Chapter

VI Private Sector Development

Author(s):
Françoise Le Gall, L. Psalida, Pietro Garibaldi, Julian Berengaut, Jerald Schiff, Kerstin Westin, Augusto López-Claros, Richard Stern, and Dennis Jones
Published Date:
November 1998
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Author(s)
Richard Stern

To address the issue of private sector development in the Baltic countries, many economists have focused on privatization, assuming that it is a proxy for private sector development. But as the experience of countries such as Poland has revealed, privatization, though important, is only part of the story. Here, a more comprehensive approach is taken; the development of the private sector is considered the nexus of a policy agenda that establishes a solid legal and institutional framework and promotes both privatization and growth of capital markets. It is argued that obstacles to private sector growth stem from inadequate legal and institutional frameworks and from barriers to the development of capital markets. Though the analysis focuses on the Baltic countries, the main conclusions might be applicable to other countries in transition as well.

Methodological Issues: Definitions and Measurement Biases

Why should attention be paid to the development of the private sector? It is clear that the development of the private sector in itself is not a sufficient condition for high levels of economic growth. Rather, private sector development is interpreted as an “index” of the progress made in a transition economy from central planning to market-driven allocation of resources. It is argued below that the development of the private sector depends on the development of strong legal and institutional frameworks as well as the continued widening and deepening of capital markets. Both conditions are signs of strong progress during the transition. Thus, private sector development can be interpreted as a proxy indicator of the extent of progress during the transition process.

A fundamental issue facing the study of private sector development is determining what is private and what is not. This issue has both micro- (firm level) and macroeconomic (aggregate) dimensions. At the micro level, for example, is a firm that has gone through privatization and has had only 30 percent of its assets transferred to private hands to be considered private or still in the state sector? From a political standpoint, the firm may be called private by the government (perhaps to fulfill quantitative privatization targets), although effective control is still in the hands of the state. At the macro level is the additional problem that countries might define the private sector differently. Most countries consider the private sector to be the “nonstate” sector. But state-owned enterprises might be considered nonstate, thus overestimating the extent of private sector development. Therefore, even with strict guidelines defining what is private and what is not, the measurements, especially at the macro level, are imprecise at best. For this paper, the private sector is defined as the “nonstate sector”; thus firms whose assets have been even partially divested by the state are considered private.

The two most common measures of private sector development are total output by the private sector as a proportion of GDP and employment in the private sector as a percentage of total employment. Both of these measures are imperfect. As regards the output-GDP measure, at the macro level it is commonly accepted that official statistics in transition economies do not fully capture private sector activity. Some of the activity is hidden to avoid taxation. Thus it is reasonable to assume that the actual level of output generated by the private sector is actually higher than reported. At the same time, private sector development measured by output contribution magnifies the importance of private sector development in general. In most transition economies, the source of private sector development is primarily the entry of new, small businesses—predominantly in the service sector (such as catering and tourism) as well as small-scale retail trade. In the data, it might appear that private sector development is large because the growth of small businesses measured as a percentage of GDP is magnified by the simultaneous sectoral output declines in manufactured goods, industrial production in general, and agriculture both in terms of volume and employment. Thus, the data are biased upward owing to the rise of small firms, and not necessarily owing to private sector control of traditionally large sectors (large as a percentage of GDP), such as heavy industry and manufacturing.

The employment measure also has its biases. First, this measurement might understate the true private sector contribution to the economy because in most cases, a private firm would use less labor than its state-owned counterpart, such that the number of workers may be low but total output may be high. Thus the greater efficiency of the private sector (in theory) suggests a lower number of workers (i.e., productivity of labor is higher in the private sector) than in a comparable state sector firm. The other problem is again under-reporting. To avoid social contributions (on the firm side) and income tax (on the worker side), a worker's labor may go unreported and therefore the total number of workers employed in the private sector might be understated.

Progress in Private Sector Development

According to EBRD estimates, private sector activity has grown rapidly, as measured in percent of total GDP and in percent of total employment. These figures compare favorably with the Czech Republic (75 percent of total GDP in 1997), Poland (65 percent of total GDP in 1997), and Russia (70 percent of GDP in 1997) (see Table 6.1). As noted above, the figures might be misleading, given the differences in definition of what constitutes private versus state sectors, as well as the caveats stated above regarding measurement. In Latvia, for example, the bulk of private sector activity is in agriculture, construction, and services (especially retail trade and financial intermediation), whereas in industry, most of the production is still in state hands.

Table 6.1.Measurement of Private Sector Development(Percent)
Country1991199219931994199519961997
Estonia
Percent of GDP181455158657070
Percent of total employment1115
Latvia
Percent of GDP50586065
Percent of total employment1231475358
Lithuania
Percent of GDP16375762656570
Percent of total employment
Source: EBRD (1995, 1996).

This figure is defined as pure private sector, whereas all other figures are defined as nonstate sector unless otherwise noted.

Source: EBRD (1995, 1996).

This figure is defined as pure private sector, whereas all other figures are defined as nonstate sector unless otherwise noted.

Necessary Conditions for Private Sector Development

Three conditions are necessary but not sufficient individually to generate private sector development:1

  • institutional foundations to create the environment conducive to private sector development;

  • privatization; and

  • availability of capital, or development of domestic capital markets.

It is argued here that the absence of these conditions imposes barriers to private sector development.

To date, most countries in transition have not fully met these conditions for private sector development; as a result, the ability of the private sector to grow has been constrained. In many cases, economic policy has explicitly impeded or prevented the development of at least one of these conditions. Where the impediments have been removed eventually, valuable time has been lost and private sector development was substantially inhibited.

At the same time, cross country analysis indicates that there is no clear optimal order of sequencing of these conditions. Many countries (such as the Czech Republic and Russia) chose to begin economic reform with privatization as the centerpiece; whereas others (Poland, Estonia, and Latvia) chose to set up the institutional foundations first before privatization. All have found that the shortage of capital (domestic and foreign), due either to microeconomic credit constraints or to insufficient financial market depth and breadth, has been a binding constraint on private sector development.

Institutional Environment Conducive to Private Sector Development

As the backbone of private sector development, a consistent and comprehensive legal framework allows entrepreneurs to know the “rules of the game” to make rational investment and production choices. Not only does this necessary condition require the adoption of laws and commercial codes, but it also requires that the legal framework be implemented in practice. Many countries, including Latvia and Lithuania, have adopted the necessary legal infrastructure but have been slow in implementation, resulting in commensurately slow private sector development and low levels of foreign direct investment.

At a minimum, a legal framework capable of fostering the development of the private sector requires:

  • a set of laws governing the incorporation of firms;

  • a transparent commercial code;

  • a competition policy and institutions dealing with competition issues;

  • a consistent set of laws governing all aspects of privatization;

  • a set of laws governing land reform and ownership;

  • clear bankruptcy legislation;

  • laws defining the legal rights of foreign participants in the domestic market; and

  • laws governing foreign investment.

In most transition countries, including the Baltics, the problem is less the adoption of the laws than their implementation. Bankruptcy laws in particular have been slow to be adopted and rarely enforced.

Privatization

Countries such as Poland have shown that privatization in itself is not a sufficient condition for private sector development.2 At the same time, privatization is a signal that the government is serious about moving forward with a key component of the transition. Because it involves the divestment of assets formerly held by the state, privatization is usually considered the engine of private sector development, as it forces firms to operate in a market environment (which in itself should necessitate firm restructuring).

The speed of implementation of privatization appears to affect its outcome. That is, the faster the transfer of assets, the faster the process of restructuring begins, and the more credible the government's program. Programs such as Estonia's and the Czech Republic's, which were designed and implemented quickly, seem to have been successful. At the same time, fast implementation of programs (such as Russia's) has drawn a lot of criticism for trading off apparent efficiency for equity. Latvia's and Lithuania's large-scale privatization programs have moved slowly and hence the credibility of the government's commitment to privatization has been called into question, although in Lithuania the new government did much in early 1997 to reinvigorate the process.

The privatization process also affects the rate of financial deepening and widening. First, privatization facilitates the growth of an equity market by listing shares of newly privatized firms on primary and secondary securities markets. Second, privatization in many countries has resulted in the creation of investment funds. These funds can act as mutual funds and brokerage houses; they have also become an important source of capital for investment and enterprise restructuring. In many countries where funds have operated as a part of the privatization experience, private sector growth has been rapid (the Czech Republic and Poland). Finally, including banks in the privatization (as in Poland) has also helped link privatization to financial market development. Banks have been involved in debt-for-equity swaps of firms being privatized and have participated directly in the privatization process through ownership of investment funds.

Availability of Capital

As mentioned above, limited availability of capital is perhaps a binding constraint on the development of the private sector. The ability to secure capital for restructuring or investment remains low in most transition economies and is an especially serious problem in Latvia and Lithuania. On the domestic side, the banking sector in many transition countries does not provide investment capital to firms. Lending rates are seen as excessively high,3 perhaps due to the fact that few firms have either the collateral or a long enough history to satisfy bank lending requirements.4 Newly privatized firms tend to face the problem of not having sufficient collateral and new start-up firms face both problems. On the other hand, money banks have been slow in developing their own risk assessment expertise and thus prefer to invest in safe alternatives such as domestic government securities.

Foreign direct investment (FDI) is a possible means to mitigate the capital shortage problem, but few countries have actively encouraged it. FDI is critical to private sector development because it allows the flow of both physical and human capital into a country with little adverse impact on the trade balance. In addition, FDI deployed in the export sector has a second order effect of creating new export markets.5 Additionally, there is growing evidence that FDI acts to “prime the pump” on domestic investment as a spillover effect.6

Most transition economies have FDI legislation on the books, but it has taken longer for countries such as Latvia and Lithuania to harmonize other institutional foundations to facilitate FDI (such as legal codes to allow foreign participation in domestic markets). Many of the barriers to FDI are “nontangible,” such as complex and nontransparent approval processes (as in Russia and Latvia) or general distrust of foreign participation in domestic markets. Estonia has been extremely successful in attracting FDI primarily due to the fact that internal (legal and institutional structures) and external policies are attractive to FDI, and Finland, its neighbor with which it shares a common cultural background and a similar language, has been investing heavily in Estonia.

In addition to the problem of augmenting the stock of capital to meet demand for investment is the issue of having access to the existing pool. That is, how easy or difficult is it for an individual entrepreneur to obtain investment capital. In many countries, notably Latvia and Lithuania, the constraint appears to apply to the ability to borrow from banks while faced with a lack of domestic equity alternatives. Apparently, Estonian entrepreneurs do not face this problem to the same degree.

Private Sector Development in the Baltics

It is difficult to generalize the experience of private sector development in the Baltics as a group. There is a wide difference especially between Estonia on one side and Latvia and Lithuania on the other. The basis of Estonia's transition program was to open the economy to the international market (and many argue that its close ties with Finland have played a strong role in Estonia's rapid transformation), while Latvia and Lithuania have undergone economic transition more slowly—especially in the sphere of opening the economy. Estonia, for example, quickly implemented the legal and institutional frameworks necessary to support FDI, harmonizing FDI legislation with other laws (such as the commercial code). As a result, Estonia does not share the same problems that Latvia and Lithuania both face, such as delays in the establishment of a consistent set of laws and accessibility to capital.

Estonia

Private sector development in Estonia has taken place at a rapid pace. Although the EBRD estimated private sector contribution to GDP at 70 percent in 1997, that figure likely understates the true level. Estonia's rapid growth of the private sector stems from the simultaneous development of institutional infrastructure, privatization, financial deepening and widening, and encouragement of FDI.

Estonia's success in private sector development can be attributed in large part to its encouragement of both start-up firms and FDI. The EBRD estimates that approximately 15,000 new firms have been established in Estonia in the six-year period to 1997. As in Poland, the initial program concentrated on creating an economic and legal environment conducive to private sector activity. Also, as in Poland, Estonia focused its privatization program on restructuring, rather than on rapid divestment of state assets. But unlike in Poland, privatization occurred quickly perhaps because of the prominent role of foreign investment in the process.

Legal and Institutional Reform

Unlike most other transition countries, Estonia concentrated its early legal and institutional reform efforts on creating a hospitable environment for foreign investment. To that end, the government accorded foreign investors national treatment immediately after independence. Most of the legal infrastructure governing commercial activity and banking reform was adopted in 1993. It is interesting to note that bankruptcy reform was implemented in late 1992, before the adoption of the commercial code. Completion of the legal foundations for private sector development was done in 1995 and involved formalizing corporate governance mechanisms and harmonizing accounting systems to EU standards.

Privatization

Estonia's move to privatize was slower than its efforts to encourage new firm entry and FDI. The Estonian program was not implemented until mid-1993, and the goal of privatization was not simply to privatize but to bring about simultaneous restructuring. To this end, although the government implemented a voucher-based system, most large enterprises were sold via tenders based on an investor's ability to provide both capital and instill effective restructuring and governance. Despite the risk of a slow, cumbersome process, privatization moved quickly, and all large enterprises, with the exception of utilities, had been privatized by the end of 1997.

In Estonia, vouchers have not acted as a link between financial markets and privatization. Vouchers themselves are being used to purchase housing and land. Although a secondary market for vouchers was formed, the nominal value of the coupons dropped to about 18 percent of their face value as of June 1996. The reason was the lack of investment opportunities available to voucher holders.

Foreign investment and especially FDI in Estonia has been successful from the beginning of transition. The main source of foreign capital is Finland, which has linguistic and cultural ties with Estonia. In per capita terms, FDI in Estonia is approximately $295 (in 1996), by far the highest in transition economies. It has become an engine for private sector development, providing both the physical and human capital for new firms to enter markets. Also, the encouragement of FDI in privatization has helped to speed the process along and provide fresh capital for restructuring.

Availability of Capital

Estonia's banking system is still in the process of consolidation. Banks face strong competition and consequently are merging.7 Bank restructuring began early in the transition, but it was only after successive banking crises (in 1992 and 1994) that the Bank of Estonia instituted an increasingly strong set of prudential regulations, including high minimum capital requirements. As a result, the number of operating banks has dropped. At the same time, bank credit to nongovernment entities rose by approximately 84 percent during 1997. Lending rates were approximately 12 percent on average in the fall of 1997, and deposit rates were 4 percentage points lower. Thus, bank finance in Estonia appears to have become a viable source of domestic capital.

The formal securities market in Estonia (the Tallinn Stock Exchange) began operations in the spring of 1996, although the first financial instruments were issued and traded in early 1993. The main players on the Tallinn Stock Exchange are banks and a few new investment funds. Despite the late start of the exchange relative to other transition countries and the low number of active traders, capitalization of the exchange has grown to almost 26 percent of GDP (end-1997).

Although investment funds exist in Estonia, they rarely have become strategic investors in firms to be privatized, nor have they become active participants on the Tallinn Stock Exchange. Thus, there is little connection between privatization and equity market development. At the same time, given the fact that the Tallinn Stock Exchange has not been in operation long, the level of stock market activity is surprisingly high, approximately 26 percent of GDP at the end of 1997 (compared with the Riga Stock Exchange, which is capitalized at approximately 6.3 percent of GDP).8 But at present, the securities market is not sectorally diverse, with most of the capital market activity concentrated in the banking sector, although the role of insurance companies is growing.

While the domestic capital market infrastructure in Estonia is thin, bank finance is possible. In part due to high levels of portfolio capital inflows, banks are able to extend credit to the private sector (i.e., the nongovernment sector). During 1997, credit to the nongovernment sector grew 84 percent in nominal terms, and in December 1997, stood at about 30 percent of GDP.9 The demand for credit is thought to stem primarily from the growth in the number of new firms.

Latvia

Due to the slow pace of structural reform, which has inhibited both privatization and the creation of new firms, Latvia's private sector development has been concentrated mainly in small service sector enterprises or retail shops. Thus if the growth of the private sector is viewed as an index of development, the seemingly high level of private sector contribution to GDP (the EBRD estimates the level at 65 percent in 1997) might be an overstatement. Since January 1996, however, Latvia has worked quickly to remove remaining barriers to the growth of the private sector.

Legal and Institutional Framework

Despite the fact that Latvia began the transition in 1992, it has taken about four years to adopt more thorough legislative and institutional frameworks necessary for private sector development. Although basic legislation was completed by 1994, the legal framework surrounding privatization, FDI, and capital market development was not completed until 1996. The incomplete legislation led to two discernible problems. First, programs such as privatization have taken much longer to complete than expected. Second, the long process resulted in the persistence of government participation in markets, with possible distortions and other adverse effects on private sector growth.

Privatization

The result of the various privatization programs as of the end of 1997 is that less than ½ of 1 percent of large enterprises has actually been privatized. Latvia has now entered the second phase of privatization, which began with a series of laws adopted in 1996 to eliminate the problems experienced during the first phase by speeding up the process and attracting foreign participation. To date, nearly 1,300 units have been approved for privatization, half of which have signed sales agreements. Second, changes in liquidation procedures now allow for liquidated firms to be sold either as one unit or in pieces, which should accelerate the process. Next, the ability to buy land both under privatized enterprises and as an asset in itself was formalized, and a law extending the right of land ownership to foreigners has been prepared and will shortly be considered by the parliament.10 Moreover, nearly all sectors have been opened to foreign participation in privatization.11 Additionally, foreign investors were granted the right to purchase vouchers, allowing them to participate directly in privatization.

Despite positive legislative changes, such as the removal of restrictions on foreign participation in both asset and land privatization and the opening of most sectors to any potential buyer, privatization in Latvia still faces informal obstacles. One strong impediment in large-scale privatization is the process itself. The approval process is long and complicated. With each level in the process, there is an opportunity to slow down or even stop privatization. While these problems might have stemmed more from a lack of political will than from explicit barriers, the process itself allows for these informal obstacles that can prove to be more formidable than the explicit barriers. For privatization to move more quickly, there must be a commitment on the part of all parties involved to accelerate the procedure by both streamlining it and eliminating the informal barriers.

Availability of Capital

In banking, credit to private enterprises has fallen from 16 percent to 10 percent of GDP from the period of the banking crisis (June 1995) to the end of 1997. This decline in credit is attributed to the fallout of the banking crisis. That is, the number of operative banks has declined steadily this year to 33 (only 19 of which can accept deposits), as a result of the implementation of strong prudential banking regulations and banking supervision in the aftermath of the banking crisis. For example, the minimum capital requirement for banks has been raised from LVL 100,000 to LVL 2 million as of April 1998. Interest rates on loans are currently low, dropping from 34 percent at the end of 1995 to 12 percent as of the end of 1997; deposit rates have dropped to approximately 5.0 percent (three-month maturity), which is still negative in real terms. The narrowing of interest rate spreads is a strong, positive signal of financial market health.

Perhaps the most serious constraint on obtaining bank finance is the scarcity of usable collateral for new start-up firms. Doubts about the viability of newly privatized firms that do not have collateral make it difficult for banks to lend, though this constraint is being reduced by land registration (one means of providing collateral). In Latvia, land registration has moved slowly, with only 25 percent of all land registered as of the end of 1997.12 Two reasons are usually cited for the slow pace: high cost and large time investment to complete the process. Estimates of the cost of registering land range from the official cost (LVL 30) to reported actual costs of LVL 280–300 (approximately $600). Most enterprises are on multiple units of land, which makes the process even more expensive. Moreover, the process of registration, which includes getting all the necessary approvals could take from six months to one year to complete. Finally, land owners fear that registration will increase their tax burden because land is a taxable asset.

On the securities side, the Riga Stock Exchange is growing rapidly, primarily due to the increasing number of newly privatized enterprises.13 The creation of a Securities Market Commission has also facilitated faster growth of the market and should strengthen investor confidence. In addition, there are currently no start-up firms listed on the Riga exchange, primarily due to the fact that most of them are small and would generate little demand for their shares. The future growth of the exchange to a large extent depends on the rate of privatization. The Riga Stock Exchange expects that capitalization will exceed 30 percent of GDP when large-scale privatization is completed.

FDI in Latvia has increased since 1992 but remains low in comparison with other transition countries. EBRD estimates that the level of FDI per capita in Latvia was $85 in 1997. Until 1996, there were many formal restrictions to FDI, ranging from exclusion of direct foreign participation in privatization to severe constraints on which sectors could receive FDI. Most of the legal restrictions were eliminated in 1996, and the Government's commitment to attracting FDI appears strong.

Lithuania

Despite the figures reported in Section II, private sector development in Lithuania is still in its beginning stages. Most of the private sector activity is in the service sector, with the share of private enterprises in manufacturing still small. The sluggish pace of private sector development in Lithuania can be attributed to the slow rate of institutional reform, especially in the area of legal reform and privatization, as well as the constraints on investment capital.

Legal and Institutional Framework

Perhaps the most formidable impediment to private sector development in Lithuania currently is the state of legal and institutional reform. The EBRD reports that the competition policy governing enterprise activity in the market has contradictory statutes. Thus the “rules of the game” for new enterprises to enter and compete are not clear. On the investment side, there are still few laws regulating investment and securities markets, and those laws that exist are unclear and impose conflicting requirements. In some cases, the law is transparent but is difficult to use in practice. For example, there is a bankruptcy law (approved in early 1997, to replace an earlier law judged to have been highly ineffective) that in itself is sound and consistent with a market-based economy, but implementation in the court system is being delayed owing to lack of legal expertise and court capacity. Further, investors complain that the laws that are currently on the books are not well adapted to local needs. Finally, information about changes are typically not published, adding to uncertainty.14

Privatization

As of mid–1996, approximately 30 percent of medium- and large-scale enterprises have been transferred into private hands.15 Though the number of large-scale enterprises privatized suggests that privatization has moved decisively forward, it should be noted that the initial privatization program (voucher-based) has been in place since 1991, and the second and more comprehensive program (cash-based, approved in 1995) is now under way after many delays. In early 1997, the new government gave a significant boost to the privatization process by announcing the sale (via international tenders) of 14 of the largest enterprises in the energy, transport, and telecommunications sectors. In addition, the government also initially reduced by 50 percent the number of enterprises excluded from privatization until the year 2000 and, by year-end, eliminated the so-called negative lists altogether, except for a narrowly defined set of enterprises in which state participation is seen to be inevitable (e.g., the Ignalina Nuclear Power Station).

Availability of Capital

The availability of domestic bank finance to entrepreneurs is low, due to the sharp contraction of the banking sector following the 1995 crisis. Lithuania's current banking system is concentrated in three state-majority-owned commercial banks (the State Savings Bank, the State Agricultural Bank, and the State Commercial Bank). State-controlled banks effectively account for 50 percent of all deposits in the banking system.

The contraction of the banking sector as a result of the crisis and implementation of stricter prudential regulations at the beginning of 1996 should provide a more solid banking system that, perhaps in the medium term, will provide capital. In the aftermath of the crisis, banks were wary of lending to the private sector, as can be inferred from the contraction of credit to the private sector in 1996,16 but a process of recovery was in evidence in 1997 when a sharp recovery of private sector credit supported real GDP growth on the order of 6 percent.

On the securities side, there has been little activity, and hence the ability to raise capital through equity offerings remains small. To date, the National Stock Exchange (which began operations in 1993) lists 400 firms, and its level of capitalization is about 18 percent of GDP as of the end of 1997. The relatively small size of the equity market can be attributed to the slow pace of privatization.

Foreign direct investment into Lithuania has not yet been a primary source of investment funds. The EBRD estimates per capita FDI at $41 in 1996. While there are no legal impediments to FDI (profits can be repatriated freely, and there are no formal restrictions), the combination of a nontransparent legal system, slow pace of privatization (as well as some restrictions on foreign participation), and underdevelopment of domestic capital markets (resulting in difficulties in local co-financing) have all contributed, at least until 1997, to a low level of FDI. In addition, the lack of experience with foreign investment has resulted in a mistrust of foreign participation in domestic markets, which is manifested in the slow approval process.

Limited access to capital in Lithuania is a direct result of the banking sector being in a process of consolidation, still relatively low levels of FDI, and the lack of collateralizable assets. At present, no system exists for registering ownership interests or pledges of assets to be used as collateral against loans. Since the banking crisis and stricter prudential regulations, banks are more wary of lending, and the lack of a formal mechanism for providing collateral raises the risk premium, again manifested in relatively high lending rates.

Policies and Program Design to Remove Obstacles to Private Sector Development

For the private sector to develop, it is important that the economic environment be conducive to firm entry and exit, investment, and competition. Promoting such an environment would involve:

  • establishing a solid legal infrastructure, comprehensive enough that it covers all areas of private sector development as a basic step in the process;

  • ensuring the rapid completion of privatization programs once they are under way;

  • establishing linkages between privatization and capital market development (through investment funds);

  • encouraging FDI involvement in privatization to accelerate the process, as well as facilitate simultaneous enterprise restructuring;

  • promoting FDI, given capital market constraints; and

  • developing domestic capital markets, given that the single most binding constraint on private sector development is the shortage of capital.

Conclusions

Private sector development is an important component of economic transition. The level of private sector development can be thought of as a measure of economic reform. In the long run, private sector development is needed to put an economy on a sustained growth path. The issue is especially important for the Baltics, where the “first stage of transition” has largely come to an end and structural obstacles are becoming the most serious impediment to economic growth. The experience of the Baltic countries shows how formidable the impediments to private sector development can be even if macroeconomic policy is sound.

First, the establishment of a solid legal infrastructure is a basic condition for private sector development. As both Latvia and Lithuania have found, without an adequate legal framework to support the other main areas of private sector development (privatization, domestic capital market development, and foreign investment), it will be difficult for the private sector to grow, given both distortions in the market and lack of knowledge of “the rules of the game.”

Second, the varied experiences of the sequencing of privatization suggest that privatization itself need not be the first item on the transition agenda as long as the legal and economic environments are conducive to the entry of start-up firms (as in Poland and Estonia). Once privatization begins, however, it is important that it be completed quickly to enhance credibility, with due regard for rule of law and good governance considerations. Thus, as long as the private sector grows, it is less important if the source of growth is privatization or new firm entry as long as both take place. The psychological importance of privatization carried out in a context of respect for the law should not be underestimated. Though the tangible results may or may not catalyze private sector development, depending on the individual conditions in each country, the fact that the process is moving ahead is a sign of governmental commitment to developing a private sector. That is, if residents see that privatization is happening quickly, it might shape expectations that transition is progressing and is irreversible. In many transition countries, changing expectations is a necessary condition to stimulating private sector development. Once an economy is privatized, it becomes increasingly difficult to reverse private sector development. Thus both domestic and foreign investors perceive the economic risk of policy reversal as minimized.

Third, all of the above country experiences suggest that the fastest, most efficient means of developing the capital market is to encourage linkages between privatization and the equity market via the use of investment funds. The funds themselves can be a catalyst for equity trading, providing both the volume of shares and continued activity in the market. Countries that have not encouraged the use of investment funds tend to have a more rudimentary equity market system. Because transition countries need financial widening (and deepening) and because many transition economy banking systems are not extending much credit, it is imperative that alternative forms of intermediation be developed.

Similarly, participation of foreign investors in the privatization process (as in Estonia and Poland) can be a catalyst for private sector development because it provides additional human and physical capital. Given the severe shortage of capital facing most private entrepreneurs, FDI is one means of alleviating this constraint. Further, FDI will increase the possition of good governance mechanisms.

Finally, alleviating the constraint on capital means that domestic capital markets must be widened and deepened. This reform must start with the banking system and involves allowing insolvent banks to fail and recapitalizing potentially solvent banks. Additionally, sound fiscal and monetary policies are necessary for the emergence of an appropriate structure of lending and deposit rates. And, equity market and alternative instruments should be developed through the adoption of appropriate government legislation, a stable economic environment, privatization, and foreign investment.

Assuming that macroeconomic foundations (price liberalization and stabilization that followed the freeing of prices) are already largely in place.

That is, the fast private sector development in Poland has occurred despite the slow progress of large-scale privatization.

The average spread between lending and deposit rates is approximately 14 percentage points in Lithuania (March 1997) and 14 percentage points in Latvia (April 1997).

See EBRD (1995), Chapter 6, for a thorough discussion of the impediments to investment in transition economies.

Stern (1997) argues that FDI into the export sector doubly benefits the host country because foreign investors are likely to have established markets in their home country or region. Thus, in addition to the transfer of human and physical technology, a host country firm might have access to a foreign market that otherwise might be closed.

From 1992 to 1995, the number of banks dropped from 42 to 21, and from 1995 to the end of 1997, the number dropped to 11. Data from the Bank of Estonia, Eesti Panic Bulletin, No. 4 (Tallinn, 1996).

Stock market capitalization refers to the market value of the shares listed.

The comparable figure for Latvia was 7 percent of GDP. The figure for both countries was calculated by using the level of domestic credit in nongovernment sectors. In Latvia, the figure includes domestic credit to enterprises, most of which are still state owned. It should be noted that the growth rate of credit to the nongovernment sector in Estonia began to slow down toward the end of 1997 in response to monetary and prudential measures taken by the Bank of Estonia.

The existing law restricts a foreign investor who wishes to purchase the land under a privatized enterprise to hold not more than 49 percent equity in the privatized firm.

Only a few sectors remain closed to foreign investors such as those pertaining to national security. Foreigners can now buy land except in a ten kilometer radius of the frontier.

The government envisaged that by the end of 1996, 20 percent of all land would be registered and by the end of 1997, 30 percent.

The Riga Stock Exchange began trading on July 25, 1995 and currently lists 28 companies, Unibanka (which constitutes 75 percent of the trading volume), and Riga Transportation Fleet (3 percent), while adding treasury bill quotations (7 percent), mortgage notes (13 percent), and other listings (2 percent). Total capitalization of the market is LVL 200 million, approximately 6.3 percent of GDP. The level of turnover on the Riga Stock Exchange has been falling since its peak earlier in 1996. This is compared with the Czech Republic, in which the Prague Stock Exchange is capitalized to about 50 percent of GDP. Latvia source: Baltic News Service; Czech source: Lieberman and others (1995), p. 36.

See EBRD (1995), p. 112.

EBRD (1996), p. 161.

Credit to the nongovernment sector contracted in nominal terms by approximately 5 percent between the third quarter of 1995 and the same period of 1996.

References

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