Investment Climate Assessment Report

Determinants of Private Sector Growth

in Ethiopia’s Urban Industry:
The Role of Investment Climate

The World Bank, Washington, D.C.

January 2004

This report builds on an earlier report prepared jointly with staff from the Ethiopian
Development Research Institute (EDRI).
 Contents

Abbreviations and Acronyms: ........................................................................................................iii

Preface.............................................................................................................................................iv
Executive Summary........................................................................................................................vi
1. Introduction..................................................................................................................................1
1.1. Sources of Economywide Growth ........................................................................................6
1.2. Macroeconomic Environment and Real Exchange Rates.....................................................7
1.3. Manufacturing Competitiveness, FDI and Investment Climate ...........................................9
1.4. Private Sector and Investment Climate Issues ....................................................................15
1.5. Structure of the Report ........................................................................................................17
2. Investment Climate and the Performance of Private Sector Industry: An
International Perspective................................................................................................................19
2.1. Ethiopia Investment Climate Survey ..................................................................................19
2.2. Proximate Causes of Lack of International Competitiveness ............................................20
2.3. Investment Climate as an Underlying Factor......................................................................24
2.3.1. Private Sector View .....................................................................................................24
2.3.2. Some Objective Indicators...........................................................................................26
2.3.3. Linking IC Indicators to Performance Indices .............................................................29
3. Differences in Investment Climate Indicators within Ethiopia ..................................................32
3.1. Regional Differences in Investment Climate ......................................................................33
3.1.1. Overall Rankings of Major Business Obstacles...........................................................34
3.1.2. Measures of Investment Climate Indicators by Region...............................................35
3.2. Sectoral Variations in Some Business Constraints .............................................................49
3.3. Investment Climate Indicators by Ownership .....................................................................52
4. Policy Assessment and Recommendations ................................................................................55
4.1. Labor Productivity ..............................................................................................................55
4.2. Tax Rate And Tax Administration......................................................................................57
4.3. Access, Availability, and Affordability of Urban Land ......................................................58
4.4. Access to Basic Physical Infrastructure (Telecommunications and Power).......................60
4.5. Business Regulations and Trade Facilitation Services .......................................................63
4.6. Access to Finance................................................................................................................66
4.7 Summary of Recommendations ...........................................................................................68
4.7.1. Matrix of Policy Suggestions .................................................................................69
Annex A .........................................................................................................................................73
Annex B .........................................................................................................................................74
Annex C .........................................................................................................................................75
Annex D .........................................................................................................................................76
Annex E..........................................................................................................................................77
Annex F: Ethiopian FACS Survey Data .......................................................................................78
Technical Annex G. Estimation and Counterfactuals ....................................................................80
References ......................................................................................................................................84

ii
 Abbreviations and Acronyms:

ADLI Agricultural Development–Led IC investment climate

Industrialization ICA Investment Climate Assessment
AFTPS Africa Region, Private Sector ICU Investment Climate Unit
Development, World Bank ICS interconnected system
CAS Country Assistance Strategy ICS Investment Climate Survey
CBB Construction and Business Bank ICT information and communication
CBE Commercial Bank of Ethiopia technology
CSR Civil Service Reform KWH kilowatt hour
DBE Development Bank of Ethiopia MFI microfinance institution
DECRG Development Economics MW megawatt
Research Group, World Bank NBE National Bank of Ethiopia
DFID Department for International NPL nonperforming loan
Development (U.K.) PRSP Poverty Reduction Strategy Paper
DTIS Diagnostic Trade Integration PSD private sector development
Study RER real exchange rate
ECA Economic Commission for Africa RPED Regional Program on Enterprise
EDRI Ethiopian Development Research Development
Institute SDPRP Sustainable Development and
EEPCO Ethiopian Electric Power Poverty Reduction Program
Corporation SME small and medium enterprise
EIA Ethiopian Investment Authority SNNP Southern Nations, Natio nalities,
EICTDA Ethiopian Information and and People
Communications Technology SOE state-owned enterprise
Development Authority SSA Sub-Saharan Africa
EPRDF Ethiopian People's Revolutionary STDF Standards and Trade
Democratic Front Development Facility
ETA Ethiopian Telecommunications TFP total factor productivity
Agency TIN taxpayer identification number
ETB Ethiopian Birr TVET Technical Vocational Education
ETC Ethiopian Telecommunications and Training
Corporation ULMAD Urban Land Management and
FACS Firm Analysis and Development
Competitiveness Survey UN United Nations
FDI foreign direct investment UNCTAD United Nations Conference on
GDP gross domestic product Trade and Development
GLS Generalized Least Squares VAT value added tax
GOE Government of Ethiopia WDI World Development Indicators
HIPC Heavily Indebted Poor Countries
Initiative
 Preface

This report was prepared by a World Bank team from the Investment Climate Unit (ICU),
Development Economics Research Group (DECRG) managed by David Dollar, and the Regional
Program on Enterprise Development (RPED) of the Africa Region managed by Ibrahim Elbadawi.
The team consisted of Ibrahim Elbadawi (team leader), Taye Mengistae and Tilahun Temesgen
(DECRG), and Gaiv Tata (Africa Region, Private Sector Development, World Bank, or AFTPS).
The report originated from a process of consultations between the Government of Ethiopia (GOE)
and the private sector, with the involvement of the World Bank and other donors, including DFID,
which provided the bulk of the funding, through RPED. Other financial contributions were also
made by the Country Team and the ICU.

The report draws heavily on the analysis of enterprise level survey data collected using a Firm
Analysis and Competitiveness Survey (FACS) survey instrument. The report addresses two pivotal
sets of issues. First, it compares Ethiopia’s Investment Climate Indicators with those from other
countries in which similar surveys were recently completed such as China and Bangladesh. Second,
it also looks at differences in specific investment climate bottlenecks within Ethiopia.

The report is part of a larger effort in the World Bank Group to systematically collect and analyze
objective indicators of the investment climate to help clients identify priorities for reform and to
monitor progress over time with improvements in their investment climate.

We would like to thank Menbere Tesfa and Agata Pawlowska (AFTPS) for their helpful comments
and suggestions to an earlier draft; the Ethiopian Chamber of Commerce, the Ethiopian Private
Industries Association, as well as other members of the Steering Committee and Melanie Mbuyi for
their help in facilitating the survey process; and Tourya Tourougui for software processing support.
We would also like to acknowledge the overall guidance and helpful substantive comments of Ishac
Diwan, the Country Director for Ethiopia and Sudan.
 Investment Climate at a glance
China, Ethiopia and Kenya

Macro environment China Ethiopia Kenya GNI per cap, PPP $

1995 2000/1 1995 2000/1 1995 2000/1
4000
GNI per capita (US$, PPP) 2650 3920 560 660 1000 1010
Population, mid year (millions) 1205 1262 57 64 26.7 30.1 3000

GDP growth (1991-95 and 1996-2000, avg %) 12.1 8.2 2.6 5.3 1.6 1.78
2000
Openness (Imports+Exports/GDP) 45.7 49.1 35.7 46.1 71.4 62.1
Private Investment (% GDP) 18.6 17.3 9.0 8.3 9.7 8.1
1000
Public Investment (% GDP) 22.2 19.9 7.5 5.8 7.4 3.8 1995 1996 1997 1998 1999 2000
FDI inflows (net, % GDP) 5.1 3.6 0.2 0.8 0.4 1.1 China Ethiopia Kenya

Micro environment
Inputs
Labor force educ. (avg yrs edu, manuf.) 10
Excess labor force, % 8.2
Suppliers avail. (used for main input), median 20
R&D (% sales) 2.0 0.3

Governance
2
Control of corruption -0.3 -0.40
2
Rule of law -0.19 -0.24
2
Political Stability 0.39 -0.55
No. of visits by gvt officials, avg per year 9
% of senior manager time with gvnt officials 4
PC per 1,000 people
Infrastructure 20

Share of firms with own generator, % 30 20 15

Days to clear imports, longest in last year 12 10

Telephone lines in largest city (per 1000 people) 294 52 78.4 78.4 5

Personal computers (per 1000 people) 16 1 0.6 4.9 0

Paved roads, % of total 22 12 13.8 12.1 1995 1996 1997 1998 1999 2000
China Ethiopia Kenya

Finance Credit to Priv. Sector (% gdp)

150
Cost of capital (lending interest rate, %) 5.85 15.08 10.89 28.8 22.3
Share of credit from financial institutions, % 100

Credit to private sector (stock, % of GDP) 125 13 29 34 30

50

0
1995 1996 1997 1998 1999 2000

China Ethiopia Kenya

Source: WDI, ICU firm surveys

1/ or most recent available year
2 Scale of -2.5 to 2.5. Higher values correspond to better outcomes
3 Transport cost as share of value of export to US, textiles, 1998.

v
 Executive Summary
The Ethiopian economy is dominated by the agriculture and services sectors—with each
accounting for about 45 percent of gross domestic product (GDP), leaving only about 10
percent for industry, of which manufacturing accounts for about 6–7 percent. Exports are
highly concentrated, with coffee alone accounting for more than 60 percent of the total.
Moreover, Ethiopia could hardly be located in the international market for manufacturing
exports, having an industrial export share much less than the already minuscule median
for Africa. The limited change in the structure of the economy, especially with regard to
manufacturing, is partly explained by the low levels of investment flows and the sluggish
growth of the private sector, which was too little to affect its historically low share in
labor- intensive manufactures. Indeed, even after more than a decade of reforms by the
current Government of Ethiopia (GOE) private economic activities in the Ethiopian
manufacturing sector remain very small, even by African standards.

Ethiopia’s lack of private sector development could partly be explained by the long
legacy of the ideological repression of private sector activities under the Derg regime.
However, a more fundamental reason is that Ethiopia remains a very low income country
with extensive poverty. At $100, Ethiopia’s real per capita GDP is among the lowest in
the world. Its population, estimated at 64 million in 2000, is the second largest in Sub-
Saharan Africa and is projected to grow at 2.4 percent per year over the next 15 years.
Under UNDP’s Human Development Index ranking, Ethiopia ranks 168 out of 172
countries. Average life expectancy is 52 years and falling, in large part because of the
HIV/AIDS pandemic. Infant and maternal mortality and child malnutrition rates are
among the highest in the world. Nearly two-thirds of the adults are illiterate. Gender
disparities significantly hamper female empowerment. Economic reforms are still at a
very early stage, and fairly substantial impediments to economic diversification and
private sector growth remain.

Despite the potential for private sector–led growth and economic diversification,
Ethiopia’s private sector is not growing as fast as it should, even by the standards of Sub-
Saharan Africa. There are far fewer businesses in Ethiopia than the country’s size would
otherwise suggest. Businesses in Ethiopia are smaller in scale by international standards
and have not managed to enter international markets or attract foreign capital. The
emerging economic diversification and private sector development (PSD) strategy
should, therefore, start by asking two basic but crucial questions: What particular
obstacles are impeding the growth of private enterprises in modern industry in Ethiopia
and their participation in the global market for labor- intensive manufactures? And what
should be done to induce the development of a more dynamic private sector?

Key Findings of the Investment Climate Survey

To address these questions, the World Bank and the Ethiopian Development Research
Institute (EDRI) conducted a survey of 427 manufacturing businesses sampled from six
regions of the country where there is a major concentration of manufacturing activities.

vi
The Investment Climate Survey of Ethiopia is a direct consequence of consultations
among the World Bank, the GOE, representatives of the private sector, and other donors.
The consultations concluded that an empirical analysis of the private sector, based on
firm- level data, would be needed to inform a sound set of policies regarding investment
climate and private sector deve lopment in Ethiopia.

The survey revealed three pivotal features of the Ethiopian manufacturing sector. First,
labor costs in Ethiopia are very low compared with those of potential competitors in and
outside Africa (for example, labor costs in Ethiopia are almost one-third of those in
China. Second, despite this huge cost advantage, exporting Ethiopian firms account for
less than 8 percent of the population of firms, which is very small by any standard. Third,
the Ethiopian manufacturing is also dominated by small private firms, which suggests
limited firm growth. To explain these stylized facts about the manufacturing sector in
Ethiopia, the analysis is focused on the concept of “value added per worker,” which
provides a measure of labor productivity (net of labor cost). Comparative analysis of this
indicator in Ethiopia and other countries provides an explanation of Ethiopia’s failure to
participate in global markets for labor- intensive manufactures as well as the limited
growth performance of Ethiopian firms. Moreover, the report also analyzes the extent to
which the investment climate can explain variations in value added per worker between
Ethiopia and other countries and which aspects of investment climate impediments are
likely to have caused the most damage.

A comparison of Ethiopian workers with those in Bangladesh and China suggests that
controlling for size and type of industry of employment, a typical worker in Ethiopia is
80 percent less productive than the average worker in Bangladesh and about more than
1.5 times less productive than the average Chinese worker. A total of 34 percent of total
productivity gap between Chinese and Ethiopian workers can be explained by the fact
that Ethiopian factory workers are less equipped and less educated; while the bulk of the
total labor productivity shortfall (the remaining 66 percent) is accounted for by TFP gap
which can be thought as a measure of the overall business productivity given skill and
capital endowment differences.

Our results also suggest that 'investment climate' differences between the two countries
contribute to about 28% of the Sino-Ethiopia labor productivity gaps (after controlling for
skill and capital endowment differences between their workers). A further 27% of labor
productivity gap is due to differences in age and industry distribution of firms in the two
countries while 'geography and market size' differences contribute to about only 4% the
gap. The remaining 42% is due to unexplained country effects representing what can be
regarded as 'structural factors'.

Moreover, the competitiveness gap between Ethiopian industries and those in the more
successful economies in the developing world also appears to be widening. With such
high and rising productivity shortfall, it is not surprising that average firm growth rates
for Ethiopia are several times smaller than for comparable firms in China or India. And
this applies even to industries in which Ethiopia is assumed to have some comparative
advantage, such as leather, garments, and textiles.

vii
The study also found several constraints to doing business in Ethiopia. Firms in the
sample identified problems with the tax rates and tax administration as constituting the
most serious impediments in all regions of the country, albeit with some regional
variation. For example, 80 percent of firms in Amhara reported tax issues among the top
three major impediments to doing business, followed by Tigray (70 percent), and the
lowest (37 percent) in the Southern region. Another factor that firms identified as a major
business impediment, again with noticeable regional variation, is access to land. Our
results also show that access to and reliability of infrastructure services (power and
telecommunications) have been among the other major business obstacles, as indicated
by the long waiting time to get connected and frequent interruptions once connected. A
fourth set of constraints was banks’ cumbersome credit procedures, perceived corruption
in their credit allocation, and stringent collateral coverage requirements. Finally, in
terms of variations in investment climate between state-owned enterprises (SOEs) and
private firms, SOEs seem to get a relatively favorable treatment, including in areas
related to telephone and power connection and customs clearance. The existence of such
differential treatments in favor of SOEs can act as an entry barrier for new private firms
or keeps existing firms from growing.

Policy Implications

The evidence suggests that Ethiopia’s manufacturing sector has experienced considerable
productivity shortfalls relative to likely competitors in the international market for labor-
intensive manufactures. A substantial share of the productivity shortfall is accounted for
by impediments in the investment climate, which put the country at a disadvantage with
most international and African low- income comparators. Several measures have been
initiated to address the constraints described above, but in many cases such measures
have not been effective, and in others it is too early to comment on their impacts (such as
the tax policy reform).

This analysis implies that the problems of Ethiopia’s manufacturing—including in sectors

such as leather, garments, and textiles where Ethiopia might be expected to be
competitive—cannot be blamed on factors such as “alleged” dumping from China. Nor
can they be blamed on Ethiopian workers being less equipped or less educated. Instead,
deficiencies in the investment climate are by far the main determinants of TFP shortfalls
in Ethiopian manufacturing. Our simulations suggest that addressing these problems
would yield both timely and substantial gains in terms of firm growth and TFP. For
example, bringing Ethiopia’s investment climate indicators up to the level of China’s
would raise average annual growth in business sales in Ethiopia by 10 percent, and TFP
in a typical Ethiopian business would increase by 180 percent. In particular,
eliminating impediments in six major areas would generate the following TFP
responses: reducing the productivity gap between Ethiopian workers and
counterparts in China would increase TFP by as much as 66 percent; doubling
businesses that have lines of bank credit would raise TFP by 36 percent; cutting
output lost due to power outages by half would raise TFP by more tha n 17
percent;and halving the number of days needed to clear customs, the number of

viii
days to get telecom connection, or the number of inspection visits would each
increase TFP by about 10 percent.

Although these calculations should be interpreted with caution, they nevertheless provide
broad orders of magnitude of the huge potential in Ethiopia for growth and poverty
reduction through the improvement of a few strategic links in its business environment.
However, to put things in perspective, it should be acknowledged that the GOE has been
taking corrective measures in many reform areas. Measures to improve the road network
infrastructure to link the different towns in the country and to improve the power sector
are examples of encouraging reforms in the areas identified by our report. Given the
underdeveloped nature of infrastructure in Ethiopia, caused by both historical and
geographic reasons, a development strategy that attaches high priorities to investment in
infrastructure such as roads, power, and telecom is central to growth. Such measures are
also clearly important to lay the foundation for strong and accelerated private sector
development. However, it should also be understood that there are remaining areas that
need to be examined closely. As mentioned earlier, tax issues, particularly transparency
in tax administration, and land and telecom issues need attention as well.

The GOE has recently initiated a significant tax reform program with two main
objectives: broadening the tax base and improving the efficiency of tax administration. It
is too early to evaluate whether the tax reform has addressed earlier tax-related problems,
but it is important that the government closely monitor the evolving situation and, in
consultation with the priva te sector, develop quantitative and qualitative indicators of
improvements in tax collection and service delivery. The government has also taken
some steps in the area of financial sector reform, specifically in the process of
restructuring the three large public financial enterprises and strengthening the regulatory
capacity of the National Bank of Ethiopia. It has also enacted a land lease system with
implementation rules, and reduced the time and cost of registering a business. Important
outstanding issues in these areas include institutional strengthening of private banks as
well as developing indicators for tracking progress in addressing the key constraints of
the high land lease cost and use of land lease as collateral. Considerable work also
remains for the Customs Authority to streamline its work to make customs procedures
faster and more user- friendly.

The monopolistic structure of the telecommunications and power sectors in Ethiopia has
resulted in limited access to and poor quality of services in these sectors. The
government, however, has recently initiated programs to enhance private sector
participation aimed at addressing telecom and power service delivery problems. The
future agenda for these reforms should include: improving the power sector structure for
competitive market segment and continuation of the process toward partial liberalization
of the telecom sector.

ix
 1. Introduction
Soon after the Ethiopian People’s Revolutionary Democratic Front (EPRDF) government
assumed office in 1991, it started to deal with an economy shattered by civil wars, massive
famines, and a legacy of rigid Marxist-style policies and institutions. The chosen development
strategy has been one of agricultural development–led industrialization (ADLI), in which
enhanced agricultural growth and expanding agricultural surpluses provide the necessary
savings for financing structural transformation and rapid industrialization. In principle, the
strategy makes both economic and political sense, because it recognizes the obvious economic
and political importance of agriculture and rural development in an essentially agrarian
economy, in which agriculture dominates economic activity and more than 80 percent of the
population lives in the countryside. It was supported by wide-ranging macrostabilization and
structural reforms, including a series of large devaluations of the exchange rate, introduction
of an auction market for foreign exchange, decontrol of most prices, and liberalization of
trade. Moreover, taking advantage of the peace dividend, the Government of Ethiopia (GOE)
embarked on a massive demobilization that permitted drastic cuts in defense expenditures—
from over 10 percent of gross domestic product (GDP) in FY1989 to as low as 2.5 percent in
FY1997, with much of the peace dividend directed to social sectors and other pro-poor
expenditures (CAS 2002, ch. 2).

Unfortunately, the outbreak of the conflict with Eritrea in May 1998 substantially impacted
the progress on the ADLI strategy, distorting resource allocation, at least in the short run,
toward defense and away from poverty-targeted sectors, straining public finances, weakening
overall macroeconomic environment, reducing donor support, and undermining investor
confidence. The share of defense expenditures rose from 4.9 percent of GDP in FY1998 to 8.7
percent in FY1999 to 13.2 percent in FY2000. The rise in defense spending has been at the
expense of social and capital sectors, especially those financed by transfers to the regions. 1

However, like most crises, the border conflict focused attention on the seriousness and
urgency of the development challenge facing Ethiopia. Soon after the conflict was resolved in
June 2000, the GOE, with support from the Bank and other donors, moved quickly to stabilize
the economy, demobilize combatants, and address the postconflict recovery issues. By the end
of 2003, the postconflict recovery program had scored major successes, with several
rehabilitation programs achieved, about 150,000 war veterans demobilized, and public
expenditure substantially realigned away from defense spending and toward poverty-targeted
sectors. Moreover, the crisis has also sparked major debates within and outside the
government on the appropriate development discourse for Ethiopia. The political outcome of
the debate within the ruling party created an atmosphere of openness on the part of the GOE
toward stakeholders (including the private sector) and facilitated a deeper and more strategic
dialogue with development partners (including the Bank).

1
However, the deep cuts in poverty-targeted programs could not compensate for the even steeper rise in defense
spending, which necessitated heavy recourse to domestic borrowing. As a result, domestic debt rose sharply
from 29.0 percent of GDP in FY1998 to 42.2 percent in FY2000. On the external sector, the combination of
massive military expenditure and deteriorating terms of trade led to large current account deficits and dwindling
reserves, which dropped to less than two months of import cover (Ethiopia CAS 2002).

1
The process of national consultations within Ethiopia and the policy dialogue with donors
evolved into a broad consensus on the need to give more priority to the objectives of
economic diversification and private sector growth, while maintaining the overall framework
of the ADLI strategy. These elements constitute the centerpiece of the new vision,
reformulated into a Poverty Reduction Strategy Paper (PRSP), known in Ethiopia as the
Sustainable Development and Poverty Reduction Program (SDPRP). 2 The rationa le for the
emerging emphasis on private sector growth and diversification could easily be explained by
analyzing the pattern of growth in the 1990s and its linkages to poverty. Despite averaging
more than 5 percent per year, real growth has been volatile, substantially limiting its impact
on poverty. The volatility of growth is a direct outcome of the failure of economic
diversification, both within and outside agriculture. Diversification within agriculture requires
investing in agricultural supply (irrigation, water harvesting, soil conservation, rural roads)
and improving marketing, finance, and other support systems for agriculture. Diversification
outside agriculture requires vigorous and broad-based private sector growth to provide for off-
farm employment in rural areas and for developing labor-intensive manufacturing in urban
centers.

The scope for economic diversification Figure 1.1 Sectoral Composition of

appears substantial. In terms of the GDP, 1992/93-2000/01 (percent)
structure of the economy, agriculture and 60

services each account for about 45 percent 45

of GDP, leaving about 10 percent for
industry. As a subsector of the industrial 30

sector, manufacturing accounts for about 15

6–7 percent of GDP. And despite the
slowly declining share for agriculture— 0

and a rising share for services—the 1980/81 1984/85 1988/89 1992/93 1996/97 2000/01

industrial and manufacturing shares of Agriculture Services All Industry Manuf.

output have essentially remained stable Source:MinistryofFinanceandEconomicDevelopment

since the early 1990s (figure 1.1).
Therefore, the decline in the share of
agriculture is not a reflection of structural transformation toward industrialization; rather it is
an outcome of a rise in the share of services sector.

Between 1991/92 and 2000/01, agriculture grew at an average rate of 3.1 percent. However,
frequent drought and falling terms of trade have hampered the sector’s ability to support the
country’s development objectives. Exports are highly concentrated in coffee, which accounts
for about 60 percent of total exports. Moreover, Ethiopia could hardly be located in the
international market for manufacturing exports, having an industrial export share much less
than the already minuscule median for Africa.

2
The PRSP also envisions major investment in education and capacity building to enhance capabilities of the
majority of the poor for achieving and participating in growth and deepening and strengthening decentralization
as a means for improving responsiveness and accountability of government and enhancing its service delivery.
2
The minimal contribution of manufacturing to Ethiopia’s exports is a reflection of the
suppressed growth of the private sector as well as the poor investment climate that resulted
mainly from the interaction of three fundamental structural forces: (a) the very high poverty
incidence in the country; (b) its geography (land- locked, highlands with difficult access); and
(c) the transitional nature of the economy from a situation in which the state used to be
heavily involved in almost all production and distribution activities. The first has resulted in
low investment in infrastructure and a low level of purchasing power and thus a low level of
domestic demand. The second is reflected by the very high transport costs that more than
offset the low-wage comparative advantage of the country vis-à-vis other in labor- intensive
manufactures. 3 The third force, tightly related to the socialist era, is reflected in a private
sector with literally suppressed growth. This means that to be competitive, goods produced by
Ethiopian manufacturing firms need to have a sufficiently high internal value added, which in
turn would require complex value chains. However, because reforms have only had a short
time to let the economy be dictated by market forces, the sector is generally characterized by
weak value chains.

What exactly do we mean by “investment climate,” and why does it matter? Investment
climate refers to the totality of macroeconomic, political, policy, and institutional conditions
in a country that, together with structural forces, determine private investment, enterprise
performance, and growth. It consists of factors that act as an incentive/disincentive in starting
and running a business such as, but not limited to, financial services, governance, regulation,
labor relations, conflict resolution, and infrastructure services. The structural factors that play
an important role in the outcomes of investment climate include geography (determining
flows of products and inputs and proximity to export markets), and level of development
(determining purchasing power of the domestic economy). An investment climate of a
country or a region determines the productivity and international competitiveness of the
private sector as well as the perceptions of the entrepreneurs and thus is a key factor in their
likelihood to invest in new ventures and to expand current businesses. The majority of
investment climate variables are prone to change and can in fact be improved through
appropriate policy reforms once their weaknesses are pinpointed. There are other components
of an investment climate that are rigid and structural in nature and thus are less prone to
change in the short to medium term through policy reforms. Indeed, these two groups of an
investment climate (variable and fixed) are interwoven such that the success of policy reforms
in changing the former also depends on the rigidity of the latter. Each of the variables of an
investment climate affect performance and cost of doing business in a country in a variety of
ways. Some mainly affect export performance and competitiveness in general, while others
may affect starting a business in a given region within a country. Table 1.1 depicts a partial
list of these variables together with those of structural factors that are less prone to change in
the short run, but which affect the outcome of investment climate variables.

3
Recent estimates suggest that on average external transport costs amount to over 11 percent of trade value
which is among the highest in the world, even though the country has managed to substantially reduce these
costs over the years.
3
 Table 1.1 Determinants of Entrepreneurial Performance

Activities Investment Climate Structural

Affected Factors
Macroeconomic stability (inflation, exchange Access to
Export activities rate), tariffs, port facility (time it takes to clear ports (land
customs), infrastructure (availability and lockedness)
efficiency of services such as power, telephone,
roads, waste disposal), corruption, Level of
communication (postal, railway, air freight, e- development
mail, fax) services, availability of export (poverty and
facilities (such as customs duty drawback, low domestic
export credit guarantee, export processing zone, demand)
export proceeds retention), skill and education
of workers, business licensing and operating Transitional
permits, customs and trade regulations, nature of the
availability of business support services, and economy
foreign currency regulation. (transition
Infrastructure (availability and efficiency of hangover )
Domestic activities services such as power, telephone, water, roads,
waste disposal), domestic demand, competition
from imports (and smuggling), communication
(postal, railway, air freight…) services,
bureaurocratic harassment (number of visits by
inspectors, time spent management in dealing
with regulations..), access to land, access to and
cost of finance, labor regulations, tax
rates/administration, availability of business
support services, and corruption

The list of investment climate variables is by no means exhaustive, and the effects on export
and domestic activities as shown in the table is rather crude. However, the table shows that
any impact of policy reforms in either export or domestic activities, through affecting the
investment climate variables listed in column two, depends also on the conduciveness of the
structural factors listed in column three. Therefore, the analyses in the assessment of
investment climate indicators and resulting policy outcomes should be viewed in relation to
the existing structural factors in each economy.

Investment climate issues will be the main focus of this report (box 1.1). The remainder of
this introductory chapter will briefly analyze the sources of economywide growth and
macroenvironment; review available regional and international evidence on industrial
competitiveness, foreign direct investment, and some aspects of the investment climate in and
outside Africa; and against this backdrop, undertakes a quick review of the history of private
industry in Ethiopia , states the investment climate issues that will be subsequently analyzed
in detail, and outlines the remaining chapters in the report.

4
 Box 1.1. What Is an Investment Climate Assessment?

Investment climate assessments (ICA) systematically analyze the conditions for private
investment and enterprise growth in a country, drawing on the experience of local firms to
pinpoint the areas where reform is most needed to improve the private sector’s productivity
and competitiveness. By providing a practical foundation for policy recommendations and
involving local partners throughout the process, the assessments are designed to give greater
impetus to policy reforms that can speed the private sector’s growth, leading to faster
economic growth and poverty reduction.

Produced by the World Bank Group in close partnership with a public or private institution in
each country, ICAs are based on a survey of private enterprises to find out what difficulties
they encounter in starting and running a business—and, if the business fails, in exiting. The
survey captures firm experience in a range of areas—financing, governance, regulation, tax
policy, labor relations, conflict resolution, infrastructure services, supplies and marketing,
technology, and training. All these are areas where difficulties can add substantially to the
costs of doing business. The survey attempts to quantify these costs. Using a standard
methodology, the assessment then compares the survey findings with those in similar
countries to evaluate how the country's private sector is faring and how well it can compete.

The findings of the survey, combined with relevant information from other sources, provide a
practical basis for identifying the most important areas for reform aimed at improving the
investment climate. The assessments look in detail at policy, regulatory, and institutional
factors that hamper the provision of good-quality infrastructure services and the functioning of
product, financial, and other markets, linking the constraints to firms’ costs and productivity.

In each country, ICAs draw on the guidance and expertise of local partners in government and
the business community. The findings and policy recommendations emerging from the
assessments are discussed extensively with the private sector and other stakeholders in the
country. This broad dissemination of the findings is aimed at engaging not only policymakers
but also business leaders, investors, nongovernmental organizations, and the donor
community in shaping the national private sector development strategy, forging consensus on
the priorities for reform of the investment climate, and laying the groundwork for concrete
responses to the problems identified. Updates of the assessment can help track progress in
improving the investment climate.

5
1.1. Sources of Economywide Growth

Easterly’s (2002) analysis of Ethiopia’s economywide growth experience over the last half
century suggests the dominance of total factor productivity (TFP) growth in explaining
growth performance throughout three political regimes, where TFP growth was positive
during the monarchy and the current reformist regimes and was negative during the Derg
regime (table 1.2). Focusing on the latter period (1992–2001) of the current reformist regime,
per capita growth averaged 2.06 percent per year, with TFP growth accounting for 2.58
percent and capital deepening for –0.52 percent. This suggests that “capital shallowing” has
taken place during this period. 4 Most of the growth experienced during this period appears to
be contributed by the service sector, which accounts for about 66 percent of the overall
growth of the economy, with industry and agriculture contributing only 17 percent each.
However, despite its small contribution to overall growth, because of its small share in the
economy (about 11 percent), the indus trial sector actually grew by 8.5 percent per year during
1992/93–1999/2000 (about 5.0 percent in per capita terms). The agricultural sector, however,
which accounts for about 49 percent of the economy, grew by about 2.1 percent (Easterly
2002).

Table 1.2 Sources of Growth Accounting for Ethiopia

Regime Dates Capital- TFP Growth of

Deepening Growth Output
Contribution (%) Per person (%)
(%)
Monarchy 1951–1973 0.25 1.26 1.51
Derg 1974–1991 0.20 -1.22 -1.02
Reformist 1992–2001 -0.52 2.58 2.06
Total 1951–2001 0.08 0.59 0.68
Note: Easterly’s growth accounting is based on the following equation:
∆ ln( Y / L) = (α 1 − α ) ∆ ln( K / Y ) + ∆ ln A
where Y is GDP, L is labor , K is capital stock, α is the share of capital in output, and A is the total factor
productivity term. The first term is referred to as “capital deepening” and the second term as “TFP growth.”
Source: Adapted from Easterly (2002).

However, both the relatively fast TFP growth of the economy during the 1990s and the strong
growth of the industrial sector may also be influenced by the recovery from the long civil war
that ended following the collapse of the Derg regime. The literature on the economic
consequences of civil war suggests that following a decisive end of a long civil war, as
happened in Ethiopia, “desired capital” is likely to be much higher than existing capital stock,
thus leading to rapid catch-up economic growth (for example, Collier 1999; Elbadawi 1999).
It is estimated that this effect could account for about 1 to 2 percent per capita growth for the
first five years following the end of conflicts. And given the transaction- intensive nature of

4
This, however, may be precipitated by adjustment from shedding off nonproductive capital accumulation
during the Derg regime.
6
economic activities in the industrial and services sectors, they are likely to be most negatively
impacted by civil wars as well as the ones that realize the fastest recovery following the
“decisive” end of a civil war. Therefore, discounting the effect of this factor from Easterly’s
estimates would give a TFP growth rate of about 0.58 to 1.58 percent. These more sustainable
estimates, given prevailing policy and institutional environment, are consistent with the TFP
and output growth estimates of an average firm in late 2002, based on the survey data.

1.2. Macroeconomic Environment and Real Exchange Rates

Figure 1.2
The high concentration of Sectoral Exposition of Exports1992/93–1999/2000
Ethiopia’s exports on a few (percent)
primary commodities, most
notably coffee, suggests the eminent 65.0
80
62.5
need for diversification through the
60
promotion of nontraditional exports,
including labor- intensive 40
14.0
manufactures (figure 1.2). At the 20 7.2
9.8
7.2
11.3 9.6 9.2
4.3
macroeconomic level, stable and 0
competitive real exchange rates are Coffee Chat Others
Hides and Oil Seeds/
by far the most important Skins Pulses
determinant of profitability of
1992/93 – 96/97 1997/98 – 99/00
noncomparative advantage exports
such as manufactured exports. 5

The extent to which real exchange rates (RER) are competitive is associated with avoidance
of real exchange rate overvaluation relative to an equilibrium level consistent with the
economy’s fundamentals. The parallel premium for foreign exchange is usually a good proxy
for the extent of RER overvaluation, which has been found to have significant short- and
long-term negative effects on Ethiopian merchandise exports (Degefa 2001). The parallel
exchange rate premium for the Ethiopian Birr (ETB) rose steadily since the early 1970s; and
during 1987–1992, it became one of the highest in the developing world, suggesting
substantial real exchange rate overvaluation during this latter period. However, following the
devaluations that started in 1992 and the subsequent adoption of an auction system of foreign

5
There is a substantial body of literature on this evidence. For example, Elbadawi (2002) estimates a
nontraditional exports performance model using data from more than 60 developing countries and finds that
what matters most in terms of nontraditional export performance is the extent of the real exchange rate (RER)
misalignment relative to the equilibrium exchange rate. The study has shown that real underevaluation of the
exchange rate, relative to equilibrium RER, does have a significant positive contribution to export performance.
The study also found out that the variability in equilibrium RER, as an indicator of macroeconomic stability
relevant for exports, has significant negative impact on export performance. This implies that the promotion of
nontraditional exports requires both appropriate and stable real exchange rate.
7
exchange, the parallel exchange rate premium declined very rapidly as significant real
exchange rate depreciation was achieved during the period (figure 1.3). 6

Figure 1.3 Although the parallel premium

Real Exchange Rate and Parallel Market Premium in has been kept to a minimum—
Ethiopia down from about 20 percent in
1995–1996 to about 4 percent in
300% 2000–2001—the exchange rate

stayed markedly stable. Stability

200% of the RER was made possible
2
by the success in achieving
overall macroeconomic stability
100%
during this period. In particular,
tight fiscal and monetary
0 0% policies have helped maintain
1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000
Ethiopia’s macroeconomic
Real effective exchange rate Parallel market Premium (%) stability, with the government
budget deficit narrowing down
to less than 5 percent in 1998.
This allowed average inflation to decline from a peak of around 13 percent in 1993 to less
than 2 percent in 2000. The fiscal deficit has, however, increased considerably during 2001–
2002 and reached more than 16 percent of GDP, due to “accelerated implementation of
special programs and capital and poverty-targeted expenditure” (IMF 2002, 3).

As noted in an IMF report, however, inflation continues to be very low, though highly
sensitive to variations in agricultural production, and the “exchange rate regime and policy
remain adequate.” Nevertheless, sustainability of these achievements suggests that some
fundamental problems in the fiscal system still need to be addressed, including the problem of
the low level of revenue collection and the associated problem of the narrowness of the tax
base. To this end, the government has started implementing some revenue-enhancing
measures and other reforms. These reforms include promulgation of a new income tax,
introduction of a VAT tax, strengthening of the tax administration, and legislation to
introduce a Taxpayer Identification Number (TIN).

Therefore, while noting the still-pending macroeconomic reform agenda, it appears that at the
macroeconomic level there is no evidence of RER overvaluation, RER volatility, or overall
macroeconomic instability. Indeed, the overall macroeconomic environment in Ethiopia
appears to be consistent with the emergence and expansion of noncomparative advantage
exports, such as labor-intensive manufactures. This suggests that the highest payoffs to this
sector could come from further reforms for improving the investment climate for the sector.

6
The official exchange rate, which was pegged at 2.07 ETB per U.S. dollar for more than two decades, was
devalued around the end of 1992 (October) first to 5.00 ETB per U.S. dollar and subsequently to around 7.00
ETB per U.S. dollar in 1997.
8
1.3. Manufacturing Competitiveness, FDI and Investment Climate

Probing further into the more sectoral aspects of manufacturing sector competitiveness in
Ethiopia, recent studies suggest four major findings. First, Ethiopia’s manufactured products
are not competitive enough even vis-à-vis products from countries at the same level of
development and those from the same region. Second, major reforms in reducing the rates and
number of bands in tariff structures have been taken, but the effective rates of protection in
Ethiopia are still high. Third, the evidence also suggests that the high protection rates in
Ethiopia seem to be associated with the high transport costs and the overall adverse
investment climate in Ethiopia, not just relative to global potential competitors but also
compared with several other African countries. Fourth, Ethiopia lags behind most African
countries in terms of foreign direct investment (FDI); however, compared with other regions,
Africa attracted only a miniscule share of global FDI. The low FDI in Ethiopia, even by
African standards, is inextricably linked to its poor investment climate, as suggested by the
international evidence.

Effective Rates of Protection. According to a COMESA Free Trade Area study, subsequent
tariff reforms since 1993 have lowered the maximum tariff rate down to 40 percent, and the
number of bands to 6. Prior to the first tariff reform of 1993, the maximum customs duty rate
was 230 percent, and the total number of tariff bands was 25. Despite such improvements,
however, the “effective rates of protection” are still quite larger than the “nominal rates of
protection” for manufacturing (table 1.3), which suggests that an evaluation of the protective
structure based only on nominal rate understates the extent of protection accorded many
activities. The evidence also suggests that there is a clear incentive bias toward protecting
manufacturing and against agriculture and mining.

Table1.3. Nominal and Effective Rates of Protection: 1995 and 2001

Nominal tariff rate Effective rate of
Input-Output I-O Sector (%) protection (ERP)
1995 2001 1995 2001
(A) Agriculture, forestry and fishing 29.0 9.3 36.6 8.5
(B) Mining 5.1 6.7 0.8 -2.6
(C) Manufacturing 22.7 14.9 39.1 26.6
Weighted average 22.2 14.7 36.2 26.0
Simple average 27.5 15.5 48.7 26.3
CV 67.1 71.2 110.0 114.9
Notes: The ERP is estimated using the formula,
ERPj = [t j -∑ (a ij *ti ))/ (1- ∑aij )]
where, tj and ti are the nominal (scheduled) tariff rates on given industry and input-supply industry
respectively, and a ij is the input coefficient indicating the share of industry i’s production used as inputs
in industry j’s output.

Sources: World Bank estimates. Nominal tariff rates are from official Ethiopian sources. Input-output
coefficients are from the Sub-Saharan Africa regional input-output table (based on data for the early 1990) in
Global Trade Analysis Project (GTAP) database. Adapted from “Ethiopia: Trade and Transformation
Challenges, Diagnostic Trade Integration Study.” 2003.

9
Competitiveness of Ethiopia’s Exports. The COMESA study mentioned above demonstrates
that Ethiopian manufactures are not competitive even by Sub-Saharan Africa standards. The
analysis considered 71 line items from various sectors to investigate their price
competitiveness vis-à-vis other COMESA member countries. Accordingly, the study found
that on an ex- factory cost versus cost- in- freight (CIF) price comparison basis, only 25 percent
of products were found to be competitive, whereas 75 percent were found to be
uncompetitive. Similarly, on an ex- factory price versus import wholesale price comparison
basis, 49 percent were found competitive and 48 percent were uncompetitive. 7

According to this study, major factors for the uncompetitiveness of Ethiopian manufacturing
sector include: capacity underutilization, underinvoicing of imports, low efficiency as a result
of obsolete technology, contraband/illicit trade that supplies the market at lower prices,
dependency on imported raw materials and intermediate goods, and lack of standardization
and control on imported goods.

Low competitiveness of Ethiopian producers and larger potential benefits from integrating the
country into a multilateral trade system has also been cited by other studies. The Diagnostic
Trade Integration Study (DTIS) also suggested a program to enhance competitiveness to
enable Ethiopia to derive larger benefits from international trade. The report also mentions
that Ethiopia is not currently competitive in terms of transport costs compared with its
neighbors (even though the country has managed to substantially reduce these costs over the
years). Recent estimates suggest that on average external transport costs amount to over 11
percent of trade value, which is among the highest in the world. 8 Clearly, any comparative
advantage Ethiopia has due to its low wages are easily offset by the high transport costs of the
products, especially when the domestic value added is low as is typical in export-led labor-
intensive manufacturing. Exports, therefore, would have to have a high domestic value added
and linkages to be competitive (for example, local cotton for garments production and local
skins for shoes exports). However, with the fall of a command economy, rural-urban linkages
have collapsed, and given the short episode of post-socialist economic reforms, market
linkages have not yet reemerged. Figure 1.4 below shows Ethiopia’s average nominal
transport rate for merchandise goods (for 1999) vis-à-vis other countries. 9

The firms surveyed have problems with competing both in domestic and export markets on
price/cost competitiveness, quality of products, and timeliness/costs of product delivery.
Nonexporting firms specifically mentioned the following issues as among the top three
reasons for not exporting:

• 35 percent of firms highlighted foreign price competition as an impediment;

7
The remaining 3 percent could not be determined due to lack of data for factory prices.
8
In fact, the high transport costs can even preclude international trade for most products. For example, the price
of transporting wheat from the wholesale market in Addis Ababa to the closest port in Djibouti is equal to the
international price of wheat.
9
The average nominal shipment rate for Ethiopia, at around 11 percent of value, is very high compared with that
of other labor-intensive producing competitors (for example, it is less than 3 percent for China).
10
 • 69 percent of firms noted the inability to produce to clients’ standards and
specifications and the high cost of meeting the clients’ technical requirements among
the three primary reasons for not engaging in export/import activities; and
• 20 percent of respondents reported the high costs of establishing foreign distribution
networks as among the main constraints to exporting.

In fact, a significant number of firms whose outputs compete with imports in the domestic
market also admitted that compared with their products, the imported goods possess some
characteristics that make them more attractive to consumers. These attractive characteristics
of the imported goods are durability (mentioned by 20 percent of respondents), better materia l
quality (36 percent), and better model/design (28 percent).

Figure 1.4 Nominal Shipment Rates, 1999

12 11.2

9.3
8.3
8
6.4 6.6

4.7 4.9

4 2.7

0
a
a

ia
ina

pia
us

ny
an
a

Ind
ric

es
Ch

riti

hio
ke
Gh
Af

lad
au

Et
uth
M

ng
Ba
So

Note: Nominal shipment rate is equal to (freight credit + freight debit + insurance credit + insurance
debit) / (merchandise exports + merchandise imports).

Source: World Bank, “Developing Exports to Promote Growth” (Washington, D.C.: 2002).

FDI to Ethiopia. Ethiopia’s record in attracting FDI has generally been poor. The amount of
FDI flowing into the country has been very small both in per capita terms and as a share of the
total FDI inflow into Sub-Saharan Africa. Of those FDI- financed projects licensed in
Ethiopia, a significant majority (estimated at more than four-fifths) have not been
implemented. Moreover, FDI in Ethiopia has concentrated in three regions of the federal
administration, mainly in Addis Ababa; and the latest figures on FDI to Ethiopia have been
more disappointing. According to UNCTAD’s Investment and Innovation Policy Review, FDI
flows to Ethiopia significantly declined by 93 percent from $288 million (the highest FDI
flows ever attained by the country) in 1997 to $20 million in 2001 (UNCTAD, 2002). This is
a very significant drop amounting to about $268 million. Ethiopia's share of Africa's FDI
11
inflows also declined from 3.5 percent (the highest share ever attained) to only 0.01 percent
during the same period. This is at a time when FDI inflows to Africa have significantly
increased by 97.5 percent from $8.69 billion in 2000 to $17.16 billion in 2001. 10

As figure 1.5 shows, FDI inflows in Ethiopia are very low—both as a percentage of its low
GDP and as a share of the total FDI inflows to Sub-Saharan Africa. The share of FDI inflows
to Ethiopia as a share of the total FDI inflows to Sub-Saharan Africa in 2001 was just 0.2
percent compared with close to 9 percent for Nigeria, 4 percent for Mozambique, 2 percent
for Tanzania, and a little more than 1 percent for Uganda. Given the low level of GDP in
Ethiopia, the contrast from this comparison is clear. To attract more FDI inflows and a larger
share of the region’s FDI, Ethiopia needs to focus on creating better perceptions about its
business environment among foreign investors, addressing land issues and streamlining the
approval process.

Figure 1.5
Ethiopia’s FDI Inflow s as Share of GDP and Total FDI to Sub-Saharan Africa, 2001

6 60%
4.7
4.4
3.9
4 40%

2.0
2 20%
0.8
0.4

0 0%
pia
ria

da

ia
ue

an
ge

a
an

hio
biq

ric
nz
Ni

Ug

Af
Et
am

Ta

uth
oz

So
M

FDI as % of GDP Share out ot total FDI to SSA

Sources: Based on data from Economic Intelligence Unit (2003) and World Development Indicators (2002)

Investment Climate in and outside Africa. The quantity and quality of investment flowing
into Ethiopia or any specific region depend on the returns that investors expect and the
uncertainties around those returns. These are influenced by two sets of interrelated factors.
First, there is a set of macro or country- level issues concerning economic and political
stability and national policy toward foreign trade and investment. By these, we generally
refer to macroeconomic, fiscal, monetary, and exchange rate policies, as well as political

10
This impressive (more than $8 billion) increase in FDI inflows to Africa was largely due to a few large FDI
projects in South Africa and Morocco. The report shows that in some African countries FDI inflows remained on
the same level as in 2000, whereas in some others FDI inflows significantly declined, as in Ethiopia (which is
one of the 20 countries rated the worst in hosting FDI).
12
stability. As discussed above, Ethiopia seems to have performed reasonably well in terms of
macroeconomic aspects of investment climate.

The second component of investment climate is composed of a host of sectoral and micro
level issues relating to the efficacy of a country’s regulatory regime and the quality of the
service delivery. From the firm’s perspective, the relevant regulatory issues relate to entry
and exit, labor relations and flexibility in labor use, efficiency and transparency of financing
and taxation, and efficiency of regulations concerning the environment, safety, health, and
other legitimate public interests. The question is not whether to regulate or not, but whether
such regulations are designed in incentive compatible ways, avoid adverse selection and
moral hazard, serve the public interest, are implemented expeditiously without harassment
and corruption, and facilitate efficient outcomes. The service delivery is determined by
infrastructure issues such as power reliability, transport time and cost, and access and
efficiency of finance, along with the lack of skilled workers and the difficulty of access to
advanced technologies as key determinants of competitiveness and profitability.

Only a few internationally comparable indicators on service delivery and regulatory aspects of
investment climate cover Ethiopia (figures 1.6–1.9). Despite its limited coverage, the
evidence clearly suggests that Ethiopia lags behind most African countries as well as all other
international comparators. The only exception is corruption, which does not seem to be as
much of a problem for Ethiopia as in other countries. This evidence would obviously need to
be updated and corroborated with the firm- level data analyzed in chapter 2. Nonetheless, the
disappointing performance of Ethiopia in terms of FDI appears plausible, given its relatively
poor investment climate relative to other African countries. Therefore, other things equal, this
evidence suggests that Ethiopia cannot favorably compete for FDI because of its relatively
poor investment climate. The same link to investment climate also explains why the
Ethiopian manufacturing sector might not be viable without high real protection rates relative
to other COMESA member countries.

Figure 1.6 Number of Days to Clear Customs, 2000

Morocco 5
Cote d'Ivoire 6
Zambia 16
Mozambique 18
Tanzania 19
Kenya 20
Cameroon 20
Zimbabwe 23
Uganda 25
Nigeria 25
Ethiopia 35

0 10 20 30 40
days
13
 Figure 1.7 Number of Internet Hosts by Country, 1999

Zimbabwe 1416
Morocco 801
Kenya 560
Zambia 478
Cote d'Ivoire 370
Tanzania 158
Mozambique 156
Uganda 125
Ethiopia 81
Nigeria 58
Cameroon 6

0 200 400 600 800 1000 1200 1400 1600

Internet hosts

Figure 1.8 Number of Internet Users, 1999

Morocco 120
Kenya 45
Uganda 36
Zimbabwe 30
Mozambique 15
Cote d'Ivoire 9
Nigeria 9
Zambia 9
Ethiopia 8
Tanzania 8
Cameroon 6

0 20 40 60 80 100 120 140

Thousands of users

14
 Figure 1.9 Corruption: Percent of Firms Reporting Paying Additional Payments for
Government Services

4 3.6 3.7
3.5
3.2 3.2 3.3
3.1
2.9
3 2.6

2 1.7

0
Zimbabwe

Uganda

Cameroon

Kenya
India
Nigeria

Coted'Ivoire

China
Zambia
Ethiopia

Source: WBES

1.4. Private Sector and Investment Climate Issues

Ethiopia has a long history of artisan manufacturing activity. However, the history of modern
manufacturing activities in the country starts mainly after World War II; and it can be
classified into three broad phases: the import-substitution period of the imperial era (early
1950s to 1974/75); the centrally planned, socialist system (1974/75 to 1991/92), which openly
discouraged private sector industrial activity by using direct government control of
production, inputs, and credit allocation, thereby preventing the private sector from accessing
them; and the market orientation phase (post–1991/92), during which various liberalization
and policy reforms were promulgated to encourage private sector investment and its
participation in economic activities.

Historically, during the imperial era, only very few privileged members of the society were
participating in large-scale investment activities, particularly in manufacturing. During the
socialist government era that followed, the private sector was further repressed, when the
already few privately owned manufacturing establishments, privately owned land, and extra
residential houses and commercial establishments were nationalized. The government then
took almost full control of the production and distribution activities in the economy.

However, since 1991/92, shortly after assuming power, the current government moved to
reverse this historical legacy by encouraging participation of the private sector in economic
activities. The current GOE has taken significant steps of liberalization and deregulation to
15
transform the economy from a centrally planned command structure to a market-based
economy and to create an environment conducive to private sector growth. Through massive
privatization and other reforms, the government has been attempting to shift its role from
active participation in production and distribution activities to that of creating an enabling
environment for the private sector and providing regulatory services. The reforms include
streamlining taxes and liberalizing the labor market.

Recently, the government has also taken further measures to ease opportunities for foreign
investors in the country. For example, it opened the tourism industry to foreign investment,
and it slashed the level of finance needed by a foreign company to invest in Ethiopia from the
previous level of $500,000 to $100,000. In the case of joint ventures, this minimum has fallen
from $300,000 to $60,000. The Ministry of Trade and Industry has taken steps to streamline
business registration processes within the Ministry, the Ethiopian Investment Authority and
related institutions. As a result, the cost of registration has reduced from $425 (which was the
highest in the world on a per capita GDP basis) to $65 and the time of registration from 44
days to 8 days.

Despite the efforts undertaken by the GOE to create a conducive business environment and
the large stock of untapped natural resources in Ethiopia, the flow of private investment, the
growth of the private sector, and its participation in the economy have so far been quite low;
and the manufacturing sector is dominated by small firms. Indeed, private enterprises in the
country are generally in their early stages of development, even by African standards. This is
partly due to the long legacy of the ideological repression of private sector activities under the
Derg regime, but also because the reform agenda still has a long way to go. Given the
relatively strong progress made on the macroeconomic front, it appears that the fundamental
reasons why the private sector is still small and exports expansion has been limited in
Ethiopia should be analyzed in the context of the more institutional and microeconomic
determinants of competitiveness—that is, analysis of the investment climate.

As mentioned, there are three interrelated structural forces that also influence the investment
climate in Ethiopia. These are the high poverty incidence/low economic development in the
country manifested, among others, by poor infrastructure and low internal demand; geography
as reflected by the very high transport cost of goods that limits the profitability and
competitiveness of labor- intensive manufacturing; and the transitional nature of the economy
from a system where the state was involved in almost all production and distribution activities
with a discouraged private sector. The interaction of these forces has suppressed the growth of
the private sector in the country.

Several issues are open for consideration in the PSD and investment climate agenda. For
example, the government has de facto monopolistic positions in telecom, power, and water
sectors (although it has just recently enacted a policy to allow private sector participation in
power and telecom services); and it is still active in some manufacturing, transport, and
construction spheres. 11 Moreover, a number of formidable challenges continue to exist

11
There is also a debate in the PSD agenda, as frequently raised by some entrepreneurs and their representatives
such as the chamber of commerce, that the playing field for the private sector vis -à-vis the foundation-owned
(party-affiliated) firms may not be leveled; that is, compared with privately owned firms, foundation-owned
16
including the limited availability and high price of urban land leases, limited provision of
infrastructure (undeveloped road network, low tele-density, low access and reliability of
power supply), low savings rate, and hence lack of resources as well as low access to finance.
As the privatization process turned out to be slower than originally expected, the private
sector continues to face strong, and possibly unfair, competition from large-sized public
enterprises, as claimed by some elements of the private sector. Although competition is
healthy and should be encouraged, the key issue is whether or not the playing field is leveled
for private firms.

The investment climate analysis in the remainder of this report addresses two fundamental
questions: What particular obstacles are impeding the growth of private enterprise in modern
industry in Ethiopia or its integration into the global economy? And what should be done to
remove those obstacles?

To address these questions, the World Bank and the Ethiopian Development Research
Institute (EDRI) conducted a survey of 427 manufacturing businesses sampled from six
regions of the country where there is a major concentration of manufacturing activities. The
Ethiopian Investment Climate Survey is a direct consequence of consultations among the
World Bank, the Ethiopian government, representatives of the private sector and of the donor
community, who argued that an empirical analysis of the private sector must underpin a sound
set of policies regarding investment and private sector development.

1.5. Structure of the Report

Chapter 2 draws up the current profile of Ethiopia’s private sector in industry in terms of a
description of its structure and performance in an international perspective. How does the
sector compare to its counterparts in the developing world in terms of concentration,
productivity, growth, and integration into the world economy? It also maps the performance
indicators to a set of specific bottlenecks in the current investment climate of Ethiopia,
providing estimates of the cost of each main bottleneck in terms of lost productivity and
forgone growth. The data from Ethiopian enterprises are compared with those from countries
such as China, Bangladesh, and Uganda, among others. China is regarded as defining the
global competitiveness “frontier” for labor- intensive manufacturing exports; Bangladesh is a
low- income, populous country with a similar manufacturing base; and Uganda has many
characteristics similar to Ethiopia.

Chapter 3 analyzes the contrasts in the investment climates across regions and sectors within
Ethiopia, as well as between private and public firms. This is important because analysis of
these variations within the national economy could shed more light on the factors shaping the
investment climate. For the case of public-private comparisons, the analysis addresses the

establishments may be receiving better and preferential treatments in terms of regulatory environment and
service delivery. This particular issue, however, is beyond the scope of this report, as it requires a more
specialized survey focused on regulatory and service delivery issues but covering services as well as
manufacturing, because there are very few foundation firms in the manufacturing sector. World Bank envisages
preparing a separate report based on such a survey.
17
perceptions that the playing field may not be leveled between public and private firms in
terms of the regulatory environment and access to finance and other services.

Chapter 4 contains the main conclusions and associated policy implications of the report’s
findings. Finally, the annexes at the end of this report contain additional data and technical
and methodological material in support of the analysis in the text.

18
 2. Investment Climate and the Performance of Private Sector
Industry: An International Perspective
“Through the Ethiopian and Addis Ababa chambers of commerce, manufacturers…had called on the government
to…rescue the local industry from…cheap imports from China.”
—Fortune, Addis Ababa, December 23, 2001

2.1. Ethiopia Investment Climate Survey

Ethiopia’s economy is predominantly agricultural and traditional in many senses. However, it

also seems clear that a large part of its future lies in significant development of manufacturing
and modern services more or less in urban settings. Private industry is not growing as fast as it
should in these sectors, even by the standards of Sub-Saharan Africa. Ethiopian businesses are
far fewer than the size of the country would seem to suggest; they are smaller in scale by
international standards, and they have not managed to enter export markets or to attract
significant foreign capital. Why is this the case? What particular obstacles are impeding the
growth of private enterprise in modern industry and services or its integration to the global
economy? In this chapter, we address these questions by comparing data from the recently
completed Ethiopia Investment Climate Survey (ICS) with similar data collected from other
developing countries with direct World Bank Group involvement in the last two years.

The survey, carried out in the first half of year 2002 as a joint undertaking of the World Bank
Group and EDRI, covered 427 manufacturing establishments sampled from Addis Ababa
and major urban centers in the Amhara, Oromia, Southern Nations, Nationalities, and People
(SNNP, or hereafter Southern), Eastern, and Tigray regions. The survey instrument consisted
of a written questionnaire that was administered to business managers and accountants
through face-to- face interviews by trained enumerators. One set of modules of the instrument
was used to generate data on a range of investment climate indicators. A second set was used
to collect information on accounting indicators of business performance.

The Ethiopia survey instrument is very similar in these respects to investment climate surveys
the Bank recently sponsored in Bangladesh, China, India, and Pakistan. 12 Partly for reasons
of the resulting comparability of data, the chapter will rely mainly on a comparison of
Ethiopian producers with their counterparts from those four countries. More important, it is
the performance of producers in China and South Asia that African manufacturers have to
match if they are to succeed in penetrating the internatio nal markets in labor- intensive
products in which they could potentially be competitive. At the same time, what is feasible or
imperative in the performance of an economy or in its reform is probably easier to assess or
convey in reference to achievements and constraints observed in economies of similar
structure or social framework. We believe that the use of South Asia and China as reference
even from this point of view is not wide off the mark, especially in the light of the more
backward parts of those regions. We have nonetheless used African comparators as well
throughout the chapter whenever comparable data were available.

12
See Annex F in this report for more information on the Ethiopian survey.
19
We begin by comparing the performance of Ethiopian businesses with their counterparts in
South Asia and China, in terms of productivity as a proximate determinant of growth and
competitiveness in international markets. We then investigate the connection between the
picture we will have drawn of relative performance with the more obvious differences
between the investment climate of industry in Ethiopia with those of the comparators. The
starting point of this latter part is the private sector’s view of outstanding problems in
Ethiopia’s business environments, as expressed in responses to the survey. We then assess the
extent to which this view is backed up by the objective indicators we have also collected
through the survey. We conclude with an estimate of the cost of the most outstanding
deficiencies of investment climate in terms of lost productivity and forgone growth.

We will have suppressed variation in investment climate within Ethiopia itself at this stage of
the analysis to bring possible deficiencies at the national level into as sharp relief as possible.
We will also defer the discussion of problems of investment climate that we are unable to put
in an international statistical perspective to chapter 3, in which we discuss domestic
disparities in business climate between regions.

2.2. Proximate Causes of Lack of International Competitiveness

The median manufacturing wage rate in

Figure 2.1 Ethiopia is almost one-third of that in
Median wages per man year (1999 USD) China and 40 percent lower than that in
Bangladesh (figure 2.1). Because the
1200 1096 level of schooling of the typical worker
902
1000 854 in Ethiopia is not that low compared to
800 636 the levels of schooling in China and
600 401 Bangladesh, the wage gap largely means
400
that labor is far cheaper in Ethiopia. 13 It
200
0
therefore would seem that Ethiopia
China Pakistan India Bangladesh Ethiopia should have competitive edge over those
countries in labor- intensive
manufactures. This, however, is not the
case. Although manufacturing in Ethiopia is heavily dependent on imported inputs, it does not
have significant exports.

13
Average number of years of workers’ schooling in the Ethiopia survey sample is 7.1. This compares with 8.6
years in Bangladesh, 8.9 in Pakistan, and 10.6 in China and India.
20
 Figure 2.2 Shortfalls In labor productivity Figure 2.3. Labor Productivity gap if differneces
or value added per worker (Bangladesh = 100) were in capital per worker only

200 171 160

161 136
140 128
146 117

Bangladesh=100
150 120 102
100
100 80
60
50 19 40
20
0
0
China India Pakistan Ethiopia Pakistan India China Ethiopia

This failure to realize what most would see as potential comparative advantage in labor-
intensive manufactures can only mean that the average manufacturing worker in Ethiopia is
significantly less productive than the typical worker in South Asia or China to an extent that
could not be made up for by Ethiopia’s lower wages. Part of the reason for Ethiopia’s labor
productivity shortfall is that its manufacturing businesses are simply too small and
consequently lack the economies of scale of their foreign counterparts. The median firm has
only 14 employees, compared to 251, 20, and 210 for China, Kenya, and Bangladesh,
respectively. However productivity in Ethiopia would still be well below that in the
comparators, even when we account for this factor. Controlling for the broad sector of
industry they work in, Ethiopian workers are about 80 percent less productive than workers in
Bangladesh and more than 1.5 times less productive than those in China (figure 2.2). Labor
productivity gaps (relative to Bangladesh) due to capital per worker differences (alone), to
differences in skills or to TFP differences are reported in figures 2.3, 2.3b and 2.4,
respectively.

Figure 2.3b. Labor Productiviy gap if Figure 2. 4. Labor productiviy Gap due to a TFP
differences were in workers' schooling only differences only

160 140
140 115 125
Bangladesh=100

109 140
120
Bangladesh=100

100 120
111
100 78 100
80
80
60 60 40
40 40
20
20
0 0
China India Pakistan Ethiopia China India Pakistan Ethiopia

Part of the labor productivity shortfall reflects that Ethiopia’s factory workers are far less
equipped than their counterparts elsewhere with machines, tools, or space. However, we
estimate that this accounts for only about 10 percent of the gap vis-à-vis China, for example
(figure 2.3). A more significant source of the shortfall is that Ethiopian workers are less
skilled on average than their Chinese counterparts, as indicated by gaps in schooling.
Figure 2.3b shows that , differences in average schooling account for 24% of the total labor
productivity gap between Chinese and Ethiopian workers.

21
The remaining 66 percent of the shortfall comes under TFP, which can be thought of as a
measure of overall business productivity, given scale, skills, and equipment. Figure 2.4 shows
that controlling for differences in skills and capital endowment, the average factory worker in
China produces 3.5 times more than the average factory worker in Ethiopia.

A formal analysis of the correlation between indicators of bottle necks in business

environment and business performance across the survey datasets pooled from Ethiopia,
China, Bangladesh, and Pakistan, shows that the bulk of the influence of Ethiopia’s
investment climate on the level of productivity and competitiveness of industry is transmitted
through its effect on TFP. Details of the analysis are given in a technical annex to this report
(annex G). We will also return to the magnitude of the influence of investment climate on
current levels of TFP following a discussion of indicators of climate later in this chapter.
Meanwhile, it should be noted that a firm’s productivity is closely intertwined with its growth
performance. On the one hand, more productive firms invest more on average and
consequently grow faster. On the other hand, growth does not always presuppose investment
and could be driven more by growth in business productivity itself. It is therefore useful to
investigate the effect that investment climate has on business growth, as well as on the level
of business productivity.

Figure 2. 6
Figure 2. 5
Average annual growth rate of fixed assets (%)
Average growth rate of annual sales (%)

15.0 12.9 17.1

20.0
8.5 8.3
10.0 10.0 3.0
4.2 0.0
5.0 1.8
-10.0
0.0 -9.3
-20.0
China India Pakistan Ethiopia
China India Ethiopia Pakistan

Figure 2.5 shows that the sales of the average business in Ethiopia grew far slower during the
survey year than those of the average businesses in India and China. This was in part because
the average Ethiopian business did not
Figure 2.7 invest as much in fixed assets as did typical
Average annual growth in value
businesses in China and India (figure 2.6).
added per worker (%)
As shown in figure 2.7, labor productivity
did seem to have grown faster in Ethiopia
15.0 10.3
10.0 than in India, suggesting that there were
5.0 1.6 significant TFP gains in the average
0.0 business in Ethiopian industry during the
-5.0 -2.3
-10.0
survey years relative to the average in India.
-8.0
China Ethiopia Pakistan India However, these gains were relatively small
compared to the high TFP growth rates
registered in Chinese businesses during the

22
same period. 14 And because wages grew at an approximately equal average of 5 percent in
Ethiopia and in China, unit labor costs of the average Ethiopian business grew by as high as
2.9 percent a year, whereas average unit labor costs were falling by nearly 5 percent in China
(figure 2.8)

The competitiveness gap that exists between Ethiopian industries and those in more
successful economies in the developing
world thus appears to be widening.
Ethiopian wages remain so low that the 6 Figure 2.8
percent growth observed for the survey Average growth in unit labor costs
year is anything but spectacular in any
context. However, it is clear that Ethiopian 15.0
10.5
industry can afford wage growth of any 10.0
magnitude, and still increase the prospects 5.0 2.9
-1.1 -4.6
of its participation in export markets, by 0.0
sustaining an even higher growth rate in India Ethiopia
-5.0 Pakistan
labor productivity through higher China
-10.0
investment rates or through growth in
overall business productivity.

These results hold up quite well if we focus instead only on industries in which it could be
easier for Ethiopia to develop comparative advantage at some point in the near future. The
conventional wisdom at the moment seems to be that textiles, garments, and leather products
are exports with that kind of potential. The failure for exports to grow significantly in any of
the sectors has also been blamed by some on “cheap imports” from China. This is very much
in line with the findings just stated. Chinese producers pay much higher wages than
manufacturers in Ethiopia, but Chinese workers are also so much more productive that they
can apparently undersell Ethiopian producers.

Sector- level calculations, not reported here, show that the finding that TFP shortfalls are the
main source of Ethiopia’s lack of competitiveness holds true even if we focus our attention on
any one of the three industries where Ethiopia is thought to have a potential comparative
advantage. For example, in garments, part of the productivity shortfall vis-à-vis China reflects
that Chinese producers are more capital intensive and have more skilled workers. However,
this is a smaller component of the labor productivity gap between the two countries than the
TFP gap. We do not have comparable data for textiles or leather products in China, but
basically the same story is told by figures for other industries regarding the productivity
shortfall of Ethiopia vis-à-vis the best performing countries of this particular group
(Bangladesh in leather goods, for example).

14
The average TFP growth rate for China for the period was 8 percent compared with 1 percent in Ethiopia. TFP
actually fell significantly in India and Pakistan during the same period.
23
2.3. Investment Climate as an Underlying Factor

2.3.1. Private Sector View

What particular aspects of Ethiopia’s investment climate can be linked directly to the lack of
international competitiveness in Ethiopian industry? What specific contrasts between the
investment climate of Ethiopia and that of China or any of the South Asian countries can be
invoked as a possible factor behind productivity or growth gaps in Ethiopia’s businesses as
described above? Practically anything that influences the mean or the spread of the rate of
return to business investment—and is, at the same time, exogenous to the decisions or
characteristics of any one investor or business—forms part of the investment climate of a
local, regional ,or, national economy. Naturally included in this definition are macroeconomic
and trade policy regimes on which business choices and activities would be conditioned, as
well as the political setting within which economic policy is formulated and implemented.

The list of elements of the investment climate that could be formed beyond these obvious and
universal components seems to be endless, with the relative importance of the items of the list
varying highly across economies and over time periods. Partly as a way of setting boundaries
for this list, the investment climate survey asked respondents to identify what they thought
were the most pressing bottlenecks in their local business climate. Specifically, managers
were asked to rate each item in a long list of possible obstacles to business expansion on a
scale of 0 (no obstacle) to 4 (very severe obstacle). Figure 2.9 shows broad categories of
aspects of investment climate in which deficiencies have been identified by a significant
proportion of respondents as a major (3) to very severe (4) obstacle, not only among
Ethiopian participants but also among survey respondents to the surveys in China,
Bangladesh, and Pakistan.

Figure 2.9
Reported 'major-to-severe' constraints to business
expansion
72.97
Regulation/Admin & Corruption 61.97
75.18
46.20
77.27
Infrastructure/Land 50.16
43.20 82.88
50.72
External Finance 47.51
56.71
51.20
Macro Policy & Stability 47.15
54.96
38.53
72.25
Tax Rate 45.60
35.85
36.80
Skill Shortage
30.73
21.47
Law and Order 39.43

20 30 40 50 60 70 80 90

China Bangladesh Pakistan Ethiopia

24
As can be seen from the figure, the private sector in Ethiopia complains the most about the
following:

• Issues relating to tax, customs, and other aspects of public administration and business
regulation
• Access to physical infrastructure and land
• What it perceives to be high taxes
• Problems of access to external finance
• Macroeconomic stability

Problems of macroeconomic policy fall outside of the purview of this report. We will also
postpone the discussion of tax issues and access to land to chapter 3. Part of the reason for this
is that these are questions on which we do not have internationally comparable data, while
there are interregional patterns of perception of problems within Ethiopia that need to be
highlighted. In the rest of this chapter we will briefly assess the gravity of problems in the
remaining categories of regulation and governance, the provision of physical infrastructure,
and access to external finance in terms of objective indicators.

As a summary of the private sector’s views, figure 2.9 reflects an essential element of the
methodology of this report and illustrates the value of subjective ratings of bottlenecks as an
essential step in the identification of problems that need to be objectively measured. Notice
also how similar the hierarchy of complaints about investment climate is between respondents
to the Ethiopian survey with respondents, particularly in Bangladesh, and how sharply
divergent it is with respondents from China. This might give rise to the temptation of
analyzing the statistical correlation between scores behind the figure and the accounting
indicators of performance discussed in the previous section.

However, figure 2.9 also illustrates a pitfall that an undertaking of this kind would entail,
particularly whe n done in the context of cross-country comparisons of economic performance.
For example, it shows that the shortage of skills is a more binding constraint in Chinese
industry than it is in Ethiopia or Bangladesh. This is plausible. However, it also would seem
to suggest that a formal analysis would show a negative correlation between the scores that
businesses would assign to shortages as constraint and business productivity or business
growth. This would not be a sensible result in view of the fact that the average worker is more
skilled in China than in either of these two countries. The general point is that while we can
relate objective indicators of investment climate, such as average workforce skills to business
performance indices, we cannot meaningfully include the managers’ rating of constraints in a
production function or a growth equation. In trying to link investment climate to performance
indices, we need to rely on objective indicators of deficiencies of the investment climate that
subjective rating scores of respondents show to be of major concern to the business
community. We now turn to these indicators.

25
2.3.2. Some Objective Indicators

Regulatory Burden and Government Services

Part of the cost of enforcement of business regulation and tax laws in much of the developing
world is the corruption and bureaucratic harassment that is normally associated with it. One
measure of this cost is the time that business managers spend dealing with enforcement
agencies. The frequency of inspection visits that officers of the agencies make to factory
premises is another. Although it is clear that the cost is substantial in Ethiopia of either of
these indicators, it is also evident from figures 2.10 and 2.11 that the country is not doing that
badly on this score relative to what we are using here as comparators.

Figure 2.10
Percent of senior management time Figure 2.11
spent dealing with regulations and Number of days of government
officials inpection visits a year
India 10.43
Ethiopia 2.91
Ethiopia 13.19
Bangladesh 4.27
Bangladesh 16.39
China 7.26
Pakistan 10.00 Pakistan 35.64

Mozambique 12.00 China 36.19

Uganda 15.5
0.00 10.00 20.00 30.00 40.00
0 5 10 15 20

For example, respondents to the Ethiopia survey reported to have spent on the average 3
percent of their time dealing with government officials and regulations. Although this is not
inconsequential, it has to be seen against an average of 7 percent in China, or, worse still, 10
percent in Pakistan (figure 2.10). The frequency of inspection visits by officials of
government tax or regulatory agencies is rather high at an annual average of 13 visits per
business per year. However, this too can be compared with figures that are three times higher
in China or Pakistan (figure 2.11).
Figure 2.12
At the same time, Ethiopia seems to have a Number of waiting days to clear customs
long way to go in improving the quality of
service delivery and public administration to
China 6.73
standards attained in these same countries.
One indicator of this is the time it takes a India 10.58
shipment of imported inputs to clear Bangladesh 11.67
customs, which can also be interpreted as an
indicator of efficiency in tax administration, Mozambiqure 12.00

on the one hand, and of government control Ethiopia 13.79

over access to foreign technology and
foreign markets, on the other. More directly, Pakistan 17.34

26 0.00 5.00 10.00 15.00 20.00

the duration of import clearance increases with cost of inventories of imported inputs that the
typical business has to incur to bridge anticipated delays in delivery. According to figure 2.12,
the average shipment in Ethiopia would take 14 days to clear customs. This is statistically
comparable to the figure for Mozambique—which is quite interesting, but is probably less
significant from a forward looking, activist perspective. The Ethiopian figure is twice that for
China, against whose exports manufacturing in Ethiopia is competing in the domestic market.

Provision of Physical Infrastructure

Figure 2.9 suggests that the strongest bottleneck in the investment climate of Ethiopia might
lie in the provision of physical infrastructure. Although this deficiency is possibly most felt or
most significant in the transport sector, it seems to be just as conspicuous in power supply and
telecommunication. It is useful to make a distinction between two aspects of provision,
namely, the ease of access to services and the quality of services assuming access. A measure
of the former is waiting time for getting connected to the public power grid or to get a new
telephone connection. Correspondingly the quality of services can be measured by the
frequency and cost of power outages on one hand and the incidence of the Internet
connectivity of businesses on the other.

Figure 2.13 Figure 2.14

Number of waiting days to connect to public Waiting days for a telephone connection (number)
grid

China 16.16
China 12.89
Pakistan 39.99 Pakistan 48.44
Bangladesh 48.57 Bangladesh 110.64
Ethiopia 114.38
Ethiopia 203.97
Uganda 177.00

0.00 50.00 100.00 150.00 200.00 0.00 50.00 100.00 150.00 200.00 250.00

We see in figure 2.13 that it could take an Ethiopian business start-up nearly four months to
get electrical connection to the public grid compared with a waiting period of less than two
weeks in China. The situation is far worse for Ethiopian businesses in terms of access to
telecom services, where the average
waiting period for getting a new fixed Figure 2.15
telephone connection is nearly 9 months Percent of output lost due to power
(figure 2.14). A Chinese firm would get outages
the same connection in two weeks. In China 1.99
terms of the quality of services, the Bangladesh 2.35
average Ethiopian firm estimates that it
loses as much as 5 percent of revenue due Pakistan 5.57

to power outages, compared with a Ethiopia 5.57

reported 2 percent revenue loss in China
(figure 2.15). It may partly be a measure 0.00 1.00 2.00 3.00 4.00 5.00 6.00

27
of the disadvantage that Ethiopian businesses have in the quality of the telecom services that
less than 10 percent of them use the Internet in business communication relative to 70 percent
of firms in China or Bangladesh (figure 2.16).

Figure 2.16
Percent using email to contact
customers

Ethiopia 6.00

Pakistan 30.00

India 45.00

Bangladesh 70.00

China 71.00

Kenya 81.10

0.00 20.00 40.00 60.00 80.00 100.00

Financial Services

Regarding finance, private sector firms in Ethiopia do not seem to be any more constrained
than those in China or South Asia on an admittedly crude measure of access to formal sector
finance—the proportion of businesses with a line of bank credit (figure 2.17). However,
Ethiopian businesses seem to be severely constrained far more by a less efficient payment
system. One measure of this is the time it would take payments to clear through the banking
system, particularly those relating to foreign transactions. For example, a foreign currency
wire that would take 8 days to clear in Ethiopia would clear in only a quarter as long in China
(figure 2.18).

Figure 2.17
Respondents with overdaft facililty Figure 2. 18
Days needed for a foreign wire to clear
(percent)
China 2.28
Bangladesh 61.70

Ethiopia 26.60 Pakistan 3.22

Pakistan 22.00
Ethiopia 7.87
China 16.50
0.00 2.00 4.00 6.00 8.00 10.00
0.00 20.00 40.00 60.00 80.00

28
2.3.3. Linking IC Indicators to Performance Indices

How much of the performance gap outlined here between the typical business in Ethiopia and
that in China or in Bangladesh can be explained in terms of the measurable deficiencies in
Ethiopia’s investment climate? In other words, how much could the same deficiencies have
cost Ethiopia’s economy in lost growth or productivity? To answer these questions, we have
computed some counterfactual growth rates and productivity indices based on the correlation
between the objective indicators just listed on a sample of observations pooled across China,
Bangladesh, Pakistan, and Ethiopia. The correlation is analyzed in terms of the estimation of
econometric specifications of productivity and growth equations in which the objective
investment climate indicators figure as right- hand-side variables.

Figure 2. 19 Figure 2.20

Ethiopia: Potential Gains in sales
growth rate from leveling up IC
indicators to China's or to
Bangladesh's
Ethiopia: potential labor Productivity
gains by leveling up IC indicators to China’s
Or to Bangladesh's

12% 250% 180%

10%
10% 200% 164%
8% 6% 150%
6%
100%
4%
2% 50%
0% 0%
Bangladesh China Bangladesh China

Details of the estimation procedure and results are annexed to this report. In using these to
calculate the cost of deficiencies in investment climate, we ask the following question: Given
that from among the four comparator countries, China has, on balance, a better investment
climate than the others, by how much could the growth rate or productivity of the average
business in Ethiopia be enhanced if Ethiopia’s investment climate were the same as China’s?
How much would the gain be if Ethiopia’s indicators were the same as those of Bangladesh?
The results are shown in figures 2.19 and 2.20, where we see that a leveling up of Ethiopia’s
indicators of investment climate to that of Bangladesh’s would raise the average annual
business (sales) growth rate in Ethiopia by 6 percent. The gain would be 10 percent if the
indicators were raised to China’s level. Labor productivity in the typical Ethiopian business
would also be higher by 164 percent if Ethiopia’s indicators were the same as Bangladesh’s
and by 180 percent if they were the same as China’s.

29
 Figure 2.21: Elasticity of labor productivity with respect to IC
Indicators
36.1

-22.6 -19.8 -17.5 -37.4

%
Percent
holding
Number of Days needed Days needed
overdraft
inspection for last to clear
facilities % output lost
visits a year telephone customs last
time due to power
connection
outage

Figure 2.22
Incremental % annual sales growth
hypothetical doubling of IC
indicators 2.4

%
-1.6
-3.9 -3.6
-8.9
Number of Days Percent of Days need Percent
inspection needed to output lost for last holding
visits a clear due to telephone overdraft
year customs power connection facilities

We hasten to add that these calculations should be interpreted with due caution, more as
orders of magnitude than accurate point estimates at this early stage in the development of
cross-country, company- level, investment climate datasets. However, they seem to us good
enough indicators of the potential scope that exists in Ethiopia for growth and poverty
reduction through the improvement of a few strategic links in its business environment.

In figures 2.21 and 2.22, we show estimated elasticity coefficients of labor productivity and
annual sales growth, respectively, with respect to the investment climate indicators used in
calculating the counterfactuals reported in figures 2.19 and 2.20. The estimates are exactly as
reported in annex G in this report except that here we have expressed them in percent and we
do not report here levels of statistical significance or other factors that we controlled for in
obtaining the estimates. 15 Although care should be taken not to read a priority scale in each set
of estimates, one can nonetheless take the set as a vector of natural weights whenever we try
averaging the indicators into some score of comparison of investment climates across regions
and countries. Thus, figures 2.21 and 2.22 suggest, for instance, that, other things being equal,
a doubling of the proportion of businesses that have lines of bank credit is associated with a
36 percent increase in labor productivity and a 2.4 percentage point increase in the annual
growth rate of sales in the average business across the four countries covered by our survey

15
Technical details of the estimation are provided in Annex G.
30
data. Similarly, a halving of output lost due to power outages would imply a 37 percent
increase in labor productivity and an increase of almost 2 percentage points in the average
annual growth rate of sales.

Finally, we tried to separate the overall contribution of investment climate variables from
those of geography, market size and other structural factors.
Figure 2.23
China-Ethiopia gaps in manufacturing labor productivity controlling for differences in
skill and capital endowments

4% 28%

27%

42%

Investment Climate Geography and market size

Age and industry distribution of firms Unexplained country effects

Figure 2.23 shows that relative magnitude of Sino-Ethiopian labor productivity gaps
(controlling for skill and capital endowments) due to differences in investment climate,
geography and market size, age and industrial characteristics of firms and as well as other
unexplained country characteristics that are structural in nature. Variables included in what is
termed as ‘investment climate’ in the figure are number of inspection visits to a firm by
government officials in a year, days needed to clear customs during the year preceding the
survey, percent of output lost due to power outage s, days needed to get telephone connection
from the time a firm applied to get one, and the percent (likelihood) of firms holding overdraft
facilities. The term ‘geography and market size’ in the figure includes the following
geography and economic density variables: distance from the nearest major international
market in miles, distance from the nearest port and the size of the population in the city where
the firm is located; while we represented differences in structural factors by country dummy
variables.

The results show that investment climate differences contribute to about 28% of the Sino-
Ethiopia labor productivity differences (after controlling for skill and capital endowment
differences). A further 27% of labor productivity gap is due to differences in age and industry
distribution of firms while ‘geography and market size’ differences contribute to about only
4% the total productivity gap. The remaining 42% is due to unexplained country effects
representing what can be regarded as structural factors.

31
 3. Differences in Investment Climate Indicators within Ethiopia
The previous sections of this report have shown the position of Ethiopian business
establishments in terms of their performance and the investment climate they operate in from
an international perspective. However, the national averages of investment climate indicators
for Ethiopia, as is the case for most other countries, are not similar across regions within the
country. They are also likely to vary by sector and ownership structure. Due to variations in
the endowment and historical characteristics of the regions in Ethiopia, for example, firm
performance, industrial structure, impediments to growth, and implied policy priorities show
variations. This section looks at some of these interregional differences and briefly discusses
variations across sectors and ownership categories.

One of the political reforms introduced by the current government soon after assuming power
in 1991/1992 was to devolve a significant share of administrative power to the regions. The
country is divided into nine regional states, mainly created along ethnic lines, and two special
city self- administrations. 16 A series of proclamations in the 1994 constitution lays the basis for
devolution of decision- making power to the regions. The constitution provides extensive
powers to the regions including, among others, formulating and executing economic, social,
and development policies, strategies, and plans; administering land and other natural
resources found in their territories; levying and collecting certain taxes not reserved for the
federal government; and designing standards for state civil service conditions and pay. The
main goal of devolving power from federal to regional governments was to promote
interregional equity and reverse the relative neglect of rural areas. Because the capacities of
the regions in development interventions, revenue collection, and overall administrative
experiences differ, there are also associated gaps in terms of conceptualizing, designing, and
implementing effective policy reforms. 17

Available statistics show that the current distribution of new investment projects in Ethiopia
highly favors a few selected cities, notably Addis Ababa. According to the statistical reports
of the Ethiopian Investment Authority, 40.1 percent of the total projects approved between
July 1992 and July 2000 were located in Addis Ababa, 22.8 percent in Oromia, 11.8 percent
in Southern, 7.5 percent each in Amhara and Tigray, and 10.3 percent in the remaining
regions (figure 3.1). Sources also indicate that Addis Ababa has attracted about 64 percent of
total approved projects with foreign capital and 56 percent of the total FDI during the same
period. Oromia and Southern regions accounted for 21 and 3.5 percent of the total number of
foreign projects, respectively, and for 15.8 and 2.5 percent of total foreign investment capital.

16 The nine regional administrations are Tigray, Afar, Amhara, Oromia, Somali, Benshangul, Gambella, Hareri,
and the Southern Nations, Nationalities, and Peoples Region (henceforth Southern); the two self-administering
cities are Addis Ababa and Dire Dawa.
17 The government envisages addressing these issues through its Civil Service Reform (CSR), which covers
areas of the judicial, legal, and financial management.
32
 Figure 3.1
Regional Distribution of Newly Approved Projects Between July 1992 and 2000

Other
10.3%

Southern
11.8%

Addis Ababa
40.1%

Amhara
7.5%

Oromia Tigray
22.8% 7.5%

Source: Ethiopian Investment Authority 2001.

Differences in regional investment climate are partly to blame for such regional variations in
investment distributions. The availability of better infrastructure and access to a modern
banking system and public services clearly attracts more new investments to Addis Ababa
than to other regions. According to a report by UNCTAD, for example, problems of
coordination and bureaucratic red tape continue to hamper investment in the poorer, primarily
agricultural regions outside Addis Ababa (UNCTAD 2002).

3.1. Regional Differences in Investment Climate

As noted earlier, the Ethiopian Investment Climate Survey covered 427 firms in six regions
that are thought to have the largest industrial concentration in the country, including Addis
Ababa, Oromia, Southern, Amhara, Tigray, and Eastern. Except Addis Ababa, we defined
these regions as combinations of two cities within the same administration and/or a reasonable
geographical proximity. 18

To examine regional differences in the investment climate, we computed a range of indicators

from our survey data. These indicators fall into two broad categories: subjective and
objective. The former refers to subjective assessments of business managers (owners)
regarding the rankings and the severity of business impediments. For example, in one section
of our survey instrument, respondents were asked to identify the three biggest obstacles to
doing business in Ethiopia in order of importance. In another section, they were also asked to
rate the severity of each business environment indicator. The objective indicators, however,

18
The Amhara region in our survey consists of Bahir Dar and Gonder; Tigray consists of Mekelle and Adigrat;
Eastern consists of Dire Dawa and Harer; Southern consists of Awassa and Dilla, and Oromia consists of
Nazareth (Adama) and Bishoftu towns.
33
are variables that can be independently measured, such as the time it takes to get “connected”
to power or telecommunication services, the number of interruptions in services delivery, or
the time it takes to get a plot of land.

Identifying regional variations in the rankings of these investment climate variables is

important for at least two reasons: (a) it enables policymakers to decide on policy instruments
to address these issues at the national level, and (b) it helps regional authorities know where
they stand relative to others so they can prioritize the use of policy instruments accordingly.

3.1.1. Overall Rankings of Major Business Obstacles

Survey respondents were asked to identify and rank factors that are relevant to their
businesses. We first focused on the obstacles they identified as the biggest (primary obstacle)
to see how pressing each problem was. Accordingly, firms identified issues of tax
administration/rate (19 percent), access to land (15 percent), insufficient domestic demand (13
percent), business regulations (9 percent), competition from cheap imports (8 percent), and
access to credit (6 percent) as the primary obstacles to business operations (figure 3.2). The
rankings of these obstacles are, however, different for each region implying that there are
regional differences in the urgency and priority that should be attached to each impediment.
Corruption and shortage of skilled manpower do not seem to be regarded as serious problems
when we look at the national averages (figure 3.2). However, this is not the case when each
region is considered separately. For example, corruption is reported as a primary business
obstacle by more than 7 percent of establishments in the Southern region. When we look at
the question whether a specific obstacle is among the top three impediments (rather than just
primary), the list of these major obstacles remains the same, but each appears to be identified
by a larger number of firms. Accordingly, the majority of firms identified tax
rate/administration (53 percent), access to land (29 percent), insufficient domestic demand (29
percent), access to credit (27 percent), competition from cheap imports (16 percent), and poor
infrastructure (11 percent) as among the top three impediments (figure 3.3).

Figure 3.2
Obstacles and Percentage of Firms Reporting Them as Primary
20 19

15 15
13

10 9
8
6
5
2 2

0
Tax Access Lack Business Competition Access to Inadequate Corruption
admin/ to land of regulation from credit infastructure
rates demand imports

S o u r c e : Ethiopian FACS Survey 2002. Unless otherwise noted, all charts and tables in this section based on this survey.

In the rankings of business obstacles, the survey instrument puts taxation issues (both rates
and administration) together; however, it would clearly be more informative to investigate the
two issues separately. To do that, we looked at another subjective indicator that measures the
perceived “severity” of each obstacle independently in a scale of 0 (no obstacle) to 4 (very
34
severe obstacle). In this indicator, the survey instrument lists tax rates and tax administration
Figure 3.3 Obstacles Identified as among the top three

Tax rate/adm 53
Acc to Land 29
Insuff. Demand 29
Credit (Acc & cost) 27
Cheap imports 16
Infrastructure 11
Corruption 9
Interest rate 8
High Collateral 8
skilled Labor 6
Business reg. 3

0 15 30 45 60
Percent of firms who identified each obstacle as among the top three

3.4 Average Severity of business obstacles

Tax rate 3.0

Foreign Credit 2.6

Tax Admin 2.6

Acc to Land 2.4

Electricity 2.0

Domestic Credit 1.9

Macro Instability 1.9

Econ. Uncertainity 1.9

Interest rate 1.8

Corruption 1.8

Customs Adm. 1.7

Telecom. 1.5

Law and Order 0.7

Bus. Regulation 0.5

0 1 2 3 4
Severity: 0=no prob, 1=Minor, 2=Moderate, 3=Major, 4=very severe

separately. Interestingly, on average both tax rates and tax administration are still rated as
somewhat close to “major obstacle” compared with most other obstacles listed (figure 3.4)

3.1.2. Measures of Investment Climate Indicators by Region

In this section, we map each of the major impediments identified earlier by the subjective
rankings with relevant objective measures of investment climate indicators. We see that the
results from both the subjective and objectives measures complement each other.
35
 Figure 3.5
Firms Reporting the Indicated Business Obstacles as Primary by Region*
(percent)

* Note that the graph shows business obstacles in each region ranked in a descending order.

Addis Ababa Amhara Region

30 40
31.8
20.0
30
20
14.1
12.4
10.0 20
7.1 13.6
10
4.1
1.2 10 6.8 6.8 6.8
0
Access to Competition Tax Business Lack of Access to Corruption 0
land from admin/rates regulation demand credit Tax admin/rates Access to land Inadequate Lack of demand Competition
imports infastructure from imports

Oromia Region
Eas tern Region
30 27.0
40
31.1 21.6

30 20
22.2

20 15.6 10.8 10.8

10 8.1
10 6.7 6.7
4.4 2.7

0 0
Lack of demand Tax admin/rates Business Access to land Access to credit Inadequate Tax admin/rates Lack of demand Access to land Access to credit Business Inadequate
regulation infastructure regulation infastructure

Southern Region
Tigray
20 18.6
40
29.6
30
9.3 9.3
10
7.0 20 15.9
13.6
4.7 4.7
9.1
2.3 10 6.8
4.6
0
Lack of Tax Access to credit Corruption 0
demand admin/rates Inadequate Competition Access to land Tax Access to land Business Lack of Access to Corruption
admin/rates regulation demand credit

36
Looking at differences in the type of primary obstacles identified by firms in each region, we
see that access to land, competition from imports, and tax administration/rates are at the top of
the list in Addis Ababa (figure 3.5). Similarly, tax administration/rates and access to land
were at the top in Amhara region (identified by 32 percent and 14 percent of firms,
respectively). These same two obstacles were also mentioned, respectively, as primary by 27
percent and 11 percent of business establishments in Oromia and 30 percent and 16 percent of
establishments in Tigray. In Eastern and Southern regions, on the other hand, the priorities are
different: In both regions, lack of demand tops the list followed by taxation. Generally, it is
clear that tax administration and access to land dominate the list of (single) primary obstacles
identified by firms in Ethiopia. Insufficient domestic demand, business regulations,
competition from imports, and access to credit are also reported as major problems by a good
number of firms.

Regarding competition from imports, firms were asked how important low price, durability,
better material quality, and better model/design of the imported goods are in relation to their
major products. Low price was cited by about 52 percent of the respondents, but it is
interesting to note that many firms also admitted that the imported goods possess more
durability (19.5 percent), better material quality (36.4 percent), and better model/design (28.4
percent), which make them attractive to consumers (see figure A.1 in annex A). For the Addis
Ababa subsample, the figures are some what higher: durability (25 percent), better material
quality (37 percent), and better model/design (41 percent).

Taxation and Customs Administration

The issues of taxation (taxation and customs administration) are a good proxy to the quality of
public services delivery. In our survey data, a majority of firms perceive tax rates and tax
administration to be among the major obstacles to doing business in Ethiopia. Overall, as
noted earlier, about 19 percent of firms in our sample rated tax administration/rate as the
single primary obstacle of doing business, and about 53 percent rated this same obstacle to be
among the top three impediments in their business operations. 19

Tax rate/administration issues are relatively serious for the Amhara and Tigray regions
(reported by 80 percent and 70 percent of firms, respectively, as among the top three
impediments). Also, about 53 percent of businesses in each of the Eastern and Oromia regions
reported it as among the top three business obstacles. Of those firms who reported tax
rate/administration issues as among the top three impediments, 34 percent in Amhara, 30
percent in Tigray, 28 percent in Oromia, 21 percent in Eastern, 11 percent in Addis Ababa,
and 10 percent in Southern regions mentioned the issue as the single most important (primary)
obstacle. In summary, while the quality of administration or public service delivery in the area
19
This is consistent with reports from other sources. For example , according to the Addis Ababa Trade and
Industry Bureau, more than 2,200 businesses returned their licenses during the last Ethiopian fiscal year (2001–
2002); tax burden and exorbitant rent had been cited as the major reasons by most of these businesses for doing
so. The returned licenses consist of about 7.1 percent of a total of 30,818 licensed wholesale, retail, and services
industry and agricultural development businesses in the city. In the form they fill out when they return their
licenses, businesses indicated that the other reasons forcing them to return licenses included shortage of working
capital and lack of marketing opportunities.
37
of tax rate/administration is a problem everywhere in the country, it seems to be more of a
bottleneck in the Amhara and Tigray regions. 20 In assessing the issues of tax administration,
we used information from our survey data to identify the types of taxes that relate to the major
tax administration problems as perceived by the respondents. We also looked at the level of
tax administration office about which businesses complain.

Reported tax administration problems are focused on the inconsistency and lack of clarity and
transparency in sales tax (identified by 68 percent of respondents as one of the two major tax
problems) and profit tax (identified by 39 percent) assessments. These were equally reported
in most regions and size groups. The only exception is the Southern region where the
percentage of respondents who identified municipality tax is more than that of profit tax (see
annex D). Given that presumptive tax assessments affect SMEs more than larger firms, there
is a higher level of complaints from that group regarding unfair treatment by the tax
inspectors and a significant level of a bureaucratic burden imposed on firms by tax
assessors. 21

Although the specific nature of the tax rate problems cannot be pinned down from survey
data, it is to be noted that the proportion of firms reporting tax rate/administration problems as
among the top three varies significantly across regions, and many firms identified regional tax
offices as the locus of the major tax administration problems they face.

Businesses described various administration problems related to these tax types. A significant
number of the respondents emphasized the inconsistency and lack of transparency in the
methods of tax assessment by tax assessors, particularly the tendency not to carefully look at
the business and profitability information provided by the firms themselves. Most firms feel
that the tax assessment procedures are not clear and that it is guess work. Many firms also
have expressed their perception that the 15 percent sales tax is too high given the overall low
demand for their products.

The survey data also indicate that these same two types of taxes constitute the lion’s share of
the total tax expenses of establishments in Ethiopia. This applies to the whole sample as well
as the sample for each region (see annex E).

Regarding the level of government to which the tax administration problems are related, a
significant majority (45 percent) of sampled enterprises mentioned regional level tax offices
to be associated with either or both of the two major tax administration problems they
mentioned. Another 38 percent mentioned the federal level, and close to 10 percent mentioned
local- level offices. One important piece of information that comes out of looking at the level
of government tax offices by region is that in all the regions (except Addis Ababa), the major
complaint is against the regional- level tax offices for both major tax administration problems.

20
However, one issue that may arise in connection with the complaints about tax administration is whether
responses of firms could have been influenced by differences in regions in terms of enforcement of tax
collection. For example, tax enforcement is generally believed to be strong in Amhara and Tigray regions.
21
In 2001, firms located in Addis Ababa and Amhara reported, on average, to have spent more than 14 and 17
days respectively in dealing with the tax inspectors compared with an average of 10 days elsewhere and a day or
less for other agencies.
38
There is a difference by size groups, however. Small firms tend to complain about regional
offices, whereas large firms complain about the federal level of tax administration.

As mentioned earlier, a significant number of respondents have mentioned that sales tax, at 15
percent, is high. A closer look at their taxes, however, shows that what Ethiopian businesses
actually pay, on average, is not that high. According to our survey data, the average of all tax
payments for an establishment, as a percentage of its total sales (in 2001) was just a little
more than 12 percent, and the largest regional average was 15.4 percent for Addis Ababa.
This means that improved transparency in the tax assessment procedures and increasing
efficiency in the tax collection process should be a priority in this case.

Figure 3.6
Percentage of Firms Identifying Taxation and Land Access as Main Business Obstacles
(Reported as among the top three)

100 60
Access to Land
Tax Admin/Rate 49
80
50
80
70

40
60 53 53 33 32
46
30
37 22
40 19
20
12
20
10

0 0
Amhara Tigray Eastern Oromia Addis Southern Tigray Addis Amhara Oromia Eastern Southern

Access, Availability, and Affordability of Urban Land

Land-related issues are perceived by a considerable number of firms as a major impediment

for business performance and growth in Ethiopia. State ownership of land and the associated
leasehold arrangements are reported to have discouraged private entrepreneurs from making
long-term capital investments on the land. In theory, problems related to land access include
the process of lease acquisition, the cost of the lease, the length of the lease, the number of
installments to be paid, the down payment required, and the red tape associated with getting
things done in relation to the lease arrangement.

According to our data, about 29 percent of private firms in the whole sample reported land
access to be among the top three obstacles to doing business—the highest being in Tigray (49
percent), followed by Addis Ababa (33 percent) and Amhara (32 percent) (figure 3.6). About
half of these (14 percent) rated it as the single most important (primary) obstacle. Similarly,
20 percent of firms in Addis Ababa, 14 percent of firms in Amhara region, 16 percent of firms
in Tigray, and 11 percent of firms in Oromia region indicated this same factor as the single

39
most important. In the Southern and Eastern regions, a relatively smaller percentage of firms
rated it as the biggest impediment (just 2 percent and 7 percent, respectively) (figure 3.5).
Other findings have also pointed out that the problem of access to land is a major impediment
to investment and business operations in Ethiopia. For example, the UN's Economic
Commission for Africa (ECA) argues in its African Economic Report (2002) that “the lack of
land reform is a brake on the otherwise healthy economy [in Ethiopia ].” A recent
investment policy report on Ethiopia by UNCTAD also mentions the “confusion over rural
land tenure and urban land-lease policies” as a major reason for the fact that regional
investment bureaus were largely unsuccessful in finding new investment (UNCTAD 2002).

The survey and other evidence point to four main interrelated factors that contribute to this
situation:

• Limited supply of new leasehold land. Only a limited number of plots are made
available each year (for example, Addis auctioned only 600 plots in the last year).

• Inability to pledge land-use rights as collateral. The 2002 Land Lease

Proclamation has extended period of lease, and currently it ranges from 50 to 99
years depending on the level of urban development and the sector/activity of
development. Although the law would appear to provide a longer term horizon,
banks are still unwilling to accept land- use rights as collateral. In addition to their
unwillingness to bear risks involved with liquidating collateral, this may also result
from lack of clarity as to the priority creditors would have vis-à-vis the rights of
local governments in cases where the lease has been purchased under an installment
payment plan.

Waiting Time to Get a Plot. According to the Investment Proclamation No. 280/2002, each
regional government is supposed to deliver, based on the federal law and its own laws, the
required land for an approved investment within 60 days of receiving an application for
allocation of land. Firms were asked ho w long it takes from the day of application for lease to
the time applicants actually received the plot of land. Of the 12 firms that responded, the
average was 305 days. The average for Addis Ababa alone was 538 days, for Amhara region
it was 151 days. The only firm that responded to this question in Tigray reported a waiting
time of 60 days. No response was obtained to this question from firms in Eastern, Oromia,
and Southern regions (figure 3.7).

40
 Figure 3.7. Average of Reported Number of Days from Application for Lease
538 to the Release of Plot
500
400
300
200 151
100 60
0
Addis Amhara Tigray Eastern Oromia Southern

Note: There were no responses for Eastern, Oromia, and Southern regions.

High price of land leases and rents. The limited supply results in higher prices for land. For
example, despite recent price reductions, the minimum/starting rates in Addis Ababa ranges
from ETB 1,300-4,300 per square- meter for prime sites. The survey results indicate that the
average share of rent payments by private firms as a percentage of their total sales is 16
percent, and even goes as high as 25 percent in Addis Ababa (figure 3.8). Only in the Amhara
and Eastern regions is this share relatively low (5 percent in both regions). It is also clear that
excessive rental expenses are more of a burden to the private sector than to state-owned
enterprises. The reported ratio of rent expenses to revenue of public enterprises was only 3
percent for the entire sample. 22 When more than 2,200 businesses returned their licenses last
year, most indicated high rent (together with the tax burden) as a main reason that forced them
to quit and return their licenses.

Figure 3.8
Rent as a Percentage of Annual Sales, 2001
(percent)
30
25

20
16
14

9
10
5 5
2 4
4

0
Addis Tigray Oromia Southern Amhara Eastern

Private Sector State Owned

22 The share of rent paid by public enterprises, as a percentage of total sales, is only 2 percent in Addis Ababa
and goes only as high as 4 percent in Eastern and Oromia regions.
41
Insufficient Domestic Demand

As mentioned at the outset, the Ethiopian economy is less diversified, and the income of its
populatio n—and thus their purchasing power—is less. For example, in PPP terms, per capita
national income in Ethiopia is close to half that of Kenya, and less than a fifth than in China.
Given such a low level of per capita income in the country and the extreme poverty situation
associated with it, it is not be surprising to see “insufficient domestic demand” mentioned by
businesses as one of the constraints to their growth.

According to our survey data, insufficient domestic demand has been identified as the primary
business obstacle by about 13 percent of the respondents, and as among the top three business
obstacles by almost 30 percent of responding enterprises. Indeed, this factor is related to the
structure of the economy, which is unlikely to change in the short to medium term and will
remain among the impediments until growth resumes and income of the population increases.
The survey data also show that there is a regional variation in the rankings of this specific
factor. As shown in figure 3.5, insufficient domestic demand has been emphasized as a
primary business obstacle in Eastern, Oromia, and Southern regions. Establishments in these
regions mainly produce items such as household and office furniture and garments that are
sold almost exclusively in the region. As a result, demand for their products depends on other
economic activities with in the region. For example, one of the reasons repeatedly mentioned
by respondents in the Southern region was the decline in household income due to a fall in
coffee prices, which in turn affected the demand for manufactured outputs by the households.

Access to Basic Physical Infrastructure (Telecommunications and Power)

In Ethiopia, the state of physical infrastructure facilities such as roads, power, and
telecommunications is generally poor for both historical and geographic reasons. The country
has one of the lowest road densities in the world, even by Sub-Saharan Africa standards (28
km/1000 km2 compared with the average of 50 km/1000 km2 for Sub-Saharan Africa); and
only less than 20 percent of this network is paved. This hampers economic development in
general and efficiency of businesses in particular by making interregional economic activities
very difficult. Availability and quality of other infrastructure services are also poor in
Ethiopia. We will look at power and telecommunication services here.

Eleven percent of respondents identified access to infrastructure among the top three
constraints and 2 percent as a primary impediment. We looked at two related objective
measures of the quality of infrastructure services in Ethiopia from our survey data: frequency
of interruptions in power and telecommunication services; and the waiting time it took to get
connected to these services once the application process was completed. 23

Frequency of Service Interruptions. As a proxy for the reliability of infrastructure services

provided, we looked at the frequency of interruptions in electricity and telephone services. In
general, power is one of the major bottlenecks almost everywhere. According to our survey

23 These data were collected only for firms who applied and received the connection during a two-year period
prior to the date of the interview.
42
data, the average frequency of power outages for the whole sample is 5.2 times per month (in
2001). The largest reported average for the same period is from Oromia (9.4 times per
month), followed by Amhara (7.0 times). 24 Tigray fares better at only 2.0 times per month
(figure 3.9). Similarly, phone calls were interrupted about 7.2 percent of the time for the
whole sample. The highest average for this variable was from Amhara region (at 14.2
percent), followed by Addis and Oromia (at about 8 percent) (figure 3.10). It should be noted
that the power problem persisted despite an overall decline in the frequency of power outages
in 2001 compared to the previous year (as shown in figure 3.9).

Telecommunication service seems to have a long way to go. Because of the low level of
access to these services, for example, only about 6 percent of the interviewed firms reported
to have used E- mail in their business communications relative to 70 percent of firms in China
or Bangladesh. Even the majority of these are concentrated in Addis Ababa and Oromia
(where 12 percent and 5 percent, respectively, reported to have used E- mail). In other regions,
the percentage of firms who use Internet communication services is nil or nonexistent.

Figure 3.9
Average Frequency of Power Outages per Month

15
12.6
12 10.5
9.4
8.4 8.0 8.3
9
7.0
6.4 6.0
6 5.1 5.2
4.7
3.7

3 2.0

0
Oromia Amhara Southern Addis Ababa Eastern Tigray Region Total
Region region Region Region

2000 2001

24 The major factors likely to affect the frequency of power outages include power rationing and the old age of
machinery/equipment with frequent maintenance needs.
43
 Figure 3.10
Frequency of Phone Line Interruptions
(percent of times used in 2001)
15 14.2

12
9 8.3 7.2
7.2
6
3.4 3.1 2.9
3
0
Amhara Addis Oromia Tigray Eastern Southern Total
region Ababa Region Region Region Region

Waiting Time to Get Connections. The waiting time to get connected to a particular service
can be considered an indicator of the institutional capacity/efficiency in service provision. On
average, according to our survey data, it takes 204 days and 114 days, respectively, to get
connections to telephone and power services in Ethiopia. As figure 3.11 shows, the shortest
average waiting time to get a telephone connection was 108 days for Eastern, followed by 119
days for Tigray region; the longest time reported was for Amhara ( 263 days). For power
connectio n, the shortest average reported waiting time was in Tigray (66 days), followed by
Southern region (71 days). Oromia (217 days) and Amhara (174 days) report the longest
waiting times.

Figure 3.11
Average Waiting Time to Get Connections (Days)

250 300
217 263
241
Power 250 Telephone
200 174

144 200
150 156
150 130
119
89 108
100
71 66 100

50 50

0
Oromia Amhara Eastern Addis Southern Tigray Amhara Addis Oromia Southern Tigray Eastern

The inability to meet industrial demand for complementary infrastructure services also feeds
into other business obstacles such as “some otherwise usable industrial land is unusable

44
because of the costs and delays involved in obtaining electrical and telephone connections.”25
In general, businesses in the Amhara, Addis, and Oromia regions are clearly worse off in
terms of both access to and reliability of telephone services compared with those in Eastern,
Southern, and Tigray.

Business Regulations and Trade Facilitation Services

If well conducted, inspection visits can help ensure that businesses meet the various standards
set by regulators, but when done excessively, they can consume a significant amount of
management and worker time, reduce focus on work, and may even lead to an opportunity for
bribes.

According to our data, senior management spent an average of 3 percent of its time dealing
with regulations. The largest reported percentage is from the Amhara region (6.5 percent),
followed by Addis Ababa (3.8 percent). The average number of visits to a particular firm by
state inspectors in Ethiopia was about 7 in 2001—indicators that compare relatively favorably
with China or Pakistan. The highest average of reported frequencies were in Amhara region
(11.4 visits) followed by Addis Ababa (10.1). Eastern region (at 1.2) and Tigray (at 1.8) have
the lowest average reported visits (figure 3.12). Overall, 28 percent of respondents identified
cumbersome public administrative and business regulatory requirements as among the top
three constraints and 19 percent as the primary impediment. The most severe problems
cited in the survey related to entry restrictions and constraints on operations such as customs
clearance. These and other perceived problem areas relating to business regulation are
discussed below.

Figure 3.12
Regulatory Burden on Firms: Averages by Region (2001/02)

Number % of time

11.36 Number of visits by Management’s time spent

12 7 6.52
10.06 government inspectors dealing with regulations
10 6
5
8 3.84
5.91 4
6
3
1.92 1.91 1.71
4 2
2.14 1.75 0.81
2 1.15 1

0 0
Amhara Addis Oromia Southern Tigray Eastern Amhara Addis Southern Oromia Tigray Eastern

Time and Cost of Registration. Though survey results indicated that the time and cost of
registration were a significant constraint, since the survey was conducted the Ministry of
Trade and Industry has taken steps to streamline business registration processes within the

25
World Bank (1997).
45
Ministry, the Ethiopian Investment Authority and related institutions. As a result, as a prior
action for the World Bank’s first Poverty Reduction Support Operation (PRSC-I), the cost of
registration has reduced from $425 (which was the highest in the world on a per capita GDP
basis) to $65 and the time of registration from 44 days to 8 days.

Sector-Specific Licenses and Permits. In addition to registering a business generally, the

survey indicated that firms must acquire an average of two licenses and at least one permit at
a sectoral level. The highest numbers were observed in the leather/leather products industry
(3.3 and 1.33), closely followed by textile/garments and food/beverage industries.

Delays in Customs Clearance. The information concerning the number of days to clear
customs in Ethiopia vary from 43 days (IMF 2003) to 14 days (survey results). Delays result
from the 72 steps involved in the customs clearance process.

Access to Credit

When asked whether they expect to make a substantial increase in investment to enhance
capacity or to improve product quality during the coming three years, more than 70 percent of
firms responded positively. The realization of planned investment by our respondents
therefore partly depends on the ability of the financial system to provide them with affordable
and efficient credit services. The business community in Ethiopia has consistently cited lack
of access to credit as one of the major impediments in various forums. Data from our survey
confirm this, though it is not as significant as the other listed obstacles (figure 3.13).

Figure 3.13 shows that credit access constraint is reported by a good number of firms as
among the three biggest obstacles to doing business in the country. About 28 percent cited
inadequate access to credit (or high collateral) as one of the three main problems. Twenty-
one percent of the firms reported the high cost of financing (interest and transaction costs of
loans) as a very severe obstacle and 16.2 percent of them reported it as a major obstacle to the
operation and growth of their businesses (see figure A.2 in annex A).

However, it should be noted that a majority of these firms did not have long business
relationships with their primary bank; in about 58 percent of the cases, their business
relationship did not exceed two years (in fact, it is far less for most of them). Considering that
the amount of information lenders have about their borrowers and the established lender-
borrower relationship are crucial in lending decisions, it is not surprising that these firms have
constrained access to credit. Access to credit is generally expected to vary across firms of
different size. From the data, we see that of the firms that reported inadequate credit access
among their three major problems, 32 percent are small, and about 51 percent are medium-
sized.

46
 Figure 3.13. Access to Credit and Collateral Requirements

50 Average of reported collateral requirements

Access to credit among the top three obstacles
(percent who reported it so) (as percent of loan value)
250
37
203.6
31 200
30
28 163.6 157.4
26
150 135.5
25 125.8 123.1 121.9
18
16
100

50

0 0

Oromia Addis Amhara Southern Eastern Tigray Total Eastern Amhara Southern Oromia Addis Tigray Total
Region Ababa region Region Region Region Region region Region Region Ababa Region

Previous studies had found a higher percentage of sample firms citing constrained access to
credit as one of the biggest obstacles. For example, in the 1995 Addis Ababa Industrial
Enterprises Survey, firms were asked to indicate their three biggest problems. Lack of credit
was reported to be among these problems by more than 38 percent. Moreover, 39.1 percent
ranked lack of credit as a severe obstacle to expansion of their firms and 18.6 percent ranked
it as a moderate obstacle. Because the 1995 survey only covered firms in Addis, we looked at
the Addis Ababa sub-sample of the current FACS survey for comparability. The data show
that 22.3 percent of the firms consider credit access constraint as one of their three biggest
problems.

However, taking firms’ complaints about access to credit at face value may be misleading: It
is useful to distinguish between those not getting credit services for prudential reasons on the
part of the lender from the rest. In the survey, firms were asked whether their application for a
term loan has been rejected and why. In 9 out of the 22 firms (41 percent) that reported
rejection, the reason for rejection was either incompleteness of their loan application or lack
of feasibility of their project as perceived by the lender.

Looking at the financing mechanism for the most recent purchase of machinery or equipment,
we also see that the majority of firms used either retained earnings (43 percent) or injections
from the owner or mother company (46 percent). Firms also reported using bank overdrafts (5
percent) and term loans (21 percent) (figure 3.14). Similarly, during 2001, an average of 64
percent of financing for working capital was reported to have come from internal funds or
retained earnings, and only 24 percent from banks. An average of 51 percent of financing for
new investments came from internal funds, compared with 16 percent from banks.

47
 Figure 3.14
Percent of Firms Who Used Bank Loans to Finance Equipment Purchases, 2001

29.5
30
23.7
20.9 20.5
19.4 19.4
20
13.6

10

0
Tigray Oromia Southern Amhara Addis Eastern Total
Region Region region Ababa Region

The survey points to three main factors that lie behind the lack of access to credit: collateral
requirements; limited outreach of banks, and low levels of medium-term lending. Other
issues include cumbersome credit procedures of banks and perceived corruption in credit
allocation.

Collateral Requirements. Lack of access is associated with collateral in several ways: 50

percent of firms rejected for credit cited lack of required collateral as the primary reason; 89
percent of firms with loans reported that collateral had been provided to secure a loan; and as
figure 3.13 shows, the collateral requirement to get loans is very high, averaging about 136
percent of the loan value (the median being 120 percent) but reaching over 200 percent in the
Eastern region.

Though the law allows it, banks do not tend to accept land as collateral. Asked whether they
could use the land or buildings on it as collateral for bank loans, 80 percent of the firms
responded positively. However, firms were also specifically asked to indicate, from a given
list of different types of collateral items (including land and buildings separately), how
frequently banks accepted each type of asset as collateral. About 85 percent of firms indicated
that buildings are always accepted as collateral, and 77 percent reported that land is never
accepted (table 3.1).

Table 3.1 Acceptability of Various Assets as Collateral

Collateral type Never accepted ( percent) Always accepted ( percent)
Land 76.7 13.1
Buildings 0.8 84.7
Machinery & equip (new) 54.5 20.9
Machinery & equip (old) 66.5 12.2
Firm equity 69.4 5.6
Trade credit/accounts receivable 90 1.6

The Ethiopian banking system relies heavily on collateral-based lending and is largely devoid
of cash flow–based lending and risk-based pricing of loans. The result is paradoxical: excess
liquidity in the banking system, while firms continue to report an unmet demand for credit.

48
The presence of high leve ls of non-performing loans points strongly toward the conclusion
that the availability of collateral does not by itself assure banks of repayment when there are
systemic shocks, and underlines the need for upgrading risk assessment capacity and
improving availability and quality of information from borrowers.

Term Finance. Our survey data also show that only about 45 percent of firms in the sample
reported currently having a term loan from a bank. This figure by itself may not necessarily be
an indication of credit constraint, unless we look further at the characteristics of those who do
not have such loans, especially those who applied but were denied the loans. About 48 percent
of the firms reported that they had never applied for a term loan. When asked why they had
never applied for a term loan, they gave reasons that fall into three categories: (a) no need for
term loan, (b) not willing to borrow at the going interest rate, and (c) were discouraged by
cumbersome bank procedures, perceived corruption in banks, or lack of appropriate collateral.
Surprisingly, a large proportion of responses (about 62 percent) fell in the first category of not
needing term loans. However, the proportion of discouraged potential borrowers (26 percent)
was also on the high side. It appears that factors mainly under the control of banks are making
many potential borrowers shy away from borrowing. That corruption in the allocation of bank
credit has been mentioned by 16 percent of the firms who did not apply for term loans
indicates the extent of the image problems banks have.

3.2. Sectoral Variations in Some Business Constraints

To see whether the overall business obstacles vary across industries, we classified the sample
firms into five sectors: food and beverages, textile and garments, leather and leather products,
wood and metal, and others. The sample is dominated by wood and metal works, which
constitute nearly 49 percent (figure 3.15).

Figure 3.15
Sectoral Distribution of Firms in the Survey
(percent)

Other 7.8

Wood & metal 48.7

Leather 5.7

Textiles and garments 12.1

Food and beverage 25.7

0 10 20 30 40 50 60

49
Considering the government’s desire to promote exports, it seems appropriate to look at the
extent of participation of firms in the export market by sector. From the data, we see that the
participation of almost all the industries in the export market is very low except for the leather
industry. As figure 3.16 shows, 46 percent of leather firms directly exported part of their
output compared with only 4 percent of textiles and garments firms and about 10 percent of
food and beverage firms. 26 The participation of wood and metal works in the export market is
almost negligible. The figures are much smaller when we look at the share of exports in total
sales. For the leather industry, 34 percent of total sales was exported in 2000–2001 (compared
with about 27 percent during the previous two years) (see figure B.1 in annex B). For the
textiles and garments sector, the share of exports in sales is negligible (less than 0.5 percent)
despite the pressure on this sector to look for external markets due to deterioration in its
domestic market in the recent past.

Figure 3.16
Percent of Exporting Firms by Sector

Other 6.1

Wood & metal 1.5

Leather 45.8

Textiles and garments 3.9

Food and beverage 9.5

0 10 20 30 40 50

Firms that are not exporting were asked to indicate their three most important impediments to
doing so. The main obstacles identified by the majority of the firms are beyond the control of
domestic policymakers (see table 3.2). About 41 percent reported inability to meet the
standards and specifications of potential clients as among the top three factors explaining the
failure to export, whereas 35 percent cited foreign price competition. Of those in the leather
industry who are not exporting, about 85 percent blame foreign price competition as the main
factor for the failure to export, and for those in the textile industry the most frequently
mentioned obstacles are price competition abroad (38.8 percent) and inability to produce to
clients’ standards and specifications (32.7 percent).

26
Firms were asked whether they had directly exported last year, which, at the time of the survey, was year 2000.
50
 Table 3.2 Percent of Nonexporters Identifying the Indicated Problem in the Top Three
Obstacles to Export
Textiles Wood
Food and and and
beverage garments Leather metal Other Total
Shipping and transport cost 17.9 12.2 38.5 13.8 12.9 15.4
Cost of meeting foreign legal and prod.
standards 24.2 32.7 23.1 30.1 35.5 29.2
Inability to produce to the potential clients
standards & specifications 35.8 38.8 30.8 44.4 41.9 40.9
Cannot match prices of foreign competitors 34.7 38.8 84.6 27.6 54.8 34.9
Foreign clients demand upgrades & changes
too frequently 6.3 14.3 0.0 9.7 16.1 9.6
Supplying the domestic market is more
profitable 92.6 20.4 23.1 22.5 45.2 28.4
High costs of establishing foreign distribution
network 14.7 18.4 53.9 20.9 19.4 20.1
Lack of capital (finance) 17.9 18.4 30.8 17.9 6.5 17.5
Lack of information (lack of export promotion
& support services) 10.5 10.2 30.8 10.2 3.2 10.4
Lack of technological capability 10.5 2.0 0.0 4.6 6.5 5.7

It also seems useful to see whether there exists sectoral variation in the perceived business
obstacles and access to basic infrastructure. To see if the regulatory requirements vary by type
of industry, we looked at the number of licenses and permits required to enter each sector.
Surprisingly, entry into the leather industry requires more than twice the average number of
licenses required in other industries. 27 The average number of permits required is the smallest
for textiles and garments (0.7), and it is almost double that for the leather industry (1.33) (see
figure B.2, annex B). In terms of these indicators, therefore, the leather and leather product
industries, which are believed to have export potential and expected to be treated favorably,
are not better off (and may even be worse off). 28

Looking at the general constraints to doing business by sector, access to land is included in
the three biggest obstacles by the largest proportion of firms in the leather industry (37.5
percent) compared with any other obstacle, whereas the major obstacle for the majority of
firms in textile and garments appears to be competition from imports, followed by inadequate
demand for their products (see annex C). Firms in textiles and garments have particular
complaints about relatively lower prices of imported goods competing with their products.

27
The figures are 3.33 for the leather industry, compared with 1. 76, 1.58, 1.25 and 1.43, respectively, for food
and beverages, textiles and garments, wood and metal, and others (see figure C.2 in annex C).
28
The leather and textiles industries are considered to hold so much promise that the government intends to
support these sectors by, among others, establishing training institutes to realize the potential.
51
3.3. Investment Climate Indicators by Ownership

One important issue that was suggested is to investigate if differences exist in the obstacles of
doing business experienced by state-owned enterprises (SOEs) as opposed to the private
sector. We compared the results from a subsample of the private firms that are large and
comparable in size with SOEs. Interestingly, SOEs also mention the same sets of obstacles
that they face as those in the private sector, but the rankings mostly differ. For example, the
primary obstacle identified by the majority of SOEs is competition from imports, followed by
access to land, insufficient domestic demand and tax issues. However, as pointed out earlier,
the majority of large private firms indicated business regulations, tax issues, and competition
from imports as the main primary obstacles, followed by the same two indicators as SOEs
(access to land and lack of demand) in the same order (figure 3.17).

Ranking the perceived severity of the business obstacles also reveals some interesting
observations: While the SOEs identified tax rate, on average, as the most severe obstacle (just
as in the privately owned firms), they rated tax administration as less severe than the rating by
private firms. For private firms, tax administration is the second in terms of severity (2.3 in a
scale of 0 to 4) after tax rate, whereas for SOEs, it is the fifth, with its average severity at 2.1.

52
 Figure 3. 17
Primary Obstacles (Large Private vs SOEs)
30 26
% who identified

20
15
13 13
11 12 12
9 9 9 9 9
10 6
3 4
2

0
Business Tax Competition Access to Lack of Inadequate Access to Skill shortage
regulation admin/rates from imports land demand infastructure credit

Private SOEs

Figure 3.18
Average Intensity of business obstacles
(Large, Private)

3 2.8
2.3 2.1 2.0 2.0 2.0
2 1.8
1.5 1.5 1.4 1.3 1.2
1

0
Tax Admin
Tax rate

Acc to
Electricity

Corruption
Foreign

Skilled

regulation
Interest

Domestic
Telecom.

Credit

Land
labor
Customs

credit
Adm.

Labor
rate

Figure 3.19
Average Intensity of business obstacles
(State Owned)

3 2.6
2.3 2.3 2.2 2.1 2.0
2 1.6 1.6 1.6

1
0.9 0.8 0.6

0
Customs
Skilled

Telecom.
Domestic

Foreign

Corruption
regulation
Interest

Electricity
Tax rate

Admin

Acc to
Credit

labor

Land
Tax
credit

Adm.
rate

Labor

53
A look at some of the objective indicators shows us that there are some differences in some of
these measures between the SOEs and comparable sized private firms; and when such
differences exist, it is the SOEs that seem to be advantaged. For example, on average, it takes
less number of days for an SOE to get connected to both power and telecom services
compared with the average of comparable sized private firms (figure 3.20). However, the
number of days that inspectors visit the firm and the percentage of management’s time spent
in dealing with regulation issues do not vary much between the two ownership categories
(figure 3.21).

Figure 3.21
Figure 3.20 12 Inspection days and % of management time
Average time to get connected (days)
400
9
308
8
6

200
4 3 3
79 85
33
0 0
Telephone Power Inspection (days) Mgt. time cost (%)
Large Private SOE
Large Private SOEs

Similarly, as shown in figures 3.22 and 3.23, the average time it takes to clear customs (both
for exports and imports) is lower for SOEs. It takes, for example, an average of 11 days for
SOEs to clear customs for their imports compared with an average of 17 days for private
firms. SOEs also reported an average of 20 days as the longest time it took them to clear
import customs compared with an average of 26 days reported by private firms.

Figure 3.23
Figure 3.22 Longest reported time to clear customs
Average time to clear customs 30 26 (Days)
17 (Days)
20 20
20
15 11
10 6 9 7
3 10
5
0 0
Imports Exports Imports Exports
Large Private SOEs
Large Private SOEs

54
 4. Policy Assessment and Recommendations
4.1. Labor Productivity

As discussed in section 2.2, Ethiopian workers are about 80 percent less productive than
workers in Bangladesh and more than 1.5 times less productive than those in China.
Furthermore, the competitiveness gap that exists between Ethiopian industries and those in
more successful economies in the developing world appears to be widening.

It is clear that the issue of low labor productivity must be addressed if Ethiopia is going to be
able to compete in the international marketplace. Investments in education, at the primary,
secondary and post-secondary level are crucial in this regard. Investments in vocation
training, skill development, and on-the-job training are also very important. The Ethiopian
government has recognized these issues and is currently undertaking major new initiatives in
the area of education. A recent World Bank report (World Bank, 2003) summarizes the
situation:

At the system level, six (soon to be eight) public universities now stand in place of the
previous two-university “system.” Over the past five years, total enrollments have more
than doubled from 39,576 in 1996/97 to 91,719 in 2000/2001. Private provision has been
initiated and encouraged; some 37 private tertiary institutions now enroll 21 percent of
all tertiary students. Government introduced student cost-sharing in September 2003
through a deferred payment taxation mechanism for all future graduates. It has also
created three system-wide supervisory bodies with respective responsibilities for further
policy development, quality assurance, and improved pedagogy. All of this —and
more—has been ratified in a new Higher Education Proclamation approved by
Parliament in June 2003. The legislation paves the way for implementation of new
reforms and development of innovative procedural mechanisms to realize the vision
framed by the Proclamation.

At the institution level, substantial autonomy has been awarded to universities by the new
Proclamation. Future recurrent funding will be provided in the form of block grants defined
on the basis of a funding formula. University Boards and staff will choose their own
institutional leaders, and non-academic staff have been de-linked from the civil service.
Strategic planning, income diversification, and ICT development are being encouraged to
meet the fiscal, space and instructional needs required to meet the on-going and planned
expansion in enrollment.

At the level of academic programs, new degree courses are being introduced in response to
anticipated labor market needs that underpin the nation’s economic development strategy and
to prepare its citizens for democratic participation in civic and social affairs. Graduate
program enrollments are expanding rapidly in the effort to increase the supply of academic
staff for the expanding system. All existing diploma programs (16 percent of public
enrollments in 2001) are being transferred to technical colleges over the coming two years so
that universities may concentrate on degree training. A major review (involving stakeholders)
and upgrading of university curricula has just been completed, adding courses in civics,
ethics, communication skills, and entrepreneurship, among others. A new oversight agency
55
will monitor both the quality and the relevance of academic programs. To shore up quality in
the classroom, a series of national and local pedagogical resource centers are being set up to
encourage instructional innovation and to assist less experienced lecturers. Incorporation of
ICT into instruction and as a vehicle for accessing the global network of information will add
greater efficiency and depth to the learning process.

A comparison of the vision outlined by the new Proclamation to the conditions that
characterized Ethiopian higher education in 2000 illustrates the enormity of the reforms now
underway. Previously, less than one percent of each age cohort reached the level of higher
education. Government routinely appointed university presidents and vice-presidents. All
non-academic staff were civil servants managed by the national civil service commission
rather than by university executives. Line item budgets prevailed and institutional allocations
were increased incrementally from one year to the next with little or no relation to enrollments
or educational quality. Additional income generated by institutions was deducted from their
government subventions, thereby creating a strong disincentive for income diversification.
Quality assurance was a much less explicit concern. Students paid no tuition fees, and also
received free food and lodging as part of their university admission.

These and other examples illustrate the breadth and ambition of the government’s current
higher education reform efforts. They also suggest that the system’s current need is not for
further reform, but rather: (i) to design effective implementation strategies and action plans
for operationalizing the reforms; (ii) to strengthen national capacities to carry out those
strategies; and (iii) to ensure that the reforms are fiscally sustainable within the overall sector
budget and within the financial resources available to higher education.
Three fundamental components are: first, shaping a coherent policy framework to institute
proactive, meaningful reforms to take advantage of the opportunities presented by the
knowledge economy and the ICT revolution; second, providing an enabling regulatory
environment aimed at fostering innovation, stimulating the private provision of education,
instituting quality assurance mechanisms, financial accountability for public institutions, and
intellectual property rights; and third, offering appropriate financial incentives to steer
institutions towards quality, efficiency, and equity goals.

The Government of Ethiopia recognizes that the need for human capacity development at all
levels is one of their most important development objectives. The newly created Ministry of
Capacity Building has committed USD 100 million over the coming five years to
strengthening the skills of civil servants, semi- skilled workers, and private sector entities
through skill development partnerships. Expansion and improvement of university level
training is seen as a critical component of this overall capacity transformation in the country.
The Ministry of Education is mid-way through its second Education Sector Development
Program (ESDP II-2002-2005), which places principal emphasis on expansion of basic
education (46% of the sector budget) followed by development of the university system (23%
of the budget).

56
4.2. Tax Rate And Tax Administration

Simple economic theory tells us that a higher marginal tax rate on a certain productive activity
and capital accumulation results in fewer such activities. As taxes constitute a significant
proportion of total cost to firms, tax rates and their administration play an important role in
the incentive structure and performance of firms. Efficient tax administration is needed to
attract and retain physical, financial, and human capital. The survey results indicated that tax
rates and administration were perceived as the most critical issues.

By 2000/01, average tax rate on total manufacturing had declined from 18.9 percent in
1997/98 to 12.4 percent. This represents a combined effect: There was a large reduction in
food and beverage taxation but many other sectors remained at high levels or increased
marginally (DTIS 2003). Consequently, the private sector was concerned that the tax burden
would make them less competitive in relation to foreign suppliers and vis-à-vis contraband
and smuggled goods.

The government initiated a significant tax reform program in 2002, which coincided with the
timing of our survey effort. The tax reform had two main objectives: to broaden the tax base
and to improve the efficiency of tax administration. The program was implemented through
legislative changes (new legislation for VAT and income tax), institutional changes (including
the introduction of a Taxpayer Identification Number); organizational changes (the
establishment of the Ministry of Revenue and organizational changes at the federal level
including the establishment of a large taxpayer office) and strengthening of personnel (new
hires and substantial training). It is noteworthy that the process of introducing VAT included
considerable participation by and consultation with the private sector. The key elements of the
2002/03 tax reform included:

• A 15 percent value added tax (VAT) introduced in place of sales and turnover taxes
on enterprises generating an annual income of more than ETB 500,000, and a lower
value tax was introduced for enterprises whose annual income is below that threshold.
• Excise tax was maintained with the maximum rate of 50 percent.
• The income tax rate was set at 30 percent for companies and registered partnerships
and 35 percent for all other businesses and individual taxpayers.
• Profit tax was reduced to 35 percent.
• Foreign investors were granted full exemption from customs duties and import tariffs
on all capital equipment (machinery and equipment) and up to 15 percent on spare
parts.
• Income tax holidays are given varying from one to five years (depending on the sector
and region within Ethiopia), taxes deductible from R&D expenditures and remittance
of capital are tax exempt.
• There are no special tax privileges provided for exporters, although all export taxes
and subsidies have been eliminated, except for a 6.5 percent tax on the value of
exports of coffee introduced in 2002.

57
It is too early to evalua te whether the 2002/03 tax reform has addressed the earlier problems.
While the legislative and organizational changes have been in place for some time, program
implementation has been slower due to the need to recruit new staff and implement new
procedures (for example, presumptive tax assessment procedures are being standardized, and
the periodicity of assessment is being increased from annual to every three years). Similarly,
implementation is more advanced at the federal level, and a considerable amount of
implementation has still to occur at the regional level and below.

Recommendation. Given that the reforms are well under way but not yet completed, there are
no additional policy recommendations to be made at this time. Implementation remains key,
particularly at the regional level and below. It is also important that the government closely
monitor the evolving situation; to do so, it should, in consultation with the private sector,
develop quantitative and qualitative indicators of improvements not only in tax collection but
in service delivery to the private sector.

4.3. Access, Availability, and Affordability of Urban Land

In Ethiopia, land is exclusively owned by the government, and land administration is in the
hands of the regions. New investors or those who want to expand operations can get plots
only on a lease-hold basis, with a right of use for periods ranging from 50 to 99 years
depending on the purpose of use and location. Each regional state has also its own land- use
regulations that fix the rental value and lease period of the land. Private investors claim that
land-lease prices are very high. According to the survey, about 29 percent of private firms in
the whole sample reported land access to be among the top three obstacles to doing business

In May 2002, a Proclamation for the Reenactment of Holding Urban Land by Lease
(272/20022003) was enacted that specified the land lease system and provided
implementation rules. There are still some outstanding issues (for example, the process of
converting existing land permit tenures to land leases and the cost to the existing permit
holders). Further, given that land is a regional responsibility, follow-up actions are being
taken by regions through passage of regional legislation and regulations. Among the most
important constraints to implementation are:

• Institutional weaknesses at the federal, regional, and city levels, as well as the
absence of a compatible and user friendly cadastral system, that hamper effective
administration of land use in areas such as registration, conveyancing, as well as land
preparation and development.

• Shortage of the indigenous supply of strategic skills in all aspects of urban land
management—from legal expertise to the maintenance of land information systems—
that limits ability of either the public or private sectors in Ethiopia to respond to
growing managerial and technical demands of developing urban land markets within
the framework of public ownership.

In recognition of these two constraints, the Ministry for Federal Affairs has designed a
multiphased program of legal reform and capacity building at the federal, regional, and city
58
levels to further implementation of its policy on Urban Land Management and Development
(ULMAD).

ULMAD focuses on consolidating the legal and regulatory framework, improving

institutional implementation capacity, and strengthening indigenous supply of skills (see box
4.1).
Box 4.1 Core Elements of the Government’s Strategy for ULMAD

The Government’s strategy for Urban Land Management and Development (ULMAD) comprises three key
elements):

1. Consolidating the legal and regulatory framework.

Under ULMAD, the government seeks to consolidate the legal framework necessary to satisfactorily implement
the 2002 land lease law, including the enactment of supplementary by-laws and regulations at the city level.
Prototype regulation for regions is also envisaged based on a model framework developed in Addis Ababa (for
example, regulation for incentive to lease holding investment, directives to supply land on a temporary basis,
regulations for implementation of compensation policy). Equally important are legal provisions for expropriation
and compensation.

2. Improving institutional implementation capacity.

In close parallel to the development of legal framework, the Ministry of Federal Affairs intends to further clarify
the roles and responsibilities of various levels of government in the implementation of ULMAD legislation. Once
functional assignments for various aspects of land administration have been clarified, a comprehensive program of
institutional capacity building is envisaged at the federal, regional, and city levels. The full range of capacity
building activities for government institutions (that is, relevant bureaus, agencies or authorities, as well as
departments within cities) involved in ULMAD would necessarily involve functional reviews, business process
reviews, and restructuring and performance improvement initiatives. Organizational performance also depends on
the development of robust working systems for land survey and cadastral records, and specifically, installation of
IT-based solutions within an overarching framework to ensure system compatibility and relevance.

3. Strengthening indigenous supply of skills.

A significant constraint on ULMAD is the lack of depth in the skills base in Ethiopia’s public and private sectors.
A key priority over the short- to medium-term is to undertake the demand- and supply-side measures necessary to
develop a critical mass of indigenous exp ertise to support ULMAD-activities related to policy formulation and
implementation. Source: ULMAD Program Support Document

Recommendations. ULMAD provides a sufficient framework to advance the agenda on urban

land development and management. Implementation of this agenda should be considered a
high priority; in this regard, there is already ongoing work but further technical assistance
might be required. It would be important to develop indicators for tracking progress in
addressing the key constraints (that is, the high cost of land lease, the shortage of new land
being developed, and the use of land lease as collateral).

59
4.4. Access to Basic Physical Infrastructure (Telecommunications and
Power)

As reported earlier, a significant number of survey respondents indicated that infrastructure

was a major obstacle to growth at the firm level. The considerable lack of access to and
quality of services results from the telecom and power sectors having a monopolistic
structure; restrictive legal environment prohibiting involvement of the private sector, coupled
with insufficient public resources for infrastructure development; and weak institutional and
human capacity for implementation (including in the new regulators).
29
Telecommunication Sector

The number of telephone mainlines in Ethiopia was 3.6 per 1,000 people in the year 2000
compared to an average of 14.2 for Sub-Saharan Africa during the same period (World Bank
2002a). All telecom services in Ethiopia are currently provided by a single government entity
with monopoly power—the Ethiopian Telecommunications Corporation (ETC). 30 The growth
in demand for telecom services in Ethiopia outstrips the growth of service expansion. For
example, the number of subscribers grew by 3.9 percent between 1991 and 1995, but demand
during the same period grew at 13.6 percent (Furzey 2000); and hundreds of thousands of
people are still on the waiting list for telephone mainline services (World Bank 2002c). The
average waiting time to obtain a fixed line varies depending on the type of customer (that is,
business and residential)and can take as long as 8 years. Use of mobile phones in Ethiopia is
very limited with the existing equipment having reached its maximum capacity of 60,000
subscribers, although there is an upgrade under way. In 2003, Internet accounts were
estimated at 10,000 (94 percent are located in Addis) and international link congestion was
quite severe for daytime connections. Costs are relatively affordable, but service quality and
availability are low.

The government is strongly interested in facilitating rural development, good governance and
service delivery in priority sectors, such as education and health, through measures to
“develop and exploit ICT [information and communications technology] as an accelerator for
the attainment of national development objectives and global competitiveness.” The Council
of Ministers has recently endorsed an ICT policy paper and a proclamation establishing the
Ethiopian ICT Development Authority (EICTDA). The government has also embarked on a
National ICT Capacity Building Program covering a wide range of areas and institutions.

Achievement of the ICT objectives will require an underlying telecom network that provides
efficient, affordable, and reliable data and voice connectivity. The government has taken some

29
The recommendations are based on the findings of the World Bank technical assistance missions of August
2002 and May 2003.
30
The telecom sector was restructured in 1996 when two independent entities were created: the Ethiopian
Telecommunications Agency (ETA) with a regulatory power to create a conducive atmosphere for private
investment in the telecom sector and to set standards for services; and the ETC to engage in development of
telecom networks. The ETC has eight regional, six zonal, and a number of area offices. The government
currently has put 30 percent of the ETC up for sale to foreign investors , which, when implemented, is expected
to expand and improve the efficiency of telecom services in the country.
60
actions including permitting the resale of retail telecommunication services and liberalizing
the customer premise equipment market. ETC has reduced international tariffs by 40 percent,
reduced Internet access charges, and increased the availability of dedicated data network
services. A new 1,100-site VSAT-based network (to connect woreda offices and secondary
schools) is being deployed.

Recommendations. The government has begun the process of introducing private sector
participation in the sector. Continuation of the process towards partial liberalization of the
telecom sector—that is, where the private sector competes in the provision of services and the
ETC focuses on becoming a wholesaler of transmission backbone capacity and international
access—appears to be the direction toward which the government is moving. Investment
requirements are likely to be significant, and some indicative figures can provide an estimate
of the financing requirements. For example, achieving a target tele-density of even three
phones per 100 persons would imply a capacity increase of approximately 1.8 million lines
and translate into a capital investment in the range of $800 million to $1.2 billion. This
amount is significant at about 17 percent of GDP and is a multiple of the recent levels of FDI
in Ethiopia.

Ensuring a successful liberalization program and private sector supply response requires that
the government undertake a number of critical steps to implement the partial liberalization
approach:

• Establish a pro-competitive and technology- neutral telecommunications policy, with

quantifiable goals and objectives and a clear liberalization timetable.
• Enact telecommunications legislation that embodies the new policy, enables
competition, and allows for the establishment of an appropriate regulatory framework
in key areas such as tariffs, interconnection, spectrum management, and licensing.
• Separate the policy, regulatory, and operational roles of the government to establish a
level playing field.
• Build up regulatory capacity within ETA to regulate and manage the sector, with the
appropriate legislative changes to ensure that it is an autonomous agency with
adequate capacity to establish and enforce a predictable and consistent regulatory
framework, including licensing.
• Develop a pro-competitive interconnection and tariff regime and establish the
principles for spectrum management, pricing, and numbering.
• Restructure ETC’s financial and operational aspects to prepare it for its new market
role as a commercially oriented wholesale provider of backbone infrastructure. Build
ETC’s capacity to enhance its ability to compete in a more competitive environment.
• Introduce competition in fixed services and facilities-based operators.

Power Sector

Despite its huge power-generating potential, Ethiopia’s generated power is currently below
the demand—and, as a result, only 600,000 people have access to electricity, representing
about 6 percent of the population, which is one of the lowest levels of electricity access in the
61
world. In 1995, electricity consumption in KWH per capita was only 22, compared with 144
in Kenya and 480 in Morocco. The Ethiopian Electric Power Corporation (EEPCO), a
government monopoly, is responsible for the generation, transmission, and distribution of
hydroelectric power in the country (although the private sector is allowed to participate in the
generation of non-hydropower below 25 MW). EEPCO currently generates about 1.2 billion
KWH/year, which is much less than 1 percent of the country’s potential. Major cities are
connected to a national grid called the ICS (Interconnected System) through which electric
power is centrally distributed to various regions in the country. Five hydroelectric plants
provide almost all of the ICS capability, and a sixth plant is expected to be operational very
soon. The problems related to power appear to be coverage and reliability of supply.
Generation is temporarily a problem—with a system predominantly hydro-based there were
shortages during the recent drought. Because of overloads in main load centers such as Addis
Ababa (accounting for over 50 percent of demand), new consumers cannot be connected.
The government aims to expand access from 13 to 20 percent by 2012. 31 The Government
strategy for the power sector comprises: (a) development of the country’s substantial
hydroresources through both public and private sector investment; (b) liberalization of
generation, transmission, distribution, and supply in isolated areas to improve operating
efficiency and the quality of service to consumers and to unlock resources for investment in
systems expansion; and (c) strengthening system regulation to improve the sector’s
commercial and operational efficiency.

To achieve these goals, GOE has embarked on:

• An intensive hydropower development program

• A program to rehabilitate and reinforce the networks in the main demand centers,
especially Addis Ababa, which accounts for over 50 percent of total demand and has
unserved demand
• Increasing capacity from 400 MW to over 600 MW with the commissioning of
Gilgel Gibe and the standby diesel plant.
• Interconnection with Sudan, planned to commence in 2004 and be completed in
2007, and ongoing network rehabilitation
• Inviting proposals from prospective private developers for the development of
several hydropower plants
• Conducting a long-term power sector strategy study
• Obtaining technical assistance from the Government of Austria to design
management support through a twinning arrangement
• Establishing a rural energy fund to facilitate private involvement in independent
generation, distribution, and supply
• Establishing regulatory capacity under a separate Ethiopian Electricity Authority

Recommendations. Despite these positive developments, there are still some critical areas for
further policy reform. Specifically, these are:

31
This refers to the percentage of the population both connected or in close proximity to the grid. Currently only
about 6 percent of the population is connected to grid supply (either the interconnected grid or isolated grids).
62
 • Improving sector structure for competitive market segments. This will involve
separating the three core business areas of generation, transmission, and distribution
(which are currently within one entity, EEPCO) and enacting legislation to allow
competitive operation of the power market, with multiple distributors and generators.
It would also include removing the limitation of supply and distribution from isolated
systems and also allowing distribution to and from the national grids in both rural and
urban areas.

• Improving access. To encourage private sponsors to go to rural areas, where the

business would otherwise not be commercially viable, the government may need to
provide output-based subsidies. Government is currently unwilling to allow for direct
transfer of the subsidies to private sponsors of projects, and this has contributed to
slow progress in access expansion. Further discussion is required in this area; the
direct transfer to private sector operators is being misconstrued as a subsidy to those
operators. In reality, it is a subsidy for poor households who are unable to pay fully
for service provision. However, rather than transferring the subsidies to households
who would in turn pay the private sector operators at full cost recovery prices, the
transfer is being made to the private sector to reduce the transaction costs.

4.5. Business Regulations and Trade Facilitation Services

Part of the cost of enforcement of business regulation and tax laws in much of the developing
world is the corruption and bureaucratic harassment that is normally associated with it.
Although it is clear from the survey that the cost is substantial in Ethiopia for these indicators,
it is also evident from the international comparison done in this report that the country is not
doing that badly on this score relative to its comparators.

At the same time, Ethiopia seems to have a long way to go in improving the quality of service
delivery and public administration to standards attained in these same countries. One indicator
of this is the time it takes a shipment of imported inputs to clear customs, which can also be
interpreted as an indicator of efficiency in tax administration, on the one hand, and of
government control over access to foreign technology and foreign markets, on the other. More
directly, the duration of import clearance increases with cost of inventories of imported inputs
that the typical business has to incur to bridge anticipated delays in delivery. The survey
showed that Ethiopian figure is twice that for China, against whose exports manufacturing in
Ethiopia is competing in the domestic market.

Entry Regulations

As mentioned earlier, the Government has reduced the cost of business registration in the
Ministry of Trade and Industry and the Ethiopian Investment Authority (EIA) from $425
(which was the highest in the world on a per capita GDP basis) to $65 and the time of
registration from 44 days to 8 days. This action should significantly reduce the constraining
effect of business registration requirements.

63
The Investment Proclamation still maintains an extensive (negative) list of 20 industries and
activities reserved for domestic investors only. The “Negative List” includes: banking and
insurance businesses, air transport service, rail transport, road and water transport, forwarding
service and shipping, retail trade and brokerage, traditional exports (such as raw coffee,
pulses, hides and skins), tanning of hides and skins, hotels and tour operations, taxi-cab
transport, bakery products for the domestic market, and barbershops and beauty salons.

The minimum capital requirements for FDI stand at US$100,000, but if foreign investors
export 75 percent of their output or reinvest all of their profits, they are not required to meet
the minimum capital.

Recommendations:

• Amendment of the Investment Code in 2002 to simplify and mainstream many of the
administrative requirements represents a step in the right direction. Although it may
be too early to evaluate whether the new legislation addresses the main constraints
expressed by the surveyed firms, considerable progress is now needed in the area of
institutional development for implementation, which should become the
government’s priority. In the medium term, the government should implement further
improvements to the investment regulatory environment where major impediments
still exist, and the scope for improvement remains considerable. Specifically,

a. The Negative List. Entry regulation should be relaxed to allow FDI to invest in
most subsectors, if not all subsectors. In particular, to invigorate the trade
sector, FDI should be allowed to participate in import trade, and in all export
business. Although the reservation of importing activities has been relaxed, as
the Negative List now allows foreign investment in the import trade “upon
approval by the Council of Ministers, [for] material inputs for export
products,” there is scope for further extension beyond chemicals and other
inputs for the horticultural export sector.

b. The minimum capital requirement, although already reduced and rather small,
should be further reduced and in the medium term abolished.

Customs Clearance 32

As the next phase of the revenue administration reform, the government is considering
modernization of the customs administration along the principles of risk-based selective
verification, service orientation, and simplified procedures supported by full automation. The
government has taken steps to upgrade the customs information system, moved the main
customs office to outside Addis Ababa, and entered into a preshipment contract with SGS.
An IMF Technical Assistance mission was fielded in June 2003 and made recommendations
to the government to continue work in this area.

32
This section draws substantially on the IMF’s 2003 mission report, Strategy for Reform of the Customs
Administration (IMF 2003).
64
The government has recently begun to pilot test measures to reduce the steps required for
customs clearance of goods down from 72 to 19.

Problems of Valuation of the Goods. Ethiopia has contracted SGS to provide limited
preshipment service, including assistance in the valuation of the goods. Despite this,
valuation occurs at least three times during the typical transaction by customs officials and
adds to the uncertainty faced by the importer.

Disputes over Custom Procedure and Valuation. Several licensed private clearance agents are
doing paper work for customs clearance. This service industry is one of the areas of
investment reserved for domestic investors. There is also a public enterprise—the Maritime
and Transit Services Corporation—that serves as a clearing agent for government agencies.

Recommendations. Considerable work remains for the Customs Authority to streamline its
customs procedure to be faster and more user- friendly. The Ministry of Revenue is
considering the IMF report that recommends covering a two- to three-year horizon that would
result in a customs administration that:

• Uses simple procedures based on self-assessment;

• Implements selective physical inspections based on systems developed by SGS; and
• Makes full use of the information systems being installed (ASYCUDA ++).

The earlier experience with tax administration reform indicates that for the reform to be
successful, it will require high- level political commitment supplemented by detailed action
planning and the provision and financing of appropriate technical assistance and training.

Quality and Standards

Ethiopia lacks an adequate infrastructure system for quality control and testing; this is,
however, an increasingly important area for exports. With the focus on agriculture-,
horticulture-, and livestock-related products, quality issues apply particularly with regard to
compliance with phytosanitary requirements.

A new law on standards is awaiting Standards Authority Board approval (expected by the end
of November 2003) before being sent to the Council of Ministers. It is anticipated that the
new law will incorporate the principle that all standards are vo luntary, until the Council of
Ministers decides to implement a cross-reference to some other regulation (for example, on
health, industrial safety, and so on) that makes a particular standard compulsory in specific
defined circumstances.

Recommendations. In line with normal international practice, the buyer and the seller
voluntarily agree on quality issues.. Ethiopia, similar to other African countries, is lagging
behind in terms of capacity to support modern testing, certification, and laboratory
infrastructure. Although the technical barriers are mostly found in meat, vegetable, and fruit
exports, manufacturing firms operating in textile/garments and leather/leather products
industries also find technical barriers to be a considerable hindrance on their ability to export.
So if the Government of Ethiopia is to successfully achieve their export diversification
65
objectives, it may need to seek technical assistance to build necessary institutional
infrastructure that would facilitate implementation of the new law on standards and allow the
enterprises to meet technical standards imposed by major importing countries. To this end, in
2002, a Standards and Trade Development Facility (STDF) has been created as a new
partnership of the World Bank, the World Trade Organization, the Food and Agriculture
Organization, and the World Health Organization. One of the main missions of the facility is
to assist developing countries, and least developed countries (LDCs) in particular, in
implementing (or modernizing) standards infrastructure and to ensure their participation in
standards development activities in the relevant international organizations. GOE should take
the initiative to benefit from this facility, possibly through a study to examine requirements,
and make recommendations for implementation options for improvements in quality
institutions and infrastructure through public sector, private sector, or public-private
collaboration.

4.6. Access to Finance

The survey revealed that more than 70 percent of firms would like to make a substantial
increase in investment to enhance capacity or to improve product quality during the coming
three years. The realization of planned investment by our respondents therefore partly
depends on the ability of the financial system to provide them with affordable and efficient
credit services. The business community in Ethiopia has consistently cited lack of access to
credit as one of the major impediments in various forums. Our view is that financial
restructuring would have a high payoff if combined with investments in reducing the skills
gap and improving other aspects of the investment climate highlighted above.

Limited Outreach. The Commerical Bank of Ethiopia (CBE), with its extensive 114 branches
in 11 districts outside Addis, controls most of the financial sector resources in the rural areas:

• CBE has ETB 4.9 billion in deposits compared with nationwide deposits of less than
ETB 0.3 billion of 21 microfinance institutions (MFIs).

• CBE’s branches outside Addis virtually stopped new lending. Despite this, the four
largest MFIs, responsible for most of the loans made in rural Ethiopia, have combined
loans representing only 20 percent of CBE lending outside of the Addis area. Further,
the expansion of the MFIs is constrained by low profitability (only the four largest
MFIs make profits), lack of provisions for bad debt in accord with regulatory
requirements and inadequate auditing.

Term Finance. As of end-2002, the stock outstanding of term financing (gross of provisions)
provided by CBE, the Development Bank of Ethiopia (DBE), the Construction and Business
Bank (CBB), and the six private commercial banks represented only about 8 percent of GDP.
A significant proportion of the existing term finance provided by DBE and CBB has become
nonperforming and does not generate cash flow repayments for granting new term loans.
Further, the resulting lack of a healthy balance sheet has an impact on new funding for these
institutions as well. The six private banks have been expanding, albeit marginally, their
volume of term lending with an emphasis on maturities between 18 and 36 months.
66
Recommendations. Important outstanding issues and recommendations in these areas are
include:33

(i) Banking System Profitability

Gross spreads (or net interest margins) in the banking system have reduced to below 1 percent
in 2002 from 2.5 to 3 percent in previous years. At this low level, the banking system is not
generating sufficient profits to cover administrative costs and provision for bad loans. As the
main issue reported from the survey is access and not levels of interest rates, it is
recommended that the National Bank of Ethiopia as the regulator should review whether the
situation improved as of June 2003 or otherwise requires corrective actions to restore spreads.

(i) Private Bank Institutional Strengthening

Foreign banks are not currently allowed to operate in Ethiopia. However, in recognition of
the need for the banking skills and technologies available from foreign banks, the
Government has allowed CBE to acquire consultancy services to assist it in institutional
development. The other commercial banks suffer from the same problems as CBE and need
to have access to similar services. However, in the absence of alternative modalities of
remunerating foreign banks (minority equity stakes) and the high costs of engaging foreign
banks as consultants (the CBE contract is reputed to be costing $2 million per year), private
banks may need some assistance (through cost sharing).

(iii) Rural Lending

The recommendations for rural lending will affect both agriculture and nonagricultural
activities; two sets of actions are recommended:

• A study exploring options for the modus operandi of the four large MFIs (that is,
whether to allow them to convert into commercial banks). Consideration should also
be given to issues such as dividing MFIs into classes based on size and strength, with
better capitalized MFIs allowed to make larger loans; provision of rights and
privileges of banks to MFIs with respect to foreclosure on collateral; linkages
between the banking system and MFIs; and institutional strengthening of the
regulator to conduct frequent onsite inspection.

• The design and piloting of appropriate rural credit products by CBE.

(iv) Term Lending

• DBE is experiencing substantial problems mobilizing term resources to finance
productive investment, some two-thirds of its portfolio is nonperforming and less than
a third has been provisioned. An in-depth, independent audit of DBE’s loan portfolio

33
The recommendations are primarily from a May 2003 World Bank financial sector technical assistance
mission.

67
 needs to be commissioned. Based on this audit, a restructuring plan needs to be
developed.

• Leasing. The necessary legal framework for the operation of leasing activities has
already been put in place. The government needs to review the adequacy of the
framework and actively support the immediate launching of leasing companies.

• Development of bond and equity markets. The development of a bond (fixed income
securities) market requires some further technical work to establish the legal and
regulatory framework. Further, such a market will require a benchmark issue by the
government around which other prices can develop; hence, the government would
need to estimate its borrowing strategy in order to estimate its medium- term
borrowing requirements and the maturity of the benchmark issue. Similarly, the
establishment of a formal equity financing system including an organized stock
exchange is a long-term process. Therefore, it is recommended that the process
toward the possible establishment of such a market be accelerated; some background
work has already been completed and a decision needs to be taken with regard to
implementation. One of the initial steps should include strengthening of the relevant
legal framework before this secondary market mechanism could operate.

4.7 Summary of Recommendations

Many of the recommendations in this report relate to issues considered in the

government’s Poverty Reduction Strategy Paper—the Sustainable Development and Poverty
Reduction Program. Subsequently, these issues were also reviewed in more detail in the
context of the Industrial Development Strategy for which consultations are currently ongoing.
Further, in the context of the ongoing sector dialogue with the Bank and other donors,
discussions are ongoing in several areas (financial sector, telecommunications, power, tax
administration, urban land and customs reform). This report captures the sectoral thinking
regarding possible solutions. There are, however, key interlinkages among various
recommendations; for example, the pace of improvements in the financial sector will be
determined by implementation of the land lease reforms (to facilitate greater availability of
collateral) and the taxation reform (to facilitate greater availability of information regarding
borrowers). Hence, a detailed short- and medium- term action plan that defines the sequence
of actions needs to be developed by the government in consultation with various stakeholders.
The overarching recommendation is, therefore, for the government to develop this action plan
in the context of finalizing the Industrial Development Strategy.

68
 4.7.1. Matrix of Policy Suggestions
Matrix of Policy Suggestions for Improving the Investment Climate in Ethiopia
Area of policy
Specific policy issues
concerns
Labor Productivity Ethiopian workers are about 80
percent less productive than
workers in Bangladesh and more
than 1.5 times less productive than
those in China. Furthermore, the
competitiveness gap that exists
between Ethiopian industries and
those in more successful
economies in the developing
world appears to be widening.
Tax Rates And Tax The survey results, which do not
Administration reflect the impact of the 2002 tax
reforms, indicated that tax rates
and administration were perceived
as the most critical problem.
A significant number of the
respondents emphasized the
inconsistency and lack of
transparency in the methods of tax
assessment by tax assessors. Most
firms feel that the tax assessment
procedures are not clear and that it
is guess work, and identified
regional tax offices as the locus of
the major tax administration
problems.
Access, Availability, In Ethiopia, land is exclusively
and Affordability of owned by the government, and
Urban Land land administration is in the hands
of the regions. High cost and low
availability of land has been cited
by investors as a constraint on
69
Observations/Comments
The Government of Ethiopia
recognizes that the need for human
capacity development at all levels is
one of their most important
development objectives. The newly
created Ministry of Capacity
Building has the mandate of
strengthening the skills of civil
servants, semi-skilled workers, and
private sector entities through skill
development partnerships.
The government initiated a
significant tax reform program in
2002, which coincided with the
timing of our survey effort. The
program included new legislation
for VAT and income tax,
introduction of Taxpayer
Identification Numbers;
establishment of the Ministry of
Revenue and establishment of a
large taxpayer office, and
strengthening of personnel. It is
too early to evaluate whether the
tax reform has addressed the earlier
problems.
The Ministry for Federal Affairs
has designed a multiphased
program of legal reform and
capacity building at the federal,
regional, and city levels to further
implementation of its policy on
Policy Suggestion
• Full implementation of education reforms
• Investment in vocational and on-the-job training
• Implementation of university curricula that foster
entrepreneurship and job-related skills.
• Implementation of skill-building in the civil service as
announced by the Ministry of Capacity Building
• Implementation remains key, particularly at the regional
level and below.
• In consultation with the private sector, develop quantitative
and qualitative indicators of improvements not only in tax
collection but in service delivery to the private sector.
• Given that the reforms are well under way but not yet
completed, there are no additional policy recommendations to be
made at this time.
Implementation of ULMAD should be considered a high
priority, and special attention should be given to the following
items:
• Develop indicators for tracking progress in addressing the
key constraints (that is, the high cost of land lease, the shortage
 Area of policy
Specific policy issues
concerns
entry and business profitability.
Access to Basic Despite its huge power-generating
Physical potential, Ethiopia’s generated
Infrastructure power is currently below the
(Power) demand—and, as a result, only
600,000 people have access to
electricity, representing about 6
percent of the population, which is
one of the lowest levels of
electricity access in the world.
Access to Basic Survey respondents indicated that
Physical infrastructure was a major
Infrastructure obstacle to growth at the firm
(Telecommunications) level. The number of telephone
mainlines in Ethiopia was 3.6 per
1,000 people in the year 2000
compared to an average of 14.2
for Sub-Saharan Africa during the
same period. The considerable
lack of access to and quality of
services results from a
monopolistic structure; restrictive
70
Observations/Comments
Urban Land Management and
Development (ULMAD).
ULMAD focuses on consolidating
the legal and regulatory framework,
improving institutional
implementation capacity, and
strengthening indigenous supply of
skills.
The government aims to expand
access from 13 to 20 percent by
2012. The Government strategy
for the power sector comprises: (a)
development of the country’s
substantial hydroresources through
both public and private sector
investment; (b) liberalization of
generation, transmission,
distribution, and supply in isolated
areas to improve operating
efficiency and the quality of service
to consumers and to unlock
resources for investment in systems
expansion; and (c) strengthening
system regulation to improve the
sector’s commercial and
operational efficiency.
The Council of Ministers has
recently endorsed an ICT policy
paper and a proclamation
establishing the Ethiopian ICT
Development Authority (EICTDA).
The government has also embarked
on a National ICT Capacity
Building Program covering a wide
range of areas and institutions.
Policy Suggestion
of new land being developed, and the use of land lease as
collateral).
• Revise Federal urban land lease law and adopt new urban
land lease proclamation in Addis Ababa *
• Adopt new urban land lease proclamation in four regions
Improving sector structure for competitive market segments.
• Separate the three core business areas of generation,
transmission, and distribution (which are currently within one
entity, EEPCO
• Enact legislation to allow competitive operation of the
power market, with multiple distributors and generators.
• Remove the limitation of supply and distribution from
isolated systems and also allow distribution to and from the
national grids in both rural and urban areas.
Improving access.
• Consider providing output-based subsidies to
encourage private sponsors to go to rural areas, where the
business would otherwise not be commercially viable. Such
subsidies would be structured to deliver the primary benefit to
consumers as opposed to private companies.
• Adoption of revised pro-competitive and technology-neutral
telecommunications policy allowing for partial liberalization of
the telecommunications sector, with quantifiable goals and
objectives and a clear liberalization timetable. *
• Enact telecommunications legislation that embodies the
new policy, enables competition, and allows for the
establishment of an appropriate regulatory framework in key
areas such as tariffs, interconnection, spectrum management,
and licensing.
• Separate the policy, regulatory, and operational roles of the
government to establish a level playing field.
 Area of policy
Specific policy issues
concerns
monopolistic structure; restrictive
legal environment prohibiting
involvement of the private sector,
coupled with insufficient public
resources for infrastructure
development; and weak
institutional and human capacity
for implementation.
Business Regulations While Ethiopia is not doing that
and Trade Facilitation badly on this score relative to its
Services international comparators, it is
clear from the survey that the cost
of regulations and dealing with
bureaucracy is still substantial for
Ethiopian firms. For example, the
survey showed that the required to
clear customs in Ethiopia is twice
that for China.
Access to Finance The business community in
Ethiopia has consistently cited
lack of access to credit as one of
the major impediments in various
forums. Data from our survey
confirm this. Financial
restructuring would have a high
payoff if combined with
investments in reducing the skills
gap and improving other aspects
71 of the investment climate.
Observations/Comments
Positive recent reforms include the
reduction of the cost of business
registration in the Ministry of Trade
and Industry and the Ethiopian
Investment Authority (EIA) from
$425 (which was the highest in the
world on a per capita GDP basis) to
$65 and the time of registration
from 44 days to 8 days.
The Government is taking steps to
reform the financial sector, which is
dominated by public sector
institutions such as the Commercial
Bank of Ethiopia (CBE) which
accounts for about 80 percent of
total deposits. The Government is
in the process of restructuring the
CBE and DBE and privatizing the
CBB; the focus at this stage is
predominantly on improving CBE’s
Policy Suggestion
• Build up regulatory capacity within ETA to regulate and
manage the sector, with the appropriate legislative changes to
ensure that it is an autonomous agency with adequate capacity to
establish and enforce a predictable and consistent regulatory
framework, including licensing.
• Develop a pro-competitive interconnection and tariff regime
and establish the principles for spectrum management, pricing,
and numbering.
• Restructure ET C’s financial and operational aspects to
prepare it for its new market role as a commercially oriented
wholesale provider of backbone infrastructure. Build ETC’s
capacity to compete in a more competitive environment.
• Introduce competition in fixed services and facilities-based
operators.
• Entry regulation should be relaxed to allow FDI to invest in
most if not all subsectors. In particular, to invigorate the trade
sector, FDI should be allowed to participate in import trade, and
in all export business.
• The minimum capital requirement should be further
reduced and in the medium term abolished.
• Implement reforms in the Customs Authority to reduce time
required for customs processing
• Seek technical assistance from the Standards and Trade
Development Facility (STDF) to build necessary institutional
infrastructure that would facilitate imple mentation of the new
law on standards and allow the enterprises to meet technical
standards imposed by major importing countries
• Implementation of CBE restructuring
• Approval by MoFED and commencement of
implementation of a restructuring plan for the Development
Bank of Ethiopia
• Review micro- and rural finance strategy and develop
action plan to improve access to micro- and rural finance *
• Carry out a study on excess liquidity / banking system
profitability problem of banking sector
• Encourage public sector institutions to diversify their
allocation of deposits
 Area of policy
Specific policy issues
concerns
of the investment climate.
Privatization and Despite the privatization and other
Competition reforms already implemented, the
government still is an active
participation in production and
distribution activities. Further,
there is a perception that state and
party owned enterprises may
benefit from preferential t reatment
from the Government For
example, the survey revealed that
on average, it takes less number of
days for an SOE to get connected
to both power and telecom
services, and to have its imports
and exports clear customs,
compared with the average of
comparable sized private firms.
* This action is also a prior action for PRSC 2.
72
Observations/Comments
predominantly on improving CBE’s
performance.
As the privatization process turned
out to be slower than originally
expected, the private sector
continues to face strong, and
possibly unfair, competition from
large-sized public enterprises, as
claimed by some elements of the
private sector. Although
competition is healthy and should
be encouraged, the key issue is
whether or not the playing field is
leveled for private firms.
Policy Suggestion
• Strengthen CBE’s retail lending operations for the rural
sector
• Satisfactory implementation of DBE restructuring
• Implementation of micro- and rural finance action plan
• Develop the regulatory framework for corporate securities
market operations
• Improve the treasury bills/ treasury bond market system
• Encourage the establishment of leasing companies
• Consider offering support (through cost-sharing) for private
banks to acquire external consultancy services
• Commence implementation of measures agreed with the
Bank for accelerating privatization program *
• Additional Enterprises brought to the point of sale under
privatization action plan
• Finalisation of Competition Commission & Secretariat, and
formulation of regulations, through consultations with the
Private Sector
• Test new competition regulations in two sectors and
publication of results
 Annex A

Figure A.1 Importance of Characeristics of Import

60 Goods Competing with Firms' Major Products
50 (percent)
40

30
52.03
20 36.4
28.4
10 19.5
0
Low price Durability Material quality Better
model/design

Figure A.2 Percent Identifying Cost of Financing as

Obstacle to Business Operation and Growth

35 32.06
30
25 21.47
20 19.41 16.18
15 10.88
10
5
0
No Minor Moderate Major Very
obstacle obstacle obstacle obstacle severe
obstacle

Figure A.3 Percent Identifying Access to Domestic Credit as

Obstacle to Business Operation and Growth
40 34.83
35
30 25.84
25
20 14.89 17.13
15
10 7.3
5
0
No obstacle Minor Moderate Major Very severe
Obstacle obstacle obstacle obstacle

73
 Annex B

Figure B.1 Share of Exports (Direct and Indirect) in Total Sales

5.97
Other 8.77
8.63 Exp/sales (percent 98/99/01)
Exp/sales (percent 99/00)
0.04
Wood and metal 0.04 Exp/sales (percent 00/01)
0.32

27.52
Leather 27.19
34.40

0.33
Textiles and 0.47
garments 0.35

3.35
Food and 2.06
beverage 3.21

0 10 20 30 40

Figure B.2 Average Number of Permits and Licenses required for entry

2.17
Other 1.43

Wood and 0.81

1.25
metal

1.33 No of permits
Leather
3.33 No of licenses

Textiles and 0.70

garments 1.58

Food and 0.85

beverage 1.76

0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50

74
 Annex C

Figure C.1 Firms Reporting the Indicated Problem in the Top Three
obstacles to doing business (percent)

60 55 56
52
50

40 38 39 37 Food and beverage

34
3133 31 33
30 Textiles and garments
27 29
30 2626 Leather
21 21 20 Wood and metal
20 17 15 1616 Other
9 9
10

0
Tax Land Inadequate Competition Credit
rate and access demand from imports access
administration

75
 Annex D

Tables D.1 Types of Taxes and Percentage of Respondents Who Associated Them with One of
the Two Major Tax Administration Problems They Face

All Sample
80% 69%
60%
40%
40%
20% 9% 7% 7% 6% 3% 2%
0%

x x ax
Ta Ta ax ax ax et uty ax
es
laes ofit gT al T eT cis sD rT
S Pr n
i c
ni
p
i om Ex m h e
old Inc sto Ot
ithh Mu Cu
W

Addis Ababa Amhara Region

80% 70% 80% 66%
60% 60%
40%
34%
40% 40% 25%
14% 9% 11%
20% 6% 6% 1% 2% 20% 7% 5% 0% 0%
0% 0%

Ta
x ax Ta
x
uty Ta
x x
xe
s Ta
x ax x ax Ta
x
uty xe
s
tT Ta
x Ta tT Ta eT Ta
x
ales rofi n g cise s D ome p
i al r Ta ales rofi p
i al m cise m
sD
n g r Ta
P i x m e P o x i e
S
old E sto Inc nic Ot
h S nic Inc E sto old Ot
h
ithh Cu Mu Mu Cu ithh
W W

Eastern Region Oromia Region

100% 80% 72%
77% 59%
80% 60%
60%
40%
40% 21%
20% 11% 11%
20% 2% 2% 0% 0% 0% 0% 2% 0% 0% 2%
0% 0%

x x x ty ax s x x x ty
Ta Ta e Ta Tax Du ax xe Ta Ta ax x Ta Du
ax es
ales rofit s
i g s alT
meT r Ta ales rofit alT Ta ise s eT r Tax
P c in m p
i o he P p
i g c m
S Ex old sto nic Inc Ot
S nic old
in Ex sto
m
Inc
o
Ot
he
ithh Cu Mu Mu ithh Cu
W W

Southern Region Tigray Region

60% 49% 80% 70%
64%
40% 60%
26%
19% 14% 40%
20% 18%
7% 5% 2% 20% 5%
0% 2% 0% 0% 2%
0% 0%

Ta
x
ax ax ax x Ta
x ty es Ta
x ax ax ax ax ty es
les al T Profi
tT eT Ta ise Du ax les ofi
tT eT lT eT Du Ta
x
Tax
a p
i m n g xc ms rT a r m ipa cs
i m
s g r
S inc co d
ol
i E to he S P
Inc
o
nic Ex sto old
in he
Mu
In
Cu
s Ot Mu Ot
ithh Cu ithh
W W
76

Source: FACS, 2002

 Annex E
Figure E.1 Components of Total Taxes Paid by Firms,
- 2001

100%

75%

50%

25%

0%
Addis Amhara Eastern Oromia Southern Tigray Total

Sales Profit Excise Municipality Other

* Includes other direct and indirect taxes, import duties,

Figure E.2 Level of Government Associated with Tax Administration Problems, by

Size

80%

60%

40%

20%

0%
Sample (<=10) (11-99) (100+)
Whole Small Medium Large

Federal Regional Local

77
 Annex F: Ethiopia n FACS Survey Data

The Ethiopian Firm Analysis and Competitiveness Survey (FACS) firm survey data was
collected from a representative sample drawn from a sample frame collected from various
sources and merged together. We originally started from a sample frame of 833 firms.
We stratified the frame by region first, then by sector and size group. There was no
updated listing, so we could not locate a significant number of firms,because of either
change in business or ceasing of operations. We replaced such firms as appropriate, based
on a continually update of firm lists and still considering the size and sectoral
characteristics of missing firms in each case. As a result, in two regions (Eastern and
Southern), where most of the firms have already been in the sample (because of a fewer
number of available firms to begin with), the sample has covered almost all of the
available firms. The sample was drawn from six major industrial cities and regions in
Ethiopia where there is a major industrial concentration. These regions are Addis Ababa,
Amhara, Eastern, Oromia, Southern, and Tigray.

Moreover, to ensure a reasonable sectoral analysis, we focused on seven major sectors.

The sector labeled here as “other” includes sectors that were covered in the 1995 Addis
Ababa survey other than the sectors mentioned above. We included some of the firms
from that survey to ensure a proportionally large enough sample from Addis and also
possibly to create a panel for such firms. Given the overall small number of firms in
Ethiopia, we believe that we have covered a sufficiently large proportion in our sample.
The following tables show the regional and sectoral distributions of our final sample as
well as the original sample frame.

Table F.1. Regional Distribution of Sample Frame and Final Sample

Sample Distr. Frame

Region Freq. Percent Distr.
Addis Ababa 203 47.5 45.7
Amhara region 44 10.3 10.7
Eastern Region 47 11.0 9.7
Oromia Region 46 10.8 13.6
Southern Region 43 10.1 10.7
Tigray Region 44 10.3 9.6
Total 427 100.0 100.0

78
Table F.2 Sectoral Distribution of Sample Frame and Final Sample

Sample Distr. Frame

Sector Freq. Percent Distr.
Food 91 21.3 26.5
Beverages 17 4.0 2.9
Textiles 14 3.3 2.7
Garments 37 8.7 9.8
Leather/L. pdcts 25 5.9 6.5
Wood and metalwork 206 48.2 46.8
commercial farming 4 0.9 0.6
Other 33 7.7 4.2
Total 427 100.0 100.0

Table F.3. Size Distribution of Final Sample

Sample Distr.
Size Group Freq. Percent
Small (<=10) 190 44.5
Medium (10-99) 148 34.7
Large (100+) 89 20.8
Total 427 100.0

Note: Size group in Table F.3 is arbitrarily defined as shown by the number of
employees.

In fact, as expected, most of the enterprises in Ethiopia are quite small size. The small
and medium enterprises dominate the size distribution in the sample, and, of course in the
sample frame (population) from where they were drawn.

79
 Technical Annex G. Estimation and Counterfactuals

Analysis of Productivity Gaps

The analysis of productivity presented in Chapter 2, is based on parameter estimates of a

two- factor Cobb-Douglas production function obtained by pooling Investment Climate
Survey Data from Bangladesh, China, Ethiopia, India, Morocco, and Pakistan. These
surveys were all carried out in the last two years with direct involvement of the World
Bank group and were based on similar survey instruments and sample designs. The
dataset on each country contained information on common indicators of investment
climate as observed during the survey year and a three-year panel of accounting
information on each responding business establishment.

Labor productivity is defined as the ratio of annual value added to total number of
employees at the end of the fiscal year, value added itself being gross annual output less
annual consumption of intermediates. All values are measured at 1999 U.S. dollars at
each country’s yearly average official exchange rate and using the official implicit GDP
deflator. The estimated production function was specified in terms of labor and capital
but was augmented by the inclusion of an indicator of labor force skills. We used end-of-
year number of employees as a proxy for annual labor input. Similarly, we used the end
of period book value of plant and equipment at constant prices as the a proxy for capital
consumption. We proxied labor force skill by the average years of schooling of workers.

Assuming workers are paid their marginal product, the best way of taking skill gaps into
account in measuring labor input seems to be to use the firm’s aggregate labor cost as the
unit of measurement rather than the average number of employees or aggregate hours of
work: Let y be value added per worker in natural log, k the log of capital stock per
worker, w the log of annual labor cost per worker, and n it the log of employment. Our
parameter estimates were obtained on the assumption that establishments shared a
production function that was identical across sectors, regions, and countries up to a firm
specific but a homoscedastic, purely temporal, and serially uncorrelated error term, ε ,
and a Hicks-neutral shift term, α (firms, sector, region, country), that could vary
between any of these, and, most importantly, between firms. In other words, we assumed
that we could describe each producers technology of production as

(1) yit = α (sec torit , countryit ) + β1kit + β 2 wit + γnit + α i + ε it

where β j and γ are factor share parameters

A possible objection to this is that in spatial comparisons, wage gaps may reflect
productivity differences only in part. Other factors, possibly including regional or
international differences in cost of living, could explain the other part. This led us to the
use of average employee schooling as an indicator of skills instead of the wage rate in the

80
estimation of productio n functions. One justification for this lies in the firm- level
analogue of the Mincerian earnings function:

(2) wit = r0 + r1Sit

where S is average years of schooling the firm’s employees and r0 sums up the
nfluence of other human capital variables. Substituting into (1) from equation (2)
gives

(3) yit = α (sec torit , countryit ) + β1kit + λS it + γnit + α i + ε it

where λ = β 2 r1 scales down the returns- to- schooling, r1 , by factor share

parameter β1 .

We obtained the estimates by applying ordinary least squares to the first difference of this
specification so as to sweep out the firm, country, or industry fixed effects from the data.
Here are the estimates.

(4) ∆yit = 0.194∆kit + 0.108∆sit − 0.408∆nit R 2 = 0.45 , observations=2792

(0.0309) (0.0374) (0.0629) F(3,2792)=43.68
where we present standard errors in parentheses.

The estimates were used in the report in two ways. First they were used to allocate
observed crosscountry sample differences in median value added per worker between
three components, namely,
a) a component due to a gap in capital per worker, β1∆k
b) a skills-gap component, λ∆s , and
c) the TFP component: TFP= ∆y − β1∆k − λ∆s − γ∆n

We also used them to generate firm- level TFP, the regression of which on a range of
investment climate indicators, IC j , is the basis for the productivity counterfactual
reported at the end of chapter 2 of the report. In so doing we have controlled for a set of
plant- level characteristics, F j , such as establishment age, scale, year of observation, and
sector of industry , on the one hand, and country characteristics, C j , on the other.
Specifically we have controlled for a country’s access to the sea, as measured by distance
from the nearest port, its distance from major international markets, the size or density of
the economy as measured by population, and business cycle effects as measured by the
deviation of actual GDP from an estimated linear trend in GDP for the last 15 to 17 years.
The estimated specification is linear in parameters and can be stated as

(5) TFPit = δ 0 + ∑ j δ j F + ∑ l δ l Clit + ∑m δ m IC mit + δ i + ηit

jit

81
 where the δ s are constants to be estimated, except δ i which is a non-transient
firm effect assumed to be random rather than fixed, and ηit is purely temporal
random error term. Estimation was done by generalized least squares in order to
take account of δ i , on the assumption that η is uncorrelated with any of the
observables of the equation.

Analysis of Growth and Investment

The same set of investment climate indicators and firm- and country- level controls were
used in the estimation of the sales growth equation used in computing the growth
counterfactual at the end of chapter 2 and the assets growth equation used in the
international comparison of rates of net fixed investment in the same chapter. Let Qit be
annual sales revenue in logs. The estimated sales growth equation was of the form:

(6) ∆Qit = γ 0 + ∑ j γ j F + ∑l γ l Clit−1 + ∑m γ m IC mit + γ i + ν it

jit −1

where the difference from the TFP equation—apart from that in the dependent
variable—was only in the use of initial, as opposed to current, values of firm
characteristics whenever these varied over time.

As a way of dealing with the endogeneity of responses or constraints all IC indicators

appearing in (6) were measured as city level averages.

The assets growth equation was specified in exactly the same way with the exception of
the fact that now size was measured in fixed assets rather than in sales. Both growth
equations were estimated in by GLS on the assumption that the establishment effects δ i
and γ i were permanent but as random variable rather than as fixed effects. The latter was
necessitated by the fact that at this stage we have investment climate indicators as one off
figures for each country or location within a country rather than as a panel of
observations over time.

82
C: Parameter Estimates: Absolute value of z-statistics in parentheses
Variables Dependent variable:
(All in natural logs whenever possible) Log TFP Annual sales growth Annual growth rate of
* significant at 5%; ** significant at 1% rate fixed assets
Establishment characteristics:
Last year's annual sales revenue -0.221 -0.209
(30.59)** (29.59)**
Book value fixed assests at the end
of last year -0.037 -0.035
(11.64)** (11.63)**
Age of the establishment 0.116 0.120 -0.088 -0.086 -0.042 -0.041
(2.71)** (2.81)** (5.14)** (5.06)** (4.96)** (4.90)**
Countries:
China 0.976 0.989 0.531 0.155 0.430 0.215
(2.98)** (7.88)** (3.61)** (2.81)** (5.35)** (8.05)**
Ethiopia -0.484 -1.410 -0.027 -0.418 0.168 0.132
(2.30)* (9.41)** (0.27) (5.27)** (3.34)** (3.78)**
Pakistan 0.108 -0.653 0.092 -0.246 0.019 -0.131
(0.49) (6.97)** (0.80) (4.70)** (0.21) (5.65)**
Investment climate indicators:
Number of inspection visits a year -0.226 -0.246 -0.040
(1.82) (4.58)** (1.65)
Days needed to clear customs last time -0.175 -0.083 0.012
(1.69) (1.79) (0.59)
Percent of output lost due to power outage -0.374 -0.102 -0.023
(4.04)** (3.27)** (1.62)
Days need for last telephone connection -0.198 -0.085 0.027
(2.14)* (1.99)* (1.40)
Percent holding overdraft facilities 0.361 0.124 0.068
(4.31)** (2.90)** (3.54)**
Country/city characteristics:
miles from the nearest major int'l market -0.210 0.184 0.036
(0.64) (1.75) (0.75)
Distance from the nearest port -0.012 0.011 -0.001
(1.39) (2.66)** (0.51)
City's population -0.026 0.073 -0.021
(0.62) (3.35)** (2.13)*
deviation of log GDP from trend (current) 0.007 0.010 0.008
(0.28) (0.68) (0.50)
deviation of log GDP from trend (last year) -0.006 -0.017 -0.025
(0.08) (0.42) (0.61)
Other controls:
sector of industry dummies Yes Yes Yes Yes Yes Yes
Year dummies Yes Yes Yes Yes Yes Yes
Constant 10.904 8.190 1.360 3.259 0.187 0.482
(3.70)** (50.00)** (1.34) (27.47)** (0.41) (10.27)**
Number of observations 3244 3244 6241 6241 6122 6122
Number of establishments 1736 1736 3212 3212 3163 3163
R-squared 0.26 0.23 0.18 0.14 0.1 0.09
Wald chi^2 of joint significance of all regressors 674 593 1134 1057 522 503
rho 0.86 0.87 0.84 0.84 0.34 0.33
Wald chi^2 (5 ) of joint signifificance of IC vars 39.7 40.1 18

83
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