The question which drives this paper is how, in the political and institutional environments typical of poor countries, public action can bring about substantial increases in productive private investment. ‘Improve the investment climate!’ is the dominant policy advice.
This paper reviews what is meant by the investment climate and then concentrates on the institutional dimension of investment climate reform. The standard advice in such reform is that governance through informal relationships should be replaced with governance through formal rules. This means above all the legal protection of property rights and the legal enforceability of contracts.
This paper agrees with this view as a long term goal, but it disagrees with the big push for the introduction of formal rules – which is at the heart of much investment climate reform. It suggests that this big push is idealistic: it is very difficult to achieve and may not produce the expected increases in investment.
The paper therefore draws on cases in which substantial increases in investment occurred even though property and contracts were not legally protected. In these cases, informal relationships between those who hold political power and those who decide on investment seem to have been critical to stepping up investment and economic growth.
The paper zooms in on such hand-in-hand arrangements between politicians and investors, suggesting that they may offer a more realistic way forward in poor countries with weak public institutions. However, it is also stresses that such arrangements can be, and indeed have been, abused. The challenge therefore is to specify the circumstances in which hand-in-hand arrangements have the desired effect. Where these arrangements are transitional and raise productive investment, they are likely to strengthen the demand for formal rules. The central issue is thus one of sequence and dynamics: do investors follow or lead institutional reform? The paper ends with suggestions for research which is comparative and investigates changes over time.