tendency to (p.129) push both workers and firms into informality.14 He further argues that informality is not innocuous, but that it imposes social costs, especially on workers who are excluded from formality, as well as economic costs, in the form of lower labor and capital productivity and, ultimately, lower growth. He proposes a system of universal social entitlements financed from general tax revenues that delinks much of social protection from job status. Because of the high costs of formality, the slowdown in public hiring in Arab economies in recent years has simply translated into an explosion of informality, especially among the growing number of young educated new entrants.

Private Provision of Public Services

Significant improvement of the quality and the productivity of government services could be made by using new technologies as well as providing the legal and incentive framework for the effective private delivery of some services. In the short and medium run, there is a need to improve the quality of the people working in the public sector and to maximize the use of new technologies, including information and communication technology (ICT) in order to enhance service delivery.

Human resources are the main pillar for effective and efficient government service delivery. They should be well qualified, carefully selected, well trained, well managed, and their performance should be continuously evaluated. In this regard, there is a need for attracting better quality civil servants to the public sector by targeting good candidates from schools and universities, offering good salary and remuneration packages, and improving the selection (p.130) criteria for candidates. This should be followed by continuous on-the-job training. It is equally important to retain the existing qualified employees by continuously motivating them, including through the improvement of the salary structure and the remuneration package. Moreover, a career path linked with performance should be established for each employee where the career path is based on commitment and accountability.

In parallel, the adoption of different approaches to service delivery, including leaner processes and the greater use of ICT, will tremendously enhance the efficiency of government services. The government should aim to align its business processes and operations with the infrastructure of ICT, which should lead to the integration of all government services across agencies. Also, the use of electronic government services (e-government) will improve the way government extends services to businesses and the public.

Outtasking/outsourcing noncore tasks in government ministries and institutions would have significant advantages in terms of quality and productivity, which, in turn, would create opportunities for new, successful private industries to emerge in service delivery functions. The government could start by pooling services together under one entity and then privatizing it. A good example would be to pool the information technology services in government institutions and allow the private sector to provide the support through service level agreements. This would be efficient and have the side benefit of freeing government institutions to focus on their core tasks of policymaking, regulation, funding, and client service provision.

To reduce the risks of outsourcing, government should start the process gradually, focusing on areas where the services could be successfully handled by the private sector. As an example, government hospitals could start outsourcing their food, cleaning, and engineering services and IT management. It is also important to (p.131) manage staff movements carefully and effectively in the outsourced areas and to provide training and placement for employees who lose their original positions.

The agenda described demands a repositioning of the relationship between public and private actors, with private actors called on to deliver public goods. Beyond this, the agenda demands judicious risk taking. Such risk taking is best undertaken when supported by rigorous impact measurement and evaluation, so as to support self-correction and adjustment.

Strategic Choices in Private Sector Reform

Governments around the world pursue a variant of two broad strategies for private sector reform: broad-based, bottom-up strategies or a more focused effort built around strategic initiatives or industries, commonly referred to as industrial policy. In practice, elements of each approach will form the basis of policy, but choices will need to be made in each case. A third strategy, somewhat of a hybrid, would be to focus on creating an environment for high potential entrepreneurs, including social entrepreneurs, to emerge.

Broad-Based Strategies: Empowering Markets

A broad-based strategy to private sector reform should focus on making markets work more effectively by introducing modern tools of regulation in place of outdated administrative controls. Not simple liberalization, it should be construed as a pragmatic approach to efficient private sector development.

If administrative choices and public policy were perfectly and continuously aligned with the most productive use of skilled labor, (p.132) land, and capital, then there would be no problem. But one of the key reasons that countries have moved away from the administrative control of markets is that markets are dynamic and internalize information. Administrative tools can simply not keep up with the rapid evolution of markets and opportunities. That is one reason why there is such a large stock of obsolete regulation, as in the case of Egypt and Tunisia, and such a gross mismatch between the stock of educated graduates in Tunisia and the market for their skills.

This requires a rethinking of regulation. Regulation in far too many instances is failing to deliver intended benefits, while also imposing high costs. However, simple deregulation is clearly not the answer. Market failures exist, and citizens are right to demand that the private sector adheres to clearly defined public norms. If the question is the balance between public and private interests, a key instrument to remedy this is better business regulation. Good regulation protects the public interest—such as a safe environment, safe food, fair competition, and the prevention of unmanaged risks—but allows good firms to thrive. Good regulations are predictable, efficient, and fair. Some of the characteristics of better regulation:

  • Participatory. Good regulation emerges from a well-structured dialogue with the private sector, through which public interests can be more clearly specified and regulatory failures—overlaps, unclear provisions, high costs—can be identified. Beyond dialogue, the private sector can play a role in enforcement through voluntary standards or self-regulation. Self-regulation can help achieve objectives efficiently and can be enforced through a threat to use formal state regulation if industry does not deliver. New Zealand has allowed industry to come up with voluntary standards for reducing carbon dioxide emissions, but if this fails, New Zealand will introduce a carbon tax.

  • (p.133) Differentiated. A good example of differentiated regulation is border control, where there is a clear public interest in preventing illegal or dangerous goods from entering the country. Countries that regulate borders badly tend to inspect every container, creating delays, damage, and a strong incentive for importers to pay bribes. The government of Morocco used information technology to identify those shipments that create the most risk and inspects only 5 to 10 percent of shipments. The rate of detection of bad shipments increased. The public interest is better protected, trade is faster, and firms are more competitive.

  • Efficient. Like many countries, the government of Tunisia had reformed many laws and regulations, but often it did not remove the old regulations. Based on a decree of the prime minister of Tunisia, the Ministry of Finance has now created a high-level technical committee and working groups in all departments to look at 500 formalities and eliminate those that are unnecessary, ineffective, not based on law, or redundant. The task will be completed by March, creating a much more competitive environment for its own recovery as the new Tunisia.

  • Predictable. Private firms, whether individual entrepreneurial entities or large corporate entities, exist to earn a profit commensurate with the risk of investment undertaken. The lack of predictability of the regulatory environment is at least as important to investors as its cost.

  • Accountable. Oversight by elected legislatures and legislative development based on hearings and stakeholder input will increase the legitimacy of legal rulings. As laws become more important, this will help limit administrative discretion so as to provide increasing clarity and predictability to the private sector as to how the rules will be applied to firms.

(p.134) Democratizing access to credit will involve building institutions (including credit bureaus), secured lending regimes, and oversight capacity that will allow for the merit-based allocation of capital, rather than allocation based on the presence of collateral or policy preferences.

Building confidence in the judiciary to uphold property rights, even in light of pressure from politically connected interests, is a central challenge of the postrevolution investment climate. Confidence has actually increased over time in several countries of the region, yet the courts remain fundamentally backlogged and inefficient. Judges are not provided with adequate resources, including court staff, court reporting, and clerks for research and administrative functions, and economic training. To help diversify the economy, a few key areas of law are crucial. Strengthening the insolvency and secured transactions systems will encourage risk taking as it allows a debtor to emerge fairly from a failed venture with the ability to learn and leverage the experience into a new venture.

Enhancing competition should be a focus for key sectors across the region. A broad-based strategy to private sector reform would be based on a vision of individual firms making choices that raise their productivity, driven by the process of competition. From a business standpoint, the goal would be to lower the fixed costs of entry and operation, allow unit costs of key inputs to reflect their economic value, while expanding opportunities for growth.

Competition policy provides a partial answer. Egypt has a good Competition Authority, but its effectiveness has been limited due to many exceptions to its mandate. The law and executive regulations could be amended to allow it to cover mergers and acquisitions, and its autonomy could be enhanced by removing the minister of trade from decision making and enforcement processes. Administrative enforcement of the competition authority's rulings could be allowed, and its investigatory powers and ability (p.135) to impose penalties could be strengthened. Finally, the competition authorities should be supported in a sector-by-sector review to identify barriers to entry, exit, and competition in key sectors, including public utilities.

This is a broad agenda, but the potential benefits are enormous. The evidence is that there are more than 20 million small enterprises in the region, so any marginal improvement in productivity through a broad-based reform could quickly result in significant increases in output and employment.

Scaling up Entrepreneurship—Commercial and Social

Getting the investment climate right for all firms is a long-term agenda. A narrower strategy might productively focus on what Dan Isenberg calls the “entrepreneurship ecosystem”—the combination of culture, infrastructure, policies, regulations, skills, technologies, and capital that are specific to enabling startups to emerge and thrive. The precise formula must be local and cannot be forced into existence, but a wealth of international experience can be applied as guiding principles for the region.15 Several parts of the broader agenda, particularly around the decriminalization of business failure, streamlining the overwhelming burden of administrative controls and democratizing access to credit, are essential.

The entrepreneurial nature of the revolutions in the region gives confidence that there are relevant skills among youth to be tapped. Building on the success of the revolution may help address the largest challenge, which is cultural: getting young students to see entrepreneurship as a viable choice. Here Injaz's annual Young (p.136) Entrepreneurs Competition, building on national competitions among schools, is playing an important role in raising the profile and skills required. Efforts to promote mentorship such as Endeavor are also important.

Finally, there is a role for the strategic deployment of capital through investment funds with the capability to identify and accelerate entrepreneurship and private sector development in the region. With a few important exceptions, such as Abraaj's Riyada Enterprise Development Fund, Silatech, and the incubator arms of several of the region's private equity funds, the availability of growth capital for capable smaller firms is as limited as debt, particularly beyond the IT sector. Given the substantial available capital in the region, raising funds should be a less binding constraint than ensuring venture capitalist (VC) talent for identifying and supporting capable firms as well as improving their governance. The latter is likely to require the return of private equity talent from global markets to support the emergence of the Middle East and North Africa region.

Many young entrepreneurs are now focused on enterprise development with a social, rather than financial, impact. They are applying the power of markets to create enterprises that apply commercial principles but through reducing costs are able to provide services to poor consumers or address social issues such as recycling, low-cost housing, education, microfinance, small renewable energy, animal husbandry, and consumer goods. Many of these enterprises originate from the NGO sector but face tremendous hurdles in registration, access to finance, and operations, in part because they operate on narrow margins and in part because there are no legal options for hybrid social enterprises. Removing those obstacles can help the private sector reestablish a “social license” to operate, while also creating sustainable sources of job creation for many inspired youth.

(p.137) Focused, Strategic Initiatives

Governments cannot do everything, and there is some justification for focused, strategic initiatives through which public action can crowd in the private sector, especially in countries where diversification is a key issue. The broad academic consensus is that diversification requires a combination of supportive exchange rate policy that promotes tradable sectors along with industrial policies.16 The region appears to be inclined toward active industrial policy. Most countries have spent huge sums on commissioned reports by the world's most reputable consulting firms advising them on the growth of sectors and industries. In Jordan, each sector has been studied multiple times. Lebanon has had 13 sectors studied in depth. Morocco and Libya each recently completed engagements covering industries and sectors. Saudi Arabia has launched programs to build economic centers, an initiative to improve competitiveness (the “10x10” program), and other ambitious efforts. The role models for this approach would be Korea, Singapore, and Malaysia in East Asia and Dubai within the region.

Yet this inventory of studies has produced few clear successes. The reasons for the low success rate are largely the same as the reasons for a failure to sustain broad-based reform: the lack of government implementation capacity and the lack of evaluation. Strategic initiatives are even more demanding of the public sector in ensuring horizontal and vertical coordination, sustained effort, and the avoidance of capture. In the best examples, focused initiatives are highly selective and either reversible or executed on a “no regrets” basis by targeting areas that have broad benefits to society.

(p.138) What areas might be most relevant? Several sectors appear to have had a good deal of traction recently, including ICT, tourism, logistics, and the education sector. Internet usage in Arab countries rose 39 percent in 2010, to 86 million people. Leading companies (Intel and Microsoft) have been attracted to Egypt as an outsourcing center, and these services now generate more than $1.1billion in revenue and employ 65,000 workers. There is similarly high potential for Jordan (serving the GCC) and Morocco (serving the European Union [EU]). For many countries, e-government has been a catalyst. Egypt is not exploiting Suez as a logistics corridor, and Libya has not started to tap its tourism potential.

The challenge for such strategic initiatives is how the tools of the state should be deployed. There is a broad consensus that government efforts should be temporary, evaluated and quickly ended if they are not yielding results. They should be neutral to the type of industry that will benefit to the extent possible (or favor sectors with a broad, rather than narrow, impact).17 Moreover, modern industrial policy is better understood as a process of joint learning and problem solving between the public and private sector, in which the next policy or action in a sequence is not understood until a first step is taken. It is not about the state picking activities and subsidizing them to create industries. This formulation requires that policy makers engage in an ongoing conversation with the private sector to prioritize such actions as the removal of constraints that arise in the diversification process, such as logistics problems, information gaps, or poorly designed institutions.18 In that conversation, the existence of a state-owned enterprise can even be beneficial and a (p.139) source of information that helps avoid policy capture by the private sector, as long as the enterprise is efficiently run. This illustrates the complexity of simplistic strategies and the need for pragmatism in developing industrial policies.

For any strategy that depends on public investment or intervention, monitoring and evaluation are essential. Diversification is a strategy that calls for self-discovery, so evaluation is of high importance. Evaluation can be technically complex or simple, but it is important that it be undertaken in order to both support and terminate activities based on their success in achieving strategic goals. Where feasible, public interventions should be piloted, in a manner that allows for evaluation using experimental or quasiexperimental methods, to maximize learning.

Notes:

(1) World Bank, (2009), From Privilege to Competition: Unlocking Private-Led Growth in the Middle East and North Africa (Washington, DC: World Bank).

(2) International Development Research Center, (2010), Global Entrepreneurship Monitor, Middle East and North Africa (GEM-MENA), (Ottawa: IDRC). The survey was based on Saudi Arabia, Turkey, UAE, Syria, West Bank/Gaza, Tunisia, Iran, Egypt, Jordan, Lebanon, Morocco, Algeria, and Yemen.

(3) Mustapha Kemal Nabli, (2007), Breaking the Barriers to Higher Economic Growth: Better Governance and Deeper Reforms in the Middle East and North Africa (Washington DC: World Bank).

(4) World Bank, (2009), Egypt Investment Climate Assessment 2009: Accelerating Private Enterprise-Led Growth (Washington, DC: World Bank).

(5) World Bank, (2011), Financial Access and Stability: A Roadmap for the MENA Region (Washington, DC: World Bank).

(6) World Bank, Doing Business Indicator, www.doingbusiness.org/rankings.

(7) Benchmark countries and years are: Brazil (2005), Chile (1995), China (2009), Malaysia (1995), Mauritius (2003), Thailand (2010), and Turkey (2004). The threshold income level for the benchmark countries is taken as $3,975 gross national income per capita in 2010 dollars. This level roughly corresponds to the average income of the region's lower middle-income countries—Egypt, Morocco, and Syria—and its upper-middle-income economies of Tunisia and Jordan.

(8) Because of a lack of data on employment, it was not possible to estimate the employment shares for individual economies.

(9) UNIDO, (2009), Industrial Development Report (Geneva: United Nations Industrial Development Organization).

(10) John Sutton, (2005), Competing in Capabilities: An Informal Overview (London School of Economics).

(11) M. Fujita, P. Krugman, and A. J. Venables, (1990), The Spatial Economy: Cities, Regions and International Trade (Cambridge, MA: MIT Press).

(12) Nazar S. Al Baharna, Anil Khurana, and Martyn F. Roetter, (2006), Creating a Knowledge-Based Society in Bahrain (Bahrain: UNDP).

(13) Marwan Muasher, (2011), A Decade of Struggling Reform Efforts in Jordan: The Resilience of the Rentier System (Washington, DC: Carnegie Endowment).

(14) Santiago Levy, (2008), Good Intentions, Bad Outcomes: Social Policy, Informality, and Economic Growth in Mexico (Washington, DC: Brookings Institution Press).

(15) Danial J. Isenberg, (2010), “How to Start an Entrepreneurial Revolution,” Harvard Business Review, available at http://hbr.org/2010/06/the-big-idea-how-tostart-an-entrepreneurial-revolution/ar/1.

(16) Dani Rodrik, (2007), “Industrial Development: Stylized Facts and Policies” in UN Department of Economic and Social Affairs, Industrial Development for the 21st Century (New York: UN-DESA).

(17) Commission on Growth and Development, (2008), Growth Report: Strategies for Sustained Growth and Inclusive Development.

(18) Charles F. Sabel, (2007), “Bootstrapping Development: Rethinking the Role of Public Intervention in Promoting Growth,” in Nee and Swedberg, eds, On Capitalism (Palo Alto, CA: Stanford University Press), p. 305.