Promoting private sector growth in fragile states could be one tangible first step toward better governance and more diverse, robust economies. However, despite a sound rationale for public sector intervention in the private sector, private sector development (PSD)–focused activities in fragile state environments remain vulnerable to a range of binding or limiting constraints.

1. private sector drivendevelopment finance inFragile andConflictStates.
Theoretically, the private sector has many opportunities to thrive inenvironments in which
traditional aid cannot succeed. For instance, the private sector canexist (and even thrive)
even when there is no central government that is stable enough to accept foreignaid(for
example, Somaliland). This could make the private sector aparticularlyviable and valuable
target for economic development interventions infragile states. Therefore, promoting private
sector growthin fragile states couldbe one tangible first steptowardbetter governance and
more diverse, robust economies.
However, despite a sound rationale for public sector interventioninthe private sector, private
sector development (PSD)–focusedactivities in fragile state environments remainvulnerable
to a range of binding or limitingconstraints. Fragile states generallyare categorizedbyvery
weak business climates that oftenrestrict individual firm activities throughseveral channels.
In particular, the indirect costsof poor infrastructure, regulatorychallenges (suchas
excessive licensingfees, bribes, and so forth), and low labor productivity can reduce profit
margins and reduce incentives for business owners and prospective entrepreneurs.
These effects canbe exacerbatedin fragile states, inwhich governments and institutions
routinelyfail to administer services, enforce contracts, andreduce corruption. Political risk
also is a major concernfor multilateral institutions that wish to invest in the African private
sector. This illustrates Africanfragile states’acute needfor customizedfinancing
instruments, suchas political riskguarantees. Fragile states also lackthe human capital
neededto operate scalable business ventures. While skilledmicro-entrepreneurs mayexist en
masse in countries, many of the most skilled business people (suchas those with formal
skills in accounting, personnel management, strategic planning, riskanalysis, marketing, and
the like) have oftenleft these hostile businessenvironments for morelucrative and/or secure
opportunities abroad. Although these highly skilledworkers oftensendhome substantial
remittances, theyfrequentlydo not maintain local businesses inthe fragile-stateenvironment
from where they came.
Many firms in fragile states are also heavily constrainedby what Ramachandran, Gelb, and
Shah (2009) refer to as “external costs.” These external or indirect costs suchas those
stemming from failures inelectricityservice provision, transport infrastructure, andsupplier
networks often erode individual businesses’profit-makingcapabilities. In other words, many
African firms’ “ability to produce value beyond the cost of their direct andindirect inputs is
heavily constrainedby the magnitude of the cost of the latter. “Finally, markets for goods in
nearly all of our 14 fragile states are particularlydisparate and weak. Even with strong
support from multilateral development banks on the supply side, the private sector will not
thrive without predictable and steadilyincreasingdemand from local consumers.
Rationale for the support ofthe private sector drivenInvestments.

2. Before launchinginto a more in-depthdiscussionof PSD initiatives in fragile states, we shall
examine several broad theoretical rationales forpublic sector support of the private sector.
First, it is believedthat PSD activities helpto create jobs and foster economic growth(the
private sector accounts for roughly90 percent of jobs inthe developing world).11 Second,
many argue that the public sector should support the private sector because individual
businesses are constrainedbynumerous government-driven limitations, ranging from
corruptionto lackof physical infrastructure. Third, many of these constraints resultfrom
market deficienciesthat theoretically canbe rectifiedby public sector initiatives. For
example, imperfect capital markets hinder businesses—notably small and medium
enterprises—bynot investing in profitable projects. This oftenoccurs because of imperfect
informationregarding profitability, high transactioncosts, and insufficient legal frameworks
and enforcement mechanisms. Relatedly, informal and small firms are oftenunable to pledge
collateral andlack formal title rights to physical property. Another example relates to
governance. PSD requires an appropriate institutional frameworkthat the private
sector cannot provide for itself. While thereare several examples of private sector firms
joiningtogether to helpstabilize the governance environment (suchas in Somaliland), most
firms in fragile states are unwilling or unable to create the institutional framework
necessary to promote PSD bythemselves.
Existing multilateral efforts—theWorldBankGroup
The WorldBank Group and others donor organizations’PSD goals in African fragile states
broadly mirror those inother low-income countries. The key differences relate to developing
policies andprojects that are tailored to the more difficult operating environments. The
WorldBank’s soft loanfacility (the International Development Association, or IDA) has a
significant presence infragile states. All the African fragile states are IDA-eligible.
Although one of IDA’s specific fociis PSD, its projects inmany sectorssuchas
infrastructure andregulatory reform result in positive spillover effects for private sector
businesses. Indeed, much of IDA’s contributionto the private sector mayresult from indirect
benefits from non-PSD–focusedIDA projects. IDA’s current eligibilityrequirementshave
significant implications for the institution’s future. A recent studyestimates that by 2025,
most IDA-eligible countries will be African fragile states—arealitythat may compel IDA to
restructureits strategy around fragile lending environments in the comingyears. By
extension, adapting to the specific constraints of fragile states will be essential to IDA’s
continuingsuccess.
To ensure that scarce public sources or resources, includingthose entrustedto IDA, are used
to the best effect, andonly when and where they are necessary, the WBG are developing a
Cascading approach to financing, especiallyfor infrastructure projects.
This Cascading approach prescribesthat private sector solutions are consideredfirst, then
Public Private Partnerships, and - if the first two are not feasible thenonly then – public
sector solutions are pursued. This approach would free-upscarce public resources andallow
them to be deployedto facilitate reforms andexpand the pool of well-structuredprojects that
can be financed with commercial capital.
This can be achieved through three-prongedapproach

3. 1. Help governments create an enabling environment for business and private
investments. Also, prepare projects;buildstrongproject pipelines, andlower existing
informational barriers anddeveloping a pipeline of well-prepared, investment-ready
infrastructure projects, as well as working on improving and standardizing
procurement processesso that the whole process becomes muchmore affordable and
more predictable, helpingto attract investors.
2. The secondpart of this approach is to explore different ways of risk-sharingwith the
private sector to alignopportunityto their riskappetite. Guarantees are a key
instrument that can help mobilize capital for projects that are viable, but will not
proceedotherwise unless investorsandlenders are protectedagainst certainrisks or
catastrophes. Byreducing project risk, the guarantees expand access to funding for a
broader universe of investors and savings.
3. The third, part of this approach is through the support the development of domestic
capital and of instruments suitable to institutional investors, so that you can mobilize
domestic resources andforeigninvestments.