Munich Personal RePEc Archive Alleviating the Barriers to Domestic Investment in Addis Ababa: Underlying Causes and Proposed Solutions Gebrehiwot, Berihu Assefa and Gebre-eyesus, Mulu and Bekele, Firew Ethiopian Development Research Institute (EDRI), Ethiopian Development Research Institute (EDRI), Ethiopian Development Research Institute (EDRI) 2014 Online at https://mpra.ub.uni-muenchen.de/80112/ MPRA Paper No. 80112, posted 11 Jul 2017 13:38 UTC Alleviating the Barriers to Domestic Investment in Addis Ababa: Underlying Causes and 1 Proposed Solutions Revised Version: January 2017 Berihu Assefa2, Mulu Gebre-eyesus3 & Firew Weldeyes4 Abstract While Addis Ababa is rapidly urbanizing, productive job creation remains to be a key challenge (i.e., unemployment rate stands at 21%). The root cause of this has been the lack of structural transformation towards industries with higher potential for growth and job creation. In response, the government of Ethiopia through its Growth and Transformation Plan (GTP2) targets the industrial sector to enhance structural transformation and create more 1 The views and opinions expressed in this article are those of the authors and do not necessarily reflect the official position of the Ethiopian Development Research Institute (EDRI) and/or the World Bank Group. This report was produced with financial support from the EDRI and WB. 2 Research Fellow at the Ethiopian Development Research Institute (EDRI) 3 Senior Research Fellow at the Ethiopian Development Research Institute (EDRI) 4 Research Fellow at the Ethiopian Development Research Institute (EDRI) 1 productive jobs in Ethiopia’s cities. Despite the priority and importance accorded to the industrial sector and efforts to improve the investment environment, quite a few domestic investors go beyond the licensing stage to start production. A recent World Bank report on the investment climate in Addis Ababa shows that only about 5% of domestic firms that receive investment licenses are able to convert from the pre-operational to the operational phase of investment to establish their businesses. This is also consistent with government reports. By any standard, this is one of the lowest investment conversion rates, and hence is quite concerning. So, the key question is: why 95% of investors were not able to move beyond the licensing stage to start operating? As we are largely looking at the pre- operation investment phase where there are no existing survey data, a qualitative research approach seems more fitting to identify the wide variety of processes and mechanisms that hinder business entry in the city. Using the qualitative/semi-structured firm level research among the firms who received an investment license but are stuck or discouraged allows us to ask questions on how and why specific processes are hindering investors and chart out the whole process investors go through, identifying the most critical barriers. Key words: Ethiopia, Addis Ababa, Domestic investment, Conversion rate, Investment barrier, Qualitative research 2 Table of Contents 1. Introduction ........................................................................................................................................... 4 2. Project background and objectives ....................................................................................................... 7 3. Addis Ababa’s (Ethiopia’s) targeted policies to enhance investment and create productive employment................................................................................................................................................. 11 3.1. Economic performance ............................................................................................................... 11 3.2. Targeted policies to enhance investment and create productive employment ............................ 13 4. Approaches ......................................................................................................................................... 16 4.1. Semi-Structured interviews with firms and key informants ....................................................... 16 4.2. Sampling strategy for semi-structured interview ........................................................................ 17 4.3. Data collection techniques .......................................................................................................... 20 4.4. Analysis Method ......................................................................................................................... 20 5. What constrains domestic investment in the Pre-Operation Stage in Addis Ababa? .......................... 21 5.1. Bureacratic inefficiency .............................................................................................................. 22 5.2. Access to land ............................................................................................................................. 24 5.3. Infrastructure ............................................................................................................................... 26 5.4. Finance ........................................................................................................................................ 28 5.5. Entrepreunerial Skills .................................................................................................................. 32 6. What Constrains Business Expansion and Growth After Domestic Firms Started Operation? .......... 33 6.1. Land or working premise ............................................................................................................ 34 6.2. Infrastructure/basic services ........................................................................................................ 35 6.3. Finance and Foreign Currency .................................................................................................... 36 6.4. Customs services ......................................................................................................................... 38 6.5. Labour: Skills, Discipline and Turnover ..................................................................................... 39 6.6. Regulatory environment .............................................................................................................. 42 7. Unlocking the city’s opportunities and solving the constraints: Key recommendations .................... 43 7.1. Land - Summary of the challenges and suggested solutions ....................................................... 44 7.2. Productivity enhancing factors - Summary of the challenges and suggested solutions .............. 52 7.3. Finance – summary of challenges and suggested solutions ........................................................ 55 7.4. Regulatory and institutional issues – summary of challenges and suggested solutions .............. 59 References ................................................................................................................................................... 75 3 1. Introduction The Government of Ethiopia (GoE) is committed to rapid and sustained economic development to realize the middle income goal by 2025. Ethiopia’s remarkable economic performance in the past decade 2003/4 – 2014/15 (averaging about 10.9 percent per annum compared to 4.6% and 2.5% growth experienced by the Sub-Saharan Africa region and the global economy over the same period) shows that the country may be well-placed to achieve this target. The conditions for this are particularly set out in the Growth and Transformation Plans (GTPs) and various strategy documents complementing the GTPs. Through the GTPs, Ethiopia aims to build an economy whose growth is driven by modern and productive sectors, including a vibrant agricultural and a competitive industrial sectors. Especially GTP2 sets out an ambitious vision to become “a leader in light manufacturing in Africa and one of the leaders in overall manufacturing globally”. Over the next five years (GTP2), the aim will be not only to continue the growth momentum but also to achieve a significant structural transformation, in terms of value addition and employment creation in the modern sectors. At the heart of structural transformation are policies that are designed to generate maximum inter-sectoral linkages and domestic enterprise capacity building. Not surprisingly, the manufacturing sector is believed to generate high inter-sectoral linkages, value additions and skills and productive and stable employment that further reinforce each other to drive the whole economy into sustained growth. To this end, the government of Ethiopia (GoE) has already highlighted in its Growth and Transformation Plan (GTP) industrialization as a key to sustaining growth and as an impetus for economic structural transformation. Despite the fast growth record in recent years, Ethiopia in general and Addis Ababa in particular faces lack of structural transformation and high urban unemployment rate. In terms of structural transformation, Addis Ababa fared little. The manufacturing sector employment stands at about 15 percent in 2015/2016 (WB 2016). With fast economic growth that is accompanied by rapid structural transformation, there is a huge potential for economic growth and job creation in the manufacturing sector to be had. Urbanization processes that are not accompanied by structural transformation tend to have limited capacity to expand and create productive jobs for the urban youth. In terms of unemployment reduction, unemployment has decreased from 33 percent in 4 2004 to 21 percent in 2015 (WB 2016). However, it is still high and remains to be a top priority in the city’s development agenda. Ethiopia has now started implementing GTP2, which sets even more ambitious targets for industry and manufacturing to grow at an average rate of 19.8% and 23.9% per annum respectively, leading to a rise in its GDP share to 23% (and manufacturing to 18.8%) by the end of the GTP2 period while that of agriculture and services decline to 36% and 41%, respectively. This industrial development vision and target hinges on attracting both domestic and FDI manufacturing firms. But especially Ethiopia’s Industrial Development Strategy (IDS) puts the role of domestic investment or manufacturing sector in the industrial journey of Ethiopia as critical or irreplaceable. The reasons for this are: − Domestic investment is reliable and sustainable. For local investors, Ethiopia is their country with which they have significant ties; hence, they continue to create more wealth and employment unlike foreign firms who tend to migrate whenever better opportunities arise elsewhere. − The anticipated benefits of FDI (technology transfer, job creation and market linkage) can only be realized if we have a dynamic domestic private sector. There is no such thing as technology transfer and market linkage unless you build a vibrant and dynamic domestic private sector. However, although the IDS emphasizes domestic investment as key to sustainable industrial development and the investment promotion strategy started to attract domestic investors to the manufacturing sector, quite a few of them go beyond the licensing stage to start production. Many domestic potential investors are either stuck or discouraged by the constraints and market failures they face along the investment process. To achieve the needed economic diversification and industrial led by robust domestic private sector, we need to understand why domestic firms get stuck or discouraged and fail to operationalize. In light of this, the key research questions this research work tries to address include: (1) The first question relates to business entry or conversion from license to operation. Studies indicate that only 5% (about 10% according to government reports) of domestic firms that receive investment licenses are able to convert from the pre-operational to the 5 operational phase of investment to establish their businesses. By any standard, this is one of the lowest investment conversion rates, and must be addressed head-on. On the other hand, conversion rates for foreign investors in Addis Ababa are high, even by international standards (at 60%). This indicates that domestic investors seem to face several possible market failures and constraints that could be affecting their ability to establish their business. And these problems seem to be particularly severe for domestic firms as can be seen from the low conversion rates. So, the key question we want to address is why 95% (90% according to government reports) of investors were not able to move beyond the licensing stage to start operating? (2) The second question relates to business expansion or growth. Even if some succeed and operationalize their business, they fail to expand or grow. So, in light of this, we want to know what particular obstacles and market failures are impeding the growth of domestic manufacturing enterprises in Addis Ababa once they are operational. (3) And what should be done to improve the low conversion rates and induce the development of a more dynamic domestic manufacturing sector? Previous studies on similar issues relied on existing survey data sources which do not contain stuck/discouraged investors in their sample. For example, most World Bank Enterprise Surveys and the Ethiopian Central Statistical Agency's surveys of large and medium scale manufacturing firms relied on data from operational firms, which could not definitively answer the question of why 95% of investors were not able to move beyond the licensing stage to start operating. In view of this, we think that qualitative firm level research among the firms who received an investment license but are stuck/discouraged is likely to be very useful in finding out, from their experience, what were the factors that led to either their success or failure in operationalizing their investment idea. The overall objective of this research is to inform the Addis Ababa city government on the key domestic investment barriers and market failures that are constraining business entry and growth. The report specifically aims a. To support the Addis Ababa City Government in understanding the key barriers to business entry in the city 6 b. To produce practical policy and practice recommendations that can be acted upon by the Addis Ababa City Government, either within their own areas of jurisdiction or in partnership with other relevant stakeholders The contributions of the current research comes from two aspects: (1) gathering more detailed information on the barriers to investment in order to understand why firms got stuck or discouraged in the investment process; and (2) making specific recommendations that are implementable by the Addis Ababa City Government based on existing stock of the quantitative and qualitative evidence available to date. The rest of the paper proceeds as follows. While Section two provides background information, objectives and research questions, section three reviews key policies that are targeted at investment promotion and job creation. Section four presents our approaches and method of analysis. Sections five and six present the key findings of both the firm and key informant interviews. And finally, section seven synthesizes the key challenges and possible recommendations of the research work. 2. Project background and objectives While African cities are rapidly urbanizing, and some have recently experienced robust economic growth, job creation in cities remains a challenge with high unemployment levels and the majority of people being employed in the informal sector. At the root cause of these problems has been the lack of structural transformation from low value added and non-tradable activities to other sectors and industries with higher potential for growth and job creation. In many African cities, rapid urbanization is taking place with little industrialization or structural transformation. Urbanization processes that are not accompanied by structural transformation tend to have limited capacity to expand and create productive jobs for the urban youth. In addition, major supply constraints and market failures are likely to be hindering the competitiveness of local firms in African cities and their ability to expand and create jobs. To support African Governments in addressing this challenge, the World Bank recently developed a framework for enhancing the economic competitiveness of cities and designed this NLTAA 7 entitled "Enhancing the Economic Performance of African Cities". The project is designed to provide insights to local policy makers on the city economy, what policies and investments could improve economic growth and job creation, and to support them in planning concrete interventions. The World Bank included Addis Ababa as one of the four focus cities under this project to support the City Government in fulfilling its mandate for promoting economic development in the city and create jobs. The main client is the Addis Ababa City Government, where top government officials have shown commitment and interest to this agenda and has established a working group of staff from the relevant Bureaus within the City Administration to work on city competitiveness. Taking account of the city government’s demand and strategic context in Addis Ababa in particular and Ethiopia in general, the project will concentrate on two main areas of support, where it can add most value: (i) city economic analyses, and (ii) institutional support and skills development. This report focuses on one of the main outputs under the city economic analyses, which focuses on “qualitative research on key constraints for investment by domestic firms at the city level”. The many consultations with the Mayor’s office and other key stakeholders helped to understand and address their specific knowledge requests and gaps, which currently constrain domestic investment entry and growth. Hence, the key research question this report tries to answer is: how is the environment for business in Addis Ababa impacting investment conversion rates of domestic investors? The research question is motivated by the low conversion rate of domestic investment. This concerning finding was highlighted by the World Bank's recent report on the investment climate in Addis Ababa5. The report highlights the fact that only 5% of domestic firms that receive investment licenses are able to convert from the pre-operational to the operational phase of investment – to establish their businesses. This is also consistent with other studies where entry regulations and processes are consistently highlighted by the private sector as burdensome and obstructive to firm entry and dynamism - such as the EEPCF National Business Agenda and the Doing Business Indicators, where Ethiopia ranks 168th out of 189 economies on the Starting a Business indicator. On the other hand, conversion rates for foreign 5 World Bank (2014). Investment Climate from the Perspective of Regions: Addis Ababa, Oromia and Dire Dawa. Addis Ababa, December 2014. 8 investors in Addis Ababa are high, even by international standards (at 60%). But in the case of domestic investors, the report highlights several possible market failures and constraints that could be affecting their ability to establish a business – such as the regulatory environment, access to finance, land, electricity, skilled labor, and others. However, as the reports relied on existing survey data sources which do not contain stuck and discouraged investors in their sample – namely the World Bank Enterprise Surveys and the Ethiopian Central Statistical Agency's surveys of large and medium scale manufacturing firms – it could not definitively answer the question of why 95% of investors were not able to move beyond the licensing stage to start operating. Answering this question is of particular relevance to policymakers at the Addis Ababa City Government, given that facilitating domestic investment is within the direct remit of its Investment Office. The low investment conversion rates of domestic firms points to the existence of some obstacles that firms face between the point where they obtain a license (at the beginning of the process for establishing a business) and the point where they obtain a business registration (at the end of the process for establishing their business). It is, therefore, important for the City Government to know what measures it can take to improve the chances of domestic businesses establishing themselves in Addis Ababa, in order to expand economic growth and job creation in the city. While abundant research evidence already exists in Ethiopia identifying the general categories of constraints affecting the performance of existing firms, there has been little focus on the ones that were stuck in the process or discouraged from entry due to the prevailing business environment. A number of high quality studies have been undertaken in the last few years on constraints to existing firms, including the Ethiopian Public Private Consultative Forum (EPPCF) National Business Agenda Report (2014); the World Bank’s Doing Business (World Bank 2014) and Enterprise Survey (World Bank/IFC 2012) reports; the World Economic Forum’s Global Competitiveness Report 2013-2014; and the various relevant studies undertaken by the Private Sector Development Hub3 and the results and recommendations of the Public-Private Consultative Fora held since 2010. For example, see Figures 1 and 2 below summarizing some of the most severe barriers mentioned by firms. In the former case, access to finance and land are the first two major obstacles. In the latter case, tax administration, access to finance and land (in 9