Incentives and obstacles to growth : lessons from manufacturing case studies in Madagascar

Regional Programon Enterprise Development Discussion Papers Incentives and Obstacles to Growth: Lessons from Manufacturing Case Studies in Madagascar Olivier Cadot and John Nasir Edited by Linda Cotton November 2001 RPED Paper No. 117 The views and interpretations expressed in this study are solely those of the authors. They do not necessarily represent the views of the World Bank or its member countries and should not be attributed to the World Bank or its affiliated organizations  Abstract Since the mid-1980s the Malagasy government has pursued fiscal and administrative reform along with economic and financial liberalization. These efforts have contributed to steady GDP growth rates since 1995, averaging 4.1 percent between 1997 and 1999. Manufacturing has been keeping pace with GDP, its share hovering around 12 percent. Firms located in Export Processing Zones (EPZs) have experienced tremendous growth, (19% a year between 1995 and 1999), but their production still represents a relatively small share of value added. Most of the growth in the Malagasy economy has occurred in transportation, construction and other non- tradable sectors. By contrast, the development of import-substituting (IS) firms has been considerably slower. In the past, IS firms became accustomed to producing for the domestic market under the protection of high import barriers. These companies are stagnating as they find themselves unprepared for the stiff competition from imports unleashed by recent liberalization. The present market structure has created distortions, pulling resources into the EPZs (and to some extent, the non-tradables sector) from the rest of the economy. Given the right environment, all segments of the economy can thrive, contributing to a faster overall growth rate with a much broader base. Despite the dramatic growth of recent years, EPZs also face constraints and there is considerable room for improvement. Firm-level studies allow for distinguishing the impediments and challenges faced by these disparate groups. Madagascar must address these issues to improve productivity and competitiveness both inside and outside EPZs, as trade barriers fall around the world and the country becomes more integrated into the global economy.  Incentives and Obstacles to Growth: Lessons from Manufacturing Case Studies in Madagascar Introduction..............................................................................................................................1 Growth and Structure of the Industrial Sector .................................................................2 Reform and Restructuring................................................................................................4 Export Processing Zones..........................................................................................................5 Textiles and Garments .....................................................................................................6 Information Technology ................................................................................................12 Handicrafts.....................................................................................................................16 The Common Law Sector ......................................................................................................22 Infrastructure..................................................................................................................28 Taxes..............................................................................................................................29 Market and Industry Structure .......................................................................................30 Barriers to Entry.............................................................................................................31 Conclusion .....................................................................................................................32 Cross-Cutting Issues ..............................................................................................................33 Infrastructure..................................................................................................................33 Finance and Banking......................................................................................................34 Training and Education..................................................................................................37 Business Environment....................................................................................................40 Conclusion .............................................................................................................................42 References..............................................................................................................................44 Abbreviations.........................................................................................................................45  Introduction In recent years Madagascar has undertaken numerous economic reforms and instituted new liberalization policies. However, while macro-economic policies are important and getting the prices "right" is necessary for international competitiveness, this is not sufficient. It is also necessary to have a supporting micro-economic environment that lowers transactions costs and facilitates trade. Barriers to entry must be removed and the incentive system structured so that capital can be deployed to the most efficient sectors. Market failures, especially in the financial sector, that inhibit investment to improve competitiveness and to acquire new technology must be minimized. Government administrative and regulatory requirements that discourage both foreign and domestic investment must also be eliminated. An inspection of the incentive system and the regulatory framework gives a general idea of the supportiveness of the business environment. However, this alone is not adequate to determine the effects of the overall environment on firm incentives and profitability. Nor does it allow us to differentiate between obstacles that are peculiar to individual firms or sectors and those that are "cross cutting," i.e. those that affect all firms in all sectors. This type of analysis is particularly important to Madagascar where the industrial sector appears to be splitting into two distinct segments, poised on unique growth trajectories. In one group are enterprises focusing on the export market, enjoying the privileges of Export Processing Zones (EPZ) and growing rapidly. In the other group are Common Law (CL) companies, which do not enjoy the favorable treatment accorded EPZ firms but are accustomed to being protected by high barriers while producing for the domestic market in the past. However, these common law companies are now stagnating as they find themselves unprepared for the stiff competition from imports unleashed by liberalization. Firm-level studies such as this one are capable of deciphering the impediments and challenges faced by these disparate groups. The micro-economic firm level approach allows us to determine which problems are firm and sector specific, which are limited to one group and which are cross cutting-issues that reduce profitability and competitiveness across all sectors. This paper examines the results of firm interviews in representative industrial sectors conducted in July 2001 as a part of the Integrated Framework program established by the World Trade Organization ministers in 1996. This program is designed to promote the integration of the least developed countries into the global economy. Following a brief review of the overall characteristics of the industrial sector, the remainder of the paper is devoted to identifying sources of competitiveness and impediments to growth. The manufacturing firms interviewed are separated into the two distinct divisions mentioned above, EPZs and Common Law sector firms, (in particular, the lagging import-substituting sector) and are considered in turn. Cross-cutting issues are covered in the final section which also forms the basis of recommendations for reforms and motivation for more detailed analysis to be carried out elsewhere. To anticipate, this paper's overall conclusions are as follows: