Home / Opinion / Why the ease of doing business matters

In the World Bank’s (WB) 2017 Doing Business ranking, India stands at the 130th place in a list of 190 nations—just a spot higher than in the 2016 rankings. Is this a worrisome sign? According to an article published in Mint (goo.gl/4PHo6n) and a paper brought out by a faculty member at the Indian Institute of Management, Bengaluru (goo.gl/66QF6g), the answer is “not so much". A curious case is being made that higher rankings do not really imply good economic outcomes such as higher foreign direct investment (FDI) inflows or higher gross domestic product (GDP) growth. I argue that this assessment is based on dodgy economic foundations.

The ease of doing business rank is a stock concept: It represents the reforms that a country has undertaken on various issues like infrastructure, legal systems, etc., over a couple of decades or even more. Hence, this rank ought to be more intricately associated with corresponding macroeconomic stock variables like the level of per capita GDP. With this concept in mind, Figure 1 plots the average ease of doing business rank during 2010-15 against per capita GDP level in the left panel.

The message is clear: In the long run, a country can’t become rich in the per capita sense unless it has a high ease of doing business index rank. Only oil-rich countries like Kuwait, Qatar, Libya, Venezuela and Angola managed to get sufficiently rich even with a relatively low ease of doing business score. On the other hand, if you have a sufficiently high ease of doing business score, then you are almost guaranteed to become a rich country.

Once we know that a high ease of doing business index is almost equivalent to being a rich country, it is foolhardy to expect that a high index will also imply higher GDP growth. Why? The answer lies in the convergence hypothesis proposed by the neo-classical growth theory, which says that poorer countries tend to grow faster in per capita terms. Estimates from the recent work of Harvard economist Robert J. Barro’s suggest that for every per-unit increase in the log of per capita income, the long-run growth rate drops by almost 1.22% per annum.

We can do a simple back-of-the-envelope calculation to adjust the observed growth rates by this magnitude to compare countries with varying ease of doing business rankings.

The real per capita income level for countries with a score below 50 is around $1,500 and for countries with a score of more than 70, it is around $38,000—that’s a huge difference. Once adjusted for the convergence factor, countries with a better score outperform by a decent rate of 0.35% per annum. Hence, the higher index not only shows better living standard in the long run but also indicates faster growth and catching-up for poorer countries.

The list of domestic economic variables positively affected by the index is, in fact, very long. For example, Figure 2 exhibits the impact of the rank on inflation. Because inflation is generally lower for richer countries, I plot the link separately for the rich and not-so-rich countries.

The message is again very clear: First, a higher ease of doing business ranking predicts lower inflation for both rich as well as lower-income countries. No country with a score greater than 70 registered an inflation greater than 5%. Brazil, Turkey, Russia and Argentina stand out as relatively higher-inflation countries precisely because they have a lower ease of doing business ranking, which indicates higher corruption, a poor legal structure, lack of infrastructure—all of which point to supply constraints.

Second, the higher ease of doing business rank for China shows up in a lower inflation compared to India, which lies above the line of best fit. This indicates how important it is for a country to target the reforms that the index reflects upon. Similar analysis shows that a better ease of doing business score is associated with a lower level of structural unemployment.

Coming to the case of FDI, in Figure 1 (right panel) I compare data from the Organisation for Economic Cooperation and Development (OECD) on inward FDI stock expressed as a percentage of GDP to the ease of doing business rank. FDI stock represents the total FDI that a country has received in the long run. Data shows a clear positive link between the two.

But there are some interesting outliers. Japan, with a high rank, attracts less FDI due to country-specific problems like customer liking for domestic known products and the connected nature of Japanese firms. On the other hand, the Netherlands, Switzerland, Luxembourg and Belgium, all ranked lower than Japan, attract very high FDI owing to their tax-haven strategies. So, country-specific factors are important for FDI success but in general, few countries with a relatively low ease of doing business scores have been able to attract FDI in the long run, except for a few tax havens.

In summary, a country can’t progress without undertaking the reforms that lead to better business conditions. These reforms are critical to achieve better living standards, moderate inflation, low-inflation uncertainty and high-growth rate. In short, India’s efforts to improve its ease of doing business ranking is not an unnecessary obsession.

Apoorva Javadekar is research director at the Centre For Advanced Financial Research And Learning, Mumbai.

Comments are welcome at theirview@livemint.com

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