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Growth and the Investment Climate

Economic growth is essential to achieving the Millennium Development Goals (MDGs), and central to the growth agenda is the investment climate, because it addresses the main sources of growth: increasing investment (local and foreign), improving efficiency, and enhancing productivity. Improving the investment climate is one of the two pillars of the World Bank’s development strategy and was the subject of the World Development Report 2005: A Better Investment Climate for Everyone

Finding from investment climate surveys
Current and future research directions

Mary Hallward-DriemeierTel: (202) 473-9120Email:   
Luis ServenTel:  (202) 473-7451Email:


Consensus is growing that the investment climate is critical to economic growth, but there is less understanding of how the different elements of the investment climate interact with one another and affect the behavior of firms. How do investment climate reforms interact with other key conditions such as infrastructure, the proximity of other firms, or the size of the market? How do investment climate dimensions, such as labor and financial sector regulation, interact with others, such as corruption and the rule of law? Lack of answers to these questions has hindered the formulation of reform priorities and weakened the case for reform in slow-growing countries.


To address these questions, it is necessary to quantify the likely benefits of specific reforms, and understand how their results can be affected by the interaction of different policy areas. For example, to understand the interaction of poverty reduction and firm growth, we need to understand the processes of growth in large, small, and informal enterprises, and how the investment climate differentially influences the potential of each. Too often, the lack of this information has delayed or distorted reforms.

The Bank’s Investment Climate Surveys are a joint initiative launched in 2001 by the World Bank’s Private Sector Development Vice-Presidency and the Development Economics Vice-Presidency. The initiative has received strong support from the Netherlands, France, and the KCP donors.


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Finding from investment climate surveys
New data are now available on more than 70,000 firms in over 100 countries. The surveys are a critical input into country-specific investment climate assessments, which in turn have been incorporated in many of the World Bank’s country assistance strategies, poverty reduction support credits, and 34 World Bank projects financed with $1.8 billion in World Bank loans. Five policy areas receive particular attention in the surveys: entry regulations and competition; labor regulations and human capital constraints; technology policies; infrastructure services; and governance and the rule of law. A website, built and operated jointly by DEC and the Bank’s Private Sector Development Sector Board, allows easy analysis of the investment climate confronting firms in several countries.

Among the general lessons from the surveys:

  • The extent to which investment climate improvements would raise growth, investment, and productivity is more substantial than expected. For example, in India, reducing the burden of business regulation and improving infrastructure (particularly for electric power) in poor states to the levels of the states with the best investment climate would increase sales growth by 5 percentage points a year in the poor states. Infrastructure disruptions such as frequent power outages or poorly maintained roads, corruption, crime, excessive regulation that causes delays, and problems in enforcing contracts can cost firms up to 30 percent of their sales, or three or four times what they typically pay in taxes.
  • Entry, exit, and competition—rather than monopoly rents—are key determinants of innovation.
  • In the right regulatory framework, specific policies to promote technological change also spur growth.
  • Regulations affect human capital constraints to growth directly—and in interactions with other policies.
  • Effective regulation, rather than ownership, is essential to improving infrastructure services and expanding their contribution to growth and poverty reduction.
  • A weak investment climate disproportionately hurts smaller firms.
  • It is not just formal policies that matter—the costs of uncertainty, corruption, and state capture must be addressed if reforms are to have an impact.Back to top

Current and future research directions

Research thus far has emphasized the potential gains fromreforms. Since our intention is that firms be re-surveyed at three- to four-year intervals, it will eventually become possible to measure the actual gains they experience from reforms that governments implement. The first countries are just launching their second rounds of surveys. Researchers plan to assess the impact of reforms on the performance of firms (on investment, innovation, job creation, training, exporting); on the spillovers across firms; and on how benefits compare with costs.


In one project in progress, researchers are evaluating the effect that economic and institutional reforms may have on macroeconomic growth and volatility. This project has multiple components. These include a study of how policyinduced regulations affect firm dynamics and the economy’s ability to recover from aggregate shocks, and a theoretical and empirical study of how some reforms, such as trade liberalization, need others such as loosening of restrictions in the labor market to be sustainable and have a positive impact. Also being evaluated are policies to offset specific market failures, and the disadvantages of economic geography.

Another ongoing project investigates the investment climate facing informal firms. With the informal sector accounting for the bulk of employment and even GDP in many developing countries, understanding the dynamics and constraints within this sector is vital to link investment climate policy recommendations more directly to the fight against poverty. Many small firms decide to remain informal for good reasons, avoiding many interactions with officials, and not complying with taxes and regulations.

And formality often fails to bring many benefits—small firms are significantly less likely to get outside finance or have confidence in the protection of their property rights even if they are in the formal sector. To encourage formality, policies must address the relative costs and benefits of remaining informal. The research focuses on access to credit and how well informal sources of credit substitute for formal credit; access to infrastructure and production decisions; and security of property rights including crime) and investment decisions.

A research project on industrial organization policy for development looks at the key lessons from 15 years of infrastructure restructuring and privatization programs. It focuses on the institutional safeguards, the legitimacy of procedures, and several second generation regulatory reforms—of  ricing, access to bottleneck facilities, and subsidies—that will be needed if such programs are to achieve their public interest goals.

Research on the determinants and consequences of international capital flows has several components. One studies the main forces determining debt and equity allocations across developing and developed countries, and another looks at the effects of different types of investment (domestic investment, mergers and acquisitions and greenfield FDI) on each other and on economic growth.


Despite the clear benefits of a better investment climate in improving growth, few countries are in fact embarking on significant reforms in this area. Underlying issues of governance help explain why. Researchers are examining how governance can be strengthened to improve the prospects of reform.

The negative correlation between the level of corruption and growth has been firmly established at the cross-country as well as at the firm level. Work is underway to examine the role of political institutions and processes, particularly democracy and credibility, in explaining the effect of corruption and clientelism in setting policy agendas.Back to top

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