# **I. UNDERSTANDING THE CHALLENGES TO REFORM**

## **BACKGROUND**

Recent analytical work has led to a broad understanding among policymakers and development practitioners that microeconomic reforms aimed at strengthening property rights, unleashing competition, and reducing the cost of doing business are critical in creating a sound investment climate and achieving growth and poverty reduction (World Bank 2004b, 2005a; Lewis 2004). Also recognized is that these changes need to be credible and sustained for private firms to respond by increasing investment and production.

Much less understood is how to manage such reforms. Investment climate reforms are challenging for three main reasons. First, the list of possible reforms is long, and figuring out the right priorities and sequencing can be a daunting task. Second, such reforms are often politically contentious because of their distributional consequences: groups that lose in the short term are often well organized and in a position to resist, while those that benefit usually do so only in the long run and are too dispersed to matter politically. And third, investment climate reforms can be institutionally challenging: their implementation typically requires coordination among diverse departments and levels of government as well as fundamental institutional changes in organization, incentives, and behavior that can be difficult to achieve.

So, in tackling the investment climate would-be reformers face many technical, political, and institutional challenges. Key among these challenges: How to identify the most important constraints, and how to sequence reforms? How to overcome opposition from interest groups and get reform onto the agenda? How to package reforms so that they are both credible and feasible? How to mobilize support for reform? How to create the incentives and capacity to implement reform? And how to create institutional mechanisms to drive, monitor and sustain reform?

This paper addresses these questions through an analysis of the literature and the findings of more than 25 case studies of reform commissioned by the _World Development Report 2005_ team and by the Foreign Investment Advisory Service (FIAS) of the World Bank Group (see annex A).<sup>1</sup> The case studies, drawn mostly from developing countries, cover the main broad areas of the investment climate: product markets,<sup>2</sup> land markets, labor markets, and capital markets. They focus on countries that adopted and implemented a

> 1 The _World Development Report_ cases can be found on the Web at http://econ.worldbank.org/wdr/.

> 2 Product market reforms include reform of the policies and institutions governing the way in which products and services are produced and sold. They tend to be industry specific. The main such regulations are those governing: entry (general business registration, industry-specific licensing, and restrictions on foreign direct investment); the import and export of goods (quotas, tariffs, and customs); and production (price regulations, product standards and government certification processes, intellectual property rights, investment incentives, subsidies, and competition policy or agency).