Profile of Activities

The private sector is concentrated in low value-added activities, with minimal potential effect on growth:

• Arbitrage activities. In Uzbekistan, for instance, local trade intermediaries provide inputs for manufacturing companies, owing to the lack of a domestic market for raw material and restrictions on the quantity of imported inputs. These trade intermediaries make enormous profits on the scarcity of hard currency and inputs. Prices are highly unpredictable and significantly higher than official prices, contributing to the uncertainty for manufacturing firms. In Azerbaijan, about two-thirds of a typical bank’s portfolio consists of lending for trading activities, which offer high turnover and high return. The social benefits of trade lending are low, however.

• Service sector. According to official statistics, 51 percent of Georgia’s GDP is produced by the service sector, with less than 2 percent of it in financial intermediation services.

• The agricultural sector. The number of people employed in the agricultural sector in the CIS-7 countries increased during the 1990s.⁴ The agrarian sector is the largest employer in both the Kyrgyz Republic and Tajikistan. This “re-agriculturalization” is a reversal of the traditional development pattern. In the Kyrgyz Republic, agricultural production grew 16 percent during the 1990s, while real GDP fell 30 percent. As in other low-income developing countries, private farms in the CIS-7 countries struggle with such basic problems as access to water, machinery, fertilizer, credit, and markets to sell their products.

The CIS-7 countries also share a dependence on a limited range of natural resources (Figure 9.2). Oil, natural gas, electric power, raw cotton, ferrous and nonferrous metals, gold, and uranium account for more than four-fifths of exports from Central Asia. In 1998, gold accounted for half of Kyrgyz exports, and electric power, aluminum, and cotton accounted for 85 percent of Tajik exports. Gold, uranium, and cotton accounted for 76 percent of Uzbek export earnings.⁵

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Share of World Price-Sensitive Goods in Total Exports of Selected CIS-7 Countries, 1996–2000

(In percent)

Source: The Economist Intelligence Unit (2000).

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This dependence on natural resources increased during the 1990s. Studies have found a negative correlation between the share of world price-sensitive goods in total exports and the ownership composition of exports in the CIS-7 countries. For instance, in Uzbekistan, where a significant share of exports depends on natural resources, private firms supply only a small share of exports. In contrast, in the Kyrgyz Republic, where there is less export dependence on natural resources, private firms supply a larger share of exports.

Worldwide experience shows that a development pattern based on natural resources has several other drawbacks:

• In extractive resource-based economies with heavy foreign direct investment, the expansion of domestic, downstream companies is generally limited because producers have well-developed technologies for living without local support.

• The economic growth derived from exports of these resources is determined by the world market—and is vulnerable to fluctuations in world demand and prices. The economy thus becomes dependent on the world market, unless development of the extracting sector is complemented by an active industrial policy.

• Investments in the extractive sector are typically of an enclave type, large enough to support their own infrastructure and sufficiently insulated that they can operate in weak regulatory environments. Evidence shows that this development pattern weakens the overall business environment.

• Governments grant privileges to foreign companies under well-crafted special agreements that give the companies bargaining power with the government and let them credibly threaten to leave—advantages that override possible dis-advantages, such as being unfamiliar with local circumstances.⁶ Domestic, nonextracting companies seeking to market goods and services to the upstream companies do not receive the same privileges from governments, putting them at a disadvantage in dealing with the foreign companies.

Economic Performance of Small Enterprises

Evidence for the CIS-7 countries and indirect evidence from neighboring countries such as Russia, Ukraine, and Kazakhstan suggest that the development of small enterprises in the CIS-7 countries has been significantly different from that in the advanced reformers of transition Europe. The (official) contribution of small enterprises to value added and employment is generally well below that in the advanced reformers. For example, registered small enterprises account for 36 percent of GDP in the Kyrgyz Republic (see Box 9.1) compared with 58 percent in the Czech Republic. Some evidence suggests that there is a threshold of about 40 percent for the shares of small enterprises in employment and value added, below which economies do not take off.⁷

In the CIS-7 countries, the productivity differential between new (mostly small) and old (mostly larger) enterprises is still considerable after a decade of transition, whereas in the advanced reformers, the differential has diminished. Empirical evidence shows that new, small enterprises in transition economies tend to be more productive than old enterprises.⁸ At the start of the transition, the labor productivity differential between new and old enterprises tends to be significant.⁹ But as the transition proceeds and resources are progressively reallocated, the productivity differential is expected to erode.

What went wrong? For a small enterprise-based pattern of development to deliver high growth, several preconditions should be met:

• enough large enterprises that can perform activities requiring large fixed investment, such as processing, marketing, and exporting;

• a well-functioning public sector that can supply necessary infrastructure and guarantee the security of transactions; and

• a structured market for development of subcontracting and supply chains (good coordination among entrepreneurs).

These conditions are often lacking in the CIS-7 countries. In the Kyrgyz Republic, a recent assessment found no mechanism to bridge the gap between the excess production capacity of large privatized enterprises and smaller enterprises’ need for production capacity. Large state enterprises, now privatized, were originally built to be self-sustaining, producing all their own inputs. By contrast, small enterprises lack access to capital equipment and have to import a large share of their inputs.¹⁰ Thus, unless there is a structured market for subcontracting, small enterprises will not be able to lead the process of economic growth.

The increase in the number of small enterprises in the CIS-7 countries has been insufficient to compensate for the collapse in activity of larger enterprises for several reasons. First, small firms have a lower capacity to deal with a defective business environment. Second, small enterprises are often spin-offs of large, vertically integrated firms that were broken down into smaller units, but with negligible effect on performance. And third, as mentioned, small enterprises are concentrated into low value-added activities.

Transfer in Ownership—Often to Insiders

Evidence for the CIS-7 countries suggests that most of the increase in private sector activity is attributable to the privatization of state enterprises rather than to the establishment of new firms. In the Kyrgyz Republic, the private sector contributes 70 percent of GDP. In Tajikistan, the poorest of the CIS-7, 98 percent of trade is in private hands, while 80 percent of industrial production is private. Even in Uzbekistan, the lagging reformer in the CIS-7, the private sector produces more than half of official GDP. Yet despite the change in ownership, there has been little impetus to grow from the new private sector.

Continuing State Interference in Private Sector Activity

The state is involved in the economies of all the CIS-7 countries, though the intensity is greater in the Central Asian countries than in the Caucasus countries or Moldova.¹⁷ Moreover, while ownership nominally may have changed, enterprises have often remained effectively under the umbrella of the state. In Moldova’s voucher-based privatizations, for instance, the population invested their vouchers in heavily indebted enterprises, only to become legal owners of firms that were effectively controlled by their creditors. Owing to tax and energy arrears, the creditor was often the state.

Continuing State Control over Land and Agriculture

Even though land has been privatized, governments still play an active role in agriculture. In Uzbekistan, the sector is largely state controlled, with the government setting targets for the production of cotton and grain and setting the local currency price for these crops. Control of cotton exports, which account for up to a third of exports, gives the government access to hard currency, which it uses to finance its industrial policy and service the foreign debt.¹⁸ In Tajikistan, about 40 percent of the arable land remains under the control of unreformed state farms.¹⁹ The government privatized the low value-added agricultural areas and kept much of the high value-added areas under state control. In mountainous areas where cotton is not grown and there is no irrigation, land from the former state and collective farms (about 30 percent of arable land) was distributed fairly equally among private farmers.

Control by Trade Associations

There is often little distinction between the role of government as policymaker and regulator, on the one hand, and business shareholder (owner) and manager, on the other. In Uzbekistan, for instance, “trade associations,” which were established by presidential decrees, control key sectors. Although the functions of the associations vary, they include lobbying to advance member interests; rationalizing output, pricing, investment, distribution, input, and foreign exchange allocation decisions; and operating as de facto holding companies. Some are thinly veiled replicas of the line ministries during Soviet times. Most associations are not in favor of privatization of their members, and they act to obstruct any movement in that direction. While association membership is not mandatory, in practice virtually every firm operating (or seeking to operate) within a given sector becomes a member of the sector’s trade association.²⁰

Shareholders’ Voting Rights Not Respected

State interference can take more subtle forms. When the state continues to hold shares in a company, legal provisions on joint stock companies often ensure that neither minority investors nor strategic investors have the ability to influence company management or to exercise shareholder rights. In Uzbekistan, for instance, if the state owns any shares in a company—as it typically does in privatized enterprises—a shareholders’ meeting is not valid if the state representative is not present. Furthermore, for 15 days after the shareholders’ meeting, the government’s agent can defer decisions made at the meeting if they “contradict the interests of the state.” In companies in which the state holds 25 percent or more of the shares, the State Property Committee can increase the amount of the charter capital unilaterally, diluting the interests of the shareholders.²¹ Other examples of state interference in the business sector abound (see Box 9.2).

High Cost of Becoming Prominent

State interference in the business sector can impede formal private sector growth when the incentive structure encourages businesses to remain small. Anecdotal evidence suggests that profitable businesses choose either to expand unofficially or to change the nature of their operations to remain unnoticed. When businesses expand unofficially, the detrimental effect on growth may be small, even though the transaction costs to circumvent the restrictions are high. In Uzbekistan, businesses adopt double bookkeeping practices to avoid “excessive” tax payments and circumvent bank restrictions and oppressive inspection controls. In Azerbaijan, banks allocate credit on the basis of both official and unofficial accounts. These and similar practices are integrated into the normal functioning of the business sector and do not preclude business growth as such. However, when businesses change the nature of their operations to remain unnoticed, the effect on growth can be substantial. In Azerbaijan, an entrepreneur borrowed money to open a small ice-cream business. As the business grew and he feared attracting attention, he reduced his business activity, reimbursed the loan, and borrowed money to open a shoe shop in the second year. The third year, he closed the shoe shop and started a third business.

Neglect of Property Rights and Corporate Governance

In Western economies, shareholders and their representatives on the board of directors serve as a check on company managers. That is often not the case in the CIS-7 countries. Georgia’s Securities Industry Association estimates that as many as a third of reporting companies fail to hold required shareholders’ meetings for such important issues as making large transfers of assets or amending the company charter. As many as half the traded companies are in violation of the basic corporate governance provisions of the company law.

Often, the laws do not prevent company managers from enriching themselves at the expense of shareholders and other stakeholders, including creditors, tax collectors, employees, and customers. In Uzbekistan, as much as half of a company’s assets can be sold without shareholder approval, with just the agreement of the supervisory council. Even worse, Tajikistan does not require shareholder approval of sales of even 100 percent of company assets.²² In Armenia, the Joint Stock Company Law allows assets of up to half the book value of the company’s assets to be sold or transferred to other parties solely on the decision of the company board.²³

Weak corporate governance also is seen in the lack of transparency of joint stock companies and even financial institutions, including banks, leasing companies, and insurance companies. Reliable information on the ownership and control of companies and financial institutions is unavailable to shareholders, creditors, and regulators. Financial-industrial groups (based on clan affiliations or other relationships) provide capital for member companies within the group but almost no financing for enterprises not owned and controlled by the groups. Access to capital remains a major stumbling block for growth of the private sector.

Public Sector Deficiencies Undermine Private Sector Development

In the CIS-7 countries, the public sector directly undermines private sector development through various channels (Table 9.2):

Table 9.2.

Private Sector Effects of Public Sector Deficiencies in the CIS-7 Countries

Source: Desai (2002).

Table 9.2.

Private Sector Effects of Public Sector Deficiencies in the CIS-7 Countries

Public Sector Deficiency		Major Problems	Private Sector Consequence
Weaknesses of monitoring, regulation, and enforcement institutions	Competition and regulatory institutions	Inability to prevent anticompetitive behavior; administrative corruption; unstable regulatory environment	Problems of new entry; bribe taxes
	Judicial system	Weak enforcement; absence of judicial specialization	High transaction costs; overreliance on court system
Weaknesses of public expenditure management institutions	Fiscal transparency	Poorly clarified division of responsibilities between branches and levels of government; off-budget expenditures and hidden expenses	Unstable fiscal environment for business
	Tax environment	Limited capacity of tax administrations; toleration of arrears; unevenly applied tax rules; gap between effective and statutory tax rate	Multiple levels of taxation; underground economy
Weaknesses of public utilities and the financial sector	Quasi-fiscal activities	Extensive system of hidden subsidies to loss-making enterprises	Poor financial discipline; exit barriers

Source: Desai (2002).

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Table 9.2.

Private Sector Effects of Public Sector Deficiencies in the CIS-7 Countries

Public Sector Deficiency		Major Problems	Private Sector Consequence
Weaknesses of monitoring, regulation, and enforcement institutions	Competition and regulatory institutions	Inability to prevent anticompetitive behavior; administrative corruption; unstable regulatory environment	Problems of new entry; bribe taxes
	Judicial system	Weak enforcement; absence of judicial specialization	High transaction costs; overreliance on court system
Weaknesses of public expenditure management institutions	Fiscal transparency	Poorly clarified division of responsibilities between branches and levels of government; off-budget expenditures and hidden expenses	Unstable fiscal environment for business
	Tax environment	Limited capacity of tax administrations; toleration of arrears; unevenly applied tax rules; gap between effective and statutory tax rate	Multiple levels of taxation; underground economy
Weaknesses of public utilities and the financial sector	Quasi-fiscal activities	Extensive system of hidden subsidies to loss-making enterprises	Poor financial discipline; exit barriers

Source: Desai (2002).

• Involvement in purely commercial activities. CIS-7 governments have entered into joint ventures with foreign and domestic companies, and they still control a large share of both the enterprise and the financial sector. In Uzbekistan, for instance, private banks have to compete against state-owned banks that can lend at below-market rates because they have access to cheap budgetary resources.

• Predatory tax enforcement. Tax enforcement tends to be predatory, with forced collection of frozen bank accounts and property seizures. Yet collection rates suffer and taxation is unevenly applied, with the most efficient firms bearing the greatest burden. Some private firms pay as much as 50 to 60 percent of their net income in taxes, while certain firms—especially former state-owned enterprises—are permitted to accumulate large tax arrears.²⁶

• Investment-based tax incentives. Tax incentives intended to attract investment have instead undermined the investment climate and retarded progress in making the tax code more efficient. Tax holidays and other incentives—most based on short-term assessments of the trade-offs between revenue collection and investment promotion—are frequently reversed, creating enormous uncertainty. In Azerbaijan, almost all tax privileges given to foreign investors were suddenly revoked by presidential decree. Such frequent changes have eroded the credibility of the tax regime rather than promoting investment and employment.

• Multiple licensing requirements. Entrepreneurs have to obtain multiple, sector-specific licenses to carry out their activities in the CIS-7 countries. These requirements, a holdover from the days of state control, often have no relevance in a market economy. They provide opportunities for corruption and consume entrepreneurs’ time and money, throwing the business sector into a vicious circle of state control and rent seeking.

Frequent and Piecemeal Changes in Laws and Regulations Feed Bureaucratic Discretion

While many laws supporting a market economy are now in place, the regulatory framework for business (licensing, basic operation, taxation, contracting) is uneven, contradictory, overlapping, and frequently amended. Ordinary legislation commonly is “supplemented” by executive decrees—often thinly disguised attempts by the executive branch to sidestep parliamentary laws in order to protect favored constituents or regions. Rule by decree also lacks accountability, since executive decrees—unlike laws—are not subject to legislative scrutiny or administrative review.

In Tajikistan, security rights over movable and immovable assets are governed primarily by the Civil Code of June 1999. However, the Mortgage Law of June 1994, as amended in 1995 and 1998, also regulates security rights over movable and immovable property. Since the two laws cover much the same subject matter; there is great uncertainty about which provisions are applicable.²⁷

Frequent and piecemeal changes in laws and regulations allow for discretionary and discriminatory interpretation by public officials. This situation has enabled officials to use the regulatory apparatus to channel benefits to favored groups (for example, regulatory forbearance is often applied to joint-stock companies in which the government participates).²⁸ Intrusive inspections by tax authorities, police, prosecutors, and other officials are common, and onerous regulations and licensing requirements encourage rent seeking by public employees. Thus, the unstable and inconsistent regulatory framework leads to corruption at all administrative levels.

Lack of Incentives to Operate Formally Weakens Demand for a Better Investment Climate

The large informal sectors in the CIS-7 countries are not just a sign of lax enforcement of tax laws. They also reflect an underlying problem in the social framework for private sector development: the absence of benefits from joining the formal sector. By choosing to stay informal, firms are saying that the costs of formalizing outweigh the expected benefits.

In the CIS-7 countries, the benefits of becoming formal are uncertain at best. In a Western developed economy, formal firms, as legal entities, have greater access to credit, can conduct business in a predictable manner with other legal entities, particularly on matters of contract enforcement; and can enjoy the advantages of modern limited liability forms, such as incorporation. In the CIS-7 countries, however, access to credit does not depend on legal institutions such as collateral, but rather on the lender’s firsthand knowledge of the applicant, while contract enforcement is weak at best.²⁹

Under these conditions, the demand from businesses for a better investment climate is likely to be minimal. In the advanced reformers of Central and Eastern Europe and the Baltics, demand for market-based institutions, including a better investment climate, and protection of property rights and the rule of law originated with the businesses themselves. Their objective has been to increase the benefits and reduce the costs of doing business. Absent this demand from businesses, improvements in the business environment in the CIS-7 countries are likely to be supply-driven only.

The indirect social costs of a growing informal sector are large. Formal sector companies must compete against companies that operate informally, paying no import tariffs or taxes. A survey in Tajikistan shows that only 59 percent of companies make full disclosure of their revenues to tax authorities.³⁰ Informal sector activity thus results in lower tax collection, reducing the ability of the public sector to perform its core functions. Another consequence is that formal sector companies must deal with the delays and high costs associated with inadequate customs administration. The financial sector is also underdeveloped as a result of extensive informal sector activity. Financial development in the CIS-7 countries is substantially below the average for the poorest group of countries. In 2000, the ratio of private sector credit to GDP in five of the CIS-7 countries was less than 10 percent of GDP—about a quarter that in countries with similar per capita GDP and less than 10 percent of the average in high-income countries (Figure 9.3).

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Average Credit to the Private Sector in Five of the CIS-7 Countries Compared with Other Countries, by Income Group

Sources: International Financial Statistics Database and World Development Indicators Database.Note: Credit to the private sector from deposit money banks and other financial institutions. High income countries had GDP per capita in 1999 of more than US$10,000; upper middle income countries had GDP per capita of between US$3,000 and US$10,000; lower middle income countries had GDP per capita of between US$1,000 and US$3,000; low income countries had GDP per capita of less than US$1,000. Data for Uzbekistan and Tajikistan were unavailable.

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Evidence from a recent survey by the Microfinance Centre indicates that the informal sector in Eastern Europe and Central Asia, including the CIS-7 countries, is financed mostly by nongovernment organizations (NGOs). In general, NGOs escape the supervision of banking authorities and the red tape and political influence of governments as a result of their legal status as international organizations operating under intergovernment agreements.³¹

Focus on Domestic Rather Than Regional Policies

The CIS-7 countries remain inward-focused even though regional issues are pressing: border conflicts, spillover risks from the war in Afghanistan and regional conflicts, and growth constraints owing to the small size of domestic markets. Consider the Caucasus, including Turkey. It offers a potential market of 110 million inhabitants. Yet each Caucasus country produces and supplies goods and services mainly to its own internal market. A critical issue is the lack of incentives for large, resource-endowed countries, such as Kazakhstan and Uzbekistan, to integrate with smaller, poorer countries, such as the Kyrgyz Republic and Tajikistan.

Within the CIS as a whole, economic and political relations generally have been established on a bilateral basis rather than CIS-wide. Many CIS countries have been unwilling to strengthen their links with post-Soviet Russia. Consequently, the CIS has never evolved into a free trade area. Some nations have formed alliances without Russia, while others have strengthened their relations with Russia (see Chapter 10). However, while international integration based on free trade can provide significant potential for catch-up growth, it exposes previously sheltered economies to new types of risk, arising from cyclical variations in external demand and private capital flows, that must be managed effectively.

Create an Environment Conducive to Private Sector Development

Evidence shows that the overall business environment is the most important determinant of enterprise competitiveness and growth. As a first step, registration, licensing, and inspections that unduly restrict business operations and encourage businesses to remain underground should be eliminated. Interventions to support the private sector should be limited and well designed. For instance, the direct provision of credit to small enterprises through state funds tends to substitute for markets rather than dealing with the underlying causes of underdeveloped markets.

Promote Entrepreneurship

The private sector in the CIS-7 countries has few truly entrepreneurial firms. The challenge is to develop a class of entrepreneurs to improve the quality of the private sector. Institutions that incubate and support entrepreneurial efforts should be supported—including microfinance and other lending institutions, both banks and nonbank financial institutions. Extensive efforts should be made to train managers and senior staff and to expose them to the way businesses operate under real market conditions. Increasingly, such opportunities exist in Central and Eastern Europe in countries and firms that have been through the transition and now operate under market conditions.

Find Ways to Support Greenfield Investments

International financial institutions such as the European Bank for Reconstruction and Development and the International Finance Corporation could support efforts to improve the basic infrastructure in CIS-7 countries. But so far, due diligence has kept them out of many activities in these countries, because so many locally owned enterprises have poor corporate governance standards, and many potential sponsors could not pass the screening and credit requirements. Alternative mechanisms, such as guarantee programs, should be explored to support greenfield investments.

Prepare Carefully for Privatization

Privatizations often have been pushed through the reform agenda with the hope that the result will be efficient, well-governed private enterprises. This result has not been achieved in many cases. A more gradual approach is needed that includes restructuring monopoly enterprises to provide for new entry and competition, as appropriate; corporatizing some state enterprises; restructuring and improving corporate governance prior to sale; using contracting out and concessions more extensively for infrastructure and utility sales when strategic private owners cannot be found; and searching for potential buyers outside traditional Western markets. For utilities and natural resource companies, adequate capacity and regulatory frameworks should be developed before sale. To compensate for deficiencies in basic infrastructure, donors may need to consider greater support for greenfield investments and using guarantees more extensively to attract private investors.

Encourage “Nontraditional” Investors

Foreign investors from Western countries had a natural financial and strategic interest in Central and Eastern Europe and the Baltics because of their proximity. Such interest in investing in the CIS-7 countries is unlikely. Foreign investment should be sought from other, more closely aligned markets. Investors from China, India, Indonesia, the Republic of Korea, Malaysia, Pakistan, Turkey, and Russia have the necessary capital and business sophistication to deal with the complex, difficult markets of the CIS-7 countries. Attracting such investors requires improving the business environment and moving toward greater regional integration to increase the potential market for investment.

Establish and Enforce a Consistent Legal Framework

Complaints about the inefficient regulation of business in the CIS-7 countries often focus on the legal system and on how well laws reflect the legal systems of industrial countries. Attention should focus instead on determining how well laws and regulations achieve desirable economic ends in the CIS-7 countries, which have very different economic and institutional constraints than advanced industrial economies. Analysts rarely address nuts and bolts questions such as, What is an efficient regulatory system for hotels? For restaurants? For barbershops? Most transition countries have ended up with a patchwork of legal reforms and little real judicial capacity.

To attract investors, to enable the growth of enterprises, and to bring firms in out of the shadow economy, the private sector strategy needs to be anchored in a sound legal framework that addresses a variety of legal needs—company law, collateral laws, security laws, bankruptcy laws, and antimonopoly laws. The legal system needs to respect shareholder and creditor rights and other contractual rights, and judicial enforcement must be competent and noncorrupt. To move toward a consistent system of laws that matter for operating a business, a careful line-by-line analysis of general business regulation should be undertaken, identifying which laws should be revised and when.

Focus on Regional Integration

Regional integration efforts are important in a context in which the market size of some of the CIS-7 countries is less than 4 million people. Growth will require businesses to sell beyond domestic markets. The advanced reformers of Central and Eastern Europe are accelerating the pace of reforms because they have the prospect of joining the European Union. It is less clear what the integrating factor might be for this region of the world. The CIS-7 countries are a diverse group, with no apparent integrating factor. The international financial institutions could help to encourage mutually beneficial cross-border efforts.