Chapter

9 Economic Development and Private Sector Growth in the CIS-7 Countries: Challenges and Policy Implications

Author(s):
Sarosh Sattar, and Clinton Shiells
Published Date:
April 2004
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Author(s)
Nancy Vandycke*

Despite widespread donor assistance and substantial amounts of aid, growth rates in the low-income CIS-7 countries have been much lower than anticipated. According to the official statistics, the CIS-7 countries are economically worse off than they were a decade ago at independence. They have been unsuccessful at “catching up” with the most advanced transition countries of Central and Eastern Europeo and the Baltics. In 2001, real GDP was about a third of its 1989 level in the CIS-7 countries, compared with 88 percent in the advanced reformers. Official per capita incomes range from US$158 (Tajikistan) to US$652 (Azerbaijan), ranking them among the low-income developing countries (though on many health and education indicators, they rank much higher); they are all International Development Association (IDA) recipient countries.

The Growth Policy Puzzle

Growth performance has been disappointing despite the remarkable expansion of the private sector. Private sector activity has grown both in absolute terms and as a percentage of gross domestic product (GDP). Official statistics show that the private sector accounts for an average of 52 percent of GDP in the CIS-7 countries. All the countries have completed small-scale privatizations, and they are more than half way toward their goals in the privatization of the large-scale enterprises and the sale of strategic enterprises and public utilities.1

If the private sector—the sector with the greatest potential for economic growth and job creation—has grown during the past 10 years, why has economic development fallen behind in the CIS-7 countries? Why is the real sector unable to move forward in countries that have completed macroeconomic stabilization and undertaken basic structural reforms? And why are the CIS-7 countries unable to catch up with the rest of the region?

On a figure plotting the private sector share of GDP and the real GDP index, the CIS-7 countries lie systematically below the trend line (Figure 9.1). It is true that the CIS-7 countries have, on average, a lower private sector share of GDP than the advanced reformers of Central and Eastern Europe and the Baltics. Yet many countries in the advanced reformers group have a similar private sector share in GDP and appear on track for growth.

Figure 9.1.Private Sector Share of GDP and Real GDP Index in Selected Eastern European and Central Asian Countries, 2000

Source: World Bank database.

One reason may be that the initial endowments in the CIS-7 countries at independence were well below those in Central and Eastern Europe and the Baltics. The CIS-7 countries were geographically far from industrial markets and the advanced economies, had no history of a market economy, and were basically rural economies. They faced far greater challenges than the advanced reformers because they had to manage the challenges of transition and development simultaneously.

Another reason is the type of activities in which the private sector in the CIS-7 countries is engaged, which tend to be low value-added activities, often in the informal sector. The private sector in the CIS-7 countries comprises a large number of “traders” but many fewer real entrepreneurs. The private sector is concentrated on exploiting arbitrage opportunities rather than on country-building activities, and it operates at the interstices between the legal and illegal worlds.2 Unless the private sector matures, creating new enterprises and competing in the international marketplace, the economic growth benefits of private ownership will be minimal.

A third reason is the high-risk environment for the private sector. The CIS-7 countries are among the poorest countries of operation for international financial institutions focused on the private sector, such as the European Bank for Reconstruction and Development and the International Finance Corporation. The international financial institutions have minimal exposure in the private sector of the CIS-7 countries, avoiding real sector investment projects with the exception of projects in natural resources. Overall, investment projects have performed poorly. Credit lines have been slow to disburse, the investment climate has not been favorable for equity investments, and the performance of regional equity funds has been limited. This low exposure and poor performance across the CIS-7 countries suggests that investing in a more advanced reformer like the Kyrgyz Republic is as challenging as investing in a lagging reformer like Uzbekistan.

Private investors have been equally reluctant to invest in the CIS-7 countries, again with the exception of natural resources. Foreign direct investment rates are among the lowest in the world. This reluctance to assume political and project risks is also evidenced by the high level of domestic interest rates. Nominal interest rates for hard currency lending average 25 to 35 percent in the CIS-7 countries, a rate that includes a large premium to compensate for the high risk.

Still, there is an inherent entrepreneurial dynamism throughout the CIS-7 countries. One indicator is the labor force, which has been increasing steadily in newly created enterprises in Azerbaijan, the Kyrgyz Republic, and Moldova relative to privatized or state-owned companies.3 This growth reflects ingenuity on the part of entrepreneurs in the context of an overall collapsing official economic system. In urban areas, businesses often show good knowledge of the tax system and the “rules of the game.”

The private sector still has a long way to go, however, before it can emerge as an independent sector, free to operate without undue government interference. Growth in the private sector has come mainly from expansion in the informal sector, which can be as large as two-thirds of GDP in the CIS-7 countries (Table 9.1).

Table 9.1.Size of the Informal Economy in the CIS-7 and Advanced Transition Countries(Percentage of GDP and employment)
CountryShare of

GDP, 2001
Share of

Employment, 1999
CIS-7 countries
Georgia6653
Azerbaijan6031
Armenia4540
Moldova.4435
Kyrgyz Republic3929
Uzbekistan3333
Advanced transition countries
Poland2721
Slovenia2722
Hungary2421
Czech Republic1813
Source: Djankov and others (2002).Note: Data for Tajikistan are unavailable.
Source: Djankov and others (2002).Note: Data for Tajikistan are unavailable.

Nature of Private Sector Growth

During the 1990s, the large-scale, Soviet-style enterprises vanished, and small enterprises began to contribute an increasing proportion of economic activity. In Uzbekistan, for instance, the number of active registered large and medium-sized firms declined by 14 percent between 1999 and 2001, while the number of small firms grew by nearly the same amount. This size distribution is consistent with the low income level in the CIS-7 countries, in which the vast majority of firms are micro- or small scale.

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

Figure 9.2.Share of World Price-Sensitive Goods in Total Exports of Selected CIS-7 Countries, 1996–2000

(In percent)

Source: The Economist Intelligence Unit (2000).

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.

Box 9.1.Estimates of the Size of the Small Enterprise Sector in the CIS-7 Countries

Lack of consistent, reliable data makes it difficult to establish the actual size and structure of the small enterprise sector in the CIS-7 countries. In Azerbaijan, estimates of the total number of registered small enterprises range between 20,000 and 30,000, while estimates for the number of people engaged in entrepreneurial activity but not registered as legal entities range from 63,000 to 180,000.1 In Georgia, registered small enterprises account for an estimated 58 percent of employment. In the Kyrgyz Republic, 154,000 registered small enterprises contribute 36 percent of GDP and 23 percent of the country’s industrial production and employ 1.1 million people. In Uzbekistan, small private enterprises—about 80 percent of them in the agricultural sector—account for 16 percent of total employment.

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.

Reforms for Private Sector Development

Official statistics suggest that much progress has been made in the CIS-7 countries in terms of increasing private sector participation in the economy and transferring ownership to the private sector. Yet the state remains ubiquitous in the economies of the CIS-7 countries.

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.

Stock of State Assets

A priori, it is difficult to see how the privatization of state assets could lead the way to high value-added private sector development. State enterprises, with their overhead of excessive staff, weak management carried over from earlier days, and stock of equipment that is fully depreciated, often have little economic value other than their buildings and land. Apart from utilities and agricultural companies, enterprises are often haphazard agglomerations of industries that are not necessarily based on economic efficiency. For example, Armenia had an extensive group of manufacturing plants serving the Soviet military-industrial complex. Many of these plants were not suited for conversion to peacetime production. Uzbekistan has a large aircraft manufacturing conglomerate that makes little sense now that its alliance with Soviet airplane production is no longer assured.

Insider Privatization

It is generally acknowledged that privatization led to better outcomes in the advanced reformers of Central and Eastern Europe and the Baltics than in the CIS-7 countries.11 In the advanced reformers, privatization often involved the sale of assets to strategic foreign investors, leading to improved performance. In contrast, the CIS-7 countries, small and remote from important industrial markets, with little of intrinsic value, attracted few external investors. Privatization was based on either voucher programs or generous concessions to insiders (workers and managers). In Tajikistan, for instance, a recent private sector survey shows that 100 of the 140 privatized large and medium-sized state enterprises were insider-owned and -controlled.12 In Armenia, for a sample of 145 large joint-stock companies in 1999, two to three of the largest shareholders held about 70 percent of company stock. And in almost all cases, these shareholders were insiders.13

Firm-Level Performance

Not surprisingly, then, improvement in economic performance appears to be weakly correlated with ownership structure in the CIS-7 countries. Data on performance for the 100 largest industrial enterprises in Armenia for 1997 and 1998 show an overall decline in output, employment, and number of firms, irrespective of ownership structure. While 64 enterprises were profitable in 1997 (contributing to 71 percent of industrial output), only 30 enterprises were left in 1999 (contributing to 33 percent).14 Another study of 50 medium-sized and large private enterprises in Armenia noted that only 3 had generated any new investment. For most of the others, the prognosis was continuing decline and ultimate bankruptcy. In Tajikistan, recent evidence shows that large state-owned and privatized firms still operate as large, horizontally and vertically integrated units.15

Improvements in economic performance seem to have less to do with the ownership structure than with the level of competition. A 1998 survey of 92 state-and privately owned firms in Georgia concluded that it was not private ownership but rather competition and financial discipline that was associated with the restructuring of enterprises.16

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).

Box 9.2.How the State Maintains Its Economic Influence

  • In Uzbekistan, a private furniture company, with the state as minority shareholder, sustains its activities through state orders, allowing the company to cross-subsidize the goods delivered to the private market.

  • In the Kyrgyz Republic, a medium-sized private radiator company distributes all its profits (through dividends) to the 1,300 shareholders (former and current employees), remaining effectively a socially owned company.

  • In Tajikistan, a private silk processing company has to sign yearly contracts with the local and central governments to purchase silk cocoons from producers in the regions, remaining dependent on the state for the supply of inputs. Silk (and cotton) ginneries operate as local monopolies or oligopolies. Local authorities prevent interregional trade and protect local companies, which are sources of taxes and other payments.

  • In Azerbaijan, the foreign private oil company is “strongly encouraged” to work with Azeri-controlled private (or public) downstream companies.

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.

Trapped in a Low-Level Equilibrium

Despite reforms to create a favorable investment climate, the environment for economic activity in the CIS-7 countries remains uncertain and unpredictable, trapped in a low-level equilibrium. Uncertainty undermines managerial incentives for maximizing enterprise value.24 This level of uncertainty is shown in the decisions of all agents in the economy. Governments focus on short-term policy remedies and lack a strategic vision, because of low political turnover (Moldova, Uzbekistan), little political change (the Kyrgyz Republic), or prolonged war or conflict (Armenia, Azerbaijan, Georgia, Tajikistan). Foreign investors delay making irreversible commitments, focusing instead on developing distribution networks or demanding government guarantees or special business enclaves. And local businesses and banks emphasize short-term objectives, from blocking advances in the reform process that threaten to eliminate special advantages and market distortions that benefit them to stripping a firm’s assets when insiders become new owners.25

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
Public Sector DeficiencyMajor ProblemsPrivate Sector Consequence
Weaknesses of monitoring, regulation, and enforcement institutionsCompetition and regulatory institutionsInability to prevent anticompetitive behavior; administrative corruption; unstable regulatory environmentProblems of new entry; bribe taxes
Judicial systemWeak enforcement; absence of judicial specializationHigh transaction costs; overreliance on court system
Weaknesses of public expenditure management institutionsFiscal transparencyPoorly clarified division of responsibilities between branches and levels of government; off-budget expenditures and hidden expensesUnstable fiscal environment for business
Tax environmentLimited capacity of tax administrations; toleration of arrears; unevenly applied tax rules; gap between effective and statutory tax rateMultiple levels of taxation; underground economy
Weaknesses of public utilities and the financial sectorQuasi-fiscal activitiesExtensive system of hidden subsidies to loss-making enterprisesPoor financial discipline; exit barriers
Source: Desai (2002).
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).

Figure 9.3.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.

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.

Recommendations

More than a decade after the start of the transition, the CIS-7 countries continue to face greater challenges than the countries in Central and Eastern Europe and the Baltics. Some lessons have emerged that can provide broad guidance for improving private sector development.32

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.

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This chapter draws on consultations on the constraints to private sector development conducted in the CIS-7 countries with the private and public sectors, nongovernmental organizations, local and international think tanks, and research institutes from March to June 2002. The author would like to thank Ira Lieberman for his guidance and support; Paul Molden. Tiftany Petros, and Raj Desai for their contributions: Lola Gulomova and Marek Hudon for their research assistance; and Yong Hong for help with production. The author also thanks Gary Fine, Itzhak Goldberg, Vlado Kreacic, Claralee McLiesh, Sue Rutledge, Paul Siegelbaum, and Jakob von Weizsacker for numerous discussions anl helpful comments on earlier drafts. The author would also like to thank the peer reviewers, Jean-Jacques Dethier and Martin Raiser. The chapter benefited from comments received form participants at a seminar sponsored by the Europe and Central Asia Private and Financial Sectors Development Sector Unit on September 19, 2002. and the CIS-7 Initiative Workshop on October 17, 2002.

Molden (2002).

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