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Finance & Development, March 1975
Article

Domestic construction industries in developing countries: How they can be promoted.

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
March 1975
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Edward V.K. Jaycox and Clifford Hardy

Construction is an essential industry in any economy and plays an important role in development. New construction typically accounts for from 4 to 8 per cent of gross domestic product (GDP), and from 45 to 65 per cent of gross fixed capital investment. Every developing country therefore has an important stake in the development of an efficient domestic construction industry. The appropriate range of activities undertaken by the industry in a particular country at any given stage in its economic development will depend on factors such as the volume and continuity of demand for different types of construction and on the availability of the requisite human and other resources. But the encouragement of an efficient construction industry should be an objective of both national policy and international assistance.

The construction industry can range from architectural design and engineering surveys through maintenance operations on completed structures. It can include the production, supply, and transport of building materials, and everything from residential and commercial buildings to major civil works. It can include contractual activities and those performed by departmental forces—i.e., by “force account.” However, for present purposes force account activity is omitted, and the industry is defined as the building and civil works contracting industry—the collection of enterprises, private or public, engaged in new construction of all sorts as contractors or subcontractors.

The uniqueness of construction

What are the peculiar features of this industry—the features which distinguish it from other industrial pursuits, such as manufacturing? Among the most important are the high proportion of total demand that originates in the public sector; the discontinuity and fluctuation of overall demand; the wide variety of technology and methods which can be employed to produce the wide range of outputs or any particular output; the lack of a standardized product, each being largely “tailor made” for a particular site and produced on that site; the geographical dispersion of operations, which raises special logistical and control problems; and the special risks inherent in long-term contracts and in exposure to natural forces and geophysical uncertainties.

Most construction demand in developing countries originates in the public sector. This is particularly true where, as in many cases, the greater part of residential building is performed by prospective homeowners who employ artisans and furnish them with the necessary materials. After eliminating this type of residential building, it is common that the public sector accounts for over 70 per cent of total construction demand. The total volume and composition of public demand may vary considerably with the effectiveness of the planning of public outlays on construction, the availability of external aid, and the fluctuations in government resources (arising from such factors as the country’s dependence on relatively few export commodities). This preponderance of public demand has both advantages and disadvantages for the construction industry. It gives the government the potential to guide and influence the industry in a positive sense, and it makes the industry less susceptible to the variations of private demand; on the other hand, it does make it extremely dependent on the government, which tends to create an unequal partnership, with the government largely dictating terms and conditions. Under these circumstances, political favoritism and corruption may affect the allocation and enforcement of contracts.

Inherent risks

Discontinuities and fluctuations characterize construction demand. The individual contractor competing in the market may well experience a period of complete or partial idleness between contracts, even under conditions where total construction demand is steady or rising. Investment activity, as the determinant of aggregate construction demand, tends to fluctuate more widely than the demand for manufactured consumer goods. In small and relatively poor countries, where the volume of construction is usually very limited, a few major projects may cause a rapid and temporary increase in construction and then be followed by a sharp decline. Even in countries where there is a reasonably steady increase in the volume of public construction, the industry is affected by considerable variations in the volume of private commercial building. Under these conditions, construction enterprises are subject to greater market risk than other industries, and this often makes it difficult for them to obtain necessary financing, to develop and maintain permanent supervisory staff and skilled labor, and to establish an appropriate fleet of basic equipment.

Construction still provides opportunities for a considerable choice of technology, involving various combinations of the factors of production, particularly capital (equipment) and labor. Governments may therefore be able to promote more labor-intensive technologies without significant cost penalty. The construction industry as a whole is considerably less capital-intensive and more labor-intensive than manufacturing. This is particularly true of building construction and, to a lesser degree, of civil works construction.

Unlike most of the manufacturing industry, the construction industry does not normally produce a standardized product. Nearly all construction projects are tailored to the particular requirements of the user. There is some demand for the construction of a number of more or less standardized units, but even these designs often have to be adapted to different sites, and costs vary in accordance with the price of materials and the wages and productivity of labor that can be mobilized there. Since most projects have special characteristics and specifications, past experience is not always an adequate guide to the costing. This again increases the risks involved. The site-bound nature of construction also means that there is a heavy bias toward the use of local labor and materials, and there is therefore likely to be a relatively high level of domestic value added in the construction process. This is true whether the work is performed by local or foreign contractors.

By its very nature, construction is geographically dispersed. Plant, materials, and labor must be brought to the site, and special care must accordingly be taken to price these factors of production at the site. The problem of management is more complicated because the contractor’s office is often some distance away, and supervision has to be provided on a number of sites at the same time. The geographic dispersion also produces a large number of small contractors whose activity is confined to a particular locality. This is particularly true of building contractors in both developed and developing countries. In the United Kingdom, for instance, there were still 73,248 construction enterprises in 1970. Of these, 33,118 employed seven persons or less and accounted for about 9 per cent of the total work performed by construction, while 70,821 firms employed 50 or less persons and accounted for almost 35 per cent of the volume of construction business performed by the enterprises.

Apart from the risks inherent in the market, the construction industry is exposed to a variety of other risks. Although most small building jobs need take only a short time, major building and construction works may take two or more years, during which prices and wages may well increase significantly, particularly under inflationary conditions. Unexpected soil or ground conditions may be encountered, labor difficulties may arise, deliveries of equipment and materials may be delayed, and the client may change his requirements and design. The impact and degree of probability of many of these contingencies, as well as the respective responsibilities of the employer and contractor for the additional or extra costs involved are difficult to determine in advance, except as they are defined in the contract documents or dictated by law. Contract provisions typically address price inflation and force majeure, but the burden of proof is often placed on the contractor, and adjudication of claims can be a difficult and time-consuming proposition in the best of circumstances.

Promotion

The government in most developing countries, because of its responsibility for promoting economic growth, and also its importance as the major purchaser of contracting services, has a leading role to play in promoting the domestic construction industry. A government’s definition of what constitutes a domestic enterprise is and must be relatively open, but its purpose must be to promote an efficient domestic industry capable of undertaking an appropriate range of construction activities. In the broadest sense, any resident firm contributing to this long-term capability serves this purpose, whether it is owned and/or managed by nationals or foreigners or by some combination of both. More restrictive definitions will be, and are, adopted by governments depending upon the stage of development of indigenous industry and the degree to which they seek to encourage foreign investment, immigration, indigenization, and other policies.

Stability and continuity of work volume are, as already mentioned, of great importance to the industry. Increases in public sector demand can strain the industry’s capacity during peak periods, inducing inefficiences that can be costly and increasing the risk of firms failing during the downward cycle. Governments could pay greater attention to the pace and pattern of public works expenditures, which should permit the industry to develop within a more stable framework. In particular, more advanced and reliable information about public sector expenditure plans will allow existing and incipient firms to make a more realistic judgment of market prospects.

Contracting procedures

The single most important means of promoting the development of the domestic construction industry is efficient and equitable contracting systems and procedures. The contractor should have full responsibility for the labor, materials, workmanship, programming, management, and all logistics of the construction operations. He should be paid promptly on portions of work done, measured according to specifications and terms of contract, and have access to mechanisms which allow prompt and fair settlement of disputes. In short, the contractor should be a full partner in the contract with clearly defined obligations, responsibilities, and rights. Unless this basic requirement is met, efforts to develop a domestic industry as defined here will not be effective.

Unfortunately, few developing countries have contracting procedures conducive to the development of an efficient industry. All too often, works are excessively fragmented into small contracts of short duration; contracts are badly specified; responsibilities are uncertain; payment procedures are haphazard; and procedures for the equitable settlement of disputes are nonexistent. It will not be easy to change such systems. There are many politically powerful vested interests that have a stake in the status quo, and major reforms will be necessary to overcome the inefficiencies generated by existing practices.

When these basic requirements are met, there are a number of further measures a government can take to tailor contracting procedures to the needs of an “infant” construction industry. By tendering major projects in a single contract or a few large contracts, government may discriminate against the domestic industry, which, because of its limited resources, may be unable to undertake large contracts. At the other extreme, tendering projects in small bits and pieces often leads to excessive overall costs and discourages the development of efficient capacity to handle large contracts and projects. The combined approach of “slice and package”—where a large project is divided into appropriately sized segments, and bidders are invited to bid either on parts or on the whole—offers the right kind of incentives and competitive environment for contractors of a wide range of sizes and stages of development.

Many potential contractors are also excluded from competition because of lack of working capital. Slow and cumbersome government payment procedures aggravate the need for working capital, and discriminate against the domestic firms whose access to it is often limited or expensive. By speeding up payments for work as it is performed and providing for appropriate financial advances in its contractual relationships, governments can remove an important competitive disadvantage of the domestic industry vis-avis foreign companies which may have access to less costly capital internationally. Finally, few of the small contractors are financially able to bear substantial risk of loss. Important elements in reducing risk are a clear specification of works to be performed, combined with fair settlement procedures that would ensure contractors an adequate opportunity to claim against losses due to unforeseeable and uncontrollable situations. In addition, government programs can be devised to ensure the prequalified domestic contractor against validated direct cost overruns beyond a certain level and up to an appropriate limit. These can be written into the contract in such a way as to maintain the incentives to control costs but also to protect the contractor against excessive risks.

Access to finance and foreign exchange

In the early stages of development of the industry, some active participation in financing may be required. The high risks associated with the industry often discourage the more conservative financial institutions from providing adequate support at reasonable cost, particularly for new firms attempting to enter the industry. Where access to capital is subject to government rationing, the importance of this industry and its legitimate financial needs are often apparently overlooked. The streamlined payment procedures discussed above may be sufficient, but governments may wish to increase credit availability either by guarantees of credit or by making or allowing public credit to be made available at prevailing long-term rates. Lack of access to foreign exchange to cover necessary imports—equipment and spare parts—is also a common disability of the construction industry in developing countries. Governments controlling access to foreign exchange should review their rationing criteria in the light of these needs.

One of the financially more demanding resources needed by the industry is equipment. High capital outlays, plus the specialized nature of many items and their limited usage on any one project, mean high equipment costs, unless ways to achieve high rates of utilization can be found. Even in the most developed countries it is common practice for a contractor to lease or rent such specialized equipment. The need for pooling equipment is more pronounced in developing countries where there is a scarcity of equipment and the skills necessary to manage, maintain, and operate it. Although equipment pooling or rental is not uncommon in developing countries, the development of firms specializing in providing these services is often inhibited by large-scale ownership of this type of equipment by the public sector, restrictions on imports of equipment and spares, or by the development of a few contracting firms which use their access to equipment as a way of maintaining market dominance. Encouraging the development of a market for leased equipment can be an important means of providing both the departmental forces of government and the private contracting industry with efficient access to scarce equipment.

Education and technical training

Deficiencies in training at many levels are barriers to the industry’s development in most developing countries. Any government program to promote the industry should include training elements—including a wide range of skills for labor, and technical as well as business/management skills and knowledge for managers.

National education plans should include vocational training in the building and construction trades, and there should be training institutes capable of giving instruction in equipment operation and maintenance, foreman skills, and the stores and bookkeeping areas. Such institutes can be government operated and financed, and available for public works departmental employees as well as those in the private sector or government enterprises. The training roles of labor unions and trade societies should also be encouraged by the government. Training in contracting procedures, cost estimation and bidding, accounting, cost control, personnel management, stores procurement, and the like can be taught through universities or workshops sponsored by the government. Trade associations and cooperatives can provide an effective means of disseminating information that is developed from the experience of the practicing group and from collaboration with other groups abroad. Such groups can provide efficient communication between government and the industry, and contractors should be encouraged to form such groups where they do not already exist.

For countries with little or no local experience in the contracting industry, one of the most effective methods for developing requisite managerial and entrepreneurial skills is through collaboration between local and foreign firms. One of the most important aspects of the construction industry is the ability to assess and assume risk in return for profit-making opportunities. Collaboration with an established firm provides a vehicle for the practical training and transfer of this knowledge which can be obtained in no other way. The results of such collaboration increase local capabilities over the long run. The institutional arrangements required to achieve this are likely to vary from country to country and could include joint ventures or subcontractual relationships. These relationships are often sought by foreign firms to reduce their costs and enhance their local competitiveness vis-avis other foreign firms. There are many possible forms of collaboration either in the short term for a single project or in the longer run by ownership and management arrangements whereby foreign participation can be phased out over time in accordance with agreed criteria and schedules as the domestic entrepreneurs gain experience and confidence.

Adapting to local conditions

Quite apart from the general economic desirability of adapting design practices and standards to local conditions, materials, and availability of production, it will also enhance the natural competitive advantage of a domestic industry familiar with these conditions, and the techniques evolved locally to meet them. There is mounting evidence that the world’s construction industry—including design engineers, contractors, and equipment manufacturers—has not been innovating and adapting design, technology, and construction practices to conditions in developing countries. Modern technology has been developed for capital-rich economies where labor is more fully employed and expensive; the developing economies, with reversed factor endowments, are forced to adopt this inappropriate technology or use very inefficient traditional techniques. In either case, the result is a high social cost. The problem is to develop design practices and technology that conform to the factor endowments of each particular situation. The competitive market can assist in this development if market price distortions are corrected through taxes and subsidies to reflect actual resource costs, or perhaps through shadow pricing incentives integrated into the bidding/ contracting and execution processes. The feasibility of establishing such shadow price incentives has, however, yet to be tested.

How much protection?

Perhaps the most controversial question in formulating a sound government policy to promote an efficient construction industry is to what extent and under what conditions the government should protect the domestic industry from external competition. This raises all the theoretical and practical issues surrounding the classic “infant industry” argument over protection of other industries.

The general economic case for protection is normally stated in terms of “traded” goods, mainly with reference to manufacturing, and in terms of increasing domestic value added—i.e., local employment and the mobilization of other domestic resources. Domestic value added as a percentage of output in the construction industry is generally higher than in manufacturing at any comparable stage of development. However, most of the value added in the construction process is “nontraded”; production occurs inevitably at the “point of sale” whether executed by foreign or local firms. Provided that the technologies employed by domestic and foreign contractors are similar, it is only the input of the entrepreneur and the returns to these management and technical skills and to capital that are “traded” (in the sense that “imports” are increased over what they otherwise would be if domestic contractors performed the work). These returns to the entrepreneur, which constitute by and large the potential additional domestic value added by domestic as opposed to foreign contractors, typically amount to about 15–20 per cent of the value of total output. The small difference in domestic value added between locally and foreign-owned construction firms is an argument for lower levels of nominal protection for construction than for manufacturing, where the incremental domestic value added is typically much larger. However, provided that the protection is applied to this relatively small element rather than to the value of total output, the argument for protection is analogous to that for manufacturing. In fact, in order not to distort the allocation of resources between sectors, it would appear that if a government is protecting entrepreneurial returns in manufacturing, it should also protect these returns to capital and management and technical skills in other sectors.

In cases where foreign contractors would use significantly more capital-intensive (imported equipment) technology than would domestic contractors, there would be a significantly larger domestic value added by domestic contractors, and higher levels of protection for domestic contractors and local employment would appear to be justified. There is little hard evidence on whether in reality there are large differences in technology generally employed by foreign and domestic contractors. A wide range of technologies are, or could be, employed by both, and much depends on the technical nature of the work to be performed. There is good reason to believe that except for a few situations where traditional practices might completely override the economic signals provided by the local pricing system (including taxes, import duties, and subsidies), both local and foreign firms would arrive at essentially similar decisions as to factor mix because they face identical prices for these factors. If either the local or foreign contractor chooses to ignore these price signals in favor of selecting his “traditional” factor mix, he seriously jeopardizes his competitive position. On the other hand, if there is any technological bias, it is undoubtedly in the direction of greater capital intensity for the international firm trying to overcome the natural protection of local firms by reliance on machines rather than on local labor.

Natural protection and quick maturity

Due to the site-bound nature of the industry, and its high dependence on a knowledge of local conditions, the legal/ administrative system, the market for materials and labor, and sociopolitical factors, the domestic construction industry has a substantial degree of natural protection against foreign competitors. There are few economies of scale in the industry; maturity of a firm in terms of efficiency and competitiveness does not depend on the volume of its business or its size, so much as it depends on experienced management, and sound financial conditions. Where the industry is adapted to the demands of the local market, it tends to mature quickly in relation to other industries. This fact helps to explain why during 1967-74 domestic contractors generally won over 50 per cent of the civil works contracts financed by the World Bank and awarded on the basis of international competitive bidding. A further 10 per cent was won by joint domestic-foreign ventures, and a sizable part of the remaining 40 per cent undoubtedly went to local contractors in subcontracts. World Bank statistics show that the record has varied from country to country; by and large the industry in the more advanced countries with larger markets has shown itself to be fully competitive with the world market. In the less developed countries where the domestic industry is very new or nonexistent, this is not the case. The overall performance of domestic contractors in civil works procurement, compared to the performance of domestic manufacturers in equipment procurement, tends to show that protection is less important or is required for a shorter time by the construction industry, which passes through infancy more rapidly because of its relatively high degree of natural protection.

Most countries which have some existing construction capacity and where development of the industry has proceeded beyond the building stage to civil works of at least modest complexity, have instituted measures to protect the industry at one point or another. Typically, the industry is protected by systems whereby contractors are prequalified for public works contracts of various sizes and only domestic contractors are invited to prequalify. Where large or overly complex contracts are involved that cannot be simplified by fragmentation or slicing, and no local contractors are qualified to under take them, then and only then are foreign contractors invited to bid. A few countries have employed a preference system in awarding public works contracts, by adding a certain percentage to the nonpre-ferred contractors’ bid for adjudication purposes. Countries at the earliest stages of development, where no organized domestic industries exist, may have protective regulations and procedures, but these are largely inoperative in practice.

The economic effects of these various practices are undoubtedly mixed, but no adequate analysis exists. Protective measures, on the whole, take the form of administrative restrictions on foreign competition. It is not at all clear, however, in cases where competitive industries have developed, whether this has been due to protection.

The theoretical argument for protection of the construction industry is analogous to that for manufacturing and other “traded” outputs though it calls for relatively lower levels of nominal and perhaps effective protection. Almost all countries protect their construction industry as well as their manufacturing industry. The best advice to governments contemplating protection of this or any industry is to evaluate the costs and benefits and to ensure that they are not merely compensating for deficiencies that can be remedied by other means at lower cost or risk. Finally, given the fast maturing nature of the construction industry and the degree of natural protection it enjoys, the protection of this industry should be re-evaluated at frequent intervals to avoid risk of the monopoly pricing and inefficient or corrupt practices often associated with unnecessary protection or limitations on competition.

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