zambia Investment Climate Assessment 2005.pdf

8/14/2019 zambia Investment Climate Assessment 2005.pdf

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AFRICA PRIVATE SECTOR GROUP

An Assessment of the Investment Climate in Zambia


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Acknowledgements

We are grateful to Andrew Stone, Iain Christie, Roy Pepper, Abebe Adugna, HartSchafer, Ahmet Soylemezoglu, Chris Walker, Rosemary Sunkutu, the PSD SectorBoard, and participants at the regional review meeting, for helpful comments andsuggestions. IMCS Consulting Services carried out the enumeration for this survey andwe wish to thank Augustine Mkandawire, Pryd Chitah and John Kasanga for thesupervision of the survey. Roy Pepper and John Nasir undertook the exploratorymission for this work and were helpful throughout this project. Melissa Himessupervised the fieldwork for several months in the field.

Our colleague and friend, Gerald Tyler, provided excellent guidance and supervision inthe field. Gerald had worked with RPED for over a decade, helping to build a programof research around firm survey data. Sadly, Gerald passed away a short while ago. The

team would like to dedicate this Assessment to him.

Project TeamConstantine Chikosi (TTL), Vijaya Ramachandran, Linda Cotton, Chad Leechor(AFTPS), James Habyarimana (Consultant).


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LIST OF ACRONYMS

CFR Country Framework Report

EIU Economist Intelligence Unit

FDI Foreign Direct Investment

FIAS Foreign Investment Advisory Services

FSAP Financial Sector Assessment Program

GDP Gross Domestic Product

HIV/ AIDS Human Immuno-Deficiency Syndrome/Acquired Immunity Deficiency

SyndromeICA Investment Climate Assessment

IMF International Monetary Fund

METR Marginal Effective Tax Rate

ZAMTEL Zambia Telecommunications Corporation

ZANACO Zambia National Commercial Bank

ZCCM Zambia Consolidated Copper Mines

ZESCO Zambia Electricity Supply CommissionZPA Zambia Privatization Agency

ZRA Zambia Revenue Authority


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EXECUTIVE SUMMARY............................................................................................ I

II. HOW PRODUCTIVE ARE ZAMBIAN FIRMS? EVIDENCE FROM THE

RPED SURVEY .............................................................................................................6 CAPACITY UTILIZATION ................................................................................................ 6CAPITAL I NTENSITY AND CAPITAL PRODUCTIVITY ....................................................... 7LABOR PRODUCTIVITY AND U NIT LABOR COSTS ..........................................................8FIRM PRODUCTIVITY IN ZAMBIA : A SIMPLE ECONOMETRIC TEST .................................13

III. WHY IS PRODUCTIVITY LOW?..................................................................... 14

EXPLANATIONS FROM ZAMBIAS BUSINESS ENVIRONMENT .................14

MACROECONOMICS AND FINANCE ...................................................................... 17PUBLIC -PRIVATE I NTERACTION ........................................................................... 24I NFRASTRUCTURE ................................................................................................... 26LABOR MARKET .....................................................................................................30CRIME AND CORRUPTION ......................................................................................32

IV. RECOMMENDATIONS ......................................................................................35

APPENDIX 1: ZAMBIA SAMPLE PROPERTIES................................................ 45

APPENDIX 2: ADDITIONAL DATA FOR SERVICES.........................................55

REFERENCES............................................................................................................. 56


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EXECUTIVE SUMMARY

In spite of broad economic reforms, Zambia today confronts the challenge of

diversifying its economy and accelerating private-led growth to address the poverty ofits people. Until recently, the people of Zambia were becoming ever poorer. Economicreforms in the late 1990s brought some tangible benefits, with a greater focus on fiscaldiscipline, better governance and promoting private-led economic growth. As the new

policies were put into effect, the economy responded favorably, producing fourconsecutive years of solid growth, with real GDP rising 3.7 percent per annum between1999 and 2002. However, the failure to complete the reform process left the economyvulnerable to circumstances, such as drought and a secular decline in copper prices,which together slowed the economy.

Although, recently, copper prices have improved and rains have fallen, Zambia mustconfront the challenge of the long-term decline in the contribution of copper to theeconomy, by creating the macro- and microeconomic conditions for private sector-ledgrowth in a more diversified economy. Zambias future does not lie in the governmentselecting sectors to promote, but in creating policies and institutions that encourageinvestors to productively and creatively employ its resources and its people. As is nowwell known, economic growth is critical to poverty reduction the central objective ofthe Government. To increase employment and wages, productivity must increase.Both productivity and growth are achieved primarily through the development of the

private sector, in the context of an enabling and competitive investment climate. Thechallenge is to continually improve conditions over a sustained period in a logicalsequence of reforms that improves Zambias competitive position as a host forinvestment, while maximizing the benefit of this growth for its people throughappropriate investments in people.

This Zambia Investment Climate Assessment (ICA) forms part of World Bank Groupglobal initiative to systematically analyze conditions for private investment andenterprise growth. Improving the investment climate is recognized as a key pillar ofdeveloping countries path to promote economic growth and reduce poverty.Investment Climate Assessments provide a standardized way of measuring andcomparing investment climate conditions in a country, highlighting the microeconomicand institutional conditions inhibiting constraining productive investment. They help to

identify priority problems whose improvement would yield the greatest and mostimmediate gains, looking in detail at impediments (including policy , regulatory andinstitutional factors) that constrain the effective functioning of product markets,financial and non-financial factor markets, and infrastructure services. The ICAcompliments and amplifies a series of diagnostic work on this issue being undertaken

by the World Bank Group in collaboration with the Government of Zambia. TheZambia Investment Climate Assessment (ICA) is also part of a broader, inter-regional

program of investment climate studies of the World Bank Group. Throughout thisreport, empirical results showing the relative position of Zambia versus potentialcompetitors will be presented. To understand the quality of investment climate inZambia from the perspective of the private sector, the report draws on the results of a


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firm survey conducted in 2003, covering a sample of more than 200 service andmanufacturing firms, large and small, located in different parts of Zambia. 1

This Investment Climate Assessment has three key parts:

(i) Empirical analysis of productivity : For Zambia to compete internationally, itmust improve productivity. Value added per worker in Zambia is about $2700,which is higher than Uganda and Tanzania but well below Kenya, India, andChina. Capital productivity is extremely low, and the capital intensity ofZambian firms is very high compared to that of comparator countries. The

productivity difference cannot be accounted for solely by the quantity andquantity of inputs, highlighting the importance of understanding how Zambiasinvestment climate is shaping firm-level performance.

(ii) Examination of Investment Climate Constraints : When firm owners andmanagers rate seven factors as the most constraining to their operation andgrowth: (i) financing cost and access, (ii) macroeconomic instability, (iii) taxrates and administration, (iv) regulatory policy uncertainty, (v) crime andcorruption and (vii) infrastructure (emphasizing electricity and telecom). Theseissue areas are detailed in national and international perspective, to betterunderstand the sources of excess costs, delays or difficulties in doing businessin Zambia.

(iii) Strategy for Improving the Investment Climate and Productivity : Thereport contains ordered recommendations in five key areas:

1. Macroeconomics and finance : Urgently focus on reducing the fiscal deficitand consequent macro-uncertainty and financial sector crowding out.

2. Public-private sector interactions:a. Improve the tax and regulatory treatment of businesses regarding equity,

transparency and predictability, with special focus on tax administration. b. Strengthen public-private dialogue on policy and institutional reform

3. Infrastructurea. Strengthen the regulatory framework for telecom privatization and entry.

b. Strengthen the regulatory framework for other privatization of infra-structure services to bring capital, competition and customer-orientation.

4. Labor market issues

a. Reduce the mandatory severance benefit in line with neighboringcountries. b. Carefully study policies and institutions shaping the supply of labor

skills, including education, training and employer incentives.5. Rule of law

a. Strengthen the independence and financing of the judiciary throughindependent budgeting and political commitment to stop interference.

b. Strengthen meritocracy as basis for public sector employment, promotion and discipline, and eliminate patronage appointments.

1 Technical details on the sample and sampling methodology are available in Appendix 1.

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How Productive are Zambian Firms? Evidence from the RPED Survey

As Zambia liberalizes its economy and its firms confront greater internationalcompetition in domestic and global markets, the issue of productivity becomes key to

the ability of Zambian enterprises to compete. The analysis of RPED survey resultsshow that the labor productivity of the median Zambian firm, while higher than that insome other African nations, is low compared the median firm surveyed in India, Chinaand Kenya. Median value added per worker in Zambia is about $2700 which is higherthan Uganda and Tanzania but well below Kenya (3,475), India ($3,432),, and China($4,397). However, when compared to lower productivity African neighbors, wagesare higher too, leading to high unit labor costs. For example, while in Zambia, wagesaccount for 41percent of value added in the median firm, the comparable figures are27percent in India, 32 percent in China, 36 percent in Kenya, and 39 percent in Ugandaand Tanzania.

By international comparison, capital productivity is extremely low: firms tend to bemore capital-intensive than in many African countries, yet capacity utilization averagesless than 50 percent. Thus the ratio of value added to capital in the median Zambianfirm surveyed is only .23, compared to .32 in Kenya, .43 in Tanzania, .50 in China, .70in Uganda, and 1.10 in India. TFP analysis suggests the marginal productivity of laboris substantially greater than that of capital.

Anecdotal evidence from firm-level interviews and experts suggest that the low labor productivity may be rooted partly in the deteriorating quality of the educational systemand in the growing problem of HIV/AIDS. The World Banks macroeconomic modelfor Zambia estimates that up to 1 percent of GDP is being lost per year due to the HIV

pandemic . There are also regulatory issues, such as the problems with the processingof employment permits identified by FIAS (2004).

In addition, RPEDs regression analysis of productivity shows the factors significantlyassociated with firm productivity are related to input constraints--firms that suffer mostfrom poor input quality and equipment damage due to power outages have much lowervalue added than others. This suggests the value of improvements in basicinfrastructure and in quality control standards for better firm performance.

However, even after accounting for these factors, a great deal of variation of

productivity within Zambia and between Zambia and other countries cannot beaccounted for by either the quantity or quality of capital, labor or material inputs.International experience suggests that the investment climate is, in fact, critical toeconomic performance, and accounts importantly for observed differences betweencountries and regional differences within countries. 2 Therefore, the next section turns

2 For example, Hall & Jones (1999) show that productivity is far more important than the quantity ofcapital and labor inputs in explaining national output differences. . Kaufmann and Kraay (2002) showthat per capital income growth is importantly linked to investment climate indicators, including rule oflaw, corruption and regulation. Earlier investment climate assessments of China, India, Bangladesh,Ethiopia and other countries demonstrate the strong association between performance outcomes and

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to the dimensions of the investment climate identified as most constraining by Zambian business managers, and how Zambia compares to other countries in these dimensions.

Zambias Investment Climate: Constraints to Productivity and Growth

In several key dimensions, Zambias investment climate imposes excess costs,delays or difficulties on its businesses that impede their ability to compete andgrow. While business perceptions reflect only the private costs experienced byfirms and must be balanced by broader public policy perspective, the majorconcerns expressed by Zambian businesses do have grounds, as revealed by acomparative analysis of Zambian conditions to those of other countries.

Business Perceptions and Indicators of Constraints . When firm owners andmanagers were asked to rate different aspects of doing business, respondents indicated

that some of the largest problems were (i) financing cost and access, (ii)macroeconomic instability, (iii) taxes, (iv) regulatory policy uncertainty, (v) crime, (vi)corruption and (vii) infrastructure. 3

Cost of and Access to Finance . Over 80 percent of firms rate the cost of financing as amajor or severe constraint. This is by far the most visible constraint across all firmtypes - small or large, exporter or non-exporter, foreign or domestic. The averagesurveyed firm having a loan paid an annual interest rate of over 28 percent, reflecting ahigh real rate even after inflation. Medium-sized firms with loans paid an average of 37

percent, while large firms paid just over 20 percent. Required collateral averaged threetimes loan value.

On average, the survey finds that banks in Zambia finance 16 percent of firms workingcapital and 18 percent of investment requirements. The corresponding averages forUganda are 7 percent and 13.4 percent, while in Kenya they are 25 percent and 27.4

percent. Small firms have the lowest access to bank loans- less than 20 percent have aloan, and of these, 93 percent must provide collateral averaging over 400 percent of theloan value. The main reason for the high cost of capital is crowding out by governmentspending. Government borrowing both dries up credit and provides financialinstitutions a low-risk alternative to investing in private businesses.

Macroeconomic Instability. An overwhelming 74 percent of firms ratedmacroeconomic stability as a major or severe constraint on their firms operation, incontrast to comparator countries where it is similarly rated by about half the firms (orless. Zambia has experienced chronic and massive fiscal imbalances. In recent years,fiscal deficits (before grants) have exceeded 13 percent of GDP. These fiscal outcomeshave major implications for price stability and external imbalances. Since 1991, the

national and sub-national differences in productivity or growth (seehttp://www.worldbank.org/privatesector/ic/ic_country_report.htm .3 These concerns echo external evaluations of the country, which focus on elevated country risk,weaknesses in trade policy, fiscal burden, macroeconomic management, regulation, and corruption. Seefor example, Institutional Investor (2003), the Index of Economic Freedom (2004), and TransparencyInternational Corruption Perceptions Index (2003).

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http://www.worldbank.org/privatesector/ic/ic_country_report.htmhttp://www.worldbank.org/privatesector/ic/ic_country_report.htm


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average annual rate of inflation has been 53 percent, with the intensity of price pressurevarying from year to year. In more recent years, it has moderated significantly,averaging around 20 percent and dropping to around 15 percent in 2003. This highinflation causes uncertainty for investors and banks, and raises both nominal interest

rates and the risk premium on loans.

The loss in purchasing power of the Kwacha through inflation is reflected in the marketdetermined exchange rate, which has depreciated precipitously, in spite of periodicofficial interventions. It took 65 Kwachas to buy one US dollar in 1991; by the end of2002, it took 4550 Kwachas. Both the decline and the volatility of the Kwacha havehad a serious impact on the private sector.

Zambias external position is very precarious. In 2001, while the trade deficit wasestimated at $355 million, the current account deficit was more than twice as large.Zambias interest payments on external debt have far exceeded its interest income fromforeign sources. The precarious external position constrains further the ability ofauthorities to exert monetary control. The government tends to rely on Bank of Zambiafinancing (bridge loans) to servicing the external debt when needed.

Tax Rates and Administration. Internationally, tax rates are almost always cited byenterprises as problematic. However in the case of Zambia, business complaints havesome validation in objective fact. For example, WDI figures show that the highestmarginal tax rate in Zambia is 5 points higher than in its neighbors. National accountsreveal that the tax-to-GDP ratio is also higher than in neighboring countries. Perhaps

just as important is the frequency with which significant penalties are arbitrarily addedto the total tax bill. Onerous taxation inhibits demand, reduces sales and cuts

profitability.

Many firms in the private sector identify themselves as equally constrained by taxadministration as by tax rates. The Foreign Investor Advisory Service (FIAS) study,conducting in coordination with the ICA study on the same sample of firms, concludedthat the firm dissatisfaction derived from three sources:

First, the high frequency of changes in tax policy, which are either unjustified orunexplained to the business community.Second, the value-added tax, which has been plagued by a variety of problems in

implementation.Third, the Zambia Revenue Authoritys (ZRA) behavior toward firms, regarded asarbitrary and punitive. Some staff lack the skills needed, are not armed with clearguidelines and are given wide discretionary power which opens the door forcorrupt practices.

Regulatory Policy Uncertainty . The ICA respondents ranked the issue of regulatory policy uncertainty as the fourth most pressing constraint to growth. Some 57 percent ofZambian respondents rate regulatory policy uncertainty as an important (major orsever) problem for their firm, compared to only 28 percent of Ugandan firms. TheGovernments history of frequent and unpredictable changes to key policies has had a

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damaging effect on both foreign and domestic investment. Most firms (an impressive70 percent) judge that government officials interpretation of regulations affecting their

businesses are inconsistent and unpredictable. Another good indicator of the cost ofregulatory uncertainty is the amount of senior management spent on regulations (e.g.

tax, customs, labor regulations, licensing, and registration), completing forms anddealings with officials. In Zambia, this amounts to about 13 percent, a rather high

percentage compared to only 4 percent in Uganda, but lower than 14 percent in Kenyaand 16 percent in Tanzania. Finally, mandatory termination benefits to employees are

both high and uncertain: for example, Doing Business reports that an employee of 20years must legally receive 40 months of severance pay upon termination, as opposed to10 months in Kenya, 12 months in Tanzania and no legally-specified payment inUganda. By making firing expensive and inflexible, this has a deterrent effect on firmhiring.

Crime and Corruption. Crime, theft, fraud and disorder was identified byinterviewees as the sixth most constraining attribute of the Zambian businessenvironment. While crime does not rank as highly as it does in Kenya, for example, it isranked as a major or very severe constraint by double the proportion ofrespondents as in Uganda and Tanzania, and about four times the proportion of severalother comparator countries around the world. An exceptional 77 percent of firmsclaimed losses due to the theft, robbery or arson in the previous year. Only half ofthese incidents were reported to authorities (suggesting low confidence in the outcome)and of those reported, only a quarter were reportedly solved (suggesting low confidencemay be justified). This suggests that public services related to law enforcement (the

police and judiciary) are in need of improvement.

A second indicator of confidence in the judicial system concerns whether firms areconfident that the judicial system will enforce their contractual and property rights in

business disputes. In Zambia some 64 percent of firms are confident of this to someextent, higher than in neighbors like Kenya where the figure is only 49 percent orTanzania (55 percent) but lower than Uganda (70 percent) or China (93 percent).

Corruption is the seventh leading constraint, but was nonetheless identified by 46 percent of firms as a major or very severe constraint. This compares to 38 percent inUganda and 73 percent in Kenya). For firms with FDI, however, it ranks among thetop five constraints, identified by 51 percent as a major or severe constraint. The

respondents reported that typical firms spend an average of 1.7 percent of their totalrevenues on bribes in order to get things done. In addition, they reported that agovernment contract would typically require an average bribe of 3.7 percent of thevalue of the contract.

Infrastructure Services . Firms in Zambia are also concerned about the generally poorquality and limited availability of infrastructure services. Electricity is the leadingconcern, cited by 40 percent of all firms and 55 percent of exporters as a major or verysevere constraint. The power supply in Zambia is reportedly unreliable. Zambianfirms recorded an average of 37.2 power outages last year. The percentage of

production lost due to these outages is very high - overall the number is 4.5 percent

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while small firms lost 5.6 percent of their output (this is a bit better than Uganda, wherefirms 6 percent of production, but far worse than China, with an average 1.8 percent

production loss).

With regard to other infrastructural services, Zambian respondents held negative perceptions of telecommunications services when compared to most other countries inthe region, except Kenya. Some 33 percent of all respondents and 51 percent ofexporters found telecommunications a major or severe constraint. This compares to 5

percent of Ugandan respondents, 12 percent of Tanzanians, and 44 percent of Kenyans.The road system has been improving in recent years, but improvement has been limitedto a few areas, thus respondents assign a poor rating to transportation when comparedto other neighboring countries, except Kenya. Regarding water, many of the industrialdistricts in the major Zambian towns must incur the extra expense of buildings wells tocompensate for an unreliable public supply of water.

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Recommendations

The following matrix describes the set of policy issues that arise from the analysis of theinvestment climate in Zambia.

Area of policyconcerns

Specific PolicyIssues Observations/Comments Policy Suggestion

1.Macroeconomicsand Finance

(a) Concernsaboutgovernment

borrowing,exchange ratedepreciation andvolatility.

(b) Cost of, and

access tofinance is animportantconstraint.

Bond market borrowing by thegovernment by governmentis driving up interest rates. Access to finance is

particularly difficult forsmall and medium sizedfirms.

Government should workwith Parliament to rationalizethe budget process. Better management of theforeign exchange market to

prevent short-run fluctuations inthe supply and demand forforeign exchange by Bank ofZambia Reduce the crowding out of

private sector lending byensuring that the governmentreduces the fiscal deficit and thelevel of government borrowing .

2. Public PrivateInteraction

(a) Zambianfirms rankedtaxes as a

bindingconstraint to

private sectorgrowth inZambia.

(b) Firms arevery concernedabout regulatory

policyuncertainty.

(c) There is a pressing need tostrengthen the

private-publicdialogue.

Firms concern is asmuch about the tax rates asit is about the structure ofthe tax regime. Increased consultationwill improve the quality of

policy formulation as wellas implementation whilehelping to reduce the deep-seated mistrust between theGovernment and the

private sector.

ZRA must reviewcollection procedures andreevaluate the emphasis on taxcollection versus otherobjectives such as increasingfirm entry. ZRA must reducesweetheart deals to individualfirms and focus on transparentand uniform method of levyingtaxes. Special attention should

be paid to recommendations inthe FIAS report. Executive Office of thePresident should create a forum

based on the best practiceexperience of other countries inSub-Saharan Africa. Thisshould include an InvestorRound Table for public-privatedialogue on key policies thataffect the private sector.

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Area of policyconcerns

Specific PolicyIssues Observations/Comments Policy Suggestion

3. Infrastructure (a) Firms reportthe availability

of infrastructureto be a serious problem.

(b) The cost ofelectricity ishigh.

Of particular concernis the time and cost of

obtaining water, telephoneand electricity connections.

Min of Telecom and otherutility agencies must streamline

the procedures by which utilityconnections are obtained. Min of Telecom must reducethe perceived risks of investing inthe private sector by reducing ad-hoc implementation ofregulations by Zamtel, otherutility agencies. Utilities including electricityshould be privatized within anappropriate regulatory frameworkin order to improve services,increase investment and promotecompetition. Assessment of infrastructureservices should be carried out viathe preparation of a CountryFramework Report (CFR).

4. Labor MarketIssues

Our data showthat Zambia is ingreat need ofimproving the

productivity ofits labor force.

Improving the skills ofthe labor force is crucial. Improving theflexibility of firms withregard to hiring locals andexpatriates is important.

Government should amendthe labor law to reduce the cost ofredundancy and to bring Zambiain line with neighboringcountries. Min of Labor should reducethe cost and barriers to obtainingemployment permits. Min of Health, donors, andthe Business Coalition mustincrease prevention and treatmentefforts for HIV/AIDS. Further work needs to bedone to determine how best toimprove access to education andtraining.

5. Crime andCorruption

(a) Firms ratecrime as a

significantconcern.

(b) Considerableuse ofdiscretionary

power bygovernment,lack oftransparency andheavy emphasison enforcementof rules.

Both economic crime(fraud) and non-economic

crime raise the cost ofdoing business,improvement needed incriminal justice system. Both corruption andred tape are serious

problems.

Government should submitto Parliament meritocratic

reforms to civil service legislationto reduce corruption andeliminate patronage. Judicial autonomy needs to

be improved via budget allocationand greater political commitment. Establishment of a smallclaims court to help reduce

backlog in pending cases.

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I. Introduction

Until very recently, the people of Zambia were steadily becoming poorer. The per capitaGDP faltered for more than three decades, falling from $700 in 1970 to $390 in 1998. Butfor now that ordeal seems to have passed. Since the late 1990s, the Government has

attempted to put together a new approach to economic management, with a new focus onfiscal discipline, better governance and promoting economic growth. This new way ofthinking is reflected in a series of policy statements, including the Interim Poverty ReductionStrategy Paper (I-PRSP, July, 2000) and the Poverty Reduction Strategy Paper (May, 2002.)As the new policies are put into effect, the economy has responded favorably, producing fourconsecutive years of solid growth, with real GDP rising 3.7 percent per annum between 1999and 2002. And this turn-around has taken place in spite of a string of bad news, includingdepressed and falling copper prices and the departure in 2002 of the largest foreign investorin copper production.

To many Zambians long accustomed to the bad old days, the recent relief may seem like justa blip in a seemingly inexorable descent. From their point of view, reversing entrenched

public-sector practices and taking away the customary largesse from interest groups wouldnot be so easily accomplished. Observers have also noted that, while the new policystatements represent a promising break from the past, few concrete actions have been put in

place. The capacity to implement them is not readily available. Furthermore, sinceindependence, Zambia has relied almost exclusively on exporting copper to generate foreignexchange. Organized efforts to diversify production and exports only began in the 1990s.

Non-traditional exports have since expanded, but their share remains less than one third ofthe total. Weaning Zambia from the reliance on copper and developing new sources ofgrowth could take decades, rather than years.

As is now well known, growth and poverty reduction the central objectives of theGovernment -- is achieved primarily through the work of the private sector. No governmentcan produce sustained growth and employment without increasing the investment, risk-takingand innovations of the private sector. The critical role of government is to create an enablingand competitive business environment, which includes the provision of price stability,freedom to enter and exit a business, openness to foreign trade, physical and financialservices and law and order. The quality of these services constitutes the investment climateas seen by the private sector. The key challenge facing the Government of Zambia inreversing the long-term economic decline, and thereby advancing the goals of povertyreduction, is to keep upgrading the investment climate and ensuring an enabling and

competitive environment.

This report is part of the World Bank Groups strategy to assist Zambia in fighting poverty.This survey in Zambia is part of a broader, inter-regional program of investment climatestudies of the World Bank Group. It attempts to explain the reasons for large variations inGDP growth across the spectrum of developing countries. Thus, the investment climate asobserved in Zambia is compared to and contrasted with those of other African countries, orwith other developing countries in a different region which might turn out to be Zambiascompetitors in world export markets. Throughout this report, empirical results showing therelative position of Zambia versus potential competitors will be presented. It sets out toreview the key elements of the prevailing investment climate in the country today. To

understand the quality of investment climate from the perspective of the private sector, thereport will draw on the results of a firm survey conducted in 2003. A total of 336 firms were

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surveyed from the manufacturing and services sectors in Lusaka, Kitwe, Ndola andLivingstone. We used a stratified random sample in the manufacturing sector to select 207firms in Agro-industry , Metals, Chemicals and Paints, Construction Materials, Mining andQuarrying, Paper/Printing/Publishing and Textiles. The services survey was administered to129 firms in Trading, Financial Services, Tourism and Transport. 4

This reports also compliments and amplifies a series of diagnostic work being undertaken bythe World Bank Group in collaboration with the Government of Zambia. A companionreport, Policies for Growth and Diversification (a country economic memorandum), willfocus on country-level (macro) issues, including economic and political stability, trade andexchange-rate regimes, fiscal policies, which include the implications of public enterprisesand privatization. Another related report is the on-going Administrative Barriers Study (conducted by the Foreign Investment Advisory Service or FIAS) which focuses on the

procedural aspects of business regulations. Together, these reports of the World Bank Group provide a detailed description and analysis of the most important issues concerning theinvestment climate, and thereby serving as analytical tools for the Government to developremedial actions.

The main thrust of the report is to examine the productivity of firms and the key constraintsto this productivity. These two findings the true cost of labor and the key constraints arerelated and, when viewed together, they provide an important insight about the investmentclimate in Zambia today.

Even though wages in Zambia, while in line with those of African countries, are lower thanwages in most of the Asian countries, Zambias productivity (measured here as value added

per worker) is much lower than those of its Asian counterparts. Therefore, the resulting realcost of labor, as measured by labor cost per unit of output (or unit labor cost), turns out to

be considerably higher in Zambia than in all the Asian countries for which data is available.In other words, from the perspective of a foreign investor, the low wages in Zambia offer noadvantage, since they are more than offset by very low productivity.

The various constraints -- high financing costs, taxes and the need to prevent crimes --impose a high financial cost on private firms. In addition to these financial costs, the poorquality of physical infrastructure such as frequent power outages and inadequate roads,causes frequent disruptions and delays, further depressing output and productivity. Theyrepresent expense items that sharply reduce the net value added, hence productivity, of the

businesses.

Thus, a picture of business impediments emerges. In spite of the recent economic recovery,most firms are still finding it difficult to operate under the current investment climate, letalone to invest more and expand their businesses. Furthermore, the constraints appear to bemore severe and widespread than in most African countries. This picture helps focus theattention of public officials on the binding constraints in the economy. Such anunderstanding can guide the formulation of corrective actions and in the allocation of limited

public resources.

Addressing the constraints will advance the Governments strategy for poverty reduction. A better investment climate with, for instance, lower inflation and interest rates, more

4 Technical details of the sampling methodology and sample frame are available in Appendix 1.

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transparent and customer-oriented tax administration and law enforcement will encouragemore investment. More people in Zambia will find new or better jobs. New localentrepreneurs will be able to make use of their talents. Foreign investors will find Zambia amore attractive place to do business. These are the essential building blocks for fighting

poverty and achieving the goals envisaged by the Government.

The discussion above is little more than a hint of what is to be discussed in the remainder ofthis report. Section II discusses the key empirical findings with respect to factor intensity and

productivity of Zambian firms. It reviews the variations among different groups of firmswithin Zambia, as well as putting Zambias position in an international perspective. InSection III, the report discusses the factors that determine the level of productivity inZambia, including the most important constraints to business operations as appraised by

private entrepreneurs who own and/or operate the firms. International and regionalcomparisons are drawn in this section as well, wherever possible.

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II. HOW PRODUCTIVE ARE ZAMBIAN FIRMS? EVIDENCE FROM THE RPEDSURVEY

As Zambia liberalizes its economy and becomes exposed to greater international competition,a key issue that arises is the productivity of Zambian enterprises and their ability to competeinternationally. We examine this issue by first looking at the characteristics of Zambiascapital stock. We then look at factor intensity and partial factor productivities, including unitlabor costs. Finally, we look at the overall determinants of productivity using an augmented

production function approach.

Our results show that Zambian labor productivity is low compared to India and China, buthigher than some other African nations. This low productivity more than offsets wages whichare presently lower than India and China, leading to high unit labor costs . Capital

productivity is extremely low because of the high capital intensity of Zambian firms.Analysis of productivity via regression analysis shows that there are constant returns to scalein Zambian manufacturing. Human capital characteristics, such as education and experience,are not significant in determining firm performance; neither are other learning channels(exports, foreign ownership). The key factors determining firm productivity are related toinput constraints--firms that suffer most from poor input quality and equipment damage dueto power outages have much lower value added than others. Improvements in basicinfrastructure and improvements in quality control standards are clearly required for betterfirm performance.

Capacity Utilization

The utilization of capital depends on factors driven by product demand or raw materialsupply bottlenecks. How efficiently is the Zambian stock of capital used? The table belowcompares capacity utilization in Uganda with other countries. We see that Zambia is aboutaverage in terms of capacity utilization among African countries. Zambian firms are usingless than 50 percent of their capacity; this is within the typical range for African countries.There is not much dispersion by size or by sector; micro and small firms utilize slightly morecapacity than other firms and the wood sector has the highest share of capacity utilizationacross the sectors surveyed (Table 2.1).

Table 2.1: Distribution of Capacity Utilization Rates (percentage)

CameroonCote

dIvoire Ghana Kenya Tanzania Zambia Uganda

Mean 46.9 70.7 54.3 63.3 51.1 48.4 58.4StandardDeviation 28.5 25.3 27.4 28.2 27.2 30.3 22.6

By SizeMicro 40.5 66.6 52.5 56.3 58.8 50.4 50.6Small 44.3 68.4 55.7 65.6 48.5 50.2 58.1

Medium 47.0 67.9 48.4 67.3 38.8 42.9 60.8Large 60.6 78.5 59.6 69.3 42.3 46.4 65.0

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By SectorFood 50.7 70.8 57.4 67.3 46.2 50.1 58.8Textile 38.0 67.9 51.1 59.9 47.3 43.4 54.4Wood 55..0 68.8 52.3 67.1 55.2 53.4 55.7Metal 41.3 77.3 57.0 59.5 53.0 47.7 61.2

Note : All values are in percentages. Data for all countries are for the early 1990s, except Uganda and Zambiawhich are from 2003. Source: RPED, 2003

Capital Intensity and Capital Productivity

In sharp contrast to India and China, the capital intensity of Zambian firms is very high ( Table 2.2). Zambian firms have over $12,000 of capital per unit of labor; this number issubstantially higher than the East African comparators shown below. These data are from

traditional manufacturing sectors (not mining or other inherently capital-intensive activities)and may well reflect capital buildup during the mid-1990s (a period of relatively low-costfinance) and/or optimism about future economic growth. Our data show that Zambian firmshave high amounts of capital stock which yield very low returns.

Table 2.2: Capital Intensity: Capital per Worker, by Firm Size, in $US

Firm Size Tanzania Uganda Kenya Zambia India China

Overall 7,757 1,464 11,186 12,161 2,380 7,654

Very Small(100 employees) 19,279 6,667 12,735 8,178 4,158 8,525

Note: Only 3 firms in Kenya and 10 firms in China have less than 10 employees

Table 2.3 shows that the productivity of Zambian capital stock is very low; the lowest in oursample of countries. Value added per dollar of capital is only 23 cents; this may reflect in partthe age and poor quality of the capital stock and/or diminishing returns. The productivity ofcapital stock in Tanzania is almost twice as high and in Uganda it is three times higher.While firms have on average, a large amount of capital, anecdotal evidence suggests thatmuch of this capital is old and/or underutilized. Thus, the Zambian private sector finds itselfin a situation where the amount of capital available is quite high but the productivity of thiscapital stock is very low due to obsolescence and low quality.

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Table 2.3: Capital Productivity: Ratio of Value-Added to Capital, by Firm Size


Overall 0.43 0.70 0.32 0.23 1.10 0.51

Very Small(100 employees) 0.26 0.89 0.30 0.35 1.16 0.47

The explanation for high capital intensity and low capital productivity may be shown by theresults presented in the next table on the average age of capital stock. Age of capital stock isstrongly correlated with the quality of capital and consequently with the productivity ofcapital. As seen in the Table 2.4 below, a majority of firms report using equipment that ismore than 5 years old. In fact, 38 percent of firms are using equipment that is more than 10years old. As expected, smaller firms use younger equipment than older firms. Medium firmshave the oldest equipment--47 percent of these firms are using equipment that is more than10 years old. This may well explain why firms simultaneously report high capital intensity as

well as the underutilization of capital. It may also explain why firms report being credit-constrained; they are in fact demanding access to new and better quality capital that wouldenable them to compete more effectively.

Table 2.4: Age of Capital Stock

Overall Small(10-49 employees)

Medium(50-99 employees)

Large(> 100 employees)

< 1 year old 1% 1% 0% 0%

1-5 years old 26% 36% 19% 20%

6-10 years old 35% 26% 34% 45%11-20 years old 22% 20% 32% 18%

>20 years old 16% 17% 15% 17%

Labor Productivity and Unit Labor Costs

Firm productivity is also low in Zambia. Figure 2.1 describes median value added perworker across several countries. Zambian firms have a median value added of about $2680

per worker, which is higher than Tanzania and Uganda, but well below China and India.Ugandan firms are 68 percent less productive while Kenyan firms are on par with their Indian

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counterparts. Zambian firms are about 22 percent less productive than their Indiancounterparts. All of the countries in East Africa have a long way to go before they can catchup with China.

Fig 2.1: Median Value-Added Per Worker

Interestingly, worker productivity does not vary all that much across firm size; only firms inthe 50-99 size class have somewhat higher productivity than the rest (Table 2.5).

Table 2.5 Labor productivity, Median Value-Added per Worker By Firm Size, in $US.


Overall 2,061 1,085 3,457 2,680 3,432 4,397

Very Small(100 employees)

3,499 3,338 4,138 2,439 5,321 4,193

Notes: 1) For very small category, there were only 70 firms in India sample, in China sample there were only 28 firms. 2) In Zambia andKenya, the sample design excluded very small firms.

Let us now consider the unit cost of labor in Zambia versus other countries in Sub-SaharanAfrica. Unit labor cost measures the total cost per unit of output. When converted to acommon currency, it enables international comparisons of competitiveness of labor.

Unit labor cost in U.S. dollars is defined as:

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ULC = (w.L/Q).(1/e)where w is the manufacturing wageL is the amount of labor employedQ is a physical measure of outpute is the exchange rate defined as domestic currency per U.S. dollar

ULC can also be approximated as a ratio of nominal wage (w) to labor productivity (Q/L).For a country to have a low (competitive) ULC, it has to do one of three things (or acombination thereof): (i) keep nominal wages low, (ii) keep its exchange rate competitive,and/or (iii) increase its labor productivity. Because it is very difficult to obtain comparable

physical measures of output across different countries, we use an approximate measure ofULC, which is the ratio of wages to value-added at the firm level, averaged across the sampleof firms. Table 2.6 describes the ratio of wages to value-added for several countries in Asiaand Sub-Saharan Africa, including Zambia in 2003.

Table 2.6: Unit Labor CostsRatio of Wages to Value-Added (median values by firm size)


Overall 0.39 0.39 0.36 0.41 0.27 0.32Very Small

(100 employees) 0.25 0.35 0.34 0.39 0.24 0.29

By definition, unit labor costs are higher in countries that have either high wages or low labor productivity (or both). Unit labor costs also tend to be higher when capital intensity is loweri.e. there is usually a negative correlation between these variables. Apart from overvaluedexchange rates that have hampered Africas competitiveness, the data on unit labor costsshow that Sub-Saharan Africa, including Zambia, has higher unit labor costs relative to Asiaat roughly equivalent stages of development. When present data from Africa are comparedwith Asian data from the 1960s and 1970s (Table 2.7), it is clear that earnings in Africa are

about two-thirds higher than was the case historically in Asia, and African productivity isabout one-fourth lower.

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Table 2.7: Unit Labor Costs: Past Estimates from East AsiaIndonesia 1981 0.21

South Korea 1963 0.26

Malaysia 1970 0.27

Singapore 1963 0.35

Taiwan 1961 0.16

Thailand 1970 0.24

Source: Lindauer and Velenchik (1994); and RPED Surveys (1990s).

Labor costs in Zambia are high; our data show that the mean unit labor cost for the sample is0.41 (Table 2.6). Also, we do not observe the usual negative correlation between unit laborcost and capital intensity in the Zambian case. This could be due to the fact that much of thecapital stock is of low quality and is consequently underutilized, thereby raising the cost oflabor in the production process.

Disaggregation of the Zambian data shows that the unit cost of labor is fairly similar acrosssize categories. When broken down by sector, unit labor costs are quite wide-ranging; sector32 has the lowest unit labor cost while sector 33 has the highest. Exporters have significantlylower unit labor cost than non-exporters (0.24 vs. 0.55); the ratio of wage to value added isalmost 50 percent lower for exporting firms. Foreign firms have lower unit labor cost thanfirm with no foreign equity and firms owned by non-indigenous entrepreneurs have lowerunit labor costs as well.

There is anecdotal evidence that suggests that with the deterioration of the educationalsystem, technically-qualified laborers are hard to find, thereby raising the cost of labor.Enrollment ratios for primary and secondary education in Zambia are roughly typical forSub-Saharan Africa. However, the quality of the education system is weak, as measured bylow mean scores in language and mathematics in the Grade 5 National Assessment. In post-secondary institutions, there are concerns about the preparedness of their intakes from thesecondary schools. Furthermore, public sector wages are relatively high and likely do notreflect the productivity of labor; this in turn may affect the wage level in the private sector.

Since early 2002, the Government has been implementing a Technical Education, Vocationaland Entrepreneurship Training (TEVET) Development Program (TDP), aimed at improving

the quality, sustainability, demand-responsiveness, and equity of TEVET in Zambia. In November/December 2003, a Joint Review of TDP was carried out by a team appointed bydonors, the Ministry of Science, Technology, and Vocational Training (MSTVT), and theTEVET Authority (TEVETA). The Joint Review found that there had been very slow

progress toward the objectives of the Program, and recommended a number of steps toimprove implementation. MSTVT and TEVETA are developing an Action Plan in responseto the Reviews findings and recommendations.

As technical skills diminish, the quality of the labor diminishes, yet the cost remains high because of a combination of low productivity and GRZ policies that create high terminal benefits for employees (Bannock Consulting, 2002). The labor law creates high terminal

benefits for employees. Termination benefits currently consist of 2 to 3 months salary; thisimposes a large burden on firms. This results in businesses being unable to afford to let go of

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unproductive workers, and also suppresses salaries because the terminal benefits are tied intosalaries The greatest misfortune with these labor policies lies in the fact that many employeesdo not earn enough take home pay to properly feed and educate their families, but, when theydie, their distant relatives end up claiming a disproportionately large sum of money. Finally,it is worth noting that the high cost of labor in the public sector (including high termination

costs) may well have created higher costs to the private sector as well.

Rather than training managers, Zambia has traditionally received funds for advisors,weakening the capacity building potential of the liberalization effort. A large portion offoreign aid went to paying the salaries of these advisors, which resulted in resentment fromlocal professionals. Additionally, during the Second Republic (1964-1991), Zambia suffereda significant "brain drain". The liberalization period would have been an excellentopportunity to attract competent Zambians living abroad to repatriate. Unfortunately, therewas little concerted effort in finding and retaining highly qualified Zambians overseas.

There are also problems with the processing of employment permits which need to beaddressed (FIAS, 2004). According to the FIAS report, an employment permit is moredifficult to obtain, and the procedures, particularly for renewal, are seen by the businesscommunity as lengthy, cumbersome, and unpredictable. The FIAS report says that evenforeigners who have been carrying out business for years in the country fear the momentwhen the self-employment permit must be renewed because of its uncertain outcome. Asforeign entrepreneurs indicated in various meetings, the procedure to obtain a self-employment permit appears to them to be driven generally by suspicion and mistrust towardsthe private sector in general and foreign businessmen in particular. The composition of theImmigration Committee, which consists mainly of representatives from bodies in charge ofnational security issues and does not include representation from the economic ministries,

was mentioned as an indication of this tendency. Various businessmen indicated that theImmigration Department gives the impression that it suspects them of trying to abuse thesystem by trying any and every way to obtain a permit to stay and work in the country or tosmuggle cheap and unqualified workers or family members into the country. There is also asignificant difference between the time that the process is supposed to take (2 to 3 weeks) andactual time to obtain a permit (2 to 3 months). There is also a high degree of discretion in theway employment permits and work visas are awarded. These problems are reflected in firmsinability to hire high quality workers in a timely manner.

Finally, the most recent data shows that the impact of HIV/AIDS in Zambia is enormous;about 1 million adults and 200,000 children were living with HIV/AIDS by the end of 2001and nearly 600,000 children have lost their mother or both parents to AIDS. Life expectancyhas been reduced from 57 years in 1990 to 37 years by 2001. Estimations of the impact ofHIV/AIDS on the economy shows that the disease is costing the country up to 1 percent inGDP per year (World Bank, forthcoming). Although we do not have firm-level data toestimate the loss from HIV/AIDS, it is fair to say that the GDP losses directly reflect

productivity losses in the private sector.

The spread of HIV/AIDS has reduced worker productivity in Zambia. The high prevalence ofthe disease among Zambia's population is not only depleting the pool of locally availableskills, it is also driving up the effective cost of doing business and in particular the cost ofemployment. As trained people die from AIDS, businesses are forced to train multiple

people for key positions, thus increasing their training and recruitment costs.

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Firm productivity in Zambia: a simple econometric test

It is worth considering the key drivers of productivity in Zambia in order to furtherunderstand the types of policies that might be effective in raising productivity. We examinethe determinants of total factor productivity in Zambia by using an augmented Cobb-Douglas

production function. Results of a log-linear specification are presented in the Table 2.8. Thefirst model presents the basic specification. The second model augments the basic one byadding additional explanatory variables.

Our regression results show that that labor and capital are highly significant in determiningvalue added. In addition to labor and capital, the key factors determining firm productivityare related to input constraints--firms that suffer the most from poor input quality and fromequipment damage due to power outages have much lower value added than others. Thisresult implies that improvements in basic infrastructure and services will lead to better firm

performance; equipment damage and low input quality are the result of a weak businessenvironment including lack of a proper supply of electricity and other infrastructure, as wellas lack of access to technology and skilled labor. 5 The explanatory variables in theaugmented production function explain almost two thirds of the variance in productivity. Wewill expand on the specific issues related to the business environment in the next chapter.

Table 2.8: Zambia Productivity: OLS Regression Results

Model 1 Model IIIntercept 4.18*

(0.78)4.82*(0.76)

Log(capital) 0.33*

(0.07)

0.31*

(0.06)Log (labor) 0.69*(0.11)

0.66*(0.10)

Capacity utilization 0.01*(0.003)

0.005(0.003)

Food 0.09(0.21)

0.17(0.20)

Textiles and Garments -0.07(0.28)

0.01(0.26)

Wood and furniture -0.33(0.48)

-0.17(0.47)

Metal working 0.25(0.31)

0.22(0.30)

Lusaka 0.20(0.18)

Low input quality -0.56**(0.27)

Equipment damage -1.22*(0.28)

Adj. Rsq 0.60 0.66

5

Other so-called investment climate variables do not appear to be directly significant; this is most likely due tothe following reasons--they are embodied in measurements of labor and capital, there is relatively little varianceacross firms in cross-sectional data and their effect shows up in variables such as measure of input quality.

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III. WHY IS PRODUCTIVITY LOW?

EXPLANATIONS FROM ZAMBIAS BUSINESS ENVIRONMENT

Since 1991, successive governments in Zambia have taken on the tremendous task ofrestructuring the economy in order to make the private sector the engine of growth and the

principal provider of employment. Nevertheless, further changes are needed to improve theinvestment climate, for both domestic and foreign investors. FDI is indeed an importantsource of growth, the prerequisites for which must be taken into account. In consideringinvestment in Zambia, foreign investors need to overcome many perceived and real hurdles.

Fig. 3.1: FDI Inflow

Foreign Direct Investment in Zambiain US$ million

0

50

100

150

200

250

1985-95 1998 1999 2000 2001 2002

Source: UNCTAD World Investment Report 2003

For most, Zambias location is a major disadvantage. Not only is it a land-locked country faraway from seaports, but certain neighboring countries are also a negative influence, with war-torn DR Congo to the North and strife-laden Zimbabwe to the South. In addition, the

perception of Zambias investment climate is largely unfavorable. The Institutional Investor,for instance, placed Zambias credit worthiness in the bottom quartile for Africa, below thatof Nigeria and Cameroon, as well as those of nearby countries such as Mozambique and

Uganda. These disadvantages are further compounded by Zambias relatively small economy.

The Index of Economic Freedom rates Zambia poorly on trade monetary and fiscal policy,regulation and corruption (Heritage Foundation, 2004). On regulation, the report states that ". . . Business in Zambia is hampered by outdated laws that do not reflect, and therefore cannot

be applied effectively to, current business practice. Acquiring a business license involvescomplex procedures and delays. An investment board screens domestic investment.According to this index, Zambia is rated 118 out of 142 countries.

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Table 3.1: Institutional Investor Ranking, 2002Regional

RankCountry Global

RankCreditRating

One- Year

Change1 Botswana 39 59.0 2.33 South Africa 52 52.7 3.2

12 Tanzania 107 21.3 0.714 Uganda 111 20.0 -1.417 Mozambique 116 19.1 0.123 Zambia 128 15.8 -0.2

27 Angola 137 14.0 1.929 Zimbabwe 142 11.9 -1.1

Average 114 21.6 1.2Notes: Only Sub-Saharan African countries are included.

Credit rating has values within the range of 0 to 100, with 100 beingthe highest rating possible.

Discussions of the manufacturing sectors perceptions of the investment climate are notmeant to be a definitive priority setting tool but can be a useful contribution to the discourse.Additional quantitative data from the survey is added, where possible, to add weight to thearguments presented and round out the information on a given issue. The qualitativesubjective rankings listed in Table 3.2 below give some indication of the relative importanceof business environment aspects from the view of the private sector.

Table 3.2: Ranking of Constraints to Business Operations in Zambia

Zambia Small Large Non-

Exporter

Exporter Foreign-

Owned

Domestic

1 Cost of financing 82.1 85.7 80.3 82.2 81.8 75.4 84.9

2 Macroeconomic instability 73.9 81.8 65.2 79.0 60.0 70.5 75.3

3 Tax rates 57.5 59.7 56.1 59.2 52.7 54.1 58.9

4 Regulatory uncertainty 57.0 58.4 60.6 59.2 50.9 59.0 56.2

5 Access to finance 54.1 66.2 42.4 56.6 47.3 47.5 56.9

6 Crime, theft, fraud and disorder 48.8 49.4 53 50.66 43.64 47.54 49.3

7 Corruption 46.4 54.6 39.4 47.4 43.6 50.8 44.5

8 Electricity 39.6 32.5 50.0 34.2 54.6 41.0 39.09 Anti-competitive behavior 38.7 42.9 28.8 40.1 34.6 34.4 40.4

10 Skills & education of workers 35.8 36.4 37.9 36.8 32.7 31.2 37.7

11 Telecommunications 32.9 32.5 37.9 26.3 50.9 29.5 34.3

12 Customs and trade regulation 32.4 24.7 34.9 32.2 32.7 34.4 31.5

13 Transportation 30.4 28.6 30.3 27.6 38.2 29.5 30.8

14 Tax administration 27.5 32.5 27.3 27.0 29.1 34.4 24.7

15 Access to land/security of tenure 17.4 22.1 16.7 20.4 9.1 23.0 15.1

16 Labor regulations 16.9 11.7 21.2 15.1 21.8 16.4 17.1

17 Business licensing & permits 10.1 7.8 9.1 11.2 7.3 13.1 8.9

Respondents' Evaluation of General Constraints to Buisness Operations(% of firms evaluating constraint as "major" or "very severe")

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When firm owners and managers were asked to rate different aspects of doing business,respondents indicated that the largest problems were the cost of financing, macroeconomicinstability, tax rates, regulatory policy uncertainty, access to financing, crime, corruption andinfrastructure. The analysis of service sector firms yielded very similar results in terms of the

biggest constraints cited by companies, (Table A.2.1). For these firms the three leading

constraints to operation are, in descending order, macroeconomic instability, cost of financingand regulatory policy uncertainty

These qualitative rankings are particularly difficult to compare across countries, given the probable difference in experience and expectations of respondents. However, there is someillustrative merit in looking at the large differences regarding certain aspects of investmentclimate which are addressed in turn in this section, (Table 3.3).

Table 3.3: International Comparisons of Constraints

Respondents' Evaluation of General Constraints to operation

(% of firms evaluating constraint as "major" or "very severe")

Z a m

b i a

K e n y a

U g a n d a

T a n z a n i a

C h i n a

T u r

k e y

1 Cost of Financing 82.1 73.3 60.3 56.2 21.6 28.2

2 Macroeconomic Instability 73.9 51.3 45.4 42.0 26.0 53.7

3 Tax rates 57.5 68.2 48.3 72.1 34.1 38.1

4 Econ & Regulatory Policy Uncertainty 57.0 51.5 27.6 30.8 28.0 53.8

5 Access to Financing 54.1 44.1 45.0 47.1 24.1 17.3

6 Crime, theft, fraud and disorder48.8 69.8 26.8 25.0 15.7 12.9

7 Corruption 44.6 73.8 38.2 50.0 22.4 23.7

8 Electricity 39.6 48.1 44.5 57.6 28.1 17.3

9 Anti-competitive/informal practices 38.7 65.3 31.1 23.9 17.6 22.7

10 Skills/Education Workers 35.8 27.6 30.8 24.6 26.7 12.8

11 Telecommunications 32.9 44.1 5.2 11.6 16.5 10.9

12 Customs and Trade Regulations 32.4 39.9 27.4 30.8 21.1 8.9

13 Transportation 30.4 37.4 22.9 22.5 19.4 8.4

14 Tax administration 27.5 50.9 36.1 54.7 23.7 33.1

15 Access to Land/Tenure Security 17.4 24.6 17.4 24.3 16.3 6.0

16 Labor Regulations 16.9 22.5 10.8 11.9 19.4 8.7

17 Business Licensing/Operating Permits 10.1 15.2 10.1 26.8 15.9 5.8

By and large, the perceived impediments to business are well grounded in reality. In theremainder of Part A, well discuss the underlying factors that have contributed to orexacerbated the constraints. Instead of reviewing each of the items individually, we havedivided the issues into five groups: (1) Macroeconomics and Finance; (2) Public-PrivateSectors Interactions; (3) Infrastructure; (4) Labor Markets; (5) Crime and Corruption.

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Macroeconomics and Finance

Cost of Finance

Without finance, businesses cannot develop, modernize or compete with other firms fromneighboring countries where finance is accessible. As long as the GRZ continues to borrow atits current rate and Treasury Bills continue to pay attractive interest rates, commercial lenderswill have no incentive to reduce their lending rates for longer term investments and workingcapital. The current Kwacha base rate is over 40 percent. After margins and other add-ons,the cost to the consumer for a Kwacha loan exceeds 50 percent per annum. Aside fromtrading firms seeking short term finance, no legitimate business can sustain this cost offinance.

The current high rate of interest (and inflation) is driven by government borrowing, which isin turn driven by large public sector deficits. Figure 3.2 below shows trends in borrowing andlending rates, inflation and budget balance. Real returns on bank deposits have recoveredfrom sub-zero levels between 1998-2000 but are currently barely positive. The uncertaintygenerated by budgetary problems poses a deterrent to savings mobilization via the bankingsystem. Consequently, the key to private sector growth depends on prudent fiscalmanagement and until the public deficit is brought under control, the private sector will beunable to access affordable external finance.

Figure 3.2: Inflation, Interest rates and Budget Balance

-3-4.289

-8.288

-3.286-5.252

-9.475

-2.423-4.566

-20

-10

0

10

20

30

40

50

60

1995 1996 1997 1998 1999 2000 2001 2002

Budget balance (% of GDP) Consumer prices (% change pa; av)

Lending interest rate (%) Deposit interest rate (%)So

urce: Economist Intelligence Unit (2003)

Evidence from this survey corroborates the very high rates of interest that firms face. Table3.2 shows that over 80 percent of firms rate the cost of financing as a major or severeconstraint. The frequency of this constraint is consistent across all size, ownership and agecategories.

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Table 3.4: Use and Cost of Loans

Sample Small(10-49 Emps)

Medium(50-99 Emps)

Large(>100 Emps)

Non-exporter

Exporter Domestic Foreign

% firms with loan 31.4 19.5 32.7 48.5 27.0 43.6 33.6 26.2% loans collateral required 87.3 93.3 94.1 78.3 92.1 76.5 86.7 90.0Value of collateral, % of loan 324.1 401.5 480.8 157.8 398.1 158.9 292.2 467.6Cost of loan, (interest rate %) 28.1 31.1 36.8 20.1 33.0 17.6 29.7 20.8

Table 3.4 above shows the percentage of firms surveyed which have loans, the percentage offirms required to provide collateral, the value of collateral required as a percentage of theloan and the rate of interest charged on the loan. The table shows that small firms have thelowest usage rate of bank loans- less than 20 percent have a loan, 93 percent are required tohave collateral on the loan the value of this collateral is over 400 percent of the value of the

loan. In contrast, close to 50 percent of large firms have loans, 78 percent of these loans are backed by collateral and the value of this collateral is only 158 percent of the loan. Largefirms pay only 20 percent in interest compared to the 31 percent charged to small firms. 6 Thelack of a robust micro-finance market structure makes it virtually impossible for small

businesses to access finance.

Average collateral requirements are 3 times as large as the typical loan. Collateral in the formof plant, land and buildings accounts for more than 95% of all loans. Surprisingly two-thirdsof overdraft facilities in the sample are also secured by fixed assets. The banks lowconfidence in the viability/ certainty of positive cash-flows from the projects funded isreflected in the high collateral required. While the size distribution of collateral levelssupports this claim, it does not satisfactorily explain collateral requirements that are onaverage 3 times the size of the typical loan. High opportunity costs of lending driven by

public sector deficits and costly foreclosure procedures are likely factors in explaining banksstringent security requirements. In addition, it is possible that a culture of non-repayment ofdebt explains why banks typically require such high levels of collateral security.

Table 3.5: Use and Cost of Overdraft

Sample Small(10-49 Emps)

Medium(50-99 Emps)

Large(>100 Emps)

Non-exporter

Exporter Foreign Domestic

% with overdraft 47.3 37.7 50.9 62.1 45.4 52.7 47.5 47.3% collateral required 81.6 66.7 100.0 82.4 75.9 100.0 81.3 81.8Cost of Overdraft 45.1 44.5 47.0 44.6 46.3 41.4 39.8 48.8

Table 3.5 above shows use and cost of overdraft facilities for the sample of firms surveyed.Again, a much lower percentage of small firms have overdrafts. 38% of small firms haveoverdraft facilities compared to 62% of large firms and an average of 47% for the entiresample. In real terms, firms pay staggering 25% per annum for short term credit. Exportersand foreign-owned firms face lower costs of overdraft facilities. The percentage of firmsrequired to provide collateral is higher for large firms and for exporting and foreign-ownedfirms. It is possible that given the larger amounts of credit lines extended to large firms,

6 With inflation currently at about 20% (and falling owing to the recovery of commodity prices), average real borrowing rates are 10% and 0% for small and large firms respectively.

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banks cover themselves against the possibility of firms using short term credit lines for longterm investments by requiring collateral.

Comparisons with other African countries. Table 3.6 below shows the contribution ofvarious sources for financing firms working capital and investment needs for Zambia,Uganda and Kenya. Caution should be exercised in interpreting these comparisons asdifferences in the composition of the sample could be driving differences in the contributionof particular sources. Nonetheless, a comparison is still informative of the magnitude of the

problem relative to experiences in similarly developed economies.

The reliance of Zambian firms on internal funds for both working capital and new investmentis not as severe as Ugandan firms but is considerably greater than Kenyan firms. Thedifference is driven by both access to bank finance and a more intensive use of trade credit.On average, banks in Zambia finance 16% and 18% of working capital and investmentrequirements. The corresponding averages for Uganda are 7% and 13.4% and 25% and27.4% for Kenya. On average, trade credit finances 12.5% of Zambian firms working capitalrequirements compared to 5.3% in Uganda and 15.3% in Kenya. The other notable exceptionis the role of leasing in financing new investment. Leasing services appear much moreimportant in Zambia than in the two East African economies.

Table 3.6: Sources of Finance 7 Working Capital Investment

Source Zambia Uganda Kenya Zambia Uganda KenyaInternal funds 60.7 80.0 45.8 53.3 71.1 44.6Local commercial banks 13.9 5.7 23.5 15.4 11.6 25.4Foreign-owned commercial banks 2.1 1.3 1.7 2.9 1.8 2.0Leasing arrangements 1.1 0.1 0.4 5.8 2.4 0.2

Investment funds 0.7 1. 5 1.3 2.6 2.2 0.4Trade credit 12.4 5.3 15.3 1.5 0.5 3.1Credit cards 0.4 0.0 1.4 0.0 0.0 0.7Equity, sale of stock 1.8 1.8 1.1 3.7 2.0 0.3Family, friends 2.2 1.4 1.2 2.0 2.0 0.8Informal sources 0.1 0.4 0.0 0.7 1.5 0.0Other 5.1 2.7 2.9 6.7 4.5 6.5

7 The data used to construct these averages comes from surveys carried out in the three countries in 2002/3.

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Macroeconomic Instability

It is not, in fact, surprising that the second highest ranked investment climate constraint ismacro-economic instability. During interviews, the interviewees were given high inflationand exchange rate volatility as examples of macroeconomic instability resulting in 74 percent

of them rating the issue as a major or severe constraint on their firms operation. Many firmsinterpreted the issue to include the predictability of macroeconomic indicators in the nextyear or two, and thus registered their uncertainty.

Fiscal Imbalances. Zambia has experienced chronic and massive fiscal imbalances. Inrecent years, fiscal deficits (before grants) have exceeded 13% of GDP. In the past, thedeficits were often considerably larger, as the Figure 3.3 shows. These fiscal outcomes havemajor implications for price stability and external imbalances.

Fig. 3.3. Budget Figures, 1995- 2001

Fiscal balance: Revenue and Expenditure

-1000000

0

1000000

2000000

3000000

1995 1996 1997 1998 1999 2000 2001

Fiscalbalance

Revenue

Expenditure

Notes: Revenue excludes grants; Expenditure includes net lending; Unit: millions oflocal currency; Sources: IMF, International Financial Statistics

Although the Government has made attempts to reduce its employment base, bothemployment and spending levels have increased significantly since 1991. These increaseshave done little to alter the Governments reputation for being inefficient and interventionistor for reducing the fiscal deficit. According to the Central Statistical Office, parastatalemployees represent only ten percent of formal employment yet they account for over 40

percent of the national formal wage bill. The average parastatal employee has a monthlysalary five times that of an average private sector employee.

Among countries at the same stage of development, Zambia has been relatively successful indomestic resource mobilization. Revenue collection is about 18% of GDP in Zambia,compared to an international average of 15% for low-income countries. The revenue thusmobilized, however, has been inadequate for public expenditures which generally exceed

30% of GDP.

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Fig. 3.4: Escalating CPI, 1989-2001With such intense deficit spending, setting monetary policy has been a challenging task.Pursuing a tight monetary policy wouldhave sent interest soaring and crowded outthe activities of the private sector. Instead,monetary policy for the most part has beenaccommodating, with the Bank of Zambiaallowing money supply to grow whilefinancing fiscal deficits.

Zambia Consumer Price Index

0

200

400

600

1 989 19 91 19 93 1 99 5 1 99 7 19 99 2001

Inflationary Pressure. Inflation has beenrampant during the last decade, as Figure3.4 shows. Since 1991, the average annualrate of inflation has been 53%, with theintensity of price pressure varying from

year to year. In the early 1990s, inflationwas higher than 60% per annum. In morerecent years, it has moderated significantly,averaging around 20%. Such high inflationcauses uncertainty and raises interest rates.

Exchange Rate. The loss in purchasing power of the kwacha through inflation is reflected inthe market determined exchange rate, which has depreciated precipitously, in spite of

periodic official interventions, (Figure 3.5). It took 65 kwachas to buy one US dollar in1991; by the end of 2002, it took 4550 kwachas.Both the volatility and the decline of the value of the kwacha have had a serious impact onthe private sector. Throughout the 1990s and to date, the real exchange rate has exhibitedhigh volatility, which creates uncertainty for investors in terms of the cost of imported capitaland returns to investment.

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Fig. 3.5: Zambia - Nominal and Real Exchange Rates, 1999- 2002

0

500

1000

1500

2000

2500

3000

3500

4000

4500

5000

J a n - 9

0

J u l - 9 0

J a n - 9

1

J u l - 9 1

J a n - 9

2

J u l - 9 2

J a n - 9

3

J u l - 9 3

J a n - 9

4

J u l - 9 4

J a n - 9

5

J u l - 9 5

J a n - 9

6

J u l - 9 6

J a n - 9

7

J u l - 9 7

J a n - 9

8

J u l - 9 8

J a n - 9

9

J u l - 9 9

J a n - 0

0

J u l - 0 0

J a n - 0

1

J u l - 0 1

J a n - 0

2

J u l - 0 2

J a n - 0

3

( K w a c

h a p e r

U S D )

40

50

60

70

80

90

100

110

120

130

140

( I n d e xn um

b e r )

Market exchange rate (left scale)

Real Effective Exchange Rate (avg.1995=100)

Source: World Bank and International Financial Statistics

The Kwacha has been vulnerable to sharp bouts of depreciationit lost 10 percent of itsvalue against the dollar in two days in the last two days of 2003 owing to low demand for US

dollars. Trade in the Kwacha was liberalized in July 2003, through the introduction of a broad-based dealing window. Since this date a regular monthly pattern has emerged wherethe kwacha depreciates for most of the month, as demand for foreign currency exceedssupply, before a relatively sharp appreciation as month-end approaches, when companiesrequire local currency to pay their salaried employees and local suppliers. The end-monthappreciation has not been enough to prevent a gradual depreciation in recent months. Thanks,however, to higher export revenue, owing to increased copper production and prices, the rateof depreciation should not be as dramatic as in previous years, (EIU, 2002 and 2003). Highinflation and a lack of confidence in the currency may well ensure that the currency continuesto lose value. Also, the market for the Kwacha is quite thin and is severely affected by theactions of a few players, on both the supply and demand side. Donors consist of a third of all

supply of foreign exchange and a few large firms make up most of the demand. Also, manyloans are denominated in foreign exchange, both in the private and public sector.

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Fi . 3.6: External Position

External Position. Zambia is a member of both COMESA (Common Market for Eastern andSouthern Africa) and SADC (Southern Africa Development Community) and has joined theirrespective free trade agreements (FTAs), designed to boost intra-regional trade.Implementation of these FTAs, however, has been slow and involved trade disputes,including Zambias ban on

Zimbabwes manufactured goods. Whentrade in services and factor incomeare taken into account, the external

position of Zambia is even more precarious. In 2001, while thetrade deficit was estimated at $355million, the current account deficitwas more than twice as large,amounting to $743 million,(Figure 3.6). A contributing factoris Zambias geographical locationas a land-locked country morethan 500 miles away from thenearest seaport. This means thatthe costs of transport (freight andinsurance) are very substantial. Inaddition, Zambias service income, primarily from tourism which amounted to $143 millionin 2001, was not sufficient to offset these expenses. In recent years, the service accountdeficit ranged from a low of $179 million to a high of $264 million. Another contributingfactor to the current account deficit is Zambias interest payments on external debt, whichhave far exceeded its interest income from foreign sources. With recent debt relief under theHIPC initiative, however, interest payment has declined, reducing the factor income accountimbalance somewhat, from more than $200 million in the late 1990s to about $140 million inthe most recent years.

Trade and Current-Account Balances

-800

-600

-400

-200

0

200

1997 1998 1999 2000 2001

Trade

balance

Current-

account

balance

The current account deficit in 2001 was offset to some extent by a surplus in the capital andfinancial accounts of close to $400 million, which reflect donors contribution and borrowing

by Zambias private businesses. Nonetheless, the foreign exchange reserves for the year fellfrom $255 million at the beginning to $183 million at the end of the year. The decline inforeign exchange reserves continued into the middle of 2002, falling to $124 million or lessthan one month equivalent of imports.

With HIPC debt relief, the stock of Zambias external debt has fallen from $6.8 billion in1998 to $5.4 billion in 2002 (or about 150% of GDP). Nearly all of the remaining debt isowed to official multilateral or bilateral lenders, including about $2 billion to IDA and $0.5

billion to the IMF. Most of this debt carries highly favorable concessionary terms. The precarious external position constrains further the ability of authorities to exert monetarycontrol. The government tends to rely on Bank of Zambia financing (bridge loans) toservicing the external debt when needed.

In conclusion, macroeconomic instability is considered a major or severe problem by nearlythree-quarters of the sample firms, contrasted to the perceptions in other countries where thissurvey has recently been implemented, (Table 3.3). Macroeconomic instability is similarly

rated by about half the firms (or less) in all comparator countries.

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Public-Private Interaction

Taxes

Zambian firms ranked tax rates as the third most binding constraint to private sector growthin Zambia. This finding concurs with that of a recent FIAS Administrative Barriers studycarried out jointly with the Investment Climate analysis which treated a smaller number ofissues in more detail. The FIAS study states that the issue of tax rates was identified as a

problem by more than 50 percent of respondents and seemed to evoke the most negativereactions. Tax rates are almost always cited by enterprises as problematic, as seen in ourinternational comparison, (Table 3.3).

Figure 3.7: Tax Rates, East Africa & Asia

Highest Marginal Corporate Tax Rate, 2002

30.0 30.0 30.0

35.0

30.0

35.7

25.0

30.0

35.0

40.0

Kenya Uganda Tanzania China Zambia India

Source: World Development Indicators

However in the case of Zambia, the issue figures quite prominently. The highest marginal taxrates is, in fact, higher than neighboring countries, (Figure 3.7). Perhaps more important isthe frequency with which significant penalties are arbitrarily added to the total tax bill.

Many firms in the private sector are just as concerned about tax administration as they areabout tax rates. This finding is all the more troubling given that the government has beenmaking great efforts to improve tax administration since the early 1990s, with donorresources. The FIAS study concluded that the firm dissatisfaction derived mainly from thefact that:

Changes in tax policy are too frequent and either unjustified or unexplained to the business community;

The VAT (set at 17.5 percent) has been plagued by various problems including lengthy procedures for registration, unclear eligibility criteria and delays in refunds; and

The Zambia Revenue Authoritys (ZRA) behavior toward firms is inappropriate andstems from the fact that the burden of proof is on the firms, particularly where penaltiesand appeals are concerned. Some ZRA staff lack the skills needed to perform their dutiesand are not armed with clear guidelines on how to interpret tax rules.

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Tax officials are given wide discretionary power which opens the door for corrupt practicesand unofficial arrangements to settle tax payments and issues. Anecdotal accounts also pointout the unfair practice of negotiating and granting special concessionary tax terms on a

project-by project-basis (especially in the mining industry) which departs from the legislatedgeneral tax regime. These sweetheart deals reduce the predictability of the tax regime and

increase the effort required to effectively collect the taxes due.

Firm owners and managers reported that the ZRA focus on tax collection seems to be at theexpense of developing a modern tax policy. They feel that because the tax base is so small,the tax burden on those entities that do pay tax is disproportionately heavy. In addition, thereis resentment that the large informal sector does not contribute substantially to the federal

budget. Measures that improve the revenue side of the budget such as improving taxcollection and expanding the tax base are particularly relevant to this issue. High tax levelsand burdensome administration are undoubtedly forcing some small firms to enter or remainin the informal sector, close their businesses or relocate in other countries in the region. Anyone of these outcomes will not only further reduce Zambia's tax base but hinder growth ofindividual firms and the economy as a whole.

Regulatory Policy Uncertainty

The ICA sample firms ranked the issue of regulatory policy uncertainty as the fourth most pressing constraint to growth. Although certain aspects of this broad category, such as business registration and customs administration, do not rank highly on their own as bindingconstraints, the overall impact of these regulations and policies is high. Firms reported thatthese shifts in policy exacerbate the risks that they associate with doing business in Zambiaand create a disincentive to invest. The decline in FDI flows to Zambia over the past fiveyears reflect the drop in confidence in the Zambian economy by potential foreign investors.The Economist Intelligence Unit (EIU) gave Zambia an overall Country Risk rating of "D" intheir December 2002 report. In comparison to neighboring countries, Zambian constraints inthis area seem generally more severe, (Table 3.3). Only 28 percent of Ugandan firms say thatregulatory policy uncertainty is an important problem in their firm compared to 57 percent inZam

Documents

zambia Investment Climate Assessment 2005.pdf