I.C. (TM 1:34)

11/9/84

# A.I.D. Policy Paper

## Private Enterprise Development

**Bureau for Program and Policy Coordination**

**U.S. Agency for International Development**

**Washington, D.C. 20523**

**May 1982**

**CONTENTS**

**Private Enterprise Development**

*Page*

I. Introduction 1

I. The Importance of the Private Sector in Third World Development 1

A. Economic Importance 1

B. Social Importance and Human Rights 3

III\. Nature of the Challenge to the Development of Market Economies in
LDCs 3

A. Constraints Established by Government Policy 4

1\. The LDCs Strategy for Economic Development 4

2\. Government Policies and Regulations Derived from

Its Development Strategy 5

3\. Policies That Discourage Private Sector Participation

In Traditional Government Programs 8

4\. Government Ownership of Enterprises and the

Designation of Monopoly Responsibility 11

B. Constraints Related to Commercial and Country Risk 12

1\. Investment (Commercial) Risks 12

2\. Country Risks 13

IV\. A.I.D. Policy to Meet the Challenge 13

Statement of General Policy 13

V. Specific Components of the A.I.D. Policy 15

A. Agency Target Group 15

B. Policy Dialogue 15

C. Legal and Regulatory Constraints 16

D. Assistance to the LDC\'s Private Sector 16

E. Private Sector Participation in the Provision

of Traditional Government Services 18

F. Parastatals and Government Authorized Monopolies 20

G. Capital Saving Technology 20

H. Training Activities 21

I. Infrastructure 21

J. Research and Studies 22

VI\. The Responsibilities of Missions and Regional Bureaus 22

ANNEX A 23

**PRIVATE ENTERPRISE DEVELOPMENT**

**I. Introduction**

A society in which individuals have freedom of economic choice, freedom
to own the means of production, freedom to compete in the market place,
freedom to take economic risk for profit and freedom to receive and
retain the rewards of economic decisions is a fundamental objective of
the A.I.D. program in less developed countries. Such a private
enterprise economy is held to be the most efficient means of achieving
broad-based economic development. Private enterprises that respond to
profitable opportunities in a free market produce jobs, managerial
skills and economic growth. They contribute wealth to society and
improve the quality of life. Moreover, significant equity objectives can
be achieved when market forces operate to stimulate an economy toward
full employment.

This policy paper builds upon A.I.D.\'s experience in assisting private
enterprise development. It also draws upon the research conducted for
the President\'s Task Force on International Private Enterprise. The
guidance in this document should help A.I.D. strengthen and more fully
integrate private enterprise development into the mainstream of Agency
activity, as recommended by the Task Force. This policy paper supersedes
the A.I.D. policy papers entitled Private Enterprise Development and the
Bureau for Private Enterprise Policy Paper (both dated May 1982).
However, the goals of A.I.D.\'s policy toward private enterprise remain
the same. These goals are, in the first instance:

 to encourage LDCs to open their economies to a greater reliance on
competitive markets and private enterprise in order to meet the basic
human needs of their poor majorities through broadly-based
self-sustained economic growth.

Secondly, as a corollary to the above:

 to foster the growth of productive, self-sustaining income and job
producing private enterprises in developing countries.

**II. The Importance of The Private Sector in Third World Development**

**A. Economic Importance**

The most efficient allocation of scarce resources occurs when
individuals seek to increase their incomes in an environment
characterized by open competition in the supply and exchange of goods
and services. When complemented by prudent management of necessary
government services, the aggregate effect of individual free market
behavior is growth and development of the economy at large.

However, many LDCs have not relied on open, competitive markets to
determine resource allocations in many sectors of their economies.
Rather, LDC governments have attempted to direct essential activity in
agricultural and industrial production and trade by administrative
determinations. Except for small-scale activities often characterized as
informal, the economies of many LDCs are marked by extensive government
efforts to determine production levels, prices and consumption
patterns.[^1] A wide variety of historic, ideological and other reasons
explain a particular LDC\'s mix of public and private sector activities.

Aside from the provision of universally accepted public goods like
national defense, public safety, monetary policy and enforcement of
contracts, further government involvement in an economy follows from the
belief either that a market cannot be established or that the result of
market decisions will lead to socially unacceptable outcomes. In certain
cases, such as natural monopolies, goods with important externalities,
and merit goods (See Annex A for definitions), a government may
determine that public involvement in production or distribution is
important to achieve social objectives. **But it is clear that LDCs
which have overextended the role of the public sector and restricted the
operation of the private sector have experienced slow growth, heavy
budget deficits and rising debt burdens.**

LDCs that maintain a broad definition of natural monopolies and public
goods pay a higher price in overall economic growth. Such countries have
typically experienced real per capita growth averaging 3% per year over
the last ten years. Many have been at or near zero growth. However,
those LDCs which have more narrowly defined the role of the public
sector and allowed competitive markets to determine the price and
quantity of most goods and services have experienced growth, rates
averaging 7% per year.[^2]

In terms of equity, countries with a high level of government
interference in the market fare no better in the short run than market
economies, probably because slow growth reduces employment
opportunities.[^3] In the long run, government dominated economies may
fare worse, because sustaining equity-oriented services becomes
difficult when growth, and therefore revenue, lags.

Government is thus in a unique position to establish a favorable climate
for private investment. Moreover, that climate is critical to the
attainment of both economic growth and equity objectives. The extent and
nature of public and private sector roles must be defined and balanced
to ensure equal access to opportunities and high economic growth. This
is the challenge in A.I.D.\'s private enterprise policy.

**B. Social Importance and Human Rights**

Economic freedom for individualsan essential condition for viable
competitive marketsencompasses the notion of the right of persons to
make personal choices in providing for their livelihood and that of
their families. Such economic freedom permits individuals to pursue,
within the bounds of generally accepted norms of behavior, activities
which utilize their comparative advantage in innate capabilities,
acquired skills and interests.

The essentially independent decisions of suppliers and consumers in
competitive markets result in a diffusion of economic power. The greater
the competitiveness of the market and the economy at large, the more
dispersed is the power to influence the market and the economy for
individual gain. Free markets are the most effective way of mobilizing
human energies, assuring responsiveness to consumer demands, and
avoiding the exploitation of the poor typical of public or private
monopoly or oligarchical enterprise. Given the close association of
economic power with political power, a key attribute of a society which
permits free competitive markets is a pluralistic body politic. As LDCs
remove restrictions on the operation of markets, they are simultaneously
encouraging behavior which supports the development of popular
representative political institutions. A democratic government is not an
automatic outcome of a competitive market environment. However,
competitive markets generate greater likelihood of progress towards a
form of government which provides for popular representation than
towards authoritarian forms of government. Furthermore, a society in
which economic power is widely dispersed is more likely to be one in
which transfer of political power by election is permitted than in a
society where exclusion from political power carries with it exclusion
from economic power.

A.I.D. notes that when representative institutions emerge in a free
market economy, reciprocal benefits in the form of efficiencies in the
provision of public goods and services are likely to occur. In societies
which permit open debate, the levels of public goods supplied and the
roles of state authorized monopolies are adjusted in the normal
political process to the particular level of popular demand. These
adjustments attempt to minimize the social and financial costs of these
exceptions to competitive markets. However, adjustments in authoritarian
societies may not occur until a situation becomes untenable; an abrupt
restructuring may then follow civil unrest, a **coup d\'etat** or
revolution. The society pays an ever increasing price in terms of
reduced growth and inequity before the change takes place. Furthermore,
the abrupt nature of the change may only produce a different but equally
inefficient solution to the supply of goods and services provided or
controlled by the public sector.

**III. Nature of the Challenge to the Development of Market Economies in
LDCs**

Greater reliance on competitive markets in LDCs and the growth of
indigenous private enterprises are constrained by policy, administrative
and developmental impediments. This section focuses on often encountered
constraints.

**A. Constraints Established by Government Policy**

**1. The LDCs\' Strategy for Economic Development**

Government determines the direction of development by establishing the
overall development policy environment and a particular strategy. From
these government determinations flow the sector policies and regulations
which govern the day-to-day activities of the economy. The success of
A.I.D. and other donor efforts to support reform of sector policies and
government procedures through individual project efforts may not meet
expectations if the country\'s strategy for economic development is not
compatible with proposed-reforms.

Many LDCs enunciate their overall strategy in their published
development plans. But this is not always the case. In fact, development
plans sometimes mask real priorities with rhetoric designed to appeal to
donors. Efforts to introduce market pricing and producer competition in
an LDC committed to socialism and central economic management will not
yield the desired results. However, A.I.D. is more often confronted with
less severe strategies which also may involve a strong element of
central control of the economy by government. In particular, an LDC with
a strategy of general import substitution may be reluctant to expose its
domestic market to imports even though this may be a policy reform
essential for long run, broad-based economic growth. A country whose
fundamental development strategy is to achieve food grain
self-sufficiency also may not be receptive to policy changes which
stress its comparative advantages in other products and its ability to
more cheaply satisfy its food requirements through international trade.

The results of general import substitution policies have largely been
contrary to the LDCs\' expectations.[^4] They have entailed serious
resource misallocations, have not reduced the dependency on imports
(although they may have changed their composition) and have inhibited
export growth. As a consequence, foreign exchange constraints and
dependency on external resources have been aggravated, not improved, and
growth potential has been adversely affected.[^5] In contrast, export
oriented strategies have given rise to a variety of LDC success
stories.[^6] Overall, countries that have adopted measures which have
let their private sectors aggressively pursue opportunities to export
have done relatively well in terms of growth and improvement in living
standards. The exports may have been products of indigenous resources
(agriculture surplus, natural resources, etc.), or value added to
imports. Export oriented strategies have proven their value in promoting
economic growth because LDC domestic demand is usually neither
sufficient to support the number or sizes of domestic production units
required for healthy competition in many product markets, nor sufficient
to achieve full employment. **Consequently, A.I.D. encourages a shift
from policies which promote general import substitution to policies
which open an economy to international trade.**[^7]

The transition to an export oriented strategy and A.I.D.\'s involvement
in it must, however, take cognizance of two basic issues. First, the
obstacles to economic liberalization are substantial. Many LDCs have
conceptualized their form of import substitution strategy in terms of
national security objectives and are reluctant to consider alternatives.
In most cases the most sensible (and feasible) approach to assisting an
LDC reorient its overall strategy involves the gradual dismantling of
controls and price distorting policies first in those areas where
success is most likely and change is least threatening to the LDC\'s
perceived national security objectives.

Second, import substitution is not bad **per se**. Efforts that do not
run counter to reliance on the price mechanism and which seek to exploit
productive activities in which a country has a real competitive
potential are sound.

Thus, A.I.D. believes it is critical to focus on the development scheme
of the government, to assure that its effects are known and weighed. It
is also critical to determine the real motives behind what otherwise
appear to be poor economic choices in the management of an LDC economy.
Finally, in cases in which an LDC is reluctant to modify its overall
strategy, there still may be significant scope for private sector
activity and use of market prices. **A key objective of A.I.D.\'s
strategy is to promote, through the policy dialogue associated with U.S.
assistance, a greater reliance on market determined prices and the
initiative of the private sector.**

**2. Government Policies and Regulations Derived from Its Development
Strategy**

A country\'s fundamental strategy gives rise to policies and regulations
through which that strategy is implemented. The economies of many LDCs
are burdened with diverse policies and regulations which seriously
impede enhancement of the private sector\'s role because, as previously
explained, many LDCs have until very recently followed development
strategies which involve import substitution and public sector control
of the economy. This section describes frequently encountered policies
and regulations. In this review, it is important to be aware that there
is frequently a lag between a change in an LDC\'s basic strategy and the
subsequent change in sector policies and regulations which were derived
from it.

 **Foreign exchange policies and regulations:** Most LDCs do not
operate an open market in foreign exchange. As a consequence, their
foreign exchange rate often differs from that which would occur under
free market conditions. When this difference reflects an undervaluation
of foreign exchange the outcome is equivalent to a tax on exports and a
subsidy on imports. This distorts factor prices in production.

In countries that do not rely on the market for foreign exchange
operations, government rules regulating banking sector activities
prohibit or severely limit the buying and selling of foreign exchange
except for specific (sanctioned) purposes as determined by the national
planning process. Foreign exchange for essential requirements of the
private sector, such as spare parts, fuel or other inputs, becomes
unavailable or is rationed on political criteria, rather than priced
according to the urgency and economic importance of its use.
Consequently, the buying and selling of foreign exchange by private
firms requiring non-sanctioned commodities occurs in black markets or
through totally offshore transactions. The domestic private sector
serving the domestic market usually operates in the black market while
foreign investors conduct their foreign exchange transactions offshore.
In both cases the regulations impose an extra cost on doing business.
While some LDCs have allowed parallel markets to develop, the exchange
rates in each market are almost always different from each other.
Individuals or firms permitted to deal in the official market have a
significant price advantage over those who must deal in the parallel
market.

 **Import and export restrictions:** LDCs frequently restrict certain
types of imports and exports, severely tax some goods, use non-market
mechanisms to allocate other imports and establish a large number
of,procedures for import and export transactions. On the import side,
most LDCs require businesses to obtain licenses prior to importing
needed commodities. The issuance or denial of these licenses is the
mechanism by which the government substitutes political control for the
economic judgments of the market place. Licenses are also used to help
ration undervalued foreign exchange. On the export side, restrictions
are imposed to artificially maintain the domestic supply of a particular
good so that prices for domestic consumers may be held down. Of course,
the result is also to depress the incentives and financial capability to
expand supply.

 **Banking restrictions:** LDCs have traditionally controlled the
activity of the private sector through a wide array of rules and
restrictions imposed on the banking sector. Interest rate regulations
frequently set less than market interest rates causing only the most
risk-free loans to be made. The low lending interest rate also
suppresses the interest rate on savings, which results in little
institutionalized mobilization of resources. Institutional capital does
not flow to the most productive uses, particularly the more dynamic and
labor intensive small and medium enterprises. Rigid controls may
substitute for economic considerations in determining the quantity of
loanable funds which can be made available for different types of
production and investment credit needs. Government imposed or permitted
collateral requirements narrow the number of entrepreneurs who are
eligible for institutional credit.

 **Market entry restrictions:** Many LDCs have erected a ponderous
structure of rules and procedures related to the issuance of business
licenses and the establishment of corporations. A firm can be
established in a few days in a developed market economy, but it may take
months or years to legally establish a firm in an LDC. Not only are a
large number of steps formally required; the reality of LDC bureaucracy
is that each step may require unofficial payments by the entrepreneur in
order to move to the next step. Even without corruption, time is money,
and long planning times impose a substantial cost which small-scale
entrepreneurs lack the capital reserves to manage. Thus, there are
considerable financial as well as administrative barriers to market
entry.

 **Limitations on investment:** Many LDCs specify a level of investment
which they feel is warranted in a particular industry. In some cases the
specification is in the form of a limitation on the maximum size of
private sector investment. Any number of entrepreneurs may enter the
industry, but none can operate above a certain size. This restriction is
usually made to protect a large firm which may be owned by the
government and would not be able to compete with a private firm of equal
size.

Other LDCs restrict the number of firms which can operate in a specific
industry. While the purpose of these restrictions is to prevent over
investment in the industry, the effect is to give the lucky investors
excess profits, and government personnel another opportunity to exercise
discretionary authority for political or other interests through the
rationing of business licenses.

 **Investment promotion programs:** Government may offer a package of
investment incentives in order to attract entrepreneurs into activity
which the government wishes to promote. This can be done without
restricting investment in other industries, but often it is not.
However, problems arise when the activities which are promoted follow
from administrative determinations which do not reflect the country\'s
comparative advantage in production as might be determined in an open
competitive market. Funds invested in promoted industries may be funds
denied to other more productive activities which have not been included
in the promotion program.

 **Price-fixing:** Countries often set a maximum price to maintain
artificially low prices for certain goods. The activity is easiest to
enforce when the government operates a price-setting parastatal.
However, price-fixing and related enforcement is practiced even without
parastatals. The most popular items for price regulation are essential
foods and agricultural inputs; however, many countries fix the price of
other commodities such as shoes, clothes, batteries and liquor. Price
fixing which results in higher than market prices also occurs when the
number of private firms in a particular industry is limited so that a
suppliers\' cartel can be formed.

 **Subsidies:** Closely related to price-fixing are government subsidy
programs. Subsidies may be offered to expand consumption or to
temporarily protect particularly vulnerable groups from the cost of well
advised corrections. However, they are often required to compensate for
inefficiencies in production which arise because of policies which
restrict private enterprise. Furthermore, perpetuation of subsidies
frequently becomes a political necessity for outlasting any temporary
justification.

 **Labor Market Laws and Regulations:** Minimum wage legislation that
sets excessive levels of wages and fringe benefits, and employment rules
that overly restrict hiring and firing processes act to reduce
employment opportunities and favor the substitution of capital for
labor. Minimum wage laws which set wages above market clearing wage
rates do not reflect labor market demand and supply conditions. Either
because they are set at unrealistic levels or through their effect on
other wages (which change when minimum wages change), they act to push
labor costs beyond the capacity of some firms. The impact of fringe
benefits, which form a substantial proportion of labor costs in many
LDCS, and of regulations covering hiring and separation practices, tends
to further dampen demand for labor. Developing countries with a large
labor surplus should ask themselves whether the economic and social
costs of higher unemployment and economic dislocation are truly
compensated for by the perceived political or social benefits of high
minimum wage laws.

 **Taxation and User Charges:** LDCs depend more on indirect taxes
which are relatively easy to administer (e.g. taxes on exports and
imports) than on direct taxes which are more expensive to administer
(e.g. income or consumption taxes). Such indirect taxes often impact
primarily upon the producers of export commodities, particularly rural
producers, and retard export growth. LDCs also tax in an effort to
accomplish a specific social purpose, sometimes resulting in very high
marginal rates being applied to high income earners and very high duties
being levied on \"luxury\" goods. In these cases, the administration of
the tax usually has serious shortcomings and tax amount of evasion is
widespread. Also, taxes on income and property usually have high
exemption floors. The effect of exemption floors and tax evasion is that
the actual number of people or amount of property subject to the tax is
very limited and inequitable; administration becomes politicized, and
law abiding taxpayers in effect subsidize those who evade taxes. High
rates exacerbate inequities and encourage the sheltering of income,
including offshore investments. Tax policies should be reviewed, and
generally revised to foster development and encourage saving and
investment.

User charges, particularly for water, sewers, power and transportation
rarely cover costs, and the supply of these services must be financed in
part from tax revenues.

**3. Policies That Discourage Private Sector Participation In
Traditional Government Programs**

A variety of policies and regulations similarly discourage private
sector participation in the social sectors. For example, the private
sector has an important role to play in the delivery of health and
family planning services in developing countries. Government resources
often cannot support the provision of services for all those individuals
who may want them, and some individuals may actually prefer to receive
services from sources other than the government.

Governmental policies not only affect their citizens\' desire for family
planning services, but also this acceptability and availability of the
services themselves. Private sector involvement is likely to be more
consumer oriented and more likely to offer the range and mixture if
product and assistance desired by the public. Moreover, and this is
especially important in the family planning area, use of the private
sector as a delivery mechanism increases emphasis on personal choice and
responsibility and reduces dependency upon the government. The active
involvement of the private sector in the delivery of family planning
services may depend to some degree on government policies regulating not
only the distribution and advertising of particular contraceptive
methods, but also on policies which cover the organization and
operations of non-governmental organizations.

Many LDC governments sustain policies whereby all government services
are provided free of charge, regardless of governments\' ability to
finance these services and in spite of demonstrated client willingness
to pay for some or many of these services. Yet, at the same time, all
LDC governments lack the financial resources to provide nationwide
access. The result of these policies is the underfunding of basic health
services, which are often of extremely poor quality (thinly staffed and
deficient in drugs and supplies) or existent more in theory than in
fact. Clients are left **de facto** to rely on whatever private health
services exist, and these services must compete with \"free\" (albeit
inaccessible) goods.[^8] Furthermore, insistence on government provision
of services has impeded the private sector from filling the health care
gap. Studies in various settings have demonstrated strong consumer
demand (as evidenced by willingness to pay) for quality health services
provided by government and private sources.

Similarly, there is potential both for involving the private sector more
fully in the provision of education and training services and inputs,
and for shifting some of the costs of education from the public to the
private account.

At the primary or basic schooling level there is potential for private
and local organizations to play larger roles in the administration of
schools. People in most LDCs are no different from people in our
country. Education of one\'s children is a highly valued objective. In
most cases, schooling at this level will continue to require some public
subsidy from central revenue sources. However, most strategies of
localizing and diversifying school systems require the active
encouragement of private and local organizations including community
self-help groups, in the provision of basic schooling (see A.I.D. Policy
Paper entitled **Basic Education and Technical Training**).

Such organizations are also prominent in the provision of pre-school
education and non-formal education or skills training for adolescents
and adults. The initiative for starting and sustaining these programs
tends to be private, as they tend to be additional to the government\'s
basic education mandate. The most effective form of public support is
often some form of technical support services, rather than direct
subsidies.

At the secondary, vocational/technical and higher education levels there
is an even stronger case for shifting more of the costs of education to
the private account, either through tuition and other fees or through
reliance on private organizations and employers to provide the training,
perhaps supported by partial tax credits. In many countries, half or
more of the education at these levels is provided privately, with little
or no public subsidy other than essential technical services such as
examinations administration. It is essential to keep in mind that at
higher levels of education and training, the private benefits tend to
equal or exceed social benefits. This is true especially where only a
minor fraction of those eligible are able to benefit. Thus, excessive
public subsidy of these levels and types of education and training
drains resources needed for the provision of basic education and skills
training with higher social benefits.

Finally, regardless of how education and training systems are
administered and funded, there is great potential for the private
provision of education and training inputs. For example, private
contractors can often build schools and handle the printing and
distribution of texts and other instructional materials at less cost,
more quickly and with more attention to local demand or design
requirements than can central ministries. (And not to be overlooked is
the development of managerial and entrepreneurial skills which can have
a multiplier effect on a society.) As school systems expand, other
opportunities for privately provided services also expand, ranging from
housing and transport for students and teachers to commercial media,
data processing and telecommunications services.

In the agricultural sector, government policies and programs have
restricted the operation of markets and entrepreneurs. Agricultural
subsidies and related price controls adopted by many LDC governments in
areas such as food marketing and distribution, marketing of agricultural
inputs, and agricultural credit have tended to result in substantial
reductions in efficiency and productivity with little or no benefit to
the disadvantaged groups they are often supposed to help. Moreover, LDC
governments often intervene directly in the physical distribution system
for both agricultural inputs and outputs in order to enforce such
controls.

While there are certain areas in the agricultural sector (such as
agricultural research and extension) where government involvement is
useful or essential, this involvement should permit parallel or
complementary private sector activity. For example, private seed and
fertilizer/pesticide companies have been important research centers in
the U.S.

Finally, many LDCs maintain policies that discourage the efficient
provision and maintenance of infrastructure, both in rural and urban
areas. Private road maintenance, urban public transit, water supply and
sanitation are examples of other areas where enhanced private
participation in the provision of both services and infrastructure can
produce significant efficiencies.

Performance contracting for private road maintenance is one such
instance. In 1970, for example, in a very large South American country,
the highway department began a contracting-out program that by mid‑1981
had reduced the size of the public maintenance network by 75% and there
were 264 contracts for private maintenance. Similar experience in many
other countries for some 19 categories of private road maintenance
activities was shown in a recent IBRD study to have resulted in an
average 37 cost percent reduction in comparison to public provision of
like services. In one large African country, the results were more
dramatic because no maintenance had been occurring prior to private
contracting.

In urban \"public\" transport also, the pressure for private provision
has grown as a result of shifts in public attitudes and the demonstrable
efficiencies that have occurred as the result of the shift from public
to private provision. Until rather recently, conventional attitudes were
that large public systems operating with fixed routes, large operating
units and larger vehicles were more efficient than private systems.
These attitudes have changed substantially as the result of careful
empirical studies comparing the relative efficiency of public vs.
private service in numerous large Asian and South American cities, as
well as the experience with large operating deficits and poor service of
the existing public systems.

The experience with private vs. public provision in the developed world
and the problems of infrastructure provisions in LDCs has also led to
renewed interest in private ownership as well as operating and
maintenance agreements between ministries and private firms. Careful
econometric studies of private water enterprises in the U.S., for
example, have shown that private operating expenses were some 25 percent
less than those of comparable public operations. Other studies have
shown that as the result of existing patterns of public
cross-subsidization in many LDCS, existing users of public systems are
resistant to extending service to low-income areas even though the
prices that low-income water users are currently paying substantially
exceed the cost of supplying water from a central system. As a result,
through private systems, with fewer cross-subsidies and appropriate
pricing, higher quality central system service can often be supplied to
low-income residents when it would not have been possible with a public
system.

The above examples are particularly interesting in that sole public
provision of infrastructure and services often has been based on
theoretical justifications (e.g. natural monopoly, externalities, merit
goods) set forth in annex A. However, these justifications have often
proved erroneous (as is clear in the case of urban transit) and rarely
justify a policy of both public finance **and** supply.

These erroneous justifications and rationales for public provision also
characterize a wider range of other state-owned and controlled public
enterprises discussed in the section to follow.

**4. Government Ownership of Enterprises and the Designation of Monopoly
Responsibility**

The policies, regulations and programs described above are often used to
support not only a specific development strategy, but also a set of
government owned enterprises (parastatals) or authorized private
monopolies. The rationales used to justify these enterprises are many.
While the validity of a public enterprise must be judged in the context
of the individual country setting, many of the original rationales
underlying their establishmentmostly having to do with self-reliance,
equity objectives and the assumed inefficiency of the private
markethave been found to be erroneous.

Even today, many LDCs operate public enterprises without having to
account for the real costs of operation. Revenues are rarely matched
against expenses in terms of full cost recovery. Nor are they ever
compared in accounting practices. During the 1970s, because markets for
primary products remained reasonably buoyant and development was
supported by borrowing from the private capital markets and by the
introduction of new technologies, the costs of public enterprises were
not an issue. However, in a number of LDCs, deceleration of development,
declines in prices of primary products, and failures to adjust to the
new cost of energy have led to mounting debt and foreign exchange
shortages. Governments have been forced to examine the economic
efficiency of current resource allocations.

The poor record of state enterprises has become a drain on scarce
resources and a liability to economic growth. However, political
pressures have slowed the dismantling of these institutions. Thus, the
changing attitudes toward parastatals have been accompanied by interest
in mechanisms short of sudden divestiture which might be used to correct
their poor performance. In general, the performance of state enterprises
appears to reflect the degree to which public authorities have relied on
market forces to guide the activities of both public and private
enterprise. Studies of the market structure in which many LDC public
enterprises operate, have revealed an essentially non-competitive
environment, including insulation from both foreign and domestic
competition. This insulation is buttressed by wide ranging subsidies as
well as tax and regulatory preferences.[^9] Indeed, where the market has
not been relied upon to allocate resources, the operation of parastatals
and government authorized monopolies has resulted in considerable
financial and economic costs.

This problem has been compounded by problems of multiple and unclear
objectives for these firms which make it easier for public enterprise
managers to excuse inefficient performance by appealing to conflicting
objectives. Furthermore, in many cases these firms are subjected to
short-term political pressures and interferences in day-to-day
operations. If objectives are multiple and unclear or political
expediency determines corporate policy, it is inherently difficult to
measure and evaluate performance on any objective scale.

**B. Constraints Related to Commercial and Country Risk**

Certain constraints to private enterprise development can be attributed
to risks associated with a country\'s level of development. Some stem
from government action or inaction but others depend upon the resource
endowment of the country. These constraints frequently include
inadequate infrastructure, lack of access to technology, underdeveloped
human resources, inadequate energy supplies, vulnerability to natural
disasters, poor communications, rural, urban and regional disparities
and other market imperfections. These constraints affect development
through the availability and cost of investment funds, including
insurance.

The large increases in LDC debt which occurred during the 1960\'s and
early 1970\'s demonstrated that many LDCs had not faced a situation
where capital was lacking. Today many LDCs still can obtain foreign
capital; however, the terms have hardened considerably. Large variations
exist, but the costs of foreign borrowing to LDCs are substantially
higher than the costs to developed countries, and the higher costs
reflect a more sober assessment of risks related to the country\'s level
of development. These risks are viewed by lenders to be of two
types-investment risks and country risks. Their relative importance
depends on the specific country in question.

**1. Investment (Commercial) Risks**

The first category of risks relates to the quality of the investment.
Many LDCs face serious constraints which limit their ability to
comprehensively design, analyze and implement public investment
proposals. In embracing a significant development agenda, staff
resources of LDC ministries become stretched too thin; important data
may be unobtainable; and adequate management resources for
implementation may not materialize. Despite potential economic gains,
public investment proposals often lack the creditability needed to
immediately obtain donor or commercial funds. Five year development
plans contain many such investment proposals. The consequence is that
donors and international lenders discount the LDC\'s estimated rate of
return on public investments and frequently conclude that even a small
investment will exceed the LDC\'s absorptive capacity. If elements of
the proposal have merit from a donor\'s perspective, the donor will
become extensively involved in assisting the LDC redesign the proposal
before making funds available. Commercial lenders will not expend such
an effort but will look elsewhere, usually to more developed countries,
for investment lending.

While an LDC\'s national pride or its sense of urgency for development
may in part explain the quality of public investment proposals, an
important cause is the scarcity of trained personnel in the LDCS. In
many LDCS, particularly those in the lower per capita income range, a
mere handful of trained people relative to the population at large can
be found to develop the public sector\'s investment proposals. A
similarly small group of people can be found to manage effectively
project implementation.

Private sector investment proposals by LDC firms may also tend to lack
realism. Particularly, assessments of indigenous firms\' capabilities in
terms of meeting production targets, delivery schedules and quality
standards may be overstated. More importantly, the success of many
investments depends upon the personal relations between the local
businessman and key government officials. These are subject to sudden
change.

**2. Country Risks**

The second group of risks which have hardened the terms of capital
available to LDCs are the risks associated with the political and
economic instability of the country. On the political side, wars,
revolutions, coups and civil disturbances will influence the cost of
commercial capital and availability of donor assistance. On the economic
side, fluctuation in the price and supply of LDC primary commodities has
raised foreign lenders\' risks.

Besides raising the interest rate of commercial capital, the risks of
political and economic instability cause the lenders to reduce the
repayment period. In fact, one of the most noteworthy behavior
characteristics of both foreign and indigenous investors in LDCs is the
extremely short time horizon expected for an investment payback.

These two risk effects have dramatically restricted investment
opportunities in LDCs since rates of return must be very high to cover
investment risk interest and very short payback periods (on the order of
six months to one year and a half to hedge the country risk. Given this
fact, there is a strong preference among foreign and indigenous
investors to finance trade rather than fixed plant and equipment.

**IV. A.I.D. Policy to Meet the Challenge**

**Statement of General Policy**

A.I.D. assistance to an LDC should encourage social and economic
development that promotes movement toward a democratic, free market
society. It is A.I.D.\'s view that such societies are most efficient for
generating broad based, sustained economic growth and social progress.
A.I.D. should program its resources in support of LDC performance
towards this objective.

A.I.D.\'s private enterprise policy is intimately related to the need to
conduct our programs in an environment of policy dialogue with the host
country. The essence of this policy dialogue should be to deal with the
country\'s development strategy and related policies as they affect the
operation and growth of free markets and private entrepreneurship.
However, policy dialogue leading to policy reforms which encourage LDC
private enterprise development may not be sufficient to achieve the
desired objective. Therefore, A.I.D. should also engage in specific
direct program actions to eliminate legal, regulatory and other
constraints to private enterprise development, and to assist and promote
private enterprises. In this regard, A.I.D. personnel who plan and
implement such programs should endeavor to learn as much about the
indigenous private sector in their host country as they do about the
operation of the ministries and parastatals which are responsible for or
involved in the principal sectors of the Country Program Strategy.

The overriding intent of A.I.D.\'s private enterprise policy is to
promote the establishment of a climate conducive to LDC private sector
activity; it is not intended primarily to finance the establishment of
individual business entities **per se**. The two-pronged objective, to
reach the ultimate goal of growth, is the establishment of viable,
competitive markets and the expansion of private enterprise in LDCs.
These objectives may not be met by establishment of a particular firm
unless the establishment of the firm leads directly towards the
development of a competitive market in the LDC or becomes a
demonstration project that can readily attract private replication.

A.I.D.\'s preference is to build up and rely on the indigenous private
sector for the long run economic development of the LDC, rather than to
assist continued reliance on parastatals. A.I.D. has a particular
interest in exposing productive activities to market forces rather than
subjecting them to administrative plans. A.I.D. has a particular
interest in reducing and eliminating subsidies. Finally, A.I.D. has an
overriding interest in ensuring that activities carried out to develop
competitive markets and private entrepreneurship can be shown to benefit
A.I.D.\'s target group as defined in the FAA.

A.I.D.\'s promotion of free markets and the private sector should not be
confused with monopoly enterprises, oligarchy or \"crony capitalism\",
which have little to do with the free market. A.I.D.\'s effort to
encourage competition and entrepreneurial activity is as much a
challenge to the limited capitalism extant in some countries as it is to
statist economies.

There are no restrictions on the types of funds or modes of assistance
applicable to the pursuit of the private enterprise objectives. ESF, DA
and PL 480 loans or grants are all appropriate ways to support private
enterprise development. Forms of assistance such as studies, short or
long term technical advisors, commodities, training or resource
transfers can be used either as components of project or non-project
assistance in exchange for appropriate policy changes or for support of
country performance in areas of significance to private enterprise
development. Local currency generated from non-project assistance can
also be programmed effectively in support of private enterprise
development.

Assistance to promote competitive market conditions and indigenous
private enterprises should not be considered as a separate portfolio of
activity independent of other sectors of interest to the country
assistance strategy, such as agriculture, health, education, etc. The
promotion of a democratic, free market economy should underpin and be
incorporated in all aspects of A.I.D.\'s country programs.

A.I.D.\'s private enterprise initiative is directed at the development
of the LDC\'s private sector. A.I.D. will utilize the U.S. private
sector to help it achieve this objective. However, the use of U.S.
private sector firms to provide technical assistance, commodities and
other services does not constitute in and of itself an act which
fulfills the intent of this private enterprise policy. In accordance
with the F.A.A., the use of U.S. firms on projects to the maximum
extent, possible is standard operating procedure for all projects.
Skills, commodities and services available in the U.S. private sector
are valuable to help solve almost all of the problems confronting
development. However, their use on a project does not automatically mean
that the outcome of the project will be the direct improvement of the
LDC private sector or the furtherance of an open, free market economy.
Therefore, the mere use of a U.S. private firm should not be construed
to mean that the project is a private enterprise promotion project in
the sense of meeting A.I.D.\'s policy objectives.

Similarly, the implementation of the private enterprise initiative need
not be exclusively through firms in the U.S. private sector. While such
firms are often the most appropriate source of expertise, U.S.
universities, PVO\'s and government agencies may also be suitable
resources particularly in helping LDCs establish a policy environment
conducive to the growth of indigenous private enterprises.

As LDCs develop more market oriented and open economies, U.S. private
enterprise should benefit from new markets for inputs to higher levels
of LDC economic activity and more opportunities to enter into mutually
profitable business relationships with LDC entrepreneurs.

**V. Specific Components of the A.I.D. Policy**

The following specific policy guidance reflects A.I.D.\'s experience in
designing, reviewing and implementing project and non-project activities
in support of private enterprise development. A specific mission program
to carry out this policy will depend on the policy, institutional and
legal conditions which prevail in the country. Therefore, this policy
paper will not set specific Agency program priorities indicating which
A.I.D. supported activity should take precedence. These decisions are to
be made at the mission strategy, program and project levels.

**A. Agency Target Group**

The FAA states in Section 101 and 102 that one of the four principal
goals of U.S. foreign economic assistance is \"\...the alleviation of
the worst physical manifestations of poverty among the world\'s poor
majority\...\". It further declares \"\...that the principal purpose of
the United States bilateral development assistance is to help the poor
majority of people in developing countries to participate in a process
of equitable growth through productive work and to influence decisions
that shape their lives, with the goal of increasing their incomes and
their access to public services which will enable them to satisfy their
basic needs and lead lives of decency, dignity, and hope.\" Projects
which implement A.I.D.\'s private enterprise policy should clearly
demonstrate the linkages between the activity which is to occur on the
project and progress toward this primary FAA objective.

**B. Policy Dialogue**

1\. Before entering into discussions with the host country
representatives on specific project activities, missions should have a
firm knowledge of the macroeconomic policy environment including the
overall development strategy of the host country and how this affects
the emergence or operation of the LDC\'s private sector. The mission\'s
program should concentrate on macroeconomic or sector policies as
appropriate in the specific country circumstance. Efforts to reform
policies considered subsidiary to the country\'s development strategy
more likely will be successful when the overall strategy is
complementary (or not an impediment) to the reform of these subsidiary
policies. However, pursuit of a policy dialogue within a specific sector
may be a valuable way to help LDCs overcome political difficulties
associated with macroeconomic reforms. \"Experimental\" reforms within a
sector may be more politically palatable to the LDC and may become a
model to be applied to other sectors and the economy at large. From our
experience, the policies most damaging to the indigenous private sector
are those discussed in Section III above.

2\. Project and non-project assistance which is primarily aimed at
reforming policy should include complementary actions which
institutionalize the reforms in the form of revised laws, regulations,
or procedures. In addition, projects should seek to institutionalize the
capacity to carry out policy analysis to support continued reforms.

3\. Each project which provides assistance to stimulate specific
activity within the indigenous private sector must recognize the policy
environment and its effects on the outcome of the project. Insofar as
the policy environment is not conducive to sustaining the outcome of a
proposed project after the A.I.D. resources have been expended, the
mission should not proceed with the final design of the project until it
can demonstrate that the appropriate policy reform will take place when
it is needed. Such reform may be undertaken by the host country as part
of the project design or implementation effort (learn-by-doing approach)
or it may result from other A.I.D. or other donor activities. However,
the project documentation must show that there is a reasonable
expectation that the appropriate policy reforms will occur.

4\. A.I.D. believes that the operation of the heterogeneous, dynamic and
largely unregulated informal economy provides a powerful argument in
favor of eliminating uneconomic controls on the formal economy. In
countries amenable to policy dialogue and related reforms, direct A.I.D.
assistance to enhance the importance of the informal economy is a
valuable complementary program to policy dialogue with the LDCs
governments. In countries which are reluctant to discuss policy,
assistance to productive activities carried out in the informal private
sector may be the only effective way to stimulate broad-based growth and
developmentsuch assistance is, in any case, highly cost effective in
terms of meeting A.I.D.\'s mandated target group who are found in great
numbers in this labor-intensive, capital-saving sector. A.I.D. has a
strong interest in programs which support the informal private sector.

**C. Legal and Regulatory Constraints**

The expansion and efficiency of the private sector depends upon a
supportive legal structure and a positive regulatory environment. The
existence of an adequate structure of property rightsincluding patent
and copyright law, contract law and judicial arrangements which
facilitate adjudication are essential.

1\. Each project which provides assistance to the indigenous private
sector must describe and analyze the relevant legal and regulatory
structure which affects the outcome of the project. The project must
also show how changes in this structure will occur as necessary for the
project to achieve its purpose.

2\. It may be that individual country circumstances will require a
significant institutional development effort to build appropriate legal
and regulatory institutions conducive to private enterprise. Specific
projects or sub-project activities which provide assistance for studies
or advisory services to review or reform legal and regulatory barriers,
are encouraged.

**D. Assistance to the LDC\'s Private Sector**

A.I.D.\'s purpose in these policies covering assistance to the
indigenous private sector, is to stress management improvement and
technology transfer through advisory services and training. In addition,
A.I.D. believes it is essential to avoid creating fictitious
(non-market) conditions for the indigenous private sector through the
offering of highly concessional terms for A.I.D. financial capital.
A.I.D.\'s highly concessional terms will not be the cost of capital
required by the indigenous private sector to sustain and expand
production and services. Consequently, A.I.D. agreement to highly
concessional terms postpones the need for the recipient firm to manage
its resource\'s and make its decisions on the basis of market forces. It
also relieves pressures to institute essential reforms in financial
markets such as the introduction of positive interest rates for savings
and lending. Finally, concessionality is, in essence, a grant of capital
to the owners of equity of the firm and, therefore, generally an
inappropriate use of U.S. funds.

1\. A.I.D. resources should be channeled through the private sector
rather than the public sector, when host country conditions make this
possible. In many cases, it may be feasible to contract with a private
sector firm to provide what might have been provided through a
government ministry.

2\. Recognizing that concessional assistance to a private sector firm
is, in essence, a grant of capital to the owners of equity of the firm,
its appropriateness must be based upon the unusual innovations or
developmental risk assumed. That is, the loan or grant must be based on
the externalities of the project which go beyond the business itself
(examples: development of a new, easily replicable technology,
introduction and marketing of new services, etc.).

3\. If an indigenous private enterprise is to receive and manage A.I.D.
resources to accomplish a specific development objective, and several
LDC firms are capable of carrying out the activities, the firm to be
used should be selected by an appropriate competitive process or
evaluation.

4\. A.I.D. may use grants or loans with concessional terms to finance
direct training of and technical assistance to LDC private enterprises.
Concessional assistance is particularly useful when:

a\) Training and technical assistance has as its direct objective the
improvement of competition in the industry.

b\) New technology is transferred to the country. In this case A.I.D.
should take care that its use of concessionary finance is proportionate
to the transfer of technology (not the normal commercial risk) and does
not hurt the marketing of such new technology by the U.S. private sector
through normal commercial channels.

5\. A.I.D. will not take an equity position in a private enterprise.
However, long term or subordinated debt or convertible debentures may be
permitted where it is appropriate that A.I.D. share in the risk or the
growth of a new operation.

6\. A.I.D.\'s provision of financial capital to an LDC private
enterprise will be subject to the following conditions:

a\) **When its purpose is to provide financial capital to a financial
institution so that it can increase its current on-lending to a specific
A.I.D. target group:** In this case A.I.D.\'s resources should be
channelled only to development activities which are 1) consistent with
A.I.D.\'s country development strategy and 2) unable to attract the full
amount of required financial capital from commercial sources. A.I.D. is
willing to assume the risks associated with a country\'s political or
economic situation, which maybe impairing institutional access to
commercial credit.

The on-lending of the financial institution to the A.I.D. target group
should be at LDC market determined terms (interest and repayment
period). If interest rates or repayment periods are artificially set by
the government, the rates agreed to under A.I.D. projects should be part
of a planned effort to achieve market terms in the LDC\'s capital
market. As a minimum, it should be at positive rates to prevent
decapitalization and economic misallocation of resources.

In situations in which foreign exchange risks make it inappropriate for
private borrowers to assume a dollar debt, A.I.D.\'s financing may be
passed through a host country\'s government entity (e.g. central bank),
the discount rate charged to the financial institution by the government
entity should reflect the real cost of capital within the LDC.

A.I.D. funds provided to financial institutions should avoid introducing
government ministries or parastatals into the on-lending approval
process where such involvement does not now exist. Furthermore, such
projects should seek to extract government ministries and parastatals
from the process if they are now so involved.

b\) **When its purpose is to initiate an entirely new venture or
activity in the LDC\'s private sector to reach a target group previously
not served.** In this case, concessionality may be warranted to finance
the extraordinary start-up costs associated with introducing the new
venture or activity. (Extraordinary costs are costs which would not be
incurred by subsequent investors who enter the market on the basis of
the success of the initial enterprise.) In this case, the
concessionality may be linked to project components such as advisory
services and training. Concessionality may also be warranted to finance
special costs arising from the newness of the venture or the requirement
of direct benefit to a specific AID target group. These special costs
could include the need to hedge certain risks and provide for normal
profit. In developing such projects, Missions are encouraged to consider
alternative methods of providing concessionality in order to avoid
distorting sound business management practices which may follow from the
offer of up-front concessionality as a hedge against losses.

c\) **Detailed guidance on A.I.D. Loan Terms will be provided in a
forthcoming Policy Determination.**

**E. Private Sector Participation in the Provision of Traditional
Government Services**

A.I.D. encourages an expanded role for the private sector in delivery of
services and supports the development of a multiplicity of channels for
services. The private sector is an important factor in allowing
consumers to have truly free choice and A.I.D. will continue to support
its growth.

1\. With regard to population, the flexibility and innovativeness of the
private sector, both voluntary and for-profit, are a vital component of
an effective system for the distribution of contraceptives. Where
supplies are sold through the commercial market, either at full price or
at subsidized prices, cost recovery can be maximized and dependence on
external sources of support is decreased. In many developing countries,
there is not a nationwide government structure for the delivery of
services. But in almost all towns there are market outlets through which
contraceptives can be sold along with other common commodities. AID
support for social marketing of contraceptives has expanded
proportionally more than any other type of delivery system over the last
few years, and we will continue to support such programs.

2\. With regard to improving health care, a variety of opportunities
should be pursued to harness private resources. First, private funds
(i.e., client fees or payments in other forms) should be encouraged to
pay for services for which there is existing demand. Fees-for-service,
fees for drugs, and prepaid cooperative or insurance schemes have been
implemented successfully in different settings. Second, private channels
(radio, advertising media) can be used to stimulate demand for services.
Third, private sources can be used to manufacture drugs and medical
supplies, and private channels employed for their distribution, thereby
eliminating costly and inefficient duplication between public and
private sources.

3\. In education, A.I.D. encourages the diversification of school
providers so that parents have a choice in determining the type and
quality of their children\'s education. For many LDC\'s this implies an
expansion of private education and community based schools. A.I.D.
supports a shifting of more costs of education to the private account,
particularly at the higher levels of education. Finally, A.I.D.
assistance should engage the private sector in a wide variety of
schooling related services from construction of facilities to the
provision of instructional materials.

4\. In agriculture, A.I.D. supports a substantial transfer of
responsibility to competitive markets and private enterprises. In
particular, the market should have primary responsibility for
determining the price of agricultural commodities and inputs. Similarly,
the private sector should have principal responsibility for the
provision of agricultural inputs and credit. For example, irrigation
offers opportunities for an expanded private sector role in activities
such as on-farm development and systems design. In addition, A.I.D.
should seek creative ways to increase the involvement of the private
sector in traditional government programs such as agricultural research
and extension. In particular, A.I.D. encourages the development of new
arrangements between input suppliers, farmers and marketing firms such
as \"contract\" or \"satellite\" farming.

5\. In energy, A.I.D. encourages private sector development of fossil
fuel resources where there is a potential for equity investment or for
private operation and management. Energy conservation activities should
tap private engineering capabilities rather than government owned or
controlled organizations. For renewable resource development, especially
for applications for rural development, the private sector should be
viewed as the primary dissemination mechanism for providing new
technologies for cooking, heating, irrigation, mechanical power and
lighting.

6\. A.I.D. supports programs to involve the private sector in a wide
variety of public service activities through such techniques as
contracting for management, operation and maintenance of facilities.
This is particularly important in the transportation sector.

**F. Parastatals and Government Authorized Monopolies**

1\. A.I.D. assistance to or through a parastatal should be given in the
context of exposing the parastatal to market forces and scheduled
divestiture of the government interest. This objective is more likely to
be achieved through an evolutionary process rather than as a result of
an A.I.D. insistence on the immediate and complete divestiture by sale
to the private sector. A.I.D. resources should start a policy dialogue
which initiates the process even if there is no initial commitment from
the LDC on eventual divestiture. AID resources should assist the process
as LDCs indicate interest in reducing the financial and management
burden accompanying state ownership of companies. The experience of a
number of LDCs which have divested parastatals suggests that measures to
improve the management and operational efficiency of a parastatal has
helped the divestiture process. A.I.D. projects designed to improve
parastatal performance must have identifiable benchmarks upon which
substantive progress towards divestiture can be measured. However, the
burden of proof rests squarely with Missions proposing such activities
to demonstrate that the proposal can achieve meaningful objectives, and
that the selected benchmarks represent substantive evolutionary progress
in moving the parastatal towards market-based operations and
divestiture.

2\. A.I.D. encourages the introduction of employee stock ownership plans
(ESOPs) as a method of transferring a parastatal to private ownership.

3\. In assisting an LDC through the divestiture process, A.I.D. should
explicitly consider the consequences to the parastatal\'s employees of
transferring all or part of the parastatal\'s activities to the private
sector. In this regard A.I.D. resources could be used to assist those
employees who may be adversely effected by the firm\'s transition from
state to private ownership by job retraining or job placement
assistance.

**G. Capital Saving Technology**

Decisions on what technologies are promoted by A.I.D.\'s private sector
related activities should be based on a rational assessment of the
particular economic and financial circumstances in which the specific
private sector effort is taking place. Where appropriate in terms of
capital and labor availability, capital saving technology should be
encouraged.

Capital saving technologies of interest include tools, production
processes and delivery systems. Capital saving technologies should in
general have the following characteristics: (1) they should be
compatible with the local cultural, economic, environmental, political
and social context in which they are imbedded and in which they
interact; (2) they should involve the local community or be otherwise
physically and financially accessible to the poor; (3) They should be
able to be maintained and repaired by relying on locally available labor
skills, spare parts and organizational capacity; (4) They should be
widely replicable; and (5) they should be economically efficient.
Generating employment and increasing income for the poor is a
fundamental objective of AID\'s development efforts. Accordingly, a
project which uses more local labor and less capital goods without
substantially increasing project costs or entailing a loss in output
quality is to be preferred to alternative projects with a more capital
intensive nature.

**H. Training Activities**

A.I.D. should promote and assist in training LDC indigenous
entrepreneurs in business related topics. Such training could range from
very short training sessions for small, independent entrepreneurs in
both the formal and informal private sector, to more substantial efforts
utilizing participant training and advisory services. A.I.D. will
encourage public and private efforts to develop the human resources of
the host country consistent with our policies as stated in the **Basic
Education and Training Policy Paper** and the **Participant Training
Policy Determination**. This is especially important in countries with
low literacy rates.

**I. Infrastructure**

The infrastructure systems most relevant to improving competitive
markets and private enterprise are reliable power, transport and
communications.

A.I.D. is willing to assist in the development of these facilities under
the following terms:

 A.I.D.\'s first priority is the provision of technical assistance and
training toward institutional development defined as improved management
so that services are reliable, well maintained and managed in a
businesslike manner in terms of cost recovery and capital growth.

 A.I.D. is willing to cooperate with other donors in parallel efforts
to improve these types of infrastructure. However, where possible,
A.I.D.\'s involvement should be focused on the institutional development
aspects of the project rather than the finance of capital development.

 When budgets permit, A.I.D. is willing to finance capital costs of
infrastructure systems when it can be demonstrated that such finance is
an essential complement to the institutional development objective and
no other funds are available. However, the long-term financing of
infrastructure is a matter of critical concern to A.I.D. Where possible,
the costs of infrastructure (particularly operation and maintenance)
should be covered by user fees. Where infrastructure is provided as a
public good such that user fees cannot be introduced, costs must be
recovered through some other mechanisms such as the use of community
funds, special assessments or general tax revenue. Where charges or
other revenue sources do not cover the cost of at least maintaining the
infrastructure, A.I.D. will not, in general, support a major investment
in infrastructure.

**J. Research and Studies**

A.I.D. is willing to assist in research and studies which provide a
better understanding of the importance of competitive markets and
private entrepreneurship to LDC policy makers. Such research and studies
should be results oriented in support of policy dialogue. These
activities could be carried out with direct A.I.D. sponsorship or by
building up the capability of host country institutions to carry out
such research and studies.

**VI. The Responsibilities of Missions and Regional Bureaus**

The principal responsibility within A.I.D. to carry out the private
enterprise policy rests with the A.I.D. field missions and their
respective regional bureaus. As noted above, the promotion of
competitive markets an private enterprise in LDCs is not a sector or an
add-on to the project. Rather, it is a fundamental objective of
A.I.D.\'s assistance to LDCS. It is firmly based in both economic theory
and successful development experience.

**ANNEX A**

**Natural Monopolies:** Until recently, the concept of a natural
monopoly was not controversial. The generation and distribution of
electric power, telecommunications and some forms of transportation were
assumed to be natural monopolies. However, today\'s technological
advances make it more difficult to define a natural monopoly. Activities
which are site-specific and require heavy investments in infrastructure
to achieve the least cost in the production and distribution of goods
have been considered as natural monopolies. However, applying this
definition to specific situations usually provokes debate among
different political and economic interests within an LDC and different
countries have reached different conclusions in similar situations.
However, even when a domestic political consensus exists that a
particular activity fits a definition of a natural monopoly, there is
considerable room in most LDCs to manage the function in a profitable or
at least a cost-minimizing fashion. The implementation, construction and
management of the public good can often best be undertaken by the
private sector with public oversight, as in the case of regulated public
utilities.

**Goods With Externalities:** An externality is associated with
particular goods or services when individuals or groups cannot be
excluded from benefiting from (or being harmed by) the provision of the
goods or services to another intended group. Furthermore, no pricing
mechanism can be established to compensate (or charge) the supplier
commensurate with the additional recipients\' estimate of the benefits
received (or costs incurred). For example, when some children in a
village are immunized against an infectious disease, those who are not
immunized still receive some benefit because their chances of infection
have been reduced. Even in situations in which there is a significant
demand for immunization, free riders can take advantage of a competitive
market\'s inability to charge them for the benefits they have received
by virtue of the consumption of others. If the prevalence of free riders
threatens the existence of the market, the good or service may be
declared a public good and non-market procedures introduced to ensure
that the supply continues.

**Merit Goods:** Merit goods are goods which society (often
paternalistically) argues are good for the individuals and should be
consumed in a greater amount than the individual would purchase in a
free market. For example, at a market determined price an individual may
not consume an amount of education that society believes he or she
should. Consequently, society, acting through government policy, may
interfere with the market by lowering the price of education through a
subsidy. However, a developing society also benefits in that the general
level of competence has risen. Consequently, it is in society\'s
interest to try to expand the supply and consumption of such a merit
good for the benefit of all. Many activities in the fields of public
health and education provide good illustrations of externalities and
merit goods. For such services a government may provide a higher level
of service or set a lower price than that which would result from purely
competitive market forces. However, many LDCs have identified natural
monopoly situations, externalities and merit in a wide variety of other
goods and services and have abrogated the market to provide an
administratively determined quantity of goods and services at an
administratively determined price. In most LDCs the list of public goods
or quasi-public goods includes such items as food, clothing, energy,
transportation, agricultural inputs, construction materials, and
communications equipment.

**A.I.D. Policy Papers and Policy Determinations**

The following reports have been issued in a series. These documents with
an identification code (e.g. PN-AAM‑323) may be ordered in microfiche or
paper copy. Please direct inquiries regarding orders to:

A.I.D. Document and Information Handling Facility

7222 47th Street

Suite 100

Chevy Chase, MD 20815

[TitlePolicy Paper]{.underline} [Date]{.underline} [Fiche
\#]{.underline}

Domestic Water and Sanitation May 1982 PN-AAM-323

Food and Agricultural Development May 1982 PN-AAM-322

Nutrition May 1982 PN-AAM-321

Recurrent Costs May 1982 PN-AAM-319

Population Assistance September 1982 PN-AAM-320

Private and Voluntary Organizations September 1982 PN-AAM-318

Women in Development October 1982 PN-AAL-777

Pricing, Subsidies, and Related Policies November 1982 PN-AAN-373

in Food and Agriculture

Approaches to the Policy Dialogue December 1982 PN-AAM-431

Basic Education and Technical Training December 1982 PN-AAM-190

Health Assistance December 1982 PN-AAL-817

Institutional Development March 1983 PN-AAN-108

Co-Financing May 1983 PN-AAN-457

Local Organizations in Development March 1984 PN-AAQ-157

Energy July 1984 PN-AAQ-160

Urban Development Policy October 1984 PN-AAQ-158

Shelter February 1985 PN-AAQ-162

Private Enterprise Development (Revised) March 1985 PN-AAQ-163

[TitlePolicy Determination]{.underline} [Date]{.underline} [Fiche
\#]{.underline}

PD #1Narcotics August 5, 1982 PN-AAM-443

PD #2Mixed Credits September 29, 1982 PN-AAM-444

PD #3Voluntary Sterilization September 1982 PN-AAM-445

PD #4Title XII October 5, 1982 PN-AAM-446

PD #5Programming PL 480 Local February 22, 1983 PN-AAM-591

Currency Generations

PD #6Environmental and Natural Resources April 26, 1983 PN-AAN-375

Aspects for Development Assistance

PD #7Forestry Policy and Programs May 16, 1983 PN-AAN-376

PD #8Participant Training July 13, 1983 PN-AAP-273

PD #9Loan Terms Under PL 480 Title I September 27, 1983 PN-AAN-753

PD #10Development Communications February 17, 1984 PN-AAP-616

PD #11Using PL 480 Title II Food Aid for July 26, 1984 PN-AAQ-159

Emergency or Refugee Relief

PD #12Human Rights September 26, 1984 PN-AAQ-161

[^1]:     ^?^ Recent efforts at measuring the extent of private sector
    activity in Sudan and Peru suggest that despite claims to the
    contrary, private enterprise is thriving. In Sudan a recent A.I.D.
    funded study identified between 13 and 16 private health care
    services per commercial block. See A. Bekele, \"Briefing Notes on
    Health Care Financing in the Democratic Republic of Sudan,\" Draft
    Report, AID OTR-4121. Peru\'s \"underground economy,\" which
    parallels the highly restricted public market in that country,
    absorbs 60 percent of the workforce, provides 85 percent of internal
    transportation and has achieved growth rates which exceed those of
    the formal, legal sector. See C. Rosette, \"How Peru Got a Free
    Market Without Really Trying,\" *Wall Street Journal*, January 27,
    1984.

[^2]:     ^?^ Agarwala, Ramgopal, \"Price Distortions and Growth in
    Developing Countries,\" World Bank Staff Working Papers Number 575,
    1983.

[^3]:     ^?^ For a convincing case showing how the expansion of the
    public sector has stretched the managerial capacity in many
    countries see The World Bank, *World Development Report 1983*. See
    also Alvin Rabushka, *Free Markets and Economic Development in
    Postwar Developing Countries* (December 1983) which shows how most
    of the countries which have outgrown poverty in the Post-War II
    period have emphasized free market economic policies.

[^4]:     ^?^ Bela Balassa and Associates, *Development Strategies in
    Semi-Industrial Economies* (The World Bank 1982).

[^5]:     ^?^ Anne O. Krueger, *Trade and Employment in Developing
    Countries Synthesis and Conclusions* (Natural Bureau of Economic
    Research 1993).

[^6]:     ^?^ *Ibid.*

[^7]:     ^?^ This overall objective is not intended to conflict with
    specific statutory provisions (e.g. FAA Section 620(d)) and existing
    Agency policies proscribing activities that would result in direct
    competition with U.S. enterprise.

[^8]:     ^?^ A.I.D. Evaluation Specific Study No. 20, \"Prospects For
    Primary Health Care In Africa: Another Look At The Sine Saloum Rural
    Health Project In Senegal\", April 1984, Abby L. Bloom.

[^9]:     ^?^ See *World Development Report 1983*, The World Bank.