POVERTY LITERATURE REVIEW SUMMARY:
INVESTMENT CLIMATE AND POVERTY REDUCTION1
Evidence from literature suggests that investment climate matters for the poor. The relationship
between investment climate (IC) reforms and poverty reduction can be understood in two ways. First,
the impact of IC reforms can be seen on the aggregate level, through facilitating investments, exports
and improving productivity. These, in turn, spur economic growth, which positively affects poor people
through improvements to their income. Second, IC reforms affect people directly. The gains can be
seen through the lenses of people capacities as consumers capitalizing on lower price levels, users of
infrastructures and finance through better access to services, and potentially entrepreneurs and
employees through private sector savings and job creation. Going forward, more country-specific and
cross-country research is needed to better understand and confirm these linkages.
Introduction
This note summarizes a literature review conducted by IFC on identifying the transmission links of
investment climate to poverty and economic growth. This exercise was undertaken as part of IFC’s
Poverty Action Plan, to better understand how IFC operations in specific sectors across its investment and
advisory operations result in eradicating poverty and boosting shared prosperity.
The operating and regulatory environments in developing countries can be challenging, thereby hindering
private sector development, which remains relatively inefficient, uncompetitive and dominated by
informal economy. Investment climate reforms seek to address these market failures by facilitating
enterprise creation and growth, fostering international trade and investment, promoting sustainable
investments in key industries (agribusiness, tourism) and encouraging private participation in
infrastructure and social sectors (ICT and health). They focus on micro, small and medium sized
enterprises and reach the poorest regions of the world. The Investment Climate Department (CIC) invests
31% of its funding in Sub-Saharan Africa, where 47.5% of the population classifies as poor by the USD
1.25 a day measure.
Indirect impact of investment climate reforms through economic growth
The linkages between IC reforms and poverty reduction are two-fold. First, IC reforms can make a
substantial contribution to private sector development and hence economic growth, which is an important
factor in poverty reduction. Analysis of enterprise survey data shows that several constraints in
investment climate together account for more than half of the most important obstacles cited by
businesses. These indirect effects are discussed below. Secondly, IC reforms have a direct impact on the
lives of the poor, through business creation, employment, improved access to infrastructure and other
improvements driven by the reforms. The international community underscored the importance of an
enabling business climate for private investment and job creation during the Group of 20 (G20) summit in
Mexico in June 2012.2 The direct effects are discussed in the next section.
Evidence from literature suggests that IC reforms can increase countries’ exports, investment and
productivity, all of which are major contributors to economic growth. Trade logistics reforms, for
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This note has been summarized from the poverty literature review conducted by the Investment Climate department. The note is
available on IFC’s poverty webpage: http://ifcnet.ifc.org/ifcint/deveffectiveness.nsf/Content/home
2 IFC Jobs Study: ‘Assessing Private Sector Contributions to Job Creation and Poverty Reduction’, January 2013
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example, have a notable impact on productivity and GDP. A 1% reduction in the time to export increases
exports by 0.4%. Exporters are on average 28% more productive than non-exporters and have a higher
rate of productivity growth. Cross-country research studies on business taxation suggest that lower
effective tax rates are associated with higher foreign direct investment (FDI), approximately 1.6-2.1% of
GDP. Reforms in competition policy can help open markets and promote competition typically resulting
in lower prices and better deals for consumers. They tend to stimulate innovation, productivity and
economic growth. A study based on Organization for Economic Cooperation and Development (OECD)
countries found that reducing state controls and barriers to competition increased long term employment
rates by 2.5-5%.
And economic growth can be good for the poor. A body of literature provides evidence that the poor
benefit from economic growth. For example, Kraay (2004) found that in the medium to long run; between
66-90% of the variation in changes in poverty can be accounted for by the growth in average incomes.
Studies also find that there is a strong positive correlation between the incomes of the poor and average
per capita income, suggesting that poverty trends track growth trends very closely.
Direct impact of investment climate reforms
The direct impact on the lives of the poor is seen through lower prices for consumers or improved
access to infrastructure. For example, various studies suggest that competition and trade also push
prices down and increase the variety of goods and services, including food, accessible to the poor.
Lowering barriers to entry by 10% can decrease price markup by nearly 6%. Electricity sector reforms
aimed at privatization and restructuring reforms in Latin America increased installed capacity and
utilization, and in some cases led to price decreases.
Evidence suggests that informal employment is associated with poverty, and hence IC reforms that aim to
increase formalization and employment benefit the poor as entrepreneurs and employees. However,
literature evidence is not conclusive and a growing number of studies show that IC reforms, which focus
mainly on the formal sector, don’t have a sizeable impact on formalization. While the effect of improved
business entry regulations on firm creation has been well documented, less is known about their impact
on firm formalization, survival and employment. This applies to the impact of business taxation,
insolvency, ADR and other IC reform areas as well. As a result, more research is needed to understand
these linkages.
The IFC Jobs Study cites several instances of studies which highlight the significant employment creation
effects of IC reforms. While Special Economic Zones (SEZs) may not have been universally successful,
these concentrated zones with good infrastructure and connectivity and governed by a comprehensive and
integrated set of rules on business environment have been instrumental in promoting local clusters,
attracting FDI, creating jobs and formality. Of the approximate 3,500 zones operative today, more than
2,300 are in developing or transition countries and employ 66 million people. Worldwide, 60-70% of the
employees in SEZs are women, who tend to be engaged in labor intensive and assembly oriented
activities.
Conclusion
A sound investment climate is critical for the private sector to develop and contribute to economic
growth. Therefore any investment climate reforms indirectly contribute to poverty reduction through this
growth. Directly, these reforms address market constraints and thus can achieve increased access to
infrastructure, to products and services at lower prices and through creation of formal jobs. IFC’s Job
Study has provided a comprehensive overview of the IC constraints businesses face and some evidence of
the degree of employment generation when these constraints are removed. However, in general, empirical
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evidence to support the links between investment climate reforms and poverty reduction are relatively
scarce. IFC’s IC department has embarked on a comprehensive evaluation program to systematically
address some of these gaps and the findings are sure to provide further evidence to validate these links.
Figure 1: Investment Climate and Links to Poverty Reduction
IC Strategic
Priorities
IC Reform Areas
Business Regulations
Fostering Enterprise
Creation and Growth
Productivity
Trade Logistics
Investment Generated
(domestic or FDI)
Unlocking Sustainable
Investment in Key
Sectors
Investment Policy
Jobs
Private Participation in Health
Sector
Private Sector Savings
- Competition Policy
- ICT
- Governance/Transparency
- Gender/Inclusion
- PPD
- Green Growth
ECONOMIC GROWTH
Returns to Creditors
Consumer Savings
IC reforms impact
directly the POOR
Cross-cutting Themes:
Encouraging Private
Participation in
Infrastructure and
Social sectors (Health
and ICT)
IC reforms impact
Firm Creation
Industry: Agribusiness and
Tourism
Private Participation in
Electricity Sector
Impact on
Poverty Reduction
Export
Debt Resolution and
Business Exit
Business Taxation
Facilitating
International Trade and
Investment
IC Impact Indicators
Improved Infrastructure
Reduction in Corruption
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