Rule of law
A good investment climate means that private-sector companies, ranging from smallscale enterprises to multinational corporations, have incentives to invest. The term investment climate refers to the entire political, legal, economic and institutional environment that has a bearing on enterprises’ opportunities and risks. Investors must assess these matters diligently, and incalculable risks are likely to scare them off.
The protection of ownership rights is crucial. Land ownership, for example, must be clear and safe. Contract enforcement is important, and low levels of corruption and crime are appreciated. Investors also want to be sure that competitors do not gain advantages due to personal contacts of monetary favours. When a business partner does not fulfil contract obligations, moreover, they need the courts to enforce that contract.
Accordingly, national laws have a bearing on investment decisions, but law enforcement matters just as much. However, the quality of both legislation and the court system diverge considerably from country to country. The interaction of the judicial, legislative and administrative branches of government is a complex affair. Generally speaking, there are always gaps between black letter law and everyday life. In the eyes of investors, non-transparent, overly complex or ambiguous legislation means greater risks.
In private contracts, partners can agree which country’s law will apply. They are not forced to simply rely on the law of the location where an investment takes place. German courts may thus get jurisdiction over investments in Africa. If an investor has the impression that local laws and local law-enforcement do not add up to legal certainty, he or she may still agree to investing if another country’s courts get the say should disputes arise.
The more trust the legal environment inspires, the more probable it becomes that promising investment ideas lead to tangible action. The rule of law makes it easier to assess – and manage – risks. All private sector companies, whether foreign or domestic, appreciate legal certainty. However, foreign investors will always ponder whether they will be treated fairly.
Foreign direct investments drive national economic development. They lead to additional employment and often increase the supply of goods on consumer markets, expanding people’s choices. In developing countries, moreover, foreign investors are prone to introducing advanced technology, so staff gets an opportunity to acquire additional skills. In the long run, tax revenues are likely to increase.
If, by contrast, governance does not inspire trust, investments become less likely. Domestic companies too are less likely to invest. On the other hand, their business model may rely on being protected from foreign competition, in which case they may charge higher prices and have less reason to worry that competent staff might be poached by other companies that offer better pay.
It is well known, moreover, that companies tend to rely on contacts and state patronage in countries where the rule of law is weak. In extreme cases, such scenarios result in individual companies enjoying monopolies in specific sectors. While those companies may obviously thrive, the impacts on the labour force and consumers are harmful.
The overall legal environment matters, and business-specific rules – including those on competition – are particularly relevant. The interaction of all branches of government should be geared to ruling out unfair competition or unfairly restricting competition. Investors pay close attention to governance in these matters.
It is generally accepted that the quality of institutions has a positive impact both on income levels and on income distribution. It is no coincidence, that the rule of law is correlated with a nation’s prosperity (see graph above). Economic research has shown that the inclination to invest increases as legal certainty improves. An independent and impartial judiciary must be fully operational. At the same time, every state agency should ensure equal opportunities. They all must respect the rights of every citizen and every company without being influenced by corruption.
During the Hamburg Summit in 2017, the G20 adopted the “Compact with Africa”. This initiative was proposed by Germany, and it is geared to improving the investment climate at nation-state levels with an eye to facilitating business activity. For obvious reasons, national governments are responsible for creating and enforcing an appropriate legal framework. Donor governments, however, are prepared to give advice and support. The reason is that, in the long run, enhanced legal certainty will lead to more investments, more jobs and sustainable growth.
Christiane Rudolph heads DEG’s Corporate Strategy and Development-Policy Department. DEG – Deutsche Investitions- und Entwicklungsgesellschaft is the subsidiary of KfW Banking Group promoting private-sector investments in developing countries and emerging markets.